Chapter

I. Overview: Fiscal Reform and Economic Growth

Author(s):
George Mackenzie, Philip Gerson, and David Orsmond
Published Date:
April 1997
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Although the immediate objectives of IMF-supported programs are financial stabilization and a sustainable external position for the member country seeking IMF assistance, the ultimate aim is the improvement of living standards through increasing employment and economic growth.1 The immediate objectives have proved more attainable, however, than this ultimate aim. A recent survey of the results of IMF-supported programs concluded that, although they were quite effective in reducing or eliminating macroeconomic imbalances—particularly external imbalances—they were less successful in achieving and sustaining higher rates of growth (Schadler and others, 1995).

The purpose of this study is to examine fiscal reforms in a group of eight countries—Bangladesh, Chile, Ghana, India, Mexico, Morocco, Senegal, and Thailand—during a recent period (usually 1978-93), in order to determine whether and to what degree the fiscal policies implemented during these adjustment efforts were supportive of growth. The study also explores why some countries enjoyed more success in this respect than others. The eight cases include both low- and middle-income countries, and countries with public sectors of varying sizes at the outset of the adjustment periods. The group includes countries forced to make a draconian adjustment to the fiscal stance in a crisis environment, but also countries whose adjustment efforts were more gradual. The analysis does not deal with the quantity of fiscal adjustment, as indicated by, for example, the magnitude of the decline in the primary deficit or other similar indicators. This and other macroeconomic aspects of the relationship between growth and adjustment are addressed in Occasional Paper 139, Reinvigorating Growth in Developing Countries: Lessons from Adjustment Policies in Eight Countries (Goldsbrough and others, 1996). Instead, this study provides a detailed exploration of the composition of the fiscal adjustment that was undertaken. It discusses reforms in expenditure policy, public expenditure management, tax policy and administration, and some aspects of public enterprise reform. Assessment of these policies is made with the aid of a stylized model of a growth-fostering public sector.

Characteristics of a Growth-Promoting Public Sector

The basic rule for a growth-promoting public sector is that its activities should complement, rather than compete with, those of the private sector. Thus, an important role is provided for the government in certain investments in human capital—particularly in primary education, public health, and basic health care—and in physical infrastructure. A certain level of expenditure on the legal system, public order, and civil administration is necessary to ensure a stable environment in which investments with long payoff periods will not be discouraged. Another basic rule is that the taxes that finance government expenditure should be as nondistortional as possible. To realize these expenditure and tax policies, a satisfactory level of organization and expertise in public administration is also necessary.

This study does not pretend to quantify exactly what the contribution of fiscal policy to actual growth has been in the eight countries examined.2 Nonetheless, the model of the “growth-friendly” public sector described in Section II is grounded in the extensive theoretical and empirical literature on the nexus between fiscal policy and growth. The model is used in Section III as a basis for assessing the extent to which the fiscal reform policies implemented by the eight countries were conducive to growth.

Common Features of the Adjustment Experience

Generalizing from the different country experiences (details on the policies pursued by each country are provided in Appendices I, II, and III) Section III notes that one of the important common features of the developments in the eight countries is a tendency to achieve the greater part of the reduction in the primary deficit in the initial adjustment years. Moreover, in these years the main emphasis was on a reduction in noninterest expenditure; only in later years did the focus shift toward an increase in revenue. The initial expenditure cuts did not affect all types of expenditure equally; rather, most fell on current outlays on nonwage goods and services and on capital projects. Within these categories, the cuts were largely across-the-board and were not based on a systematic effort to minimize losses to productivity and growth. Expenditure on wages and salaries was generally protected, while outlays on subsidies and transfers fell gradually throughout the adjustment period.

Although a significant increase in revenue usually did not occur until late in the adjustment period, some reforms of the structure of the tax system were initiated in the first adjustment period. The most substantial tax reforms involved the replacement of a conventional sales tax by a value-added tax (VAT), which led in some cases to a broadening of the base of indirect taxation. The base of direct taxes was typically not broadened significantly.

Administrative reform, when it did occur, was more successful with tax administration than with public expenditure management. The most substantive reforms were undertaken by the countries that already had well-established basic systems in place before the adjustment efforts began; those countries where tax administration and public expenditure management were weak to begin with did not generally make major reforms to their administrative systems during the adjustment period. In some countries, these inadequacies hampered the successful implementation of expenditure and tax policy reforms, especially base-broadening measures such as the VAT.

