Chapter

III. Country Experiences with Public Sector Reform

Author(s):
George Mackenzie, Philip Gerson, and David Orsmond
Published Date:
April 1997
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The objective of this section is to assess the growth-fostering characteristics of the public sector reforms undertaken by eight countries during a period normally of about 15 years (usually 1978–93). Section II sketched the outlines of a growth-promoting public sector. However, a sketch of the final destination or target of economic policy cannot necessarily serve as a road map that explains how to get there. In interpreting the actual policies implemented by the eight countries, one must recognize that, even if growth were the paramount policy objective, all the countries faced institutional constraints that limited their ability, at least in the short run, to pursue a growth-oriented fiscal policy.

These constraints are examined below, and some basic features of the adjustment common to the eight countries are set out. The section then appraises the growth-promoting character of the public sector reforms adopted by each of the eight countries (using the model in Section II), while at the same time taking into account the constraints the countries faced.

To speak first of methodology, for each country, the period under review is divided into three sub-periods: a preadjustment period and two subsequent adjustment periods. The latter two periods can be distinguished by the intensity and type of fiscal (and other) reform efforts undertaken (Table 1).27 The adjustment periods tend to be about six years long and were selected to coincide with a substantial adjustment effort, often prompted by a balance of payments crisis. Each country’s adjustment efforts were supported by at least one arrangement with the IMF.

Table 1.Designation of “Adjustment Periods”
CountryPreadjustmentAdjustment IAdjustment II
Bangladesh1978/79-1979/801980/81-1984/851985/86-1993/94
Chile1972-731974-821983-89
Ghana1978-821983-861987-91
India1978/79-1990/911991/92-1992/93
Mexico1978-19821983-871988-93
Morocco1978-801981-851986-93
Senegal1979/80-1982/831983/84-1987/881988/89-1993
Thailand1978-801981-861987-93

The analysis here is concerned mainly with developments at the central government level; where possible, the study uses data on the financial operations of the consolidated central government.28 It also deals with some aspects of reforms undertaken in the public enterprise sector, mainly with a view to assessing their impact on the central government’s budget.

Box I.Overview of Adjustment in the Eight Countries

Bangladesh. After an extended period in the 1970s of political turmoil, heavy government intervention in the economy, and poor growth performance, the government initiated an ambitious growth-oriented strategy in 1979. This strategy targeted increased saving and investment combined with extensive structural reforms; in the event, these targets were missed by wide margins on account of adverse shocks and policy slippages, so that macroeconomic imbalances continued to increase. A second phase of adjustment started in the mid-1980s; the combination of fiscal tightening and structural reforms, in particular unification of the foreign exchange market and trade liberalization, succeeded in reducing inflation and improving the external current account. Real per capita GDP growth remained low, however, reflecting continuing serious structural distortions.

Chile. A large drop in output in 1973 accompanied by hyperinflation led to the adoption of an economic program in 1974–75 involving a sharp tightening of fiscal policy, large corrective price increases, a flexible exchange rate policy, and significant structural reforms, including a reversal of the previous expropriation of enterprises. Aiming to reduce inflation to world levels, the government fixed the exchange rate in mid-1979, but the inconsistency of this policy with wage indexation and ongoing inflation in nontradables led to a sharp real effective appreciation of the peso and a boom in consumption and imports financed by large external borrowing, accompanied by lax control of banking activity. A drop in the price of copper and an abrupt decline in access to external financing in the wake of the debt crisis led to a severe recession and a banking crisis in 1982-83. The medium-term stabilization and adjustment program adopted in 1983 included a flexible exchange rate, eliminating mandatory wage indexation, restoring the financial system, and reducing the fiscal deficit. Further privatization of public enterprises was carried out, and there was a major reform of the social security system. Since 1985, Chile has enjoyed strong economic growth.

Ghana. The Economic Recovery Program (ERP) introduced in 1983 followed a protracted period of economic decline caused by massively interventionist policies, widespread price controls and exchange restrictions, and a large decline in the terms of trade. The first phase of the ERP (1983-86)—based on restrained financial policies, elimination of widespread domestic price controls and other regulatory restrictions, and large devaluations to correct a severely overvalued exchange rate—succeeded in eliminating the most severe macroeconomic imbalances. At the same time, a resumption of official external financing supported a pickup in public investment. The second phase (1987-91) completed the comprehensive liberalization of the trade and exchange system and featured a reform of the financial system as well as more vigorous efforts to restructure and privatize a large public enterprise sector (see Hadjimichael and others, 1996).

India. In the second half of the 1980s, expansionary fiscal policies, including stepped-up public investment, brought about some pickup in growth but also contributed to wider external current account deficits and rising external debt. Shocks to the balance of payments, associated with the 1990 Middle East crisis, and internal political problems triggered an outflow of capital and a major liquidity crisis in early 1991. The new government responded by depreciating the rupee, raising interest rates, cutting the public sector deficit, and implementing significant, but incomplete, structural reforms—most notably industrial deregulation, partial trade liberalization, and an opening up to foreign investment. In response, the balance of payments position strengthened substantially during 1992-94, aided by capital inflows (see Chopra and others, 1996).

Mexico. After the 1982 debt crisis and a cutoff from external financing, Mexico introduced an adjustment strategy based on fiscal tightening, frequent adjustments of the exchange rate, some moderate privatization, and, after 1985, trade liberalization. Inflation remained high, however, and growth and private investment stagnated. A new disinflation strategy, introduced in December 1987, was based on further fiscal tightening and the use of the exchange rate as the main nominal anchor supported by income policy agreements between labor, business, and the government. Together with a successful restructuring of external debt, this strategy slowed inflation and paved the way for a resumption of access to international financial markets, and a surge of capital inflows. However, the real exchange rate appreciated, private saving declined sharply, and a large external current account deficit emerged, leading eventually to a new crisis in late 1994.

