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Public Disclosure Authorized Policy,Planning,and Rasoarch WORKING PAPERS PublicEconomic, CountryEconomicsDepartment The WorldBank December1988 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized WPS128 Public Finance in Ad ustmentPrograms AjayChhibber and Javad Khalilzadeh-Shirazi Countries undergoingadjustmenthave increasinglyfound it difficultto sustaincutsin publicsectordeficitsto matchcuts in external financing,thus exacerbatinginflation and financial disequilibrium. Moreover,fiscal contractionhas often been short-termoriented. Fundamentalfiscal reform involvinga medium-termperspectivehas been rare. Given the central importanceof fiscal issues in adjustmentprograms,however, greater focus on them is essential if such programs aze to. succeed. The Pblicy, Planning. and Research Complex distributes PPR Woiking Papers to disseminate the findings of wockin progess and to aicourage the exchange of ideas ainang Bank staff and all others interested in development issues. These papess carry the names of the authors, reflect only hicr views, and should be used and cited accordingly 'ne findings, interpretations, and concdsions are the authors own. lEey should not be atributed to theWorld Bank, its Board of Dirctors, itumanagasent, orany of its manber euntries. Polk, PanIng, and Reserch PblicEoonomko This paper, prepared in part as a background study for the Bank's Peport on Adjustment Lending, reviews the experience with pubic finance issues under adjustment programs. This experience shows that fiscal changes are often triggered by budget and balance of payment crises. As a result, short-term considerations have dominated the policy measures introduced. Traditional stabilization policies usually emphasize measures aimed at reducing aggregate demand. On the fiscal side, this has implied cutbacks in public expenditures. There is, however, growing recognition of the need for more growth-oriented adjustment programs, which entail a more comprehensive and durable approach to fiscal reform and therefore require a medium-term perspective. Countries committed to fundamental reform of fiscal and other key policy areas should be able to avail themselves of external financial support that lasts long enough for them to initiate and sustain the change process. They must strike a balance between stabilization and adjustment. On the expenditure side, this includes a much better understanding of and attention to compositional changes followed by reorientation of the expenditure program. On the revenue side, it entails comprehensive tax reform designed to reduce distortions, to increase buoyancy, and to ensure equity. This paper is a product of the Public Economics Division, Country Economics Department. Copies are available free from the World Bank, 1818 H Street NW, Washington DC20433. Please contact AnnBhalla, room N1-061,extension 60359. The PPR Wooking Paper Series disseminates the findings of work under way in the Bans Policy, Planing, and Research Complex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclus;ionsin thee papers do not necessarily represent official policy of the Bank. Produced at the PPR Dissemination Center PUBLIC FINANCES IN ADJUSTMENT PROGRAMS' Table of Contents PAGE I. Introduction................................................ 1 II. Macro-Economic Aspects of Fiscal Adjustment.................2 Fiscal Deficit Adjustment: The Experience and Implications........................................... 4 Fiscal Deficit Adjustment in SAL Countries..............15 Consistency of Fiscal Policy with other Measures........22 Fiscal Deficits, Public Sector Size and Growth..........26 III. Public Sector Resource Allocation and Use..................32 'RecurrentExpenditures..................................32 Public Investment....................................... 36 Institutional Processes for Expenditure Policy..........41 Fiscal Consequences of Public Enterprises Operations ....41 IV. Reform of Taxation......................................... 43 Experience with Tax Reform in Adjustment Programs.......46 V. Growth-Oriented Fiscal Programs: Lessons of Experience.....50 BOX: Targetting the Budget Deficit: Clarifying Concepts........55 Appendix A ....................................................... 60 Bibliography..................................................... 