Evaluating Whether Fiscal Reforms Promoted Growth

The model in Section II provides a basic standard of comparison that may be used in evaluating the extent to which fiscal reforms in the eight countries promoted growth. However, a meaningful evaluation has to take account of a country’s starting point, as well as the constraints it faced as a result of its existing administrative and other systems, and the size of the quantitative fiscal adjustment it had to undertake. If no consideration were given to the initial impediments to high-quality adjustment, one might conclude that the initial adjustment was not optimal. However, the type of adjustment that did occur may have been necessary precisely because of the need to lay the administrative groundwork for a subsequent higher-quality adjustment. The following criteria embody both the desideratum of the model and these more practical considerations:

  • the extent to which expenditures with a high social rate of return were protected and inefficient changes in the mix of expenditure avoided (in other words, the extent to which productive expenditure was maintained, despite the need for a decline in total expenditure);
  • how quickly the countries started to address more fundamental issues in expenditure and public enterprise reform;
  • how quickly they addressed basic tax reform issues; and
  • how quickly administrative systems were reformed so as to support more efficient expenditure choices and better revenue-raising policies.

A brief summary of the individual country experiences shows that, among countries that made a major adjustment to their primary deficit, Chile stands out. It not only achieved a huge quantitative fiscal adjustment, it also dramatically transformed its public sector. Public expenditure was reduced, but the most productive expenditures were protected. The tax system was overhauled early in the adjustment effort: the need to rely on comparatively distortional taxes was lessened by the introduction of a broadly based VAT, and marginal effective rates of taxation of business income were substantially reduced. The public enterprise sector was drastically shrunk through privatization.

Mexico’s reform was almost as broad in scope as Chile’s, although it had difficulty maintaining the level of some productive expenditure during the adjustment efforts. Morocco had successes in various areas, although the size of the civil service remained excessive and progress in privatization was relatively limited.

Among the more moderate quantitative fiscal adjusters, Thailand also implemented some important reforms, although these were not as far reaching as those of Chile. Thailand’s rapid growth allowed it to increase productive public expenditure, and distortional features of the tax system were reduced. Ghana made significant progress in expenditure policy and administrative reform, albeit from a low base. Bangladesh also made progress in reforming the tax structure. Much less progress was made by India in this area. In both India and Bangladesh, administrative deficiencies and problems with expenditure priorities remained largely unaddressed during the adjustment process, although India’s adjustment efforts have only just begun. Senegal’s reform effort was largely unsuccessful in fostering a growth-oriented fiscal policy.

Lessons from Experience

Section IV draws lessons from the experiences of the eight countries in the implementation of their public sector reforms. In particular, the study suggests the following.

  • Stabilization need not play havoc with a growth-friendly fiscal policy regime. It is possible to shelter most expenditures that exhibit a high social rate of return.
  • Often there is a sequencing problem, where deficiencies in public expenditure management and tax administration initially require a rather crude approach to expenditure restraint and prevent the speedy reform of the tax system. Some expenditure cuts can, however, be damaging if not reversed in due course. To facilitate their reversal and to improve expenditure allocation, immediate action to reform both tax administration and public expenditure management is necessary. Whatever the pattern of expenditure reduction or tax increases initially adopted, structural reform will, for most countries, be an essential part of growth-oriented fiscal adjustment.
  • The countries that either had basically good public expenditure management systems at the outset of the adjustment process or substantially improved a deficient system were more successful in protecting expenditure with a high social rate of return.
  • Major reform of a tax policy regime requires either a reasonably well-functioning tax administration or a concurrent effort at administrative reform. At the same time, tax design must be cognizant of the limitations of tax administration.
  • Substantial increases in revenue are possible without increases in average tax rates.
  • Some basic structural reforms, such as civil service and enterprise reforms, important as they may be, cannot realize substantial budgetary saving in the short run. Reform in these areas should nonetheless start as soon as possible so as to achieve budgetary saving and to enhance growth prospects over the medium term.

The study also has the following implications for the design of adjustment programs.

  • Given the crucial role of administrative reform in the successful implementation of tax and expenditure policy reform, there is a need for closer integration of improvements in tax administration and public expenditure management with basic program design at the outset of IMF-supported programs. However, a significant increase in the application of conditionality to administrative reforms is probably not feasible.3
  • Tax policy measures are more easily made the object of conditionality than are measures of administrative reform. The application of conditionality to the composition of expenditure may, however, raise sensitive issues, which in some cases make it impracticable.
  • More emphasis on the implications of fiscal adjustment for growth will require that increased attention be paid to the composition of expenditure.
  • Similarly, IMF-supported programs should be sensitive to the risk that the initial heavy emphasis on expenditure restraint may become permanent and, by suppressing growth-fostering expenditure, may damage a country’s growth prospects.
  • A reorientation of social expenditure toward the primary levels (for example, primary education and public health and clinics) is doubly desirable: it yields positive effects on human capital formation and reinforces the social safety net, thus supporting the income and well-being of the poor.
  • Certain reforms can entail, at least in principle, a trade-off between deficit reduction now and deficit reduction in the future, and this can be an issue when there is some flexibility in the timing of fiscal adjustment. Consequently, in the design of programs there is a need to view the budget increasingly in a multiperiod rather than a single-period framework.

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