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Africa’s Quest for Prosperity: Has Adjustment Helped?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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AS FORMER centrally planned economies make the transition to market orientation, they are finding it hard to both achieve strong economic growth and maintain the system of cradle-to-grave security their governments have long provided by means of extensive transfer payments.

Central planning in the economies of Eastern and Central Europe and the former Soviet Union had many shortcomings. Nonetheless, they performed better in three significant respects than market economies with comparable income levels: they provided broad access to health care and education; a considerable degree of income security resulting from an employment guarantee; and a low incidence of income poverty, with social assistance playing a highly subsidiary role. Social transfers were a key part of that system, ranging from family allowances to benefits provided in kind (for example, housing) to pensions. At the same time, of course, the prospects for income growth were dim and consumer goods were scarce.

Economic insecurity has been a striking feature of centrally planned economies’ initial phase of the transition to capitalism. It occurred because of the combination of macro-economic shocks and the partial removal of guaranteed employment. Despite pressure on government revenues exerted by declining real incomes and enterprise profits, most governments have continued to devote large shares of their resources to spending on social transfer payments, resembling or “bettering” Western European welfare states in many ways. Cash transfers’ share of GDP increased in Eastern Europe from about 10 percent in 1987 to more than 15 percent in 1993, and held steady in the Baltic countries, Russia, and the other countries of the former Soviet Union (BRO countries) at about 9 percent, as a result of the relatively marginal reforms of inherited social-transfer systems, combined with the introduction of explicit benefits for the unemployed. The figures would be even higher—particularly in the BRO—if they included implicit transfers to support state enterprises that have remained part of the transfer mechanisms aimed at workers, families, and pensioners.

These economies face sharp trade-offs between providing comprehensive social transfers and economic growth, which suggests that maintaining high levels of social transfers may be difficult. The main channel for the trade-off—and the focus of this article—is spending related to growth and capital accumulation at the macroeconomic level. The channel can be either via the government budget, with higher transfers leading to lower spending for market-friendly infrastructure, public health, and education (for given revenues), or via private investment, with higher costs of taxation or lower returns owing to lower government spending on publicly provided capital. A second channel involves incentives: providing transfers can have a negative effect on growth by creating disincentives to work and save. (See Danziger and others, 1981.)

Role of transfers

Implications of pursuing present policies. Most transition economies share the consensus view that they can enhance income growth by sharply reducing the role of the state. They have found it harder, however, to decide how much income security they can provide without experiencing significant shortfalls in growth and public spending on such essentials as schools or roads. Since most countries are accustomed to a high degree of state-provided income security, the prospect of moving to greater insecurity is viewed with considerable alarm, and their initial efforts to address this issue have been strongly influenced by what Western European countries provide for their citizens. What is not fully appreciated is that the latter’s transfer systems are feasible only because of their greater productivity; in fact, even these countries are currently debating the appropriateness of their comprehensive welfare systems in an increasingly competitive world.

The objectives of raising living standards and maintaining a high degree of income security are interdependent. Providing income security may prove difficult without income growth, and some degree of income security may be necessary to provide a favorable environment for investment, allow restructuring, and prevent losses of human capital. What is likely to happen if policies are pursued that attempt to favor income security (via transfers) over growth? Two illustrative scenarios—each of which depends on the country’s initial political and institutional conditions, the extent of external shocks, and the effectiveness of reform in other areas—can be envisaged. (See chart.)

Sclerotic economy. For some of the Central European countries in transition—the Czech Republic, Hungary, and Poland—the economy looks reasonably solid. Enterprises and others pay taxes and other revenues amounting to about 45 percent of GDP (and to more than 50 percent of GDP in Hungary). The revenues collected fund transfers to the unemployed and pensioners amounting to more than 15 percent of GDP, with the remainder devoted almost entirely to current spending. The private sector is taking off. However, there is a more subtle potential problem. To get dynamic private sector growth, investment of 25-30 percent of GDP is not inappropriate—say, 10 percent from the government and 15-20 percent from the private sector (mainly enterprises, but also households).