64 / Background Paper for the Report on Adjustment Lending. John Brondolo and Reza Firuzabadi provided excellent research assistance. The authors are grateful for very useful comments to Bela Balassa, Francis Colaco, Pradeep Mitra, W. McCleary, Catherine Mann and Wayne Thirsk. List of Tables Page Table 1 Table 2 Table 3 Table 4 Table 5 Table 6 Table 7 Table 8 Table 9 Total Long Term Debt by Region and the Share of Private Non-GuaranteedDebt........................ 7 Pattern of Growth of Real DomesticCredit.10 AverageAnnual Inflation. 11 Budget Deficit and ita Financingin Selection SAL Countries.17 Correlationof Externaland Fiscal Positionsin SelectedSAL Countries1980-86.19 Public Expenditureand Its Composltion .21 Compositionof GovernmentExpenditures .38 Compositionof Tax Revenues for Countries Groupedby Income, 1975 and 1983.44 GovernmbntRevenuesby Broad Categories .47 List of Figures Figure 1 Figure 2 Figure 3 Figure 4 Figure 5 Figure 6 Figure 7 Current Account and Public Sector Deficit. Index of Ratio of .Moneyto GDP.12. CurrentAccount and Public Sector Deficit.16 Total Revenue and Expenditure .20 Percent Change in Real Cirrent Exp.34 Capital and Current Expp!tditure .37 SectoralPublic Investment .40 5 I. 1. Introduction Public sector finances and related policies are a central part of economicmanagementand influenceoverallmacroeconomicperformanceas well as the distributionof resources between the public and private sectors. There is a growing recognitionthat the developingcountries' efforts to restoreand maintain macroeconomicstabilitywith a reasonable growth of output must include wide-rangingfiscal reforms covering not only the size and financingpatternsof governmentdeficits,but also the structure of taxation and the level and composition of public expenditures. How government deficits are financed, taxes raised, and public resources allocated and utilized has important consequencesfor incentives,distributionand growth. 2. The broad objectives this paper are to examine the role of fiscal reform in adjustmentprograms and to draw out the experiencein this area, as well as the major lessons that emerge for the design of fiscal reform recommendationsand conditionalityin adjustment lending. While the scope of the paper is broad, the extent of the coverageof the issues and countries is highly selective and, moreover, the country referencesare more illustrativerather than exhaustive. Part 'I focuses on the macroeconomicimplicationsof fiscal deficits,the extent to which they have been reduced in selectedcountries,the consistencyof fiscal policy with other instruments,and the question of sustainabilityof fiscal policy and growth. Part III deals with expenditurepolicy issues, particularlythose related to the level and compositionof recurrent and public investmentoutlays. Part IV outlines the desirable elements of -2change in tax systems and the experiencewith reform. The final section the key conclusions and outlines the set of fiscal summarizes considerationsappropriate for inclusion in growth-orientedadjustment programs and lending. II. MacroeconomicAsRects of Fiscal Adjustment 3. Over the past several years, many developing countries have faced macroeconomicimbalances,both external and internal, of varying degrees. There are many reasons why a country could face a problem of this nature. Among them are external factors such as terms of trade shocks, low demand in export markets, unanticipatedreduction in, or cessation of, external capital flows, high interest rates on external loans, and inappropriatedomestic economic policies and mismanagement. Often a combinationof these factors is at work. Unless the underlying source of disequilibriumis temporary,in which case external capital,if available,could be used to cover the resource shortfall,adjustmentso as to restore macroeconomicstability and revive growth is necessary. Depending on the source of macroeconomic disequilibria, the path of adjustmentand the ease with which it can be carried out may vary. 4. Large public sector deficits, or, more generally,inappropriate expenditure and revenue policies, are an important source of macroeconomicdisequilibriumin many developingcountries. An economic crisis can be generatedby heavy expenditureson subsidies,transfers to loss-producing public enterprises, or ambitious public investment programs. Attempts to restore economic stability often require adjustmentsin fiscal policy. -35. If adjustmentis necessary,how much of it should take place in the public sector as opposed to the private sector? How much of the adjustment should be in the form of aggregate demand restraint and how much should come from efforts to increase