Morocco. During the 1970s, expansionary financial policies—prompted by the 1974 phosphate boom—resulted in large fiscal and external current account deficits and a rapid buildup of external debt. These imbalances added to a wide range of structural weaknesses. A succession of adverse exogenous shocks critically weakened the external position, leading to debt-servicing difficulties by the early 1980s. The subsequent adjustment strategy had several phases: through 1985, the emphasis was on fiscal adjustment through large cuts in capital expenditure (with most of the adjustment occurring in 1983-85), tight monetary policy, and active exchange rate policy to improve competitiveness; the next phase (1986–93) emphasized greater trade liberalization and deregulation, extensive tax reforms, financial market reform, and reforms of pricing policies and state enterprises. In this phase, the nominal exchange rate was anchored to a currency basket, apart from small step devaluations in 1990 and 1992.

Senegal. During the late 1970s and early 1980s, a succession of droughts, deterioration of the terms of trade, and inappropriate policies resulted in large fiscal and external current account deficits and a rising external debt. After a period of unsuccessful stabilization efforts, sustained adjustment was achieved during 1983-88, founded on significant fiscal consolidation and structural reforms. Together with more favorable terms of trade and weather conditions, this led to an improved economic performance. But the gains were not long-lasting: in 1989-93, financial policies weakened, structural reform stalled, and external competitiveness continued to deteriorate in the face of adverse terms of trade shocks. In early 1994, adjustment efforts were renewed, and the CFA franc was devalued by 50 percent (see Hadjimichael and others, 1996).

Thailand. The expansionary public sector policies of the late 1970s resulted in growing fiscal and external imbalances and left the Thai economy in a vulnerable position when it was hit with the external shocks of 1980-82. Following a brief period when adjustment measures produced only marginal improvements, a major adjustment effort was undertaken in 1984-85, when the baht was devalued, significant fiscal consolidation began, and a decisive change was made in the orientation of trade and industrial policies toward export-led growth. Since 1987, Thailand has been in the midst of an investment- and export-led economic boom with large accompanying capital inflows (see Kochhar and others, 1996).

Initial Constraints and Pattern of Adjustment

Initial Conditions

At the outset of adjustment, all eight countries were experiencing macroeconomic imbalances of varying degrees of severity (Box 1). The need for substantial fiscal adjustment was evident because the primary deficit—the difference between noninterest expenditure and revenue—averaged 6.0 percent of GDP (varying from 3.7 percent in Ghana to 10.2 percent in Bangladesh).

There were signs of serious structural problems as well. In Bangladesh, Ghana, and India, deficiencies in tax administration had contributed to a heavy reliance on taxes that are comparatively simple to administer—specific excise and international trade taxes—rather than on more broadly based—and allocationally efficient—taxes.29 Effective tax rates were high, mainly to compensate for the narrow base of the system, a problem aggravated in India and Bangladesh by the impact of numerous ad hoc exemptions and preferences. These and other features of the tax system complicated its administration and created distortions. Further, the low revenue yield limited the opportunity of these countries to undertake necessary productive expenditure, and weak public expenditure management—and inefficient public sector enterprises—led to wasteful subsidies and diminished the productivity of the expenditure that could be financed. Education and health expenditures were low overall and did not emphasize the primary level sufficiently, so that a large part of the populace was without even basic medical care. In addition, consumer subsidies for basic foodstuffs and other goods were not well targeted.

The public sector in some of the other countries during the preadjustment period had similar features. A weak tax administration in Senegal contributed to a heavy reliance on international trade taxes, although an effort had been taken to broaden the tax base with the introduction of a VAT. Expenditure was high, in part because of excessive salaries and employment in the civil service and because of high but relatively unproductive capital expenditure. In Mexico a large public enterprise sector, despite being protected by substantial tariff and nontariff barriers, was proving to be a significant drain on the budget. Although a VAT had been introduced, its structure made it difficult to administer. The base of the system as a whole was not as broad as it could be, and evasion was a serious problem.

Morocco’s expenditure was inflated at the outset of the first adjustment period, having increased following the phosphate boom in the early 1970s but not having declined when the terms of trade deteriorated after 1975. Ad hoc tax exemptions and high import tariffs further complicated a complex tax system that suffered from low revenue elasticity and hampered tax administration. Weaknesses in budget programming and monitoring, especially of capital expenditure, contributed to the public sector’s structural deficiencies.

In Chile, a deterioration in the terms of trade exacerbated a weak fiscal position. High rates of inflation eroded the ratio of revenue to GDP, and the ratio of expenditure to GDP was high. Import restrictions had proliferated, and the nationalization of most industrial enterprises entailed a drain on the budget because of the subsidies required.

Finally, in Thailand, defense and other expenditure had been stepped up in the preadjustment period. The tax base had eroded through extensive reliance on exemptions, and the main sales tax was highly cascaded. Import tariffs were numerous and often specific, and they entailed fairly high average effective rates of protection. That said, Thailand did not have structural problems as severe as some of the other countries.