These numbers clearly do not add up, either for the fiscal or the private sector accounts (and any reasonable assumption concerning external balance). Raising taxes would absurdly squeeze a private sector that is expected to lead the transition. Alternatively, full financing of the investment from private sources would leave only 25-30 percent of GDP for consumption out of nongovernment income, implying a saving rate of more than 50 percent! It seems more likely that private sector growth would become confined to onetime adjustments to new opportunities or, at best, to the gray economy because of high payroll taxes for formal sector workers and insufficient resources for public investment. There is significant unemployment hysteresis (that is, irreversible one-time rises in unemployment) and the level of transfers is permanently high. Broad-based, pay-as-you-go pension schemes are a permanent burden on the economy. The economy behaves rather like those of Western European countries in the late 1970s and early 1980s—with continuing strong pressures on public finance, a growing gray economy, and periodic fiscal crises—but at a much lower level of income.

Two scenarios: collapse and sclerosis

Source: Kathie Krumm, Branko Milanovic, and Michael Walton, “Transfers and the Transition from Socialism: Key Tradeoffs,” World Bank, Policy Research Working Paper No. 1380, November 1994.

Collapsing economy. For some transition economies, attempts to maintain aggregate government spending in the range of 40-50 percent of GDP and extensive transfer systems merely contribute to crisis and a disorderly loss of entitlements. Financing of the government and enterprise sector is increasingly by arrears; tax revenues are collapsing (to well under 30 percent of GDP); many “discretionary” categories of public spending are crowded out; and the real value of transfers declines sharply ex post through inflation erosion (to less than 10 percent of GDP) and in an ad hoc manner that fails to provide for targeting of the most vulnerable. Private investment is strongly affected by the lack of credible economic management, even if the government is extracting less resources. Components of such a scenario are in the making in a number of transition economies. Before its recent reform effort, Ukraine’s economy was on the brink of financial collapse and entitlements for transfers were disrupted. Bulgaria has already partly inflated away many claims and could be heading toward fiscal crisis. If these indicative scenarios are realized, the comprehensive transfer systems in place in economies in transition could jeopardize their ability to shift resources into investment to provide for reasonable growth (sclerosis scenario) and lead to failure to utilize the ex post lower level of transfers in an orderly and equitable fashion (collapse scenario).

Relevant trade-offs. Using the overall intertemporal framework for a middle-income market economy developed by Bourguignon (1991), the costs of transfers in terms of income growth increase even for the relatively moderate transitions experienced by market economies. If there is a need to move the economy to a new growth path, the amount of spending required for capital accumulation and expanded private sector activity increases further. Because of the initial conditions in a transition economy, the trade-off between the future and the present is going to be steeper than in economies that are already market based, for three reasons. First, revenues are so high as to be highly distortionary. Second, the scale of transformation required is very much greater than in economies that are already market based, and the costs of delays in the transition to a new growth path are correspondingly higher. Third, much of the inherited infrastructural and human capital may be inappropriate for the country’s new economic directions, and public investment will therefore be important.

Comprehensive transfers also have important trade-offs with labor market incentives and can be replaced with a range of coping mechanisms intended to cushion the shock of, for example, losing a job in a state enterprise. It may sound harsh to emphasize coping over caring, but the fact is that many countries have little choice in the matter.

Transfer “needs” during the transition. Although the costs of transfers in terms of income growth forgone are higher than in economies that are already market based, the need for transfers is greater in transition economies. First, a large proportion of elderly people in the population, combined with limited extended family networks and the fact that savings were virtually wiped out by inflation, means that the state will need to continue to play a significant role in supporting elderly persons who will not have time to benefit from the transition to a market economy. Second, the scale of the macroeconomic shocks experienced by these countries has had more radical effects on the extent and depth of poverty. Third, the political economy of the transition is fragile, since households experience wrenching changes. Hence there are widespread increases in “needs” for transfers at a time of short-run pressures on revenues.

Cross-country experience. How have other countries determined the amounts of social transfers they will provide to the elderly, the unemployed, and the needy—including in periods of economic shock? Other middle-income developing countries spend a mere 3 percent of GDP on social transfers while spending a higher share of GDP on health and education than the transition economies. (See table.) The experiences of these countries—notably the East Asian countries and Chile—suggest that “growth-mediated security” requires strong support for human resource development and a growth strategy that emphasizes openness combined with use of clearly temporary instruments, such as temporary employment schemes, for shielding citizens against the impact of recessions or other economic shocks, and only moderate levels of cash transfers. Jordan is another country that has used selective transfers with some success.

Four country groups: revenues, spending, and social transfers

(percent of GDP unweighted) 1

Central and Eastern Europe 2Union 3Former Soviet OECD4Middle-income4
Revenues44333525
Spending49434029
Cash transfers159163
Health and education810812
Source: Kathie Krumm, Branko Milanovic, and Michael Walton, “Transfers and the Transition from Socialism: Key Tradeoffs,” World Bank, Policy Research Working Paper No. 1380, November 1994.

