Chapter

5 Fiscal Policy Responses to Exogenous Shocks in Developing Countries

Editor(s):
Mario Bléjer, and Ke-young Chu
Published Date:
June 1989
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Vito Tanzi*

During the past decade, the developing countries have been subjected to various exogenous shocks that have made the pursuit of sound economic policy, and particularly sound fiscal policy, very difficult. In this paper, I discuss the factors associated with these exogenous shocks; the impact of these shocks on fiscal variables; and some of the policy responses by countries. “Exogenous shocks” are defined as uncontrollable external events that have substantial effects on a country’s income level.

I. Factors Associated with Exogenous Shocks

The most important exogenous shocks have been the following:

1. Changes in Export Earnings

Many developing countries rely heavily on the export of one or a few commodities (oil, coffee, copper, etc.) for their foreign exchange earnings. Shocks may originate in unexpected changes in their prices arising from changes in supply conditions or in the demand for these commodities. A frost in Brazil that raises the international price of coffee also raises the foreign exchange earnings of other coffee exporters. An oil embargo by the major Middle Eastern oil exporting countries had the same effect on the earnings of other oil exporting countries. Major world booms and recessions, by affecting commodity demand, have generated positive or negative shocks for developing country exports.

2. Changes in Major Import Prices

The most obvious example is provided by oil price movements since 1973. In view of the great importance of oil in many countries’ imports, when oil prices rose sharply in the 1970s, the real incomes of many oil importing countries were significantly reduced.

3. Change in Cost of Foreign Borrowing

As many developing countries are heavy borrowers, an increase in the interest rate in international capital markets can be an important exogenous shock. The cost of international borrowing to a given country can also go up because of a changed perception of the risk associated with lending to that country. Although the effects on borrowing costs may be the same, the latter is not a truly “exogenous” shock. When the cost of borrowing rises, it affects the cost of new funds as well as the cost of servicing the existing stock of foreign debt. If the debt is large and its maturity is short, the rise in interest expenditure can be substantial. If the foreign debt is mostly public, budgetary expenditures are directly affected.

4. Changes in Availability of Foreign Credit

This type of shock is not the same as the previous one. Around 1982, the world witnessed a dramatic reduction in the willingness of commercial banks to lend to many developing countries. Mexico, for example, saw its foreign borrowing fall from $18 billion in 1981 to $5 billion in 1983. The debt crisis made new loans unavailable to many countries, thus reducing their ability to continue using this source to finance their current expenditure levels.

5. Changes in Level of Foreign Grants

In many countries, and especially in the smaller ones, an important exogenous shock may come in the form of sudden changes in the availability of foreign grants or of concessionary loans. Countries that have relied on these sources for their domestic expenditure will be forced to reduce their spending when those grants are no longer available. Examples of these shocks abound, especially in Africa.

6. Changes in Other Factors

Shocks may at times also be associated with such factors as changes in foreign workers’ remittances, in direct foreign investment, in capital outflows carried out by nationals, and so on. In many cases, these changes can be traced to the countries’ own policies; therefore, they are not genuinely exogenous.

II. Effects of Exogenous Shocks on Fiscal Variables

The factors mentioned above affect not just the incomes of countries but also their fiscal variables. They may improve or worsen the fiscal situation and, by so doing, may bring about policy responses. The automatic impact of external shocks on the fiscal variables is likely to be much more important in developing countries than in industrial countries. At the same time, the ability of developing countries to neutralize these effects, if they wish to do so, is much more limited.

In industrial countries the external shocks affect incomes and economic activity much more than the fiscal variables themselves, since the fiscal sector is closely linked to the external sector. Therefore, the observed changes in the fiscal variables can be attributed to policy responses. For example, when the oil price increase in 1974 reduced the real incomes of industrial countries, their governments responded by increasing public spending in the form of transfers to families. This increase in public spending was not automatic but reflected a conscious, discretionary governmental reaction. Apart from the cyclical impact that affected tax revenues, the increases in fiscal deficits in the Organization for Economic Cooperation and Development (OECD) countries in 1975 were policy induced.

