Chapter

Fiscal Policy and Growth

Author(s):
International Monetary Fund
Published Date:
August 2002
Share
  • ShareShare
Show Summary Details

Economic Growth, Sustainable Development, and the Millennium Development Goals (MDGs)

Economic growth is essential for sustainable development and improving social outcomes.4 Growth usually—but not always—benefits the poor; in about 90 percent of the cases in which countries have experienced per capita GDP growth of at least 2 percent per year over a five-year period, the poor also experienced rising real incomes. While, in general, there is no pro-rich bias in growth,5 appropriate development of the poor’s income-earning potential can help ensure that they also share in the fruits of an expanding economy (see the section on “Fiscal Policy, Human Development, and the MDGs”). Not surprisingly, there is also a strong link between economic growth and improvements in non-income dimensions of poverty. For example, a 10 percent increase in GDP per capita typically results in a 3–5 percent decrease in infant and child mortality rates.6 Similarly, disparities between male and female literacy rates fall markedly as GDP increases.7 In this light, fiscal policy can play a pivotal role in achieving the MDGs by fostering robust economic growth.

Economic growth can support environmental sustainability and vice versa. Growth can help the environment by increasing the resources available for environmental improvement. For example, access to safe water and sanitation has been steadily increasing with economic growth in East Asia.8 However, the experiences of developed countries show that growth is no panacea. Good policies and institutions are also important, not least in relation to fiscal policy; recent studies show that they can significantly reduce environmental degradation in low-income countries and speed up improvements in high-income countries.9 Policy must also recognize that important links run in the other direction as well; environmental quality and sustainable resource use can affect economic growth.10 The morbidity and mortality costs of air pollution, for instance, are substantial in many parts of the developing world, with adverse consequences for economic growth.

Fiscal Balances and Growth

A prudent, sustainable fiscal position promotes economic growth. In the long run, low and stable levels of government deficits (the difference between government revenues and expenditures) and debt are typically associated with higher rates of economic growth.11 In countries with high deficits and debt, reducing budget imbalances generally increases growth, even in the short run.12 Since there is less need to create money to finance government expenditure, the resulting inflation rates for countries with low budget deficits are often lower.13 Low fiscal deficits also increase the pool of savings for higher levels of investment, leading to higher economic growth.14 In addition, low deficits promote growth by reducing the probability of economic crises caused by concerns about the government’s ability to service its debt. Indeed, research suggests that the macroeconomic stability associated with the absence of such crises yields numerous benefits, including higher rates of investment, growth, and educational attainment, increased distributional equity, and reduced poverty.15

The appropriate fiscal policy to promote growth varies, depending on the economic situation and time frame. Over the long run, fiscal policy should aim to keep government debt at sustainable levels. In the short run, the optimal fiscal stance varies, with tightening being appropriate for countries with substantial fiscal deficits and fiscal expansion (larger deficits) being appropriate for countries that have achieved fiscal stability but are experiencing severe economic downturns (as, for example, Asian countries were during the 1997–99 crisis). In addition, fiscal expansion may also be warranted in low-income countries with solid macroeconomic positions (for example, low inflation and budget deficits) that wish to support higher public spending as part of their poverty-reduction strategies.

This line of thinking is reflected in IMF policy advice. For example, once the magnitude of the economic contraction in countries affected by the 1997–99 Asian crisis became clear, the IMF supported a significant expansion in public spending to bolster economic activity.16 Once the crisis had subsided, the IMF supported fiscal tightening to help these economies keep their government debt at moderate levels. Similarly, flexibility in fiscal targets is reflected in the design of adjustment programs in low-income countries supported by the IMF’s Poverty Reduction and Growth Facility (PRGF). In practice, this has meant that in countries that have already achieved low budget deficits and low inflation, adjustment programs incorporate increases in the deficit to support their poverty-reduction strategies. Deficits in these countries have been programmed to increase by ½ of 1 percentage point of GDP, on average, in order to accommodate high-priority, pro-poor expenditure. In contrast, in countries that have not yet achieved macroeconomic stability, fiscal restraint has been more common, with the average deficit remaining roughly unchanged.17

