Guidelines for Fiscal Adjustment

How Should Fiscal Adjustment Be Effected?

Undertaking fiscal adjustment often requires difficult decisions involving increasing government revenue and reducing spending.18 Expenditure reductions often tend to be stressed in the initial stages of adjustment, with particular emphasis on cuts in capital spending and current outlays on other goods and services (excluding wages, subsidies and transfers, and interest payments). Cuts in productive capital spending and essential operations and maintenance spending are liable to be damaging to growth. Consequently, countries need to move quickly on structural reforms affecting expenditure, revenue, and public enterprises in order to allow a more balanced approach to fiscal adjustment and to generate the resources necessary to support spending that addresses social and productive needs. As noted in Box 5, strengthening policy design and institutional capacity has been a major part of the Fiscal Affairs Department's technical assistance effort in recent years.

In designing fiscal adjustment strategies, policymakers often face short-term costs and constraints. Such concerns include the output and employment losses that may be incurred in rationalizing expenditure, the possible short-term negative effect on growth of raising taxes, and the difficulties in modifying implicit social contracts by altering the role of government. Experience with adjustment in many countries has, however, shown the high costs of delayed or disorderly adjustment. Inflation and overvalued exchange rates hit the poor hardest, as their incomes are often fixed in nominal terms or may depend on the production of tradable goods and services.

Attention to a proper mix and phasing of policy instruments is essential to minimize harm to the very poor and to provide social support for adjustment programs. Nevertheless, in many cases adverse effects still remain, and vulnerable groups need to be protected through well-targeted social safety nets. Some aspects of the design of social safety nets are discussed in Box 6.19

Box 5. Technical Assistance for Growth
Technical assistance by the IMF supports fiscal structural reform. The central objective is to assist member countries in the detailed design and implementation of fiscal policies needed for macroeconomic and structural adjustment and for sustainable growth. Considerable emphasis is placed on institution building. Technical assistance by the IMF's Fiscal Affairs Department (FAD) has traditionally focused on tax policy, tax and customs administration, and public expenditure management (budgeting, control of budget execution, reporting, and government accounting). More recently, FAD has expanded the scope of technical assistance to include Treasury and public debt management; expenditure policy, including the reform of social safety nets and social security; intergovernmental fiscal relations; and strengthening institutional capacity for fiscal analysis and fiscal management. Technical assistance on government finance statistics is provided by the IMF's Statistics Department.

Box 6. Social Safety Nets
Importance of Social Safety Nets (SSNs)

SSNs are a combination of measures aimed at mitigating the short-term adverse effects of economic reforms on the poor. Without SSNs, economic reform may, in the short term, lower the poor's living standards; it may also weaken the political sustainability of reform. Typical reforms with important consequences for the poor include reduction of generalized price subsidies on basic necessities; reform and restructuring of state enterprises and the civil service; and reduction of cash benefits.

Common Elements

Because SSNs need to work quickly and reliably, they have to be tailored to the specific circumstances of each country, including its administrative capabilities, the strength of its informal and formal social support systems, and the characteristics of the poor. Typically, the major components of SSNs have included the following:

  • Targeted commodity subsidies and cash compensation. These schemes have sought to protect the consumption of basic food items by the poor in the face of rising prices, while reducing budgetary expenditure.

  • Adaptation of permanent social security arrangements. The existing social security system, to the extent that it reaches significant portions of the poor, can be bolstered and its targeting and incentive/equity structure improved. The major schemes used are pension and disability insurances, and child allowances.

  • Unemployment benefits, severance pay, and public works schemes. Because reforms usually involve a temporary increase in unemployment, an important aspect of SSNs has been enhanced unemployment benefit schemes, the provision of severance pay, and low-wage public works schemes.

Major Issues in Design

  • Targeting. To limit fiscal cost, social benefits should be limited to those most in need. Sophisticated means testing is generally not possible. Many countries rely on categorical targeting, such as limiting benefits to children or pensioners, or to households in certain regions. Commodity subsidies can be limited to goods consumed disproportionately by the poor or limiting the quantity that each household can consume, for example, via coupons.

