IV. Lessons

George Mackenzie, Philip Gerson, and David Orsmond
Published Date:
April 1997
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Lessons from Public Sector Reform

The experience of public sector reform in Chile and Thailand makes clear that, just as a given quantity of fiscal adjustment can be achieved in different ways, high-quality fiscal adjustment can take quite different forms. It is nonetheless possible to draw some lessons from the Chilean and Thai experiences, and from the experiences of the other six countries. First and most important, stabilization need not play havoc with a growth-promoting fiscal strategy. Even though the imperatives of the adjustment process may require that deep cuts be made in total public expenditure, it is possible to protect most if not all of a core program of the most productive expenditure. Initial cuts can then be at least partially restored once stabilization takes hold and revenue-raising measures take effect.

Second, and as already described, the initial adjustment undertaken by the eight countries tended primarily to emphasize expenditure cuts, particularly expenditure on capital goods and on other current goods and services. Such cuts would have been potentially damaging had they not been reversed subsequently. The increase in revenues and elimination of unproductive expenditure that would make these expenditures affordable, however, would normally require fundamental reforms to tax and expenditure systems. Whatever the pattern of expenditure reduction or tax increases initially adopted, structural reform will, for most countries, be an essential component of sustainable and growth-oriented fiscal adjustment.40

Third, the countries that started the adjustment period with an adequate public expenditure management system or made serious efforts to upgrade a deficient system were, on the whole, more successful in preserving expenditure with a high social rate of return. The prevailing pattern of adjustment, with its initial emphasis on expenditure reduction, meant that the public expenditure management system was tested early in the adjustment process. In general, the better the system was able to set priorities, and then enforce the changes in the composition of expenditure that was consistent with them, the more productive was the ultimate expenditure outcome. A corollary is that some minimum level of public expenditure management expertise is a sine qua non for a radical change in public expenditure priorities and in the efficiency of the public expenditure program. Of course, these administrative abilities can complement, but can not substitute for, a political commitment to a growth-oriented fiscal adjustment strategy. Put another way, good public expenditure management can help to ensure that sectoral targets are achieved, but the establishment of these targets requires a political decision. It is not an automatic result of reforms in public expenditure management.

Fourth, substantial reform of the tax policy regime tended to go hand in hand with administrative reforms; countries implementing substantial reforms to the structure of their tax systems usually had a reasonably well-functioning tax administration to begin with. A poorly functioning administration limited the ability to introduce allocationally superior but administratively demanding taxes such as the VAT, even if it did not prevent some reform measures altogether. A corollary to this point is that the design of tax reform must be sensitive to the limitations of tax administration. For example, a VAT with multiple rates is definitely problematic for a weak tax department. In addition—and as for public expenditure management—there may be a critical minimum level of administrative ability if tax reform is to succeed. Further, administrative reform, when the tax system itself is poorly designed, is unlikely to produce a significant increase in revenue.

Fifth, increases in the tax ratio can be accomplished without major increases in the rates of existing taxes. Conversely, decreases in rates do not inevitably presage a decline in revenue. With the exception of Ghana, the countries achieving substantial increases in the tax ratio did so by broadening the effective base of the tax system, usually with the introduction of a VAT that not only increased revenue but also presented an opportunity to increase the allocative efficiency of the tax regime (see World Bank, 1991b).

Finally, certain structural expenditure reforms that are important or even necessary to the long-run success of the adjustment effort may take time to come to fruition—and may realize only limited budgetary saving in the short run. For example, a civil service reform program that substantially reduces employment may seem unattractive in comparison with a general salary freeze, since it will save little or nothing initially. Yet it is the only lasting solution to overemployment and salary compression. In consequence, such structural reforms have to start early.

Role of Structural Fiscal Reform in Adjustment Programs

This study has argued that maximizing the contribution of the public sector to growth requires attention to the composition of expenditure, as much as to total expenditure, and to the structure of the tax system, as much as to tax yield. Further, the way a tax system is administered is as important as its structure, and public expenditure management systems have a vital bearing on the quality of the realized public expenditure program, translating policy commitments at an aggregate or sectoral level into efficient allocations at the micro level.