Quantity and Pattern of Adjustment

Quantitative Adjustment

All countries reduced the size of their primary deficit over the two adjustment periods combined (Table 2; Figures 1, 2, and 3); the average decline was 6.1 percent of GDP. The largest declines were recorded in the countries that began their adjustment efforts with the largest primary deficits (Bangladesh, Chile, Mexico, and Morocco). More than half of the average decline of 4 percent of GDP occurred during the first adjustment period, reflecting the emphasis initially placed in some countries on restoring macroeconomic stability.30

Table 2.Summary of Adjustment Efforts(In percentage points of GDP)
LevelChange1
CountryInitialEnd of periodOverallAdj. 1Adj. II
Primary balance
Bangladesh-10.2-4.65.63.81.8
Chile-6.12.28.32.06.3
Ghana-3.7-2.61.10.40.8
India-4.5-1.72.82.8
Mexico-6.73.410.010.0
Morocco-7.83.010.74.46.4
Senegal-5.6-1.83.86.3-2.5
Thailand-3.82.96.72.24.5
Average-6.00.16.14.02.5
Noninterest expenditure
Bangladesh18.815.9-2.9-3.80.9
Chile34.919.2-15.7-1.3-14.4
Ghana9.716.36.67.2-0.6
India18.015.9-2.1-2.1
Mexico222.413.7-8.7-8.6-0.1
Morocco29.923.9-6.0-5.8-0.2
Senegal24.618.0-6.6-7.71.1
Thailand18.815.6-3.1-1.6-1.5
Average22.117.3-4.8-3.0-2.1
Revenue3
Bangladesh8.611.32.6-0.12.7
Chile28.821.4-7.40.7-8.1
Ghana6.013.87.77.60.1
India13.514.20.70.7
Mexico15.717.01.31.4-0.1
Morocco22.126.84.7-1.46.2
Senegal19.016.1-2.8-1.4-1.4
Thailand14.918.53.60.63.0
Average16.117.41.31.00.3
Sources: IMF, Government Finance Statistics Yearbook (various issues); and various IMF Staff Country Reports.

Positive figures represent improvements in the primary balance.

Includes exchange rate subsidies between 1982-87.

Excluding grants.

Sources: IMF, Government Finance Statistics Yearbook (various issues); and various IMF Staff Country Reports.

Positive figures represent improvements in the primary balance.

Includes exchange rate subsidies between 1982-87.

Excluding grants.

Figure 1.Primary Balance

(In percent of GDP)1

Sources: IMF, Government Finance Statistics Yearbook (various years); and various IMF Staff Country Reports.

1For Bangladesh, India, and Senegal, data refer to fiscal years. Averages over subperiods are shown as bars.

Figure 2.Expenditure Excluding Interest Payments

(In percent of GDP)1

Sources: IMF, Government Finance Statistics Yearbook (various years); and various IMF Staff Country Reports.

1For Bangladesh, India, and Senegal, data refer to fiscal years. Averages over subperiods are shown as bars.

Figure 3.Total Revenue Excluding Grants

(In percent of GDP)1

Sources: IMF, Government Finance Statistics Yearbook (various years); and various IMF Staff Country Reports.

1For Bangladesh, India, and Senegal, data refer to fiscal years. Averages over subperiods are shown as bars.

The relative emphasis of the adjustment effort on expenditure or revenue measures changed over time. The adjustments in the first period were principally undertaken through a reduction in noninterest expenditure (which declined by an average of 3 percent of GDP, compared with an average increase in revenue of just 1 percent).31 In contrast, the reductions in the primary deficit (for some countries, increases in the primary surplus) in the second period relied more on increasing the revenue share in GDP and less on cuts in expenditure, Chile being the exception.32 The largest decreases in the share of non-interest expenditure in GDP during the adjustment efforts were in the countries that initially had the highest ratios of expenditure to GDP (Chile, Mexico, Morocco, and Senegal). In contrast, countries with a low initial ratio of revenue to GDP were not necessarily the ones that had a large increase in the revenue share.

Pattern of Adjustment

The adjustments made to each of the components of fiscal policy and administration are summarized in Box 2, which draws heavily on the detailed and more country-specific accounts of the public sector reforms presented in Appendix I.33 This summary indicates that, taking the adjustment period as a whole, there are some clear differences in the quality of the fiscal adjustment undertaken in the eight countries. However, the data also suggest a fairly common pattern of adjustment in the early years.

As noted previously, noninterest expenditure typically bore the brunt of adjustment, especially during the first adjustment period. A greater contribution from the revenue side could, in principle, have been had by implementing one or more of three changes to the tax structure:

  • increasing the rates of existing taxes;
  • widening the base of existing taxes; and
  • introducing new and more broadly based taxes.

The first option was unlikely to raise significant revenue, since tax rates were already high and probably quite distortional.34 The possibility that the second option could raise significant amounts of revenue was limited by the difficulty of taxing agriculture and services, and by the increased cascading that broadening the base of the existing sales tax would entail.

This left the third option—introducing new and more broadly based taxes, such as the VAT. Mexico and Senegal had already introduced a VAT; and Chile introduced a VAT early in the first adjustment period. Although Chile experienced a substantial increase in sales tax receipts (5 percent of GDP), the increase in Mexico and Senegal was more modest; the differences can be explained in part by the simplicity of design of the Chilean VAT and the comparative efficiency of Chile’s tax department. For various reasons—including the complex preparations necessary for the successful introduction of a VAT—none of the five remaining countries introduced a VAT during the first adjustment period. Of these countries, only Ghana substantially increased revenue in the first adjustment period, and this was mainly attributable to the effect of the exchange rate devaluation on customs, export, and excise tax receipts rather than to fundamental tax reform.

The limited scope for increasing revenue explains why the bulk of the adjustment in the first period fell on noninterest expenditure. These expenditure cutbacks were not usually spread equally across all economic categories. In particular, the scope for quick but substantial and lasting reductions in the civil service wage bill was limited (Figure 4). Wage freezes were commonly tried, only to be at least partially reversed subsequently. Hiring freezes were also ineffective. The lack of success and unsustainability of these policies stemmed in part from the difficulties they created for efforts to fill senior and professional positions in the civil service. Employment reductions would prove expensive at the outset because of the need to make severance payments. A policy to reduce employment at the unskilled level, combined with increased pay and employment for skilled workers, was the most growth-enhancing approach (and was followed in Chile toward the end of the first adjustment period and in Ghana during the second).