In the developing countries, the impact of external shocks on the fiscal variables is much more direct or automatic. Therefore, the observed change in the fiscal variable should not be attributed mainly to policy changes. For this reason, it is very difficult, when dealing with developing countries, to isolate the changes in fiscal variables that reflect genuine policy responses from those that reflect automatic effects. Thus, studies that attempt to estimate from observed fiscal changes the fiscal policy response to exogenous shocks are likely to reach misleading conclusions.

The reason for the above conclusion is the close link that exists in developing countries between the budget and the foreign sector. This link depends on (a) the high proportion of foreign trade taxes in total revenue, (b) the high proportion of domestic sales taxes collected from imports, (c) the heavy reliance of corporate income taxes on exports of mineral products, (d) the public sector’s reliance on foreign borrowing or foreign grants, (e) the high proportion of foreign debt that is public, (f) the widespread attempts in these countries to insulate some domestic prices from movements in world prices, and so on.

Foreign trade taxes (import duties plus export duties) account for more than one third of developing countries’ total tax revenue. This estimated share, however, does not convey the full importance of the external sector in public revenue, since corporate income taxes, which are mostly collected from mineral exports, account for another 18 percent and “domestic” taxes on goods and services are often levied largely on imported goods. More than 50 percent of the tax revenue of developing countries may be directly related to the foreign sector. Furthermore, in many of these countries some of the important export sectors (petroleum, phosphates, bauxite, etc.) are government owned. (See Tanzi (1987).) When the prices of those commodities change, the effect on public revenue can be direct and immediate. Much of the developing countries’ foreign borrowing is done by the public sector. When the availability or the cost of foreign loans changes, government resources are, again, immediately and directly affected.

To some extent, the same close link between the fiscal sector and the foreign sector exists on the expenditure side. Some government expenditures are financed by earmarked taxes. When tax revenue declines because of external shocks, the resources available for these expenditures also decline. The sizes of many subsidies depend on the differences between the international prices and the domestic prices of some imported products. When the international price increases or the exchange rate appreciates, the amount of the subsidy, and thus the budget deficit, also increases. Some external shocks have an immediate impact on the financing of investment expenditure, since concessionary loans or grants are often tied to specific projects; thus, when the availability of these loans or grants changes, the amount of resources available for investments also changes.

In conclusion, while shocks affect real incomes in both industrial and developing countries, they have far more pronounced and direct effects on the fiscal sectors of the latter.

III. Policy Response

Some literature is relevant for those assessing what the “optimal” fiscal reaction of developing countries to exogenous shocks should be. (See Tabellini (1985).) However, much of this literature is highly theoretical and assumes that over the short run, policymakers can control the policy instruments; it also assumes that they have sufficient interest and knowledge to pursue optimal policies. Unfortunately, the real world is much more complex. Some obstacles that exist in all countries are far more important in developing countries than elsewhere.

First, there are the contrasting views on how developing countries’ economies operate and how they respond to various policy tools. Under the best of circumstances, policymakers would receive conflicting advice. The ongoing controversy about Fund programs is an indication of this phenomenon. Second, some of the civil servants entrusted with implementing the policies decided upon by the policymakers may not respond in the required fashion. For example, it is easy to change a tax law; it is much more difficult to make the tax administrators fully implement the change. Third, statistics that are essential for good policymaking are often not available or are available with considerable delays or with sizable errors. Fourth, changes in policy instruments are often neutralized by the reaction of forces outside the control of the policymakers or even of the the civil servants. For example, an increase in import duties or in income tax rates may have little effect on revenue if smuggling is easy and tax evasion is rampant. Fifth, the authorities often find unacceptable, for various reasons, policies that may be seen as desirable by economists. Considering all these reasons, one should expect different fiscal responses to exogenous shocks in developing countries than in industrial countries. There is also the complication that exogenous shocks generate not just fiscal imbalances but also external imbalances, which may not be easily financeable. The policymakers often find themselves in situations where they have to coordinate conflicting objectives concerning internal and external imbalances.

The countries that, in the 1970s, were faced with rising public revenues owing to higher export prices generally reacted in three different ways. The first, and very small, group considered the increase as a temporary windfall which would affect only marginally the permanent income of the country and of the government. These countries used the additional revenue to pay off foreign debt or to accumulate foreign assets (foreign exchange or real assets). They thus were in a position to liquidate these assets in future years when foreign earnings declined, in order to maintain domestic spending on some trend which they hoped would be permanent. This behavior is an application of the permanent-income hypothesis of consumption to the government.

