Chapter

III. Fiscal Policy and Reform

Editor(s):
Jeffrey Davis
Published Date:
January 1992
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Author(s)
Jeffrey M. Davis

1. Introduction

The effectiveness of fiscal policy is a major factor determining macroeconomic performance. In part this follows from the size of the public sector, with Central Government spending alone averaging almost 25 percent of GDP in developing countries in the mid–1980s. Further, governments have sought to use taxing, spending and borrowing powers both to maintain the desired level of economic activity and to manipulate the allocation of resources to achieve growth and equity objectives.

Despite impressive objectives, the results of fiscal policy intervention in developing countries have often been far from favorable. Indeed, substantial evidence exists that in many cases poor fiscal management has been a major factor underlying problems of internal and external balance and low growth rates. Consequently, there is a need to focus on fiscal policy both as a possible source of disequilibrium and as a major tool for achieving growth–oriented adjustment.

For countries that now face unsustainable fiscal deficits, macroeconomic stabilization represents a top priority. However, achievement of growth–oriented adjustment requires that comparable emphasis be given to the structure of taxation and the establishment of priorities for government spending. This chapter initially reviews stabilization aspects of fiscal policy. Subsequent sections review tax and expenditure policy issues, respectively.

2. Contribution to macroeconomic stability

a. The importance of budget deficits

Consideration of the appropriateness of the fiscal policy stance often focuses on the size of budget deficits. Such deficits provide a measure of the excess of the government’s spending over its revenue and, as such, an indication of budgetary addition to domestic demand. There are, however, important problems in measuring and interpreting budget deficits which must be considered in policy analysis. The following problems may be noted:

  • the impact of a given deficit on domestic demand, external balance and aggregate supply depends crucially on the structure of revenues and expenditures;
  • extrabudgetary funds and quasi–fiscal operations of public sector financial and nonfinancial institutions may require a more comprehensive measure than provided by conventional deficits; and
  • the conventional deficit may tend to overstate the expansionary thrust originating from fiscal operations in situations of high inflation. In these circumstances, a significant share of the government’s nominal interest payments may effectively compensate bondholders for the erosion in the real value of their principal rather than representing a transfer of purchasing power.

Nevertheless, an understanding of the possible relationships between budget deficits and their financing, and macroeconomic targets is crucial to developing an effective fiscal policy. As, however, illustrated in Box III.1 it may be necessary to complement the conventionally measured deficit with alternative indicators of fiscal impact.

Box III.lAlternative Concepts of Fiscal

The appropriate measure of the fiscal deficit may need to be adapted to the particular circumstances of each country. This may be illustrated with respect to the fiscal deficit concepts used in the monitoring the 1986–87 Fund–supported program with Mexico. The high inflation rate that prevailed during this period and the large stock domestic debt complicated the evaluation and monitoring of fiscal solely on the basis of conventional concepts of the fiscal deficit. The public sector borrowing requirement (PSBR) measures the difference between total expenditures and revenues of the non–financial public sector. In the context of inflation, the concept of the PSBR contains a large element of debt amortization in its interest component. Thus, the concept of the operational balance, which corrects for this component, was adopted along with the usual calculation of the PSBR. The operational balance derived by subtracting from the overall economic balance the inflationary component of the interest payments on the internal public debt denominated in Mexican currency. Also, to assess the fiscal effort resulting from the measures being implemented, the concept of the primary balance was employed. The primary balance is defined as the economic balance, excluding all interest payments.

In the context of adjustment programs, particular importance attaches to the relationships between budget deficits and the external current account balance, and those between the methods of financing deficits and other stabilization objectives.

b. The budget and external balance

A simple accounting relationship can be established between budgetary and external current account balances. Gross national product (GNP) can be defined in terms of expenditure components or income uses:

where,

Cp = private consumption;

Ip = private investment;

G = government spending;

X = exports of goods and services;

M = imports of goods and services;

Sp = private savings;

T = government revenue; and

R = net current transfers to abroad.

Rearranging,

Equation (III.2) shows the external current account balance as the counterpart of the domestic private sector’s investment–savings balance and the overall budget deficit. Thus, an overall budget deficit must be matched by a domestic private sector that saves more than it invests and/or by an external current account deficit.

Considerable caution is required in moving from the accounting identity to the assumption that a simple causal relationship exists between budget and external deficits. Establishment of such relationship requires consideration of the impact of fiscal policy on private sector savings and investment; budget deficits also respond to, as well as influence, external balances.