Figure 4.Wages and Salaries Expenditure

(In percent of GDP)1

Sources: IMF, Government Finance Statistics Yearbook (various years); and various IMF Staff Country Reports.

1For Bangladesh, India, and Senegal, data refer to fiscal years. Averages over subperiods are shown as bars.

Some success was achieved in cutting back subsidies and transfers; better targeting of consumer subsidies toward the poor contributed to this result. Similarly, transfers to enterprises could be decreased through adjustment of their tariffs, with an associated decrease in the degree of distortion to relative prices. Reduced transfers to enterprises made possible by efficiency gains, however, typically took considerable time and could not be relied on for substantial budgetary saving, at least in the short run (Table 3 and Figure 5).

Table 3.Enterprises and Indicators of Reform(In percent of GDP, unless otherwise noted)
CountryPreadjustmentAdjustment IAdjustment II
Share of value added of public enterprises in nonagricultural GDP
Bangladesh3.515.05.4
Chile39.014.112.6
Ghana7.7215.215.7
India18.93
Mexico14.814.59.04
Morocco23.517.717.85
Senegal11.16.4
Thailand6.2
Overall balances of public enterprises before transfers
Bangladesh-1.61-4.1-1.84
Chile5.89.9
Ghana-3.30.92.45
India-2.53
Mexico-0.33.43.14
Morocco-4.9-3.9
Senegal-9.0-1.5
Thailand-4.40.5-1.54
Privatization initiatives (number of public enterprises)6
Bangladesh2353
Chile59654818
Ghana22063
India236
Mexico1,155538402
Morocco62035
Senegal12047
Thailand572
Sources: World Bank (1995a); and various IMF Staff Country Reports.

In 1981.

In 1984.

In 1989.

In 1991.

In 1990.

For preadjustment period, number at outset of the adjustment period; for others, number privatized or liquidated at end of adjustment periods I and II.

Sources: World Bank (1995a); and various IMF Staff Country Reports.

In 1981.

In 1984.

In 1989.

In 1991.

In 1990.

For preadjustment period, number at outset of the adjustment period; for others, number privatized or liquidated at end of adjustment periods I and II.

Figure 5.Subsidies and Current Transfers Expenditure

(In percent of GDP)1

Sources: IMF, Government Finance Statistics Yearbook (various years); and various IMF Staff Country Reports.

1For Bangladesh, India, and Senegal, data refer to fiscal years. Averages over subperiods are shown as bars.

Given these rigidities and the need to realize quickly the required level of budgetary saving, two vulnerable forms of expenditure were cut by virtually all countries: expenditure on other current goods and services, and capital expenditure (Figures 6 and 7). These cuts would not have much impact on a country’s growth prospects if the expenditures eliminated were wasteful (had a low rate of return). That said, a decline large enough to cut deeply into productive capital expenditure would eventually reduce medium-term growth prospects if slow progress in fiscal reform meant that these reductions could not be reversed. Similarly, over time an inadequate level of operation and maintenance expenditure would rapidly reduce the productivity of the public capital stock, while cuts in other goods and services expenditure would contribute to a growing imbalance between labor and materials and supplies.

Figure 6.Other Current Goods and Services Expenditure

(In percent of GDP)1

Sources: IMF, Government Finance Statistics Yearbook (various years); and various IMF Staff Country Reports.

1For Bangladesh, India, and Senegal, data refer to fiscal years. Averages over subperiods are shown as bars.

Figure 7.Capital Expenditure

(In percent of GDP)1

Sources: IMF, Government Finance Statistics Yearbook (various years); and various IMF Staff Country Reports.

1For Bangladesh, India, and Senegal, data refer to fiscal years. Averages over subperiods are shown as bars.

Establishing Criteria for Assessing the Growth-Fostering Character of Fiscal Policies

In light of the impediments that countries confronted in their efforts to reform the public sector, and their different starting points, it would not be sensible to judge a country’s efforts on the basis of how close it had come, by the end of the adjustment period, to some ideal or model of a growth-fostering public sector. Instead, a country’s efforts should be judged by the direction that reform took, by the depth of reforms, and by the degree to which reforms were implemented in the right sequence. The growth-enhancing nature of a country’s adjustment efforts would depend considerably on how quickly it was able to undertake reforms that could counteract the effects of the initial cuts in expenditure on capital and other goods and services. More generally, a country’s efforts would be judged on the basis of how far they took the economy down the road to the ideal. The countries with the best growth adjustment profile, then, would be those that, from the start of the adjustment process:

  • reallocated expenditure priorities toward, or at least preserved, the most productive areas, especially for operation and maintenance and within the capital budget;
  • minimized reliance on indiscriminate expenditure cuts across broad expenditure categories such as other current goods and services, which would typically prove to be temporary;
  • took early action to reform the tax system;
  • strengthened expenditure and tax administration so as to improve the efficiency of expenditure, increase the tax yield over time, and allow for the adoption of a less distortive tax system; and
  • undertook reform of public enterprises to eliminate uneconomic subsidies and increase the enterprises’ operational efficiency.

Assessing the Growth Conduciveness of Public Sector Reform

To some extent, all the countries adopted policies along the lines described above. There are, nonetheless, striking differences among them. For a variety of reasons—most important, the influence of other macroeconomic and structural policies, and the lags between public expenditure on human and physical capital and its effect on output—these differences cannot be said to “explain” differences in the countries’ actual growth performances during the adjustment periods (Figure 8). As emphasized in Section II, a general quantification of the impact of “quality” fiscal adjustment is not feasible.