Population-weighted numbers are not significantly different for Eastern and Central Europe and the BRO countries: GDP-weighted numbers have been avoided for the transition economies because of issues involving exchange rates; for the sake of consistency, the same has been done for the other country groups; population and GDP-weighted numbers are not significantly different for OECD countries, and, if anything, indicate even lower state involvement for middle-income countries—that is, spending at 21-22 percent of GDP, cash transfers at 2 percent of GDP, and health and education at 5 percent of GDP.

Data for 1993 for Bulgaria, the Czech Republic, Hungary, Poland, Romania, and the Slovak Republic.

Data for the first half of 1994 for Ukraine, 1993 for Russia, and 1992 for all of the other BRO countries except Armenia (which was not included).

Data for 1991 for 18 OECD countries and 34 middle-income countries.

Source: Kathie Krumm, Branko Milanovic, and Michael Walton, “Transfers and the Transition from Socialism: Key Tradeoffs,” World Bank, Policy Research Working Paper No. 1380, November 1994.

Population-weighted numbers are not significantly different for Eastern and Central Europe and the BRO countries: GDP-weighted numbers have been avoided for the transition economies because of issues involving exchange rates; for the sake of consistency, the same has been done for the other country groups; population and GDP-weighted numbers are not significantly different for OECD countries, and, if anything, indicate even lower state involvement for middle-income countries—that is, spending at 21-22 percent of GDP, cash transfers at 2 percent of GDP, and health and education at 5 percent of GDP.

Data for 1993 for Bulgaria, the Czech Republic, Hungary, Poland, Romania, and the Slovak Republic.

Data for the first half of 1994 for Ukraine, 1993 for Russia, and 1992 for all of the other BRO countries except Armenia (which was not included).

Data for 1991 for 18 OECD countries and 34 middle-income countries.

Major design issues

There is, indeed, a case for avoiding comprehensive transfers that involve a steep trade-off with growth. Yet there is also a case for providing higher levels of transfers during the transition, compared with those that will be needed later on, in order to both minimize the adverse impact on the poor and improve the political acceptability of the reform program. However, this argues for some transfers that are an intrinsic feature of the transition, and that automatically fade away. If this approach is followed, transfers that facilitate adjustment by households should be provided but not transfers that encourage permanent withdrawal from the labor force and long-term entitlements.

Unemployment insurance. Most transition countries have introduced unemployment insurance, with benefits provided for a limited duration to workers who lost their jobs. These are quite appropriate to the transitional labor market shocks and may need to be complemented with special but temporary measures in particularly insecure segments of the labor market. The rationale for earnings-related unemployment benefits—that they are indeed insurance premiums—does not hold in transition economies because there was no unemployment insurance prior to transition. Because of the sudden and massive character of unemployment, unemployment benefits have more in common with temporary welfare payments to a specific set of individuals (one can think of them as categorical social assistance) than with unemployment insurance in its strict sense. Eligibility for unemployment compensation should be quite restrictive, for example, excluding school leavers and requiring extended previous employment.

Severance payments are generally considered obligations of enterprises in order to avoid moral hazard problems (that is, shifting obligations to the government). Government obligations to provide such payments could therefore be confined to cases of enterprise liquidation or significant downsizing when it serves as financier of last resort; and even that limited role may prove infeasible for economies headed toward fiscal collapse.

In recognition of the particularly insecure situation facing workers in the next couple of years (when massive enterprise privatization and restructuring gets under way and until the emerging private sector invests heavily), special but temporary measures are entirely appropriate, since unemployment compensation and/or severance packages may not be enough. Particularly in hard-hit regions and one-company towns, the authorities should encourage experimentation with a variety of programs, such as temporary employment programs, to see what works best under different circumstances.

Pensions. Pensions are both a central and a difficult area for reform. They are central for two reasons: the sheer size of pensions compared with total transfers and the longevity of this form of transfer. They are difficult because of the nature of the tradeoffs. Given the need to lower the claim of public pensions on current and future resources economy-wide (both benefits and contributions), how can governments substantially pare down the publicly funded, pay-as-you-go pension schemes they have inherited? At the same time, how can the economy provide for those who have worked all their lives and formed expectations with regard to their pensions?