supply? In the case of the former, i.e., reduction in aggregate demand, the need to reduce the budget deficit which is an indicator of the excess demand pressure exerted by the public sector on the economy is obvious. At one extreme, the approachmay be to view fiscal policy as primarilyan instrumentfor expenditure reduction, and to r.slyon other instruments such as the exchange rate and pricing to shift expendituresand resources towards tradeable goods--expenditureswitching. But, the magnitude and the manner in which the budget deficit is reduced, and the consistency of other policieswith fiscal policy significantlyaffect the ability of the economy to increaseoutput and thereby diminish need to cut demand, and consequentlyaffect as well the sustainabilityof fiscal changes. The availabilityof external finance to smooth the process of reform is, of course, a key factor. 6. Ha fiscal adjustmentbeen enough in relation to the decline in externalfinancingthat has been experiencedby many developingcountries in recent years? If not, how have budget deficitsbeen financedand what are the implicationsfor the economy of alternate financing packages? Has fiscal policy "crowded-in"or "crowded-out"the private sector and thereby affected the sustainabilityof reform? An attempt is made to answer these questions,in a preliminaryway, in the rest of this section along with a broad assessmentof Bank-Fundconditionalityon macro fiscal issues, and a discussion of consistency of fiscal policy with other instrumentsof adjustment. - 4 - Fiscal DeficitAdjustment: The Experienceand Implications 7. Fiscal policy forms a key component of the policy package in most adjustmentprograms. This is inevitablesince fiscal crises, in the form of large budget deficits,have been diagnosed as a primary feature of external disequilibria and macroeconomic instability in many developing countries. The massive flow of financial resources to the developing countries in the 1970s, largely recycled oil exporters' deposits, helped finance (or some may say caused) these deficits. Foreign savings were used to cover shortfallsin public sector savings. But since 1982 (see Figure 1), these flows dried up as the enormity of the debt build-upwas revealed,exposing the underlyingunsustainability of fiscal policy in a large number of developingcountries. Moreover, external conditions deteriorated sharply; real interest rates rose dramatically,oil and commodityprices fell and industrialcountry growth decelerated reducing export markets. These factors added to the deterioration in economic performance and to fiscal problems. Heavy adjustments were required in the budget deficit and government expenditures, especially excluding interest payments which now rose sharply,had to be cut sharply. 8. With the onset of the debt crises, the burden of debt servic- on the governmentincreasedin many countries. This happened because of (1) higher internationalinterest rates, (2) devaluationwhich raised the foreign interestbill in domesticcurrency, (3) takeover of private debt by the public sector and (4) increased domestic borrowing at high Current Account and Shores 11 Public Sector Deficit 1985 1986 of GDP I/ - ... ___ 9 8 0 7 4.) 6- 5 4 1980 - 1982 1483 1984 Yea r o Current 1/ Account Unweighted average for 33 randomlv + Public selected cotmtries. Sect Deficit -6 domestic interestrates (Brazil,Turkey, Pakistanand Malaysia). Table 1 shows the declining shares of private non-guaranteeddebt in medium and long term debt which came about due to reduced foreign credit to the private sector and the takeoverof some oi the private debt by the public which would restrict sector so as to avoid problemsof credit-worthiness other sources of credit. This was particularlytrue in Latin America and in some countries in East Asia. Note that in the case of Latin America there was a substantialabsolutedecline in private non-guaranteeddebt. Since 1982, substantialreductionsin the size of the fiscal deficithave taken place in a number of countries (Figure 1). However, the extent of fiscal deficit adjustmenthas in many cases been smaller than the cuts in availabilityof externalfunds. 