Fiscal Policy, Incentives, and Growth

Fiscal policy can also affect growth through its effects on the incentives faced by individuals and firms. Business taxes can affect firms’ decisions regarding how much to invest and in what kind of assets; taxes on labor can affect the level of employment and decisions on the acquisition of education and job training; stumpage fees can discourage tree cutting (or encourage illegal logging); taxes on capital income can affect incentives to save; the absence of emissions charges can lead to excessive pollution; the availability of special tax breaks and subsidies for those with political connections (rent-seeking) can reduce incentives to engage in productive activity; and excessively generous social programs can reduce incentives to work and save. Incentive effects are not limited to the private sector; they play just as important a role within the public sector. Pay and disciplinary policies, for instance, shape the extent of corruption in the civil service and the productivity of public sector employees.

Incentive effects can constrain the effectiveness of fiscal policies. An increase in the corporate tax rate intended to increase revenues will fail to do so, for instance, insofar as this leads businesses to invest instead in other countries or to shift their profits to jurisdictions offering low tax rates.18 High benefit levels in social programs may discourage recipients from seeking employment and gaining job skills, miring individuals in a “poverty trap.” These problems have implications for policy design. For example, poverty relief may be more cost-effective if linked to work participation or to children’s school attendance.

Tax and expenditure policies should, in general, be designed to minimize adverse incentive effects. In choosing tax policy measures to raise revenues, for example, there should be preference for those that least distort labor supply, consumption, saving, and other decisions. When the aim of a policy is to help the poor, little is gained by discouraging them from raising their own living standards. In some important cases, however, notably in relation to the environment and natural resources, tax and spending policies have a role in correcting what would otherwise be inappropriate incentives for overconsumption. For example, the price of energy determined by the private market is too low if the true social cost of energy consumption (which includes the cost of pollution and traffic congestion) is not incorporated into the private sector price. The role of incentives in designing fiscal policies to support sustainable development is a central consideration in many of the issues addressed in this pamphlet.

Revenue Composition and Growth

An efficient and fair tax system is an important component of a progrowth strategy.19 While foreign aid can make an important contribution, the main source of finance for a country’s public expenditure must be its own tax revenue. This requires an effective tax administration and a tax policy that minimizes distortions to ensure that the best use is made of resources across the economy. To minimize distortions, tax systems should avoid excessive complexity, focusing on taxing a broad range of goods and services at relatively uniform rates. Income taxation also has a role to play, although weak administrative capacity limits revenue from this source in many developing countries. Tax systems should also be sensitive to the possibility of market failure, not least in relation to the use of the environment and natural resources, and be administered in a manner that is transparent, impartial, and rules-based.20

The tax system also needs to be accepted by domestic constituencies as equitable, although experience has shown that taxation is generally less effective than well-targeted spending programs in pursuing pro-poor policies. The wealthy have proved adept in avoiding high tax rates on their income by, for instance, locating assets abroad or taking advantage of relatively favorable treatment of capital gains. Taxes on consumption and trade, which are particularly important in many developing countries, are also blunt instruments for pursuing equity objectives. For example, exempting some basic foodstuffs from the value-added tax (VAT) certainly conveys some benefit to the poor, since they are likely to spend a larger fraction of their income on food. However, the rich may well spend a larger absolute amount on the exempted good, so they derive the largest benefit. Removing the exemption would yield revenue that could be spent in a more propoor way,21 along the lines discussed in the section on “Fiscal Policy, Human Development, and the MDGs.”

Improving the efficiency and equity of tax systems is a critical component of IMF-supported programs. Almost three-fourths of PRGF-supported programs in low-income countries incorporate measures to broaden the tax base and improve horizontal equity (treating taxpayers with similar incomes equally) by, for example, removing exemptions and abolishing special tax breaks for foreign investors. Many programs also seek to improve tax efficiency by lowering or reducing the number of import tariff rates, simplifying the structure of the personal income tax, or improving tax administration. Similarly, some programs seek to improve equity by, for example, increasing the progressivity of the personal income tax.22 The IMF also continues to play a key role in the adoption and improvement of the VAT, which has proved to be a key tax innovation for many developing countries. By introducing modern methods of self-assessment, the VAT is also seen as an important first step toward modernizing tax administration.