  • Incentives. The fiscal cost of the SSN is reduced the more sharply benefits are phased out with household income. This, however, is at the cost of increasing the implicit marginal tax rate facing beneficiaries, and thus the potential adverse impact on incentives.

Measures to Improve the Tax System and Increase Revenue

In some cases, revenue can be increased by raising rates within an existing system. However, the ability to generate increased revenue in this manner may be limited. This is particularly likely when an economy is undergoing substantial structural change, traditional tax bases are declining, and there are fundamental weaknesses in the tax system. Structural problems in the tax system may well be a major factor underlying not only fiscal deficits, but also poor growth and employment performance. Consequently, programs of fiscal adjustment are often accompanied by an effort to improve or even restructure the tax system.

This section focuses on questions relating to tax policy design during a reform period. It must be emphasized, however, that improvements in tax policy are more likely to be successful when they are accompanied by measures to strengthen tax administration. A brief overview of key issues in the administration area is provided in Box 7.

Box 7. Reforming Tax Administration
The essential elements required for successful tax administration reform include: an explicit and sustained political commitment; a team of capable officials dedicated to tax administration reform; a well-defined and appropriate reform strategy; relevant training for staff; additional resources for the tax administration or, at least, some reallocation of resources; and changes in incentives for both taxpayers and tax administrators.

Tax administration reform must strive to enhance both its effectiveness and efficiency. Interventions to improve effectiveness include promotion of taxpayer self-assessment, provision of taxpayer education, adoption of procedures for minimizing the cost of compliance, implementation of systems for tax returns processing and accounting that quickly detect noncompliance and take appropriate actions, and establishment of an audit plan to detect violations as efficiently as possible. Also needed are adequate penalties for violations that strike at the heart of the tax system, such as failure to file returns and to pay taxes on time.

Along with a strategy for enhancing effectiveness, tax administrations can adopt a number of measures to focus their scarce resources in the most efficient manner for revenue collection and enforcement. These measures include establishment of a large taxpayers' unit; adoption of a threshold for tax registration that exempts small enterprises from major taxes; the imposition of an alternative tax on small enterprises with limited revenue potential; use of final withholding of taxes on individual taxes; and use of banks for receiving tax payments.

The above measures for improving the effectiveness and efficiency of tax administration suggest an organization of the tax administration to support five principal functions: taxpayer education; registration, accounting, and returns processing; collection enforcement; auditing; and legal services and appeals.

Major reforms in tax design and administration take time to implement. New legislation is often required, and basic systems and procedures frequently need modification. In addition, reform may lead to changes in the relative tax burden of different groups and economic sectors. Short-term revenue requirements must also be addressed during the reform process. In developing short-term tax policy packages, particular consideration needs to be given to the revenue productivity of proposed measures, their administrative feasibility, and their likely consistency with the desired direction of more fundamental tax reform. On the basis of such criteria, the most promising short-term measures may emphasize increases in the rates of indirect taxes (particularly broad-based sales taxes and excises) and expansion of the tax base by eliminating exemptions.

Characteristics of a Desirable Tax System

The characteristics of a desirable tax system outlined below represent a blend of both macroeconomic and microeconomic considerations. In the former case, a tax system's responsiveness to GDP growth and its revenue-generating capacity are paramount. But since overall economic growth may be affected by the microeconomic allocative effects of a tax system and the post-tax distribution of income and wealth, the system's efficiency and transparency, for example, are also critical.

Design of Major Taxes

Drawing on the above criteria, the following design features for major taxes are often recommended:

Rationalization of Expenditure Policies

Expenditure reduction measures have to be pragmatic, adequate to achieve the intended stabilization, but nonetheless economically, politically, and socially feasible. Several types of expenditure measures can be adapted quickly to contain a deteriorating fiscal situation. Sustainable expenditure reform, however, requires a review of underlying government policies, the composition of spending, the coverage of activities by the public sector, and the modes of delivery of public services. Quite often, a thorough structural reform of government expenditure policies can be done only in a medium-term framework.

Similar to the importance of tax administration in tax reform, efficient spending reduction usually requires improvements in systems of budget design, preparation, and execution. The broad direction of such reforms are reviewed in Box 8.

Box 8. The Budget and Expenditure Control
A government's ability to identify and execute expenditure cuts will depend on the quality of its budget--the primary instrument of expenditure management--and of its Treasury, which is responsible for the financial management of government operations. Budget design, preparation, and execution are all important elements of expenditure control.

  • Design. The budget should be (i) comprehensive--hidden off-budget outlays reduce the effectiveness of budgetary policy; (ii) realistic--based on a solid macroframework; (iii) fully financed--based on expenditure policies that are genuinely consistent with reasonable revenue projections and financing provisions; and (iv) forward-looking--taking into account future costs, as well as immediate expenses.

  • Preparation. The review of government priorities can often be strengthened through improvements in budget preparation. For instance, budget circulars may require (i) the strict costing of existing policies at existing standards of service; (ii) that no new policy be introduced without identifying offsetting savings and fully evaluating the full year's cost of the policy change for later years; and (iii) that each ministry identify how it would spend any additional specified percentage increase or decrease in its present ceiling.

  • Execution. A flexible and responsive execution of the budget is necessary if fiscal policy is to be an effective demand management tool. Needed inputs include (i) a timely and comprehensive monitoring system, which provides early warnings about expenditure pressures, and revenue and financing shortfalls; (ii) an effective cash management system to contain gaps between resources and spending requests; and (iii) a broader financial management function, which projects fiscal needs and coordinates government operations with monetary and balance of payments policies. The organizational structure of these functions differs widely from country to country; however, experience suggests that a strong Treasury can play a decisive role in effective budget management.

The important functions of the Treasury include (i) cash management--the control of all flows to and from government accounts, either directly or through banks; (ii) financial planning--the projection of inflows and resource requirements; (iii) public debt management; and (iv) the control of government financial assets.

Expenditure Reduction in the Short Run

There are no hard and fast rules about how public expenditure should be cut. This will depend partly on the factors driving the growth in spending (for example, wages and salaries or the capital program), as well as on the social and political constraints facing policymakers. However, experience suggests some guidelines.

Structural Public Expenditure Reform

Fundamental structural reform requires consideration of basic questions on the need for different government activities, the appropriateness of their provision in the public sector, the importance of their provision by public institutions (as opposed to contracting out), and the possibility of introducing a market framework for their provision, even when public institutions are responsible for delivery. For activities selected to remain in the public sector, specific objectives need to be set, desired outputs quantified (where possible), inputs determined, and managerial freedom given to pursue the most efficient delivery of services.

The tools for expenditure rationalization are long established, but growing in sophistication--particularly in a relatively small number of OECD countries. They include program- and zero-based budgeting, "value-for- money" audits, fundamental reviews, etc., which are being increasingly used to require ministries to demonstrate the need for individual programs and to evaluate the efficiency of service delivery.

Certain requirements are key: the assessment should start from a zero base--questions must be posed about why an activity is being undertaken, rather than just about the standards and efficiency of the current service; the evaluation must be patently objective, which requires either an external review, for instance by value-for-money auditors, or a review by central (independent) ministry officials; and it should likewise be comprehensive so that no ministry escapes review over time. Finally, the government's long-term commitment to a reform and review process needs to be clear.

A comprehensive review might generate the following types of reforms:

18 Comparable decisions have to be made by countries undertaking fiscal stimulus. Factors influencing the choice of measures should include, inter alia: the effects of different tax and spending measures on private sector demand (for example, tax cuts are liable to have greater impact on modifying the expenditure decisions of households if they are viewed as permanent); the productivity of proposed increases in government spending; and the likely difficulty of reversing the stimulus measures in the event of the need for future fiscal consolidation.
19 The more general issues of the impact of fiscal and other adjustment policies on income distribution were presented at a conference on "Income Distribution and Growth," held at the IMF, Washington, June 12, 1995.
20 Squeezing of cash limits is an extreme variant of an across-the-board approach. It is often applied by deliberate underprovisioning for inflation in setting annual budget ceilings.