Figure 8.Average Real GDP Growth and Average Real Per Capita GDP Growth

Source: IMF, International Financial Statistics (various years)

Box 2.Overview by Type of Fiscal Component

Expenditure

Directly Productive Expenditure. The share of total education expenditure in GDP decreased in some countries during the adjustment period, but the declines were proportionately less than that for total noninterest expenditure. Of particular importance from the growth perspective, in Chile and Thailand, primary education standards were protected and improved. This was not the case in most of the other countries.

The trends in health expenditure were similar to those in education. The share of total health expenditure in GDP was not substantially reduced during the adjustment efforts, despite the decrease in total noninterest expenditure. Although in general there was some improvement in primary care, the countries with the poorest health indicators at the outset of the adjustment efforts—such as Bangladesh, Ghana, and Senegal—were not those that made the most progress in increasing the focus on primary health expenditure.

Government investment often experienced a disproportionately large share of the expenditure adjustment effort, especially during the initial years. Chile, Ghana, Morocco, and Thailand appear to have best preserved investment in the more productive areas. Almost every country increased somewhat the level of government investment in the second adjustment period, in reflection of growing bottlenecks and the increased availability of resources.

Indirectly Productive Expenditure. The civil service wage bill was generally protected from the bulk of the decrease in noninterest expenditure. Chile and Ghana were the only countries that initiated a substantial reform of the civil service. Morocco and Senegal, which had large wage bills at the outset of adjustment, also had large wage bills at the end of the adjustment periods. Wage freezes were a popular policy but generally proved to be unsustainable, sometimes because of the growing unattractiveness of government employment for skilled employees. Although the rate of increase in employment was typically slowed, declines in the number of civil servants during the adjustment period—which have a better chance than wage freezes of being permanent—were uncommon. There was no clear trend in defense expenditure—a large component of which is wages—except in Chile, Morocco, and Thailand, where it declined.

Commodity subsidies were reduced in the course of the adjustment efforts, and in nearly all countries there appears to have been some sensitivity to protecting the poor during these efforts. Finally, other current expenditure on goods and services took a disproportionately large share of the adjustment in total expenditure; within this category, operations and maintenance expenditure increased in Bangladesh and Ghana and decreased in India, Morocco, and Senegal (the five countries where data were available).

Revenue

The top personal income tax rate was reduced over the adjustment periods, and the number of tax brackets were rationalized. Corporate income tax rates were also reduced; they were unified in some countries (Chile, Morocco, and Thailand), but their structure remained complex in others (Bangladesh, Ghana, and India). Efforts in most countries to widen the personal and corporate tax base and thereby reduce the distortive aspects of the tax were confined to the introduction of a minimum corporate tax and—in Chile, Mexico, and Morocco—to a rollback of tax holidays. Exemptions and preferences in the income tax code generally remained prolific.

Reforms of indirect taxation were more substantial. In particular, Bangladesh, Chile, Morocco, and Thailand all introduced value-added taxes (VATs), but only in the case of Chile was this done early in the adjustment period. Following the substitution of the VAT for other forms of sales taxes, receipts (as a share of GDP) from domestic taxes tended to increase. The VATs in Bangladesh, Morocco, and Senegal excluded the retail or at least part of the wholesale sector (or both), while those in Morocco, Senegal, and initially that in Mexico had up to five rates, which made them more distortive, more difficult to administer, and less elastic. In Ghana and Morocco, excise taxes remained important sources of revenue, particularly those on petroleum. There was usually a switch from specific to ad valorem excise rates, which increased their elasticity, but excise tax structure remained complex in Bangladesh, India, Morocco, and Senegal.

The dispersion and maximum rates of import duties declined in all countries—implying some reduction in their complexity and distortive aspects—though the extent and pace of adjustment varied (being most substantial and rapid in Chile, India, Mexico, and Morocco). Export and other international taxes were virtually abolished during the adjustment efforts, except in Ghana.

Administration Efforts

In Chile, India, Mexico, Morocco, and Thailand, the public expenditure management system was comparatively strong in many if not all respects. In Bangladesh, Senegal, and Ghana, public expenditure management was comparatively weak in virtually all respects; of this group, only in Ghana was there some improvement during the adjustment effort. The most substantive improvements were undertaken by countries that had already achieved an effective basic system, characterized by the use of a “top down” approach to establishing expenditure aggregates, a primary role of the Ministry of Finance in the budget process, reliance on tight expenditure control mechanisms during the fiscal year, and the regular compilation of transparent fiscal accounts. Granting the difficulty of assessing the role of public expenditure management in sustaining productive expenditure, it appears that countries with strong public expenditure management systems had more efficient expenditure programs.

More efforts were undertaken to improve tax and customs administration systems than public expenditure management systems. As with public expenditure management, the most substantial reforms were undertaken in Chile, Mexico, and Thailand, which started with a solid basic system at the outset of the adjustment effort, and in Ghana, which, like Mexico, had a high degree of government commitment. Bangladesh and India had great need yet showed little improvement in their tax and customs administration systems, and in Senegal some reform efforts were initiated but were not sustained. The tax and customs administration system was variously compromised in some countries by external factors such as civil service policies, provision of supplies, the tax code, and the revenue-sharing and constitutional arrangements.

Enterprise Reform

Although the data were incomplete, the operating position of the public enterprise sector improved, and the cost of budgetary support declined, during the adjustment period in all countries but Bangladesh. Enterprise reform was typically limited to increases in tariffs during the initial years of the adjustment period; reforms to increase efficiency were generally delayed until the second adjustment period. Reform took a variety of forms including outright privatization, establishment of performance contracts for enterprises remaining in the public domain, and private sector involvement in public enterprise operations. The evidence did not suggest a general rule concerning the relative success of one of these approaches to enterprise reform over another, although all countries undertook at least some steps toward privatization.