Expenditure Composition and Growth

Allocating a higher share of public spending to physical and human capital formation can also promote growth. Investments in physical capital, such as roads and other infrastructure, can increase the economy’s productive capacity.23 Although the efficacy of such investment varies across projects and countries, recent research indicates that it may have a significant impact on economic growth. One study finds, for instance, that an increase in public investment in transportation and communication of 1 percent of GDP is associated, on average, with an increase in annual per capita GDP growth of as much as 0.6 percentage points.24

A better-educated and healthier population contributes to growth. Beyond their direct effects on well-being, improvements in the education and health status of the population also increase worker productivity. Reductions in communicable diseases such as malaria have positive spillover effects on growth by promoting tourism and foreign direct investment.25 Indeed, it has been estimated that each 10 percent improvement in life expectancy at birth can raise the per capita GDP growth rate by 0.4 percentage points.26 Although it has been difficult for economic research to quantify the magnitude of the effect of education on growth, there is nonetheless evidence that it can be significant.27 Economic growth, in turn, has beneficial effects on education attainment and health status, contributing to a virtuous cycle of stronger education, health, and growth.

Physical and human capital spending should also be protected during fiscal adjustments. Fiscal consolidations that protect capital expenditure tend to be both more sustainable and better for growth.28 This finding reinforces the notion that reorienting public expenditures away from less productive spending, such as untargeted subsidies, and toward more productive spending, such as investments in physical and human capital, facilitates growth in many countries in both the short and long runs.

However, capital accumulation should not come at the expense of unsustainable damage to the environment. Economies that derive much of their income from natural resources cannot sustain growth by substituting physical capital accumulation for deteriorating natural capital. Severe environmental degradation can affect a country’s long-run macroeconomic performance. The impact of this may be most devastating for the poor, who often depend on natural resources for their income and have few possibilities for substituting other assets. In the long run, growth strategies that pay attention to environmental quality and the efficiency of natural resource use contribute to investment, economic growth, and human welfare.29

Increased public expenditure on other items, such as law enforcement and the judiciary, may also be important for growth. However, data problems have significantly limited research on the impact of these outlays on growth.

Improving the composition of government outlays is an important element of the IMF’s fiscal policy advice. Under reform programs supported by the IMF’s PRGF, physical capital expenditures are targeted to rise, on average, by ¾ of 1 percentage point of GDP. At the same time, many of these programs involve measures to improve the efficiency of government spending and increases in spending for human development and poverty reduction (see the section on “Fiscal Policy, Human Development, and the MDGs”).30

Many Countries Fall Short

There is substantial scope to make budgets more growth oriented. Significant budget imbalances remain in many low-income countries, which have an average central government deficit and debt of 4½ percent and 83 percent of GDP, respectively (Table 1). Just under one-fifth of these countries have deficits above 7½ percent of GDP and about one-third have debt exceeding 100 percent of GDP. Given the positive relationship between fiscal sustainability and growth, many countries could promote economic growth by embarking on fiscal consolidation.

Table 1.Central Government Deficit and Debt, by Country groups1(Unweighted averages; most recent year for which data are available)
Central

Government Deficit
Central

Government Debt2
Number of

countries
Percent

of GDP
Number of

countries
Percent

of GDP
Developing and transition countries1423.63065
Of which: Low-income countries614.61483
OECD322-0.41559
Sources: IMF, World Economic Outlook (Washington); and IMF staff estimates.
1Central government deficit equals central government revenue and grants minus central government expenditure and net lending (times minus one).
2For the OECD countries, debt refers to gross public debt as defined under the Maastricht Criterion.
3OECD denotes the Organization for Economic Cooperation and Development. Figures shown exclude the Czech Republic, Hungary, Korea, Mexico, Poland, the Slovak Republic, and Turkey.
Sources: IMF, World Economic Outlook (Washington); and IMF staff estimates.
1Central government deficit equals central government revenue and grants minus central government expenditure and net lending (times minus one).
2For the OECD countries, debt refers to gross public debt as defined under the Maastricht Criterion.
3OECD denotes the Organization for Economic Cooperation and Development. Figures shown exclude the Czech Republic, Hungary, Korea, Mexico, Poland, the Slovak Republic, and Turkey.