The second, and larger, group engaged in capital accumulation at home by expanding public investment. Provided that the investment had as high a rate of return as the country could have received on foreign assets, that the “additional” investment spending had been limited to the windfall income, and that this spending could have been phased out when the windfall income began to disappear, this policy response could have been considered a good one. However, experience indicates that these requirements often were not met. Investment was often not as productive as it could have been, since it was distorted by poor management and by political considerations, was often too large, and was too rigid to be phased out when conditions made such action appropriate. These countries faced difficulties when the windfall disappeared and foreign financing dried up. These changes called for a quick reduction of investment expenditure.

The third, and largest, group increased public spending by increasing public employment, the amount of transfers, investment, and so on. In this particular situation, when the decline in foreign earnings inevitably came, the countries were tied to patterns and levels of spending that were difficult to change. As long as foreign loans were available, the countries used these to maintain spending at levels that could no longer be sustained with ordinary revenue. This reaction prolonged the problem and, in many cases, made it worse by leaving the countries with huge foreign debts. When the crisis came, and the countries found that they had to adjust, since financing was no longer available, the consequences were very serious.

Shocks that reduce public sector revenue are even more difficult to deal with. In this case, countries are often unable to make up the revenue losses in the short run. The loss of foreign trade taxes could, in theory, be compensated for by increasing income taxes or taxing domestically produced products. But income taxes take a very long time to introduce and collect, and their scope is limited in developing countries. For this reason, countries have often been forced to rely on inferior revenue sources, such as inflationary finance, regressive excises, or the building up of arrears.

IV. Conclusions

Unlike the situation in industrial countries—where the government has much greater control over revenue sources, revenues are rarely tied to the foreign sector, and there is always the option of selling bonds domestically to generate additional domestic revenue for the public sector in a non-inflationary way—in the developing countries the degree of freedom in the policy area is much more limited, for some of the reasons already indicated. Another reason is that the potential for generation of domestic non-inflationary and non-tax sources of revenues is extremely limited. Therefore, in the absence of foreign borrowing, and once the possibility of financing spending through the building up of arrears has been exhausted, there is a limit to the amount of public spending (expressed in real terms or as a share of gross national product). This is not a rigid limit, but it exists all the same. (See Tanzi (1985).) Attempting to exceed that limit will bring about inflation, since the government will have to finance the additional spending through money creation. This channel itself has a limit, and inflationary finance may reduce the real value of tax revenue. (See Tanzi (1978).) That absolute limit on real government spending falls when an exogenous shock reduces tax revenue; it falls even more when foreign borrowing is constrained by the unwillingness of commercial banks to lend to the country. Of course, within the budget itself, to the extent that the servicing of foreign public debt increases, other expenditures have to be reduced even more.

Thus, often the only realistic alternative that these countries have is to reduce public spending. As it is often politically difficult to reduce current spending in the short run, the adjustment pressure is often shifted to capital spending. This is normally seen as an undesirable type of adjustment, although if unproductive investment projects are eliminated, it may not be as undesirable as is often believed.

References

    TabelliniGuido“Fiscal Policy Response to the External Shocks of 1979 in Selected Developing Countries: Theory and Facts” (unpublished International Monetary FundDecember261985).

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    TanziVito“Inflation, Real Tax Revenue, and the Case for Inflationary Finance: Theory with an Application to Argentina,”Staff PapersInternational Monetary Fund (Washington) Vol. 25 (September1978) pp. 417-51.

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    TanziVito“Is There a Limit to the Size of Fiscal Deficits in Developing Countries?” in Public Finance and Public Debt Proceedings of the 40th Congress of the International Institute of Public Finance Innsbruck 1984ed. by Bernard P.Herber (Detroit, Michigan: Wayne State University Press1986) pp. 139-52.

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    TanziVito“Quantitative Characteristics of the Tax Systems of Developing Countries,” in The Theory of Taxation for Developing Countriesed. by David M. G.Newbery and Nicholas H.Stern (New York: Oxford University Press1987) pp. 205-41.

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*This paper was first published in the May 1986 issue of American Economic Review. The assistance I have received from Ke-young Chu and Bassirou A. Sarr is greatly appreciated.

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