The analysis has also emphasized the importance of appropriate sequencing in expenditure and tax reform and has advocated that administrative reform must be seen as a necessary component of major growth-oriented reforms of the tax system and the structure of expenditure. One basic lesson for successful growth-oriented fiscal adjustment is that, to the extent possible, it should emphasize administrative reforms right at the outset. The experience of the eight countries suggests that early reform is more likely to be substantial reform.

A greater emphasis on administrative reform poses technical challenges for the design of IMF-supported programs. In principle, the experiences described would argue for a greater application of conditionality to administrative reform; however, the scope for this is not likely to expand quickly. Only certain steps in the complex and typically detailed process of administrative reform are readily susceptible to measurement or quantification, given the difficulty of monitoring what has actually taken place. It is also difficult to predict how quickly the various stages of an administrative reform can be accomplished.41

This being said, no amount of efficient administration can really rectify a poorly designed tax policy regime or an expenditure program that is inimical to growth. Indeed, the worst outcome would be for a poor tax regime to be well administered. Tax policy measures can be monitored, however, and are more readily the object of conditionality.

The study’s findings also imply that more attention needs to be paid to the composition of expenditure and to expenditure policy issues, even if national sensitivities make the widespread application of conditionality to expenditure composition impractical.42 An adequate knowledge of the structure of expenditure, and even comprehensive and timely data on expenditure composition, is often difficult to come by, however.

In view of the intrinsic difficulties in building informed and up-to-date analyses of public expenditure patterns and priorities, especially in the large countries and those with poor databases, the staffs of the World Bank and the IMF have recently strengthened their collaborative arrangements in this area. The objective is to facilitate the sharing of relevant macroeconomic and public finance data and to identify priority issues to be studied in a multiyear work program. Success in these endeavors would mean that advice on expenditure policy would place more weight on preserving the expenditure areas that are critical for growth.

IMF-supported programs are already sensitive to the need to achieve an appropriate balance between expenditure restraint and revenue increases, although the concern has chiefly been with the risk that a lack of balance would threaten sustainability. This study would add to this concern the need to ensure that potentially productive expenditure—such as spending on primary health and education, operations and maintenance, and essential infrastructure—is not cut to the bone. Equally, it is critical to ensure that the composition of spending in potentially productive areas is appropriate (for example, ensuring an adequate balance between wage and nonwage outlays, between new investments and operations and maintenance).

The IMF has for some time encouraged the inclusion of cost-effective and affordable social safety net measures in the programs it supports. Even if they have no direct effect on capital formation and saving, such measures can foster growth by enhancing the political sustainability of an adjustment program. The discussion has also stressed the importance of expenditures on primary health care and education, not only because of their impact on human capital but also because they can have an impact on the income and well-being of the poor.43 This is an additional reason for supporting a reorientation of expenditure to these subsectors in an IMF-supported program and for ensuring an efficient allocation of resources within them, particularly with respect to the mix of labor and nonlabor inputs.

Finally, it is clear that at times there will be a tradeoff between deficit reduction in the short run and certain kinds of structural reform, or effectively between deficit reduction now and deficit reduction in the future. A prime example of this is civil service reform. Employment reduction costs money, and so do efforts to undo wage compression. Clearly, if in any period there is some “maximum” value of the deficit that can be financed, the extra costs of structural reform will have to be offset by economies elsewhere in the budget. In many if not most cases, countries will be hard pressed not to exceed this maximum value, and in these cases no trade-off is possible. But for budget deficits below this amount, a trade-off may exist. For example, lump-sum severance payments might increase the current-period deficit but will loosen the government’s intertemporal budget constraint (by permitting lower levels of expenditure on wages and salaries, hence reducing future deficits). Thus, the study’s findings emphasize the importance of viewing the budget constraint not simply in a single period, but in a multiperiod framework.44

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