A qualitative assessment can be made, however, of the components of public sector reform in the eight countries, using the criteria just described. To facilitate this assessment, the group is split into two: the countries that undertook the largest fiscal adjustment (as measured by the decline in their primary deficit), which typically were also the countries that had the highest initial level of expenditure and largest initial primary deficit (Chile, Mexico, and Morocco); and the countries that undertook more moderate adjustments in their primary balance (Bangladesh, Ghana, India, Senegal, and Thailand).

Major Fiscal Adjusters

The structure of the public sector in Chile was transformed during the adjustment period. On the expenditure side, capital expenditure was cut severely at the outset of adjustment. But much of this was the result of the replacement of public housing investment programs by housing subsidies (a current expense). The decline was at least partially reversed during the second period to alleviate growing bottlenecks in infrastructure, and capital expenditure on schools and roads increased. Education and health expenditures, for their part, were relatively protected—indeed, spending on primary and secondary education increased at the outset of the adjustment period—and the country’s education and health standards, which were high to begin with, remained so (Figures 9 and 10). Salaries of teachers and health workers did decline in real terms during the second adjustment period, however.

Figure 9.Indicators of Education Expenditure and Quality

Sources: IMF, Government Finance Statistics Yearbook (various years); various IMF Staff Country Reports; and World Bank, Social Indicators database.

Figure 10.Indicators of Health Expenditure and Quality

Sources: IMF, Government Finance Statistics Yearbook (various years); various IMF Staff Country Reports; and World Bank, Social Indicators database.

The pension reform of 1981, which was unique to Chile, stimulated the development of capital markets and reduced labor costs.35 The gradual elimination of public employment programs in the course of the 1980s, as the country recovered from the severe recession earlier in the decade, contributed to a substantial decrease in transfers and subsidies during the second adjustment period (Figure 5). The public works program offering employment at the minimum wage had a substantial coverage at its peak in the early 1980s, and the evidence suggests that it was well targeted.36

Chile was one of only two countries—the other was Ghana—to achieve a substantial restructuring of the civil service. The wage bill was reduced through wage restraint, measures to cut employment, and the devolution of social expenditure to the local authorities, while at the same time salary differentials were widened (see Figure 4). These latter measures began to pay off during the second adjustment period, when the wage bill declined sharply. The transformation in the structure of expenditure just described was facilitated by a public expenditure management system that was functioning well at the outset and was strengthened during the adjustment period.

The Chilean tax system was radically reformed. In particular, the relative efficiency of the tax department made possible the early introduction of a broadly based VAT, which yielded substantial revenue and replaced a cascading sales tax. Similarly, early reform of business income taxation and tax incentives substantially reduced the cost of capital and the dispersion of effective tax rates. The tariff structure was quickly and radically reformed so that the range of effective rates of protection was drastically reduced (Velasco, 1994). The overall reduction in tax collections in the second period—to which the reform of social security arrangements and a reduction in the standard VAT rate contributed—did not reflect any erosion in the statutory base, and compliance remained relatively high. By reducing the average rate of business income taxation and the spread of marginal effective rates of taxation, and thereby sending a signal to investors that the government was pro-business, these changes, in and of themselves, probably promoted growth. Finally, enterprises were restructured, and the structure of their prices rationalized, as a basic preparatory step for the massive privatization program that began right at the outset of the adjustment period.

The extent of reform in Mexico rivaled that in Chile, particularly as regards privatization. With the huge cuts in total expenditure of the federal government, however, Mexico did not maintain the share of primary education expenditure in GDP, even though the share of tertiary education expenditure was increased. But Mexico had already achieved a high level of coverage of the school-age population by the start of the adjustment efforts, and there was no significant change in primary enrollment rates or in pupil-teacher ratios over the period. Similarly, Mexico’s health indicators were generally good, but at the end of the adjustment period 11-21 percent of the population still lived an excessive distance from a health center. Capital expenditure declined throughout the adjustment period, and the decline in both public works expenditure and education and health expenditure in the first adjustment period was particularly marked. Subsidies and transfers to enterprises also declined, largely because of the scope of the privatization program, which, unlike the Chilean program, only started in earnest in the second adjustment period. The relatively small reduction in the wage bill was mainly effected by real average wage declines; a bolder attack on excess civil service employment could have been more productive.

The major issue for Mexico was perhaps not what happened to the composition of expenditure, but to its level. Mexico ended its adjustment period with the lowest noninterest expenditure of the group. It is, nonetheless, very difficult to infer that public expenditure was too low. The cuts in capital expenditure might have fallen on projects with a low rate of return. Other current goods and services expenditure declined to only 1 percent of GDP in the first adjustment period, and did not recover. Its level was far below that in other countries, but it had always been low, and the figure might reflect classification errors, since it is essentially a residual. That said, it is quite possible that more revenue adjustment, for a given deficit target, might have permitted an increase in productive expenditure in a number of areas.

The Mexican tax system was sufficiently broadly based, at least in potential, to have made such a strategy possible. The VAT reform arguably reduced the distortions of the old sales tax, although its fairly extensive use of zero-rating and initial reliance on multiple rates both reduced its effective base and increased the resources necessary to administer it. Mexico’s reform of its corporate income tax during the first adjustment period may have been less substantial than it appeared. It did replace a progressive tax with 11 rates with a unified system, albeit with preferential rates for previously favored sectors. The elimination of the old, progressive system would also have eliminated the artificial incentives to split corporate assets. Because the top rate applied at a relatively low level of income, however, the impact of the reform on corporate structure was not likely to be great. Perhaps more important as a spur to efficient investment was the simplification and reduction in tax holidays and incentives that took place later in the adjustment effort. Like Chile, Mexico implemented a comprehensive tariff reform early in its adjustment efforts. Improvements at various stages of the administrative process, in addition to their impact on revenue yield, contributed to a more stable business climate by making tax administration more predictable.

The quality of expenditure adjustment in Morocco was uneven. Expenditure on health and education, which was fairly high at the outset of its adjustment efforts, was relatively well protected, albeit skewed toward the tertiary level in the health sector. The share of primary education did not fall appreciably, although enrollment ratios did, contributing to the decline in the pupil-teacher ratio. Civil service employment remained excessive, although average real wages declined. Commodity subsidies were better targeted, and improved public expenditure management appraisal procedures arguably increased the efficiency of capital expenditure, despite its sharp decline from a very high level at the beginning of the adjustment period.

Like the other countries, Morocco unified its corporate income tax, although its failure to eliminate the temporary exclusion of corporate agricultural income (together with the continued exclusion of agricultural income of individuals from the tax base) distorted the incentive to invest in agricultural rather than nonagricultural activities. The introduction of the VAT in 1986 reduced the cascading effect associated with the sales tax it replaced; however, the prevalence of exemptions, the extensive use of the zero-rate, and the use of multiple rates did not facilitate administration of the VAT. Morocco did implement a major tariff liberalization, although the share of revenue generated by taxes on imports remained high. In addition to tax policy reforms, Morocco also introduced substantial improvements in tax administration toward the end of the second adjustment phase. Public enterprise reform, however, has been very gradual.

Moderate Fiscal Adjusters

Thailand did not start the period with a large public sector or a serious fiscal imbalance, so that a drastic structural change on the order of what was accomplished in Chile was not necessary. Nonetheless, the country’s rapid growth allowed it to increase very substantially the level of real resources it devoted to education, and to primary education in particular. This coincided with efforts to improve the effectiveness of the country’s education system and its administrative efficiency. Health expenditure also increased rapidly, with special emphasis on preventive and primary care. As with education, the country’s health indicators have now reached high levels.

Thailand’s capital expenditure policy is more difficult to evaluate. The decline in the first adjustment period spared the health and education sectors but contributed to the bottlenecks in infrastructure entailed by the country’s rapid growth rates. It was subsequently reversed when public expenditure management stopped relying on the rule that capital expenditure in areas other than health and education could only be undertaken once a clear need had been demonstrated for it. The ratio of outlays on other current goods and services to wages and salaries declined, but this resulted at least in part from the increase in the relative price of labor and not from a decline in the ratio of real complementary inputs to labor. Thailand did not have to deal with the problem of a large and inefficient nonfinancial public enterprise sector and was able to reduce subsidies. Finally, along with Morocco, Thailand benefited from a significant decline in military expenditure, albeit from a comparatively high starting point.

Thailand was the only country apart from Ghana where the contribution of revenue to the reduction in the primary deficit outweighed the contribution of expenditure. Because of Thailand’s rapid economic growth, most of the increase in revenue came from income taxes, despite the unification of the rate structure and the cut in the average rate of the corporate income tax. The taxation of domestically produced goods and services was reformed in two distinct stages, culminating in the introduction of a VAT late in the adjustment process, whose anticascading features and broad base would have been growth promoting. Thailand’s reform of its tariff system was not as fundamental as those of some of the other countries, but its system was less in need of reform to begin with.

In Bangladesh, the shortcomings of public expenditure management arguably hobbled efforts to make the expenditure side of the budget more growth-promoting. In particular, the reliance on incremental budgeting and a lack of control over transfers between budgetary heads probably militated against switches in budgetary allocations to more productive uses. Despite very high illiteracy rates, relative spending on primary education actually declined during much of the adjustment period. This trend has only recently been reversed. As regards health expenditure, a greater emphasis was placed on the primary sector, but total spending remained low. The country’s investment program—which was largely financed from abroad—remained inefficient, with much of it ending up effectively as operating subsidies to public enterprises. Some trends were arguably growth-promoting, however: subsidies declined in the second adjustment period, in part because of better targeting of commodity subsidies and food-for-work programs, while other current expenditure on goods and services increased from an unsustainably low level.

The failure to increase productive expenditure can in large part be explained by a failure to increase the tax ratio. The tax effort in Bangladesh was the second lowest of the eight countries at the outset of adjustment—a sign of serious problems with tax administration. Bangladesh did, nonetheless, make real efforts to reform the structure of its tax system. This reform included a drop in the top marginal rate of the personal income tax from 60 percent plus a variable surcharge to 25 percent. Given the small number of taxpayers and the problems with the National Board of Revenue, this would not, however, have had a major impact on incentives. The introduction in 1991 of a VAT levied at the manufacturerimporter stage, which eliminated differential rates of sales taxation on certain domestically produced and imported goods, could have eliminated some serious distortions and lowered the cost of capital, as could the moves to rationalize the external tariff. These reforms, however, were not effectively complemented by an improvement in tax administration. Finally, the performance of the public enterprise sector, if anything, deteriorated.

In Ghana, expenditure increased almost across the board. This general increase was undoubtedly necessary just to provide a minimum level of public services. In the health sector, however, the share of the tertiary level in expenditure appears to have increased; in education, the share of the tertiary level remained high. Ghana was the one country with serious expenditure management problems that implemented major reforms to its public expenditure management system; the scope of these reforms was enough to make a difference in the functioning of most components of the system. Arguably, these increases would have combined with the lessening of budgetary constraints as revenue increased in the mid-to-late 1980s to boost the rate of return on public investment in human and physical capital. Ghana was able to effect a substantial reduction in the civil service in 1987-90, something none of the other countries apart from Chile achieved. Improved public expenditure management would probably have played a role in this success, although the subsequent acceleration of expenditure indicates the need for a reinforcement of the reform effort.

Much of the revenue to finance these efforts came from the increase in trade taxes following the devaluation of the cedi. Indeed, Ghana reduced the average rate of the corporate income tax without unifying the tax or greatly changing the structure of the base or related incentive schemes. It was the only country to retain a single-stage sales tax, albeit one with an anticascading feature. Ghana’s customs tariff had a relatively narrow dispersion at the outset of the adjustment efforts, and this did not change further. The major changes Ghana made to its administrative system, however, clearly contributed to the huge increase—in proportional terms at least—in the yield of its tax system. Substantial reforms were initiated in the public enterprise sector.

In India, the bulk of the adjustment effort began in earnest in 1991, so that the time available for fundamental reform has been short. Transfers to the states and subsidies have been reduced—particularly the fertilizer and export subsidies, both of which are highly distortional. Social expenditure has been largely protected during the adjustment, although the need for more expenditure, particularly on health, remains great. Although public expenditure management procedures were generally satisfactory, expenditure control has not typically been effective, as shown by the repeated expenditure overruns of state governments.

The major focus of tax reform efforts was in trade taxes, with a narrowing of the dispersion between tariff rates during the trade liberalization process. In addition, the central excise tax system was strengthened by reducing the number of bands, lowering rates, extending the number of goods under the Modvat system, and use of invoice-based valuation.37 The recent decision to extend the Modvat’s credit feature to capital goods would have reduced the cost of capital. In contrast, the corporate income tax has not been unified, although the average rate was reduced, and tax holidays for new industrial undertakings were restricted but not eliminated. Comparatively little has been done to reform the public enterprise sector.

Finally, Senegal was adversely affected during the adjustment period by the corrosive impact on its revenue base of the growing overvaluation of the CFA franc.38 Because Senegal made few changes to its tax structure and its efforts to improve tax administration were not always sustained, it was all the more necessary to concentrate its fiscal adjustment efforts on the expenditure side of the budget. These efforts were not, however, particularly successful. In particular, the education program appears to have been inefficient in its allocation of resources both across and within subsectors. In particular, primary education’s share in the total slipped, and Senegal continued to suffer from low enrollment ratios and high pupil-teacher ratios. Although overall expenditure at the primary level relative to GDP was fairly high, this was attributable in part to the high salary levels for teachers.

Some progress was achieved. In the health sector, primary care was given comparatively more emphasis. The civil service wage bill was reduced but remained high relative to that of other countries. The growing imbalance between wage and salary and other current expenditure, which marked the 1980s, and the poor experience with cost-recovery programs are, however, consistent with the lack of flexibility and incentives for efficiency that characterize public expenditure management in Senegal. Finally, the enterprise reform strategy was at least partly successful.

Where Was Fiscal Reform Most Growth-Promoting?

Among the major fiscal adjusters, there can be little dissent about the proposition that reform in Chile was most conducive to growth. Once the financial crisis and ensuing deep recession of the early 1980s had been surmounted, the combination of generally conservative financial policies and retrenchment of the state must have helped to create an environment that fostered growth.

Among the moderate fiscal adjusters, Thailand stands out. No major redefinition of the role of the state took place. Instead, sound overall economic policies and a high saving rate, among other factors, contributed to the rapid growth that made possible an increase in social and infrastructural investment, which in turn contributed to growth, thus creating a virtuous circle. Granted the major differences in their starting points and the kinds of reforms they pursued, Chile and Thailand display important similarities. Both countries began their adjustment efforts with the great advantage of well-educated populations; another point in common was adequate public expenditure management. Both made major changes to their tax systems, although the changes to the Chilean system were the more radical; both also implemented administrative reforms. Of interest is that the overall level and composition of tax revenue in the two countries are now similar (Figure 11, on preceding page).39

Figure 11.Tax Structure

(In percent of GDP)

Sources: IMF, Government Finance Statistics Yearbook (various years); and various IMF Staff Country Reports.

1For India, end of adjustment period I.

How conducive to growth was fiscal reform among the other major adjusters? In Mexico’s case, the overall change in public sector structure rivals what took place in Chile. There is, however, a question about the distribution of adjustment between revenue and expenditure, with the possibility that cuts in expenditure were excessive. Morocco was moderately successful in making its tax system and the composition of its expenditure more conducive to growth; however, it did not resolve overstaffing in the civil service, despite some improvements in public expenditure management.

After Thailand, Ghana stands out among the other moderate adjusters, mainly because it increased productive expenditure rapidly, albeit from an abysmally low base; implemented substantial changes to public expenditure management; and improved tax administration. Only Ghana and Chile among the eight countries succeeded in reducing the size of the civil service, although it remains overstaffed in Ghana. Bangladesh’s public expenditure management remained unreformed, and, despite certain growth-promoting changes in expenditure composition, its expenditure program remained inefficient. Its efforts at tax reform appear to have been handicapped by a failure to improve an inefficient tax administration. There are parallels in these respects with India, where the quality of expenditure does not seem to have changed much thus far during the adjustment period, and public enterprise reform has yet to begin in earnest. Finally, Senegal did not reform public expenditure management, and the productivity of its expenditure program does not appear to have improved materially. Despite its quantitative adjustment efforts, it was unable to do much to make its public sector more growth-oriented, except perhaps to reduce the size of the nonfinancial public enterprise sector.

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