The process and dilemmas are likely to differ between the economies already wracked by inflation or heading toward collapse and those economies headed toward sclerosis. In many of the BRO countries, notably the Baltics and Russia, and in Bulgaria in the Eastern European group, inflation had already whittled down—in some cases excessively—the level of real benefits. Entitlements are, by and large, being eroded in an unplanned and ad hoc manner, often leading to inadequate funding or provision of extremely low pensions to those—generally older—pensioners without other sources of income. By contrast, in some countries—such as Hungary, Poland, and Slovenia—pensions have been relatively well protected and continue to represent a sizable share of GDP, consequently threatening the fiscal accounts and future growth.

A significant increase in the retirement age (say to 65, with gender equality) and elimination of most early retirement schemes are the critical steps in achieving sustainability in public pay-as-you-go systems in the medium term. But this generally will not be sufficient to reduce pension spending in the short run. The need to reduce benefits and replacement ratios (which relate benefits to wages) has to be confronted. Where there have already been real reductions through inflation combined with flatter benefit schedules, as happened in the Baltics, the issue becomes one of holding on to the adjustment that has occurred.

Social assistance. One of the policy areas characterized by significant trade-offs is the design of social assistance to alleviate poverty. A comprehensive program of means-tested monetary assistance aimed at guaranteeing a minimum income runs the risk of covering too many households. An alternative approach emphasizes the role of households and the community in preventing households from falling into poverty, with the government narrowly targeting its assistance; this approach, however, may risk failing to reach all of the poor unless adequate funding is provided. Family allowances should also be regarded as part of social assistance. This is particularly the case, since, during the transition, larger families have been disproportionately affected by poverty (in Poland, for example). However, family allowances are still not a targeted tool to combat poverty. Lots of money “leaks” to families that are relatively well off. Several options, which are not mutually exclusive, to reduce the leakage may be envisaged: (1) simple income testing of family allowances; (2) increasing family allowances as the number of children rises; and (3) increasing family allowances for some categories of households (for example, those headed by single mothers), as was recently done in Russia.

Illustrative country case. To show what a significant cut in transfers might mean, this article presents some results of a simple quantitative exercise undertaken for Bulgaria. If one assumes that there is no change in the share of transfer recipients and benefit levels during the latter half of the 1990s, the share of transfers to GDP would be 14 percent, compared with contributions of about 9 percent, during this period. Under an alternative scenario, transfers would be cut back in a manner that most effectively protected the poor (for example, by reducing benefits relative to average wages but protecting minimum benefit levels, reducing the pension eligibility of persons under 65, increasing allocations for social assistance and/or temporary programs for the unemployed, and instituting rough means testing of family allowances) and payroll taxes would be cut in half. These feasible measures would cut total transfers to 8-9 percent of GDP and contributions to less than 7 percent of GDP. Over 5-10 years, raising the retirement age to 65 would nearly eliminate pension payments to persons under 65 and reduce transfers to some 7 percent of GDP. The impact on growth of a reallocation of 5-7 percent of GDP from transfers to investment and private sector activity would be sizable.

Conclusions

Transition societies face acute conflicts as they move to a market economy. This involves greater risk-taking and less security—and almost certainly greater income inequality. Should transition societies use transfers to compensate for these changes? The short-run collapse in their citizens’ incomes, their heritage of cradle-to-grave state protection, and the vision of the Western European welfare state all provide compelling motivations for the widespread use of transfers. Maintaining (or attempting to maintain) a comprehensive welfare state, however, could very well delay or make impossible a shift to a dynamic growing economy. The transition economies do not have the underlying productivity levels or the tax bases to sustain the tax effort needed to provide transfers on a very large scale. Short-run gains in security could therefore entail high long-run costs, leading to insufficient private and public investment and a continued lack of competitiveness. This could eventually result in either financial collapse or very slow growth at low levels of income. Under either scenario, it is likely that the poor, the elderly, the disabled, the unemployed—precisely those groups that transfers are supposed to protect—will suffer disproportionately over the medium-to-long term, as well as in the short term.

This article is drawn from the authors’ World Bank Policy Research Working Paper No. 1380, “Transfers and the Transition from Socialism: Key Tradeoffs,” which was issued in November 1994.

Further reading: Francois Bourguignon, “Optimal Poverty Reduction, Adjustment, and Growth,” World Bank Economic Review, Vol. 5 (May 1991), pp. 315-38; Sheldon Danziger and others, “How Income Transfer Programs Affect Work, Savings, and the Income Distribution: An Overview,” Journal of Economic Literature, Vol. 19 (September 1981), pp. 975-1028.

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