9. Trade-offsin Financingthe Fiscal Deficit. The implicationof a smallerreduction in the budget deficit than in the current account can be best understood by looking at the sources of financing the fiscal deficits. A fiscal deficit can be financed in three ways:1 (a) external borrowing or grants; (b) domestic borrowing from the banking system; and (c) domesticborrowingfrom non-banksources. A large fiscal deficit creates problems in terms of one or more macroeconomictargets dependingon how it is financed. Large externalborrowing creates a debt problem; inflationary financing leads to high inflation; and heavy domestic borrowing either leads to insufficientcredit availabilityto the private sector if eredit is allocatedby the governmentand financial 1/ The build-up of arrearshas emerged in recent times as a significant fiscal issue. rhese can be treated as forced borrowing by the governmentand can have very damag'ngimpact on fiscal credibilityof the system. -7 Table 1 Total Long Term Debt by Region and the Share A/ of PrivateNon-GuaranteedDebt (US$ billion) 433.6 (17.2) 44.1 (6.4) 64.2 (18.1) 556.9 (18.4) 56.3 (6.9) 88.0 (19.4) 870.7 (10.4) 88.2 (4.6) 149.1 (13.1) Latin America and Caribbean 172.4 (25.0) 237.7 (26.2) 351.8 (14.4) North Africa and Middle East 46.8 (1.3) 51.4 (1.6) 71.3 (1.8) South Asia 33.4 (1.1) 39.4 (3.3) 61.6 (4.4) 204.1 (28.1) 277.6 (28.3) 414.0 (14.4) 27.0 (3.8) 31.8 (2.3) 46.3 (1.1) All Countries Africa, South of Sahara East Asia and Pacific High Debt Countries Low Income Africa A/ Figures in bracketsare share of private non-guaranteedin total. The balance is public and publicallyguaranteed. Source: The World Bank, World Debt Tables. 1987-88. institutionscontrolledby it or it leads to high real interestrates and less private sector credit, which reduce private investmentand future output growth. A large budget deficit can therefore have adverse implicationsfor three key macroeconomictargets: debt, inflation and 2 the growth rate of the economy. 10. The real counterpart of these financial flows is the relationshipbetween the budget deficit, foreign savings and net private savings. The budget deficit is equal to foreign savings (currentaccount balance) and the net savings of the private sector. If external flows are not forthcoming, the government's budget deficit must imply a correspondingnet private savings surplus. This can be elicitedby.high inflation,which acts as a tax on holders of money, or through high real interest rates which could lower private investmentand sometimes raise savings. 11. Large and unsustainablefiscal deficitshave quite clearly been a central element in the economic crises faced by many developing countries. Government expendituresrose sharply for varied reasons in the 1970's. In some cases it was the misperceptionthat a temporary commodity boom was permanent, in others it was the easy availabilityof cheap extert.al finance. Once expendituresrose, they were more difficult 2.1 For a fuller expositionsee W. Buiter, (1985): "A Guide to Public Sector Debt and Deficits", Economic Policy 1 (November):13-19and "Turkey:ExternalDebt, Fiscal Policy and Growth (1988)",World Bank, Green Cover Report. See also World DevelogmentReport. 1988, for a detailedtreatmentof many of these issues. - 9 - to cut back. A marked feature of fiscal crises was a rapid prior expansion of credit to the government or the public enterprises (See Table 2). Five countriesshown in the Table--Argentina, Malawi, Nigeria, Mexico and the Philippines--had a large build up of credit to the governmencor the public enterprisesector prior to a financial crises. Once the crises occurred,the credit squeezeaffectedboth the public and the private sector. In the case of Malawi and the Philippines,where more recent data is available,the private sector was affectedmuch more than the public sector by the credit squeeze. Countrieswhich restrained the growth of credit to the public sector, such as for example Pakistan, Korea and Indonesia,appear to have avoided those problems. Both Korea and Indonesiahad temporaryproblems in the early 1980s again because of excessivecredit expansionto the governmentbut adjustedvery quickly by among other things cutting growth of credit to the public sector drastically. 12. Internal financing of the fiscal deficit (as opposed to borrowing from abroad) has increasedparticularlysince 1985. The gap between the public sector deficit and the current accounL has widened and net private savings have risen (as seen in Figure 1). If external financinghas declined,tho pressurefrom excessivebudget deficitsfalls on inflationor on higher interestrates unless the private sector can be persuaded to hold government debt at low levels of interest. High inflation and high real interest rates are indicatorsof the need for 3 further fiscal contractionin the economy. Bringinginflationdown to i./ There is a growing literatureon the various concepts of the fiscal deficit and how they reflect on the fiscal stance of the government. These are summarizedin Box 1. - 10 - Table 2 Pattern of Growth of Real Domestic Credit (Percent per annum) 1984-85 1985-86 -5.9 14.4 -23.9 9.2 20.0 -20.8 23.0 -8.2 0.1 43.9 98.5 -1.1 6.9 -34.6 -1.5 -7.0 -9.2 -1.2 113.1 92.1 -36.5 -37.7 18.5 -48.5 -30.1 9.5 23.4 35.8 -24.9 -1.3 PhiliRRines (1983)* G 51.3 PE 5.3 PV 10.7 74.9 25.3 5.1 14.7 34.3 15.3 -44.2 -19.4 -50.0 -27.5 10.0 -35.2 69.2 -48.2 -23.8 Pakistan G,PE PV -4.0 10.0 19.2 10.8 3.2 14.0 2.5 7.6 -1.4 22.2 9.5 12.9 Korea (1981)* G PE PV 69.5 21.5 10.8 18.1 20.5 18.6 -1.6 17.4 13.7 0.6 -3.9 10.3 4.5 -4.0 15.0 8.9 -2.4 12.7 52.3 -21.4 21.4 5.6 11.0 35.6 -18.1 -14.0 15.3 51.4 -7.4 23.5 6.6 3.2 16.3 1980-81 1981-82 1982-83 1983-84 Argentina (1982)* G PE PV 337.2 98.2 58.4 23.1 895.4 27.1 320.4 -185.0 -27.5 -135.9 -174.9 -100.8 Malawi (1981)* G PE PV 74.6 -7.4 -12.2 16.6 -3.7 4.9 12.0 -13.0 4.8 63.4 16.2 17.6 53.9 -13.0 8.4 22.8 33.5 18.6 Mugria G PE PV (1983)* Mexico (1982)* G PE PV . Indonesia (1981)* G PE PV Source: International Financial Statistics, IMF. G-Government; PE-Public Enterprises, PV-Pri.ate * Indicates the year when a major economic crisis occurred in the country. moderate levels is necessary to reduce uncertainty and provide the stable environmentfor adjustment. Contraryto trends in the industrial countries,inflation increasedin the developingcountries in the early 1980s and has remainedhigh (See Table 3). Table 3 AVERAGE ANNUALINFLATION (CPI) 1973-80 Category SAL IntensiveCountries World IndustrialCountries DevelopingCountries 15.8 12.6 9.9 22.6 1980-84 20.9 13.3 6.9 35.4 1985 1986 16.4 13.5 4.3 47.0 15.3 8.6 2.4 29.8 The SAL Intensive Countries include: Chile, Colombia, C6te d'Ivoire, Jamaica,Korea, Malawi, Mexico, Morocco,Pakistan,Philippines, Thailand,Turkey, Zambia. These countriesreceivedthree or more adjustmentloans prior to 1987. * Source: InternationalFinancialStatisticsand World Bank Reviewed File. 13. There are limits to both sources of internal financing. The inflation tax increases the cost of holding money so that the monetary base declines. Figure 2 shows the marked declining trend in tho ratio of money to GDP in a sample of high inflationcountries in contrast to its stable and in some cases increasing trend in low inflation countries. Beyond a certain level, with explosiveinflationthe revenue from the inflation tax beg;ns to fall. This happened in Argentina in 1984 when despite acceleratinginflation,the revenue from the inflation tax fell. A currency reform was inevitable. High inflation also increases the size of the deficit although it might assist in its financing. Under high inflation,tax revenuesfall because of - 12 Figure 2: Index of Ratio of Honey to GDP Low Inflation Countries 170 140 - 130- 120o 110 100 - 196|0 1981 El O 1952 F+ IN 1963 0 Year Iu 1964 A 1965 MO V 1986 TH .High Inflation Countries 120 - 110 \ 100 so 70 60 1960 1951 0 ARGEN1NA 1982 1963 Yew + GHANA 1964 1965 @ MeiCO 1966 - 13 collection lags,4 tax evasion and lack of indexation of nominal interest expenses which generally fully reflect inflation. In some countries the government increased its seignorage revenues without monetary expansionby increasingthe reserve requirementson depositsin the domestic banking ,ystem. An increase in reserve requirementswas 5 resortedto, for example, in Uruguay,Mexico and Ghana. 14. Some countrieshave attemptedto impose price controlsin a bid to control inflation, often in the mistaken belief that inflationary expectationscontributedto high inflation. In Brazil under the Cruzado Plan, price controlswere put in place as a vigorous expenditureprogram was being undertaken. Real wages were increasedby 8% and with price controls public enterprisedeficits increased. A consumer boom eroded the trade surplus and the program collapsed with much higher inflation than before the plan was put in place.6 iJ See Tanzi, V (1977): "Inflation,Lags in Collection and the Real Value of Tax Revenues",IMF Staff Papers, 24: 154-67. i/ For details see AppendixA, Table A.l. £./ See Cardoso, E. and R. Dornbusch (1987): "Brazil'sTropical Plan", AER PaDers and Proceedings,77 (May): 288-92. - 14 15. Countrieswhich tried to finance large budget deficits through the sale of public bonds to the private sector faced problems of high real interestrates. If the real interestrate exceeds the real growth of public revenue, this source of financing is unsustainableas the growth of domestic debt becomes explosive. The problem of high real interest rates and explosive domestic debt is particularlyacute, for 7 example, in Brazil. In order to avoid this problem, some countries such as Mexico used mandatorysales of governmentbonds at low and often very negativeinterestrates to raise finance. Financialrepressionwas used to ensure that funds were availableto the public sector at highly negative interest rates, eroding confidence in the domestic financial system and leading in many cases to capital flight. 