While such caveats are important they do not lessen the likelihood that large and prolonged fiscal deficits will be reflected in a deteriorating external current account balance. Correspondingly, a recent World Bank study suggested that budget deficits were a principal cause of the international debt crisis, with the aggregate current account deficit of the seventeen highly indebted countries widening in step with their aggregate fiscal deficit.

c. Financing the deficit

Budget deficits may be financed by borrowing from domestic bank and nonbank sources, and from the rest of the world. Excessive reliance on any of these methods of finance has its dangers and potentially adverse effects on macroeconomic targets.

  • Monetization of deficits. Government borrowing from the central bank directly affects the monetary base and the money supply. Reliance on commercial bank finance may be expected to have similar effects if banks are not forced to constrain credit to other borrowers. In many developing countries, the government sector is the primary influence on the money supply. Excessive growth in the money supply leads to high inflation rates and balance of payments problems.
  • Reliance on nonbank financing. Substantial borrowing from the nonbank sector may adversely effect the structure of demand and growth potential. In particular, this borrowing may limit the availability of resources to finance private investment. Such “crowding out” of private investment may occur through the impact of government borrowing on domestic interest rates.
  • Borrowing from abroad. Reliance on external finance leads to the accumulation of debt, which needs to be serviced and eventually repaid. The dangers of excessive, or inappropriate, borrowing are well evidenced by the recent situation of heavily–indebted countries.
  • Accumulation of arrears. Delays in payments on debt service, or on goods purchases, are considered a particularly unfortunate means of budgetary finance. Such arrears have similar macroeconomic consequences to other forms of public borrowing, as well as jeopardizing future financing and the integrity of the budgetary system.

d. Consideration of a prudent fiscal deficit

The appropriateness of deficits needs to be assessed in the context of the way resources are utilized and the overall macroeconomic environment and objectives.

  • If the use of public resources is sufficiently productive, future income can be generated to cover the servicing costs of any debts incurred.
  • Deficits can be more easily absorbed by countries with high rates of domestic private savings and well–developed capital markets.
  • More generally, a prudent fiscal policy can be defined as maintaining the public deficit at a level consistent with other macroeconomic objectives: controlling inflation, promoting private investment, and maintaining external creditworthiness.

e. Fiscal policy and adjustment strategy

Fiscal measures in Fund–supported adjustment programs seek to reduce pressures arising from excess demand and to enhance the contribution of the public sector to growth.

  • Limitation of excess demand. Reduction of fiscal deficits usually represents an important target of adjustment programs. Emphasis is also given to the financing of deficits, with limitations on government borrowing from the banking system and ceilings on commercial external borrowing by the government (or public) sectors.
  • Structural measures. Adjustment programs have, in recent years, given increasing attention to the supply–side effects of fiscal measures. This requires more detailed emphasis on the structure of taxation and expenditure priorities.

3. Tax policy issues

Countries undertaking adjustment programs usually need to increase revenue quickly to address urgent stabilization problems. Emphasis also needs to be given to raising tax elasticity; this involves enhancing the ability of the tax system to generate increases in revenue in response to growth in the economy, without continued resort to new tax measures or rate increases. Over time, achievement of growth–oriented adjustment may require a fundamental reform of the tax structure.

a. Tax structures

Tax policy issues need to be seen in the context of the actual and potential tax structure in particular countries. The tax structure tends to vary substantially according to the level of development, reflecting the availability of tax bases and administrative capacity. Tax structures in low–income countries often reflect the features described below.

  • A heavy reliance on domestic commodity and international trade taxes; together these accounted for 70 percent of tax revenue in low–income countries, in 1985, with import duties alone representing over 40 percent of this amount.
  • Domestic income taxes tend to be of more limited importance (25 percent of 1985 tax revenue), with greater reliance on company than personal taxes. This reflects the convenience of large (often foreign) companies as sources of revenue and the administrative difficulties of applying an effective personal income tax.

By contrast, international trade taxes are insignificant in industrial countries, while personal and social security taxes are major sources of revenue.

b. Problems in tax systems

Concerns have been expressed as to the possible adverse effects of the tax structure, and the design of particular taxes, on growth in many developing countries. Essentially, such concerns reflect the impact of taxes on relative prices and the possible adverse effects on incentives of inappropriate price signals. These problems may be exacerbated by weak tax administration. Tax issues that arise in developing countries include:

  • import duties with high and variable rates that give unintended effective protection and encourage inefficient import substitution (see Chapter V for a review of these concepts);
  • export taxes and implicit taxation through surpluses of marketing boards and overvalued exchange rates that serve as disincentives to production and export;
  • high nominal rates and ad hoc exemptions from direct taxes that may adversely affect the level and pattern of investment, saving, work effort, and capital flows; and
  • reliance on turnover taxes that are not neutral with respect to the number of stages of production and distribution.

c. Tax system design

Recent studies have reviewed some of the desired features of the tax system that should emerge as countries develop. These suggestions have reflected theoretical and empirical work that has questioned the equity of existing tax systems and emphasized the resource allocation costs associated with high marginal tax rates and wide exemptions. Importance has also been attached to designing tax systems that ensure revenue increases in line with growth in the economy.

  • Concentration of revenue sources. A system that raises revenue from a limited number of taxes and rates may substantially reduce administration and compliance costs. Avoidance of numerous taxes, and rate schedules that yield limited revenue, may also facilitate the assessment of the effects of policy changes and avoid an impression of excessive taxation.
  • Broad and objectively defined tax bases. A broad tax base with limited exemptions enables revenue to be raised with relatively low rates. Substantial erosion of the tax base through exemptions requires much higher rates to achieve a given amount of revenue. The likelihood of adverse incentive and resource allocation costs, and of tax evasion, is consequently increased. Tax bases should be defined so as to ensure that producers and consumers can clearly estimate their tax liability given their planned activities.
  • Minimization of collection lags. In an inflationary environment the real value of tax receipts may decline substantially when there are long lags in payments. High penalties are necessary to ensure that legal delays are not compounded by delinquency lags. Payment delays are more likely to occur for capital than wage income, leading to equity problems.
  • Tax neutrality. The tax system should finance government operations with the least cost and disturbance to the patterns of production, and the generation and use of income. Hence, neutrality of the tax system is considered desirable, in the sense that distortions in incentives should be limited unless there are compelling reasons to discourage the production, consumption, or trade of a particular commodity. Insofar as possible the activity most profitable before tax should remain most attractive after tax.

d. Tax instruments

Particular tax instruments may be viewed in relation to the above criteria, and their comparative efficiency in generating revenue, discouraging consumption of particular products, providing protection to specific industries and in the short run influencing the balance of payments.

  • A general sales tax should serve as a major instrument of revenue generation. To fulfill this role, while adhering to the criteria for efficient tax design, the tax should be levied at a uniform rate on as broad a base as possible. Problems of cascading, that is cumulative taxation as goods move through successive stages of production, can be avoided by utilizing a value-added tax (VAT) or single–stage sales tax.
  • Excises (selective commodity taxes) can discourage consumption of particular items, or link tax payments to special costs. Taxes on alcohol and tobacco provide examples of the former function, and those on products to offset the cost of roads, the latter. Discouragement of luxury consumption should be achieved through excises on both domestic and imported products; this avoids an unintended stimulation of local production of the latter. Particularly in an inflationary environment, ad valorem are preferable to specific excise duties.
  • Import duties. Assignment of the major revenue–raising role to a general sales tax leaves import duties to provide protection or effect short–term balance of payments objectives. These objectives could be achieved through a low general ad valorem tax on imports, with high rates reflecting explicit decisions to allow particular industries or sectors special protection.
  • Export taxes may serve to obtain revenue from the hard–to–tax agricultural sector, to tax windfall gains from devaluation or exceptional movements in world prices, and to divert production to the domestic market. Reliance on export taxes should, however, be limited by their possible serious adverse effects on production and exports.
  • Income taxes. Personal income taxes may serve revenue generation and equity objectives. Exemptions should be geared to administrative capacity and a proliferation of high rates with limited yields should be avoided. Separate taxation of enterprises may be justified by equity and revenue objectives. Integration of the personal and corporate taxes would be administratively very complicated, particularly for the treatment of nonresident shareholders.
  • Investment incentives. Governments often use special investment incentives such as exemptions, tax allowances, tax credits, or special reliefs designed to assist particular groups or activities in specified industries or locations. Recent thinking has questioned the effectiveness of such tax incentives, with preference for low tax rates. Consideration, however, needs to be given to tax incentive legislation in neighboring countries.

e. Tax reform

The serious structural problems in many developing countries has led to the introduction of major tax reforms in developing and industrial countries. Central to several reforms have been measures to broaden the tax base, reduce exemptions, and achieve a simplified and more easily administered tax system. These objectives are illustrated in Box III.2 by reference to aspects of tax reform in Jamaica and Indonesia.

Box III.2Tax Reform – Developing Countries

In 1985, the government of Jamaica embarked on a comprehensive tax reform. This reform included changes in the personal income tax, the company tax, and indirect taxes. The reforms of the personal income tax were particularly profound. A complicated, narrowly–based individual income tax levied under a progressive statutory rate was replaced by a broadly–based single–rate tax in 1986. Before the reform, the highest marginal tax rate of 60 percent (including payroll taxes) was reached at the relatively low annual income level of less than three times per capita GDP. The provisions of the tax code were complicated, with no standard deduction and sixteen separate credits. In addition, employers could grant nontaxable allowances to employees. The resulting tax system was difficult and costly to administer and contained important disincentives; evasion and avoidance all but negated the progressivity of the statutory rate structure.

Under the reformed system, the complex rate structure was replaced with a single rate of 33 1/3 percent; the 16 tax credits were replaced with a standard deduction equal to two times per capita GDP; most non–taxable allowances were incorporated into the tax base; and interest income was included in the tax base. Initial results suggest that the combination of a higher standard deduction, a broadened base, and a lower flat rate has improved administration, increased the progressivity of the tax system, and raised tax yields.

The government of Indonesia adopted a major tax reform in late 1983. An important aspect of this reform was the wholesale elimination of tax incentives for investment. Before 1983, a massive array of incentives in the investment code was designed to favor specific industries, promote exports, develop remote regions, promote technology transfers, strengthen the stock exchange, and even encourage firms to be audited by public accountants. The numerous, and often contradictory, tax incentives created an excessively complicated system unable to fulfill its revenue function or to serve the special purposes originally intended. Further, such incentives created effective tax rates that varied both between and within sectors and thus misallocated the capital stock. Tax reform eliminated nearly all special tax incentives, allowing the company tax rate to be reduced. The simplified incentive system was intended to minimize tax–induced inter–sectoral preferences, while the lowered company tax rate would provide more uniform benefit to all investors.

4. Expenditure policy issues

a. Expenditure cutbacks

Adjustment programs, often mandated by fiscal crises, have forced cutbacks in government spending in many developing countries. Real central government spending in fifteen (mainly highly–indebted) countries, fell on average by over 18 percent in the early 1980s. Capital spending suffered more than a 35 percent decline, while current spending fell by less than 8 percent.

The magnitude of the resource constraints facing developing countries has emphasized the need to carefully consider the areas where public sector involvement is necessary as opposed to reliance on markets. Consideration also needs to be given to the most effective utilization of scarce government sector resources in areas where public sector involvement is judged necessary.

b. Expenditure reform

Experience with structurally–oriented adjustment programs has suggested several areas where expenditure reform can help to promote higher productivity and greater utilization of existing productive capacity.

  • Encouragement of productive government investment. Importance should be attached to ensuring that the investment program is of a high quality and that projects pass a number of economic tests, because the cost of poorly designed or inefficiently implemented projects can be high. Such assessment is liable to be most effective in the context of more general policies to correct distortions in relative factor and commodity prices. Emphasis should be given to government investment that complements, rather than competes with, market–determined activities.
  • Funding operations and maintenance. Part of current spending on goods and services goes for the operation and maintenance of capital investment and is critical for the success of such investment. Inadequate spending on operations (whether supplies or personnel costs) can lead to low levels of effectiveness in areas such as education and health. Similarly, inadequate spending on maintenance can lead to rapid deterioration of physical capital. A corollary of the concern for operations and maintenance is the need to avoid across–the–board cuts in materials, supplies, and services.
  • Addressing sources of low productivity in government. Low pay and inadequate salary differentials for skilled managerial and technical staff may discourage work effort and contribute to low productivity in the public sector. At the same time, the common practice of the public sector acting as the employer of last resort may substantially increase wage costs. Recent reforms in several countries have emphasized the difficult tasks of reducing the wage bill and increasing the salary differentials in favor of senior staff.
  • Cost–effective expenditure policies. Lack of resources has emphasized the need to use more cost–effective expenditure policies to attain given political goals, such as income redistribution, external or internal security, or self–sufficiency. As an example, general food price subsidies may not be the most cost–effective means of improving the nutritional status of the poor and could be replaced by target schemes.
  • Limiting government consumption. Reduction of the less productive forms of government consumption increases the contribution of the public sector to national savings as well as limits the need for raising taxes further. Gradual diminution of such spending may represent the most appropriate means of financing growth–oriented adjustment.

c. Budget planning and control

Improving the efficiency and effectiveness of public spending requires reform of fiscal planning, budgeting, implementation, and monitoring.

  • Fiscal planning ideally involves formulating a phased investment program, projecting current spending needs, and assessing revenue availability and borrowing requirements for three to five years.
  • The annual budget would then be a comprehensive one–year slice of the medium–term plan. For plans and budgets to promote effective decision making, the trade–offs among agencies, programs and projects must be explicit, and the budget constraints firm.
  • Budget and expenditure control systems should be strengthened, with an increase in the transparency and timeliness of fiscal reporting particularly critical for effective fiscal management and for monitoring both the government and public enterprises.
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