Low levels of social spending—and lags in social indicators relative to other countries—also indicate that there is room to reallocate public outlays to pro-growth spending. For example, public health spending in the poorest countries is only US$40 per person (in purchasing power parity terms); as a share of GDP, low-income countries spend only about one-third of the Organization for Economic Cooperation and Development (OECD) average (Table 2). This low level of spending is partly reflected in these countries’ health indicators; for instance, average life expectancy is only 55 years, compared with 78 in OECD countries. Spending for education is somewhat more generous in low-income countries (Table 3); nevertheless, low literacy rates (63 percent) indicate significant room for upgrading the human capital and productivity of the workforce. Also, recent estimates of subsidies in non-OECD countries for the exploitation of natural resources and the energy and industry sectors suggest that during 1994–98, the cost of environmentally harmful subsidies amounted to US$340 billion per annum, or 6.3 percent of GDP (Table 4), which was roughly equivalent to total public spending on education and health. Thus, there may be room to further reorient expenditure toward more productive areas31.

Table 2.Public Health Care Spending and Life Expectancy, by Country Groups(Unweighted averages; most recent year for which data are available)
Public Spending on Health
Number

of

Countries
Percent

of GDP
Percent

of total

government

spending
Per capita

spending in

PPP dollars1
Life

Expectancy

(years)
Developing and transition countries1182.48.011763
Of which: Low-income countries532.27.64055
OECD2246.114.42,87278
Sources: OECD (2001b); World Bank (2001b); national authorities; and IMF staff estimates.

PPP denotes purchasing power parity.

OECD denotes the Organization for Economic Cooperation and Development. Figures shown exclude the Czech Republic, Hungary, Korea, Mexico, Poland, the Slovak Republic, and Turkey.

Sources: OECD (2001b); World Bank (2001b); national authorities; and IMF staff estimates.

PPP denotes purchasing power parity.

OECD denotes the Organization for Economic Cooperation and Development. Figures shown exclude the Czech Republic, Hungary, Korea, Mexico, Poland, the Slovak Republic, and Turkey.

Table 3.Public Education Spending and Literacy Rate, by Country Groups(Unweighted averages; most recent year for which data are available)
Public Spending on Education
Number

of

Countries
Percent

of GDP
Percent

of total

government

spending
Per capita

spending in

PPP dollars1
Literacy

Rate

(percent)
Developing and transition countries1184.515.519975
Of which: Low-income countries534.315.68263
OECD2245.212.01,23197
Sources: OECD (2001b); World Bank (2001b); national authorities; and IMF staff estimates.
1PPP denotes purchasing power parity.
2OECD denotes the Organization for Economic Cooperation and Development. Figures shown exclude the Czech Republic, Hungary, Korea, Mexico, Poland, the Slovak Republic, and Turkey.
Sources: OECD (2001b); World Bank (2001b); national authorities; and IMF staff estimates.
1PPP denotes purchasing power parity.
2OECD denotes the Organization for Economic Cooperation and Development. Figures shown exclude the Czech Republic, Hungary, Korea, Mexico, Poland, the Slovak Republic, and Turkey.
Table 4.Global Costs of Public Subsidies per Year, 1994–981(In billion U.S. dollars, unless otherwise noted)
OECD2Non-OECDWorld
Natural resource sectors390155545
Agriculture33565400
Water154560
Forestry53035
Fisheries101020
Mining25530
Energy and industry sectors335185520
Energy80160240
Road transport20025225
Manufacturing industry5555
Total7253401,065
Total in percent of GDP3.46.34.0
Source: Van Beers and de Moor (2001).
1Subsidies are measured on a gross basis—that is, they are not net of taxes.
2OECD denotes the Organization for Economic Cooperation and Development.
Source: Van Beers and de Moor (2001).
1Subsidies are measured on a gross basis—that is, they are not net of taxes.
2OECD denotes the Organization for Economic Cooperation and Development.

Improving the efficiency and targeting of social spending are also essential for promoting growth. Higher spending will only contribute to better health and education outcomes if it is efficient and well targeted—an issue we turn to in the section on “Fiscal Policy, Human Development, and the MDGs.”

    Other Resources Citing This Publication