16. These problemsare interconnectedand ultimatelyarose in those countries which did not sufficiently reduce their budget deficits. Therefore,adjustmentpolicieswere difficult to pursue in this unstable macroeconomicenvironment. In many cases, confidencein the government and the financialsystem fell and investmentground to a halt. But this raises the issue of what is a sustainablelevel of the budget deficit in relation to a country's debt and growth strategy? Too large and too rapid a cut in the fiscal deficit can also be costly. If reducing the budget deficit in order to contain debt and inflationcomes at a heavy 8 cost to growth, the sustainabilityof reform is obviously in question. The composition of public expenditurecuts and the effect of overall Z/ See AppendixA, Table A.2. L/ See Corbo, V., M. Goldsteinand H. Khan eds (1987) "Growth-Oriented AdjustmentPrograms",Washington,D.C.; IMF/WorldBank. - 15 - fiscal policy on private savings and investmentmatter a great deal. Before discussing these issues, however, it would be useful to review the experience of the selected SAL sample countries and discuss the question of consistency between fiscal policy and other adjustment instruments. Fiscal DeficitAdjustmentin SAL Countries 17. The reduction in the budget deficit follows the decline in the cur. -t account balance closely in the sample SAL countries (Figure 3) upto 1984. But after 1984, there is again substantial divergence between the public deficit and the current account balance implying increased pressure on the private sector to generate a net savings surplus. If anything, SAL intensivecountries appear to have greater difficultyin later years in controllingthe fiscal deficit,because of greater terms of trade shocks and rising interestpayments. Domestic financing of the budget deficit rose sharply in a number of countries (Table 4).9 As a result some countriessuch as Zambia and Mexico faced problemsof high inflationwhich in turn led to higher deficits;whereas others such as Turkey,10 Philippines and Thailand experiencedhigh real interestrates. 2/ In Colombia (1986) and Chile (1985, 1986) the governmentreduced its domesticobligations. 1Q/ Turkey's inflation rate was also high but not explosive averaging 30-40 percent per annum between 1980 and 1986. - Figure 16 - CURRENT ACCOUWANDPUBIC SECTOR DEFICITS 3: 87 3 2 1 I 1980 1982 ~ 19U ~ ~~I I I 1964 1985 1986 NotetCAD- Cuirent ACCount Dct as erentaoeofGOP PSD Pu-licSo eOWt asperentag of GDP Urmighted v ra 13ALcountxe(Chile Colormbia Coto r ioire JamXac Kora. Ma1aW.MAdco. Maocco.Pakin. Philipine Tailan Turkey. and Zambia.) PUBUC SECTOR DEFICIT ASSHARE OFGDP 11 6 1900 1982 1963 1984 19685 196 NotesAUa Unwightd averg f 13 djutnt lenin intensvo countie AL- UnwegtedIverg for25adment lending countrie NMAL - Urwegted averge for16nonadjstmentWndno count Source Woea k data. - 17 - Table 4 Bud2et Deficit and its Financingin SelectedSAL Countries (% of GDP) p/ 1222 lS_83 192A 1 1986 Chile 3.5 (37.1) 3.0 (133.3) 4.4 (38.6) 2.6 (-57.7) 2.3 (-56.5) Colombia 4.4 (56.9) 4.5 %66.2) 4.4 (72.1) 2.6 (11.6) 1.4 (-540.0) Cote d'Ivoire 15.2 (25.6) 9.5 (86.8) 3.8 (-73.2) 1.9 (-58.6) 1.7 (14.3) 12.3 (1.3) 13.7 (27.6) 4.0 (40.4) 3.2 (51.4) 1.7 (151.8) Korea 3.3 (60.6) 1.0 (30.0) 1.1 (54.5) 1.5 (60.0) Malawi* 12.5 (34.1) 10.3 (16.0) 8.9 (50.8) 8.1 (66.7) Jamaica Mexico 17.7 8.4 7.2 9.0 (124.4) p (149.4)q/ (147.9) ./ (127.0)q/ 1.6 (7.50) 12.0 (48.9) 15.6 (93.1) Morocco* 9.5 (30.6) Pakistan 5.3 (69.8) 7.0 (77.5) 6.0 (80.0) 8.0 (85.7) 7.7 (79.2) 4.2 2.0 1.9 1.9 4.5 Thailand 5.7 (56.8) 4.3 (66.7) 4.2 (55.8) 5.0 (70.5) 5.2 (77.8) Turkey* 1.8 (N.A) 2.6 (73.9) 5.4 (63.9) Zambia 18.7 (78.6) 8.1 (66.7) 6.6 (63.6) Philippines 10.9 6.9 (107.0) p/ (31.8) / 8.4 5.5 (126.8) p/(622.2) P 2.9 3.2 (132.6)hI (123.5)la 8.0 (87.5) 28.2 (40.1) A/ Figures in bracketsare percentageof domesticfinancing to total deficit. hi A negativenumber implies that domesticdebt of the governmentwas being reduced. q/ A number larger than 100.0 implies foreigndebt of the governmentwas being reduced. * Central governmentonly. Source: IMF and World Bank Data. - 18 18. Table 5 provides a more disaggregated picture of the relationshipbetween the public deficit and the current account of the balance of payments. In a majority of the cases an improvementin the fiscal deficit is associatedwith an improved external account. The exceptionsare Thailand where the external position showed improvement while the budget deficit increased. On the opposite end is Jamaica where the budget deficit fell while the externalposition worsened. In both cases unexpected terms of trade changes explain the divergent trends in the public sector and external deficits. In Thailand, improvementsin the terms of trade, brought about by increasesin prices for Thailand's exports and a fall in oil prices, reduced the external deficit,whereas in Jamaica the fall in the price of bauxite/aluminahad a much larger adverse impact on the externalaccount than on the fiscal side. 19. Fiscal adjustments in the sample SAL countries were on the whole not very different from a larger sample of developingcountries. It should be noted of course that the larger sample includesmany cases where the Fund has had stand-by, SAF or EFF agreements. Between 1982 and 1986 changes in the budget deficit were effected largely through changes in real expenditure. There was very little increase in revenues (Figure4). Real expendituresfell sharplybetween 1982 and 1984 (Table 6) but then rose substantiallyin some countriessuch as Mexico, Malawi, Philippinesand Zambia where economicgrowth was disrupted for a variety of reasons,and the adjustmentprogramssufferedsevere setbacks. - 19 - Table 5 Correlationof Externaland Fiscal Positions in SelectedSAL Countries1980-86 -/ External Worsening F I Worsening Improvement Malawi Mexico, Pakistan Turkey, Zambia Cote d'Ivoire Thailand Pakistan Philippines Jamaica Chile, Colombia Korea, Malawi Mexico, Morrocco Pakistan Philippines,Turkey Zambia, Cote d'Ivoire S C A L Improvement A/ Countrieslisted more than once indicatethere was no uniform pattern. Note: Externalrefers to the current accountbalances, fiscal to the public sector deficit. 20. Malawi's problems arose from the combined effect of terms of trade deteriorationand the difficultiesit has faced.in keeping its lines of communicationopen. As a result of terms of trade losses, imports had to be curtailed and revenue from import duties fell. Company taxes also registereda drop as economicactivitywas curtailed. At the same time expendituresrose sharplyreflectingincreasedmilitary expendituresand a general lack of budgetarymonitoringand discipline. 21. The sharp drop in the price of copper and the government's inability to control expendituresare the primary causes of Zambia's financial crisis. As the exchange rate was devalued, the rising domestic currency costs of debt repayment led to further fiscal deterioration. Subsequently, the government suspended the reform Figure 4 Total Revenueand Expenditure Sample SAL Countries 1! 30-- 29 28 27 26 IL 25 0 ~~ U- o22 ~ ~ ~ ~ ~ ~ ~ - 224 21 20 1980 0 1982 Total Revenue 1983 1984 + 1985 Total Expenditure Korea, Malawi, 1/ Unweightedaveragefor: Chile,Colombia,Coted'Tvoire,Jarnaica, Thailand,Turkey, Merico,Morocco,Pakistan.Philippines, Zaubia 1986 - 21 - Table 6 Public Sector ExDenditureand Its Composition (Percentof GDP) Country Current Cagital Total Chile 1982 1984 1986 31.9 30.7 27.1 4.7 6.4 7.7 36.6 37.1 34.8 8.9 9.7 9.5 3.8 2.7 2.3 12.7 12.4 11.8 26.5 27.3 26.7 15.2 8.0 6.3 41.7 35.3 33.0 ColombiaA/ 1982 1984 1986 Cote d'Ivoire 1982 1984 1986 Capital Total 37.6 32.7 40.6 9.9 7.5 5.8 47.5 40.2 46.4 Morocco a/ 1982 1984 1986 23.4 23.9 22.8 11.9 8.7 4.2 35.3 35.3 27.0 Pakistan 1982 1984 1986 14.4 17.8 18.0 7.7 6.1 6.9 22.1 23.9 24.9 Countrv Mexico 1982 1984 1986 Current Philippines_/ Ghana 1982 9.1 3.0 12.1 1984 1986 8.6 11.9 2.5 6.1 11.1 18.0 1984 1986 8.0 10.6 1.9 2.1 9.9 12.7 Jamaica 1982 1984 1986 29.8 28.2 26.4 12.5 5.8 7.5 42.3 34.0 33.9 Thailanda/ 1982 1984 1986 15.0 15.4 16.4 4.5 3.7 3.7 19.5 19.1 20.1 Korea 1982 1984 1986 16.4 15.4 16.2 6.5 6.1 6.1 22.9 21.5 22.3 Turkey 1982 1984 1986 10.9 8.9 8.8 12.2 10.0 14.1 23.1 18.9 22.9 Malawi 1982 1984 1986 21.0 21.6 24.6 11.2 8.2 7.8 33.2 29.8 32.4 Zambia 1982 1984 1986 32.3 26.4 41.9 2.8 2.5 6.3 35.1 28.9 48.2 1982 -/ - - Central GovernmentOnly. Source: World Bank Data. - - program. 22 - Terms of trade losses due to a weakening oil market and inability to rein in expenditures were also a major factor in the difficulties Mexico faced in its adjustment program. In Philippine.,the deterioration in the fiscal accounts from 1985-86 onwards reflectslarge losses on poorly selectedprivate sector projects financed with loans and guarantees from public financial institutions whose losses were then coveredby the government. 22. A common feature in the difficulties faced by all these countries was a large budget deficit in relation to the availabilityof external inflows and domestic savings as well as the inabilityto plan for and deal with higher interest payments and the changes in their terms of trade. High budget deficits are also prevalent in some countries such as Pakistan but have not yet led to macroeconomic instability. This is due partly to Pakistan's ability to draw down accumulated foreign reserves and at the risk of accumulatinga large domestic debt whose impact will be felt in the future. Consistencyof Fiscal Policy with other Measures 23. Consistency between various components of the adjustment program is a major concern in the design of adjustmentprograms. Almost every component of an adjustmentprogram has fiscal implications. In particular, exchange rate and trade policies, financial liberalization and price liberalizationin selected sectorshave large effects on the budget. Unless these effects are anticipated and appropriately - 23 incorporatedinto fiscal programming,their impact through the budget can sometimes be destabilizingand disruptive, possibly leading to a collapseof the program and policy reversals. 24. The need to get consistencybetween the Fund and the Bank on some of these issues is another complicatingfactor. In several of the early loans, difficultiesin coordinationof policies arose due to the desire of both institutionsnot to impingeon each other's jurisdiction. Lately, the Bank has found it necessary to take a more active role in exchange rate and fiscal policy in order to achieve better consistency in its adjustment programs. At the same time the Fund is planning greater emphasison the medium-termeffectsof its programe. 25. Fiscal and ExchangeRate Policies. Consistencybetween fiscal and exchangerate policies is a major issue in the design of adjustment programs. In general, the need for coordinationbetween the two is obvious. Devaluationis unlikely to be effectiveunless accompaniedby appropriatereductionsin demand managementpolicies, includinga tight budget. This would reduce aggregate demand and imports, thereby lowering the pressure on the current account. Without appropriate fiscal restraint, the real effective devaluation is quickly eroded, inflationincreaseswith little resourceallocationeffects. 26. Coordinationbetween exchangerate and fiscal policy can become complex since exchange rate changes affect the size of the budget deficit. With a nominal devaluation,the base for customs duties, which form a substantialshare of revenue in many developingcountries,is now evaluated at a more favorable exchange rate. The revenue from this - 24 source would increaseunless the governmentreduces tariff rates by the extent of the devaluation. Export incomes rise and governmentrevenues will increase either from higher export taxes or through increased profits or reduced losses of state-owned enterpriaes. Public sector corporationswith access to the overvalued foreign exchange would now lose heavily, and may need large supportingtransfers from the budget. Typical exampleswould be power authorities,or the agencieswhich runs the food subsidy system. 27. On the loss side, an increasinglyimportantcomponentwould be the domestic currency counterpart of foreign debt service which would now rise in direct proportionto the devaluation. In a large number of developingcountries,devaluationhas resulted in a marked rise in che local currency equivalent of foreign interest payments (see Table 7, Section III). Moreover,an importantconsequenceof devaluation(real), often ignored, is its impact on revaluationof existing external debt. In general, if including debt service the governmentis a net importer of tradeable goods and services it will lose net revenues through a devaluation. The assessmentof the impact of devaluationon the budget can be quite complicated if there are multiple exchange rates. The governmentthen receivesand allocatesforeignexchangeat various rates to differententities in the economy. 28. If the impact of devaluation is likely to be adverse on the budget, it may be counterproductiveto recommend a free float of the currency (such as an exchange auction). Movements in the exchange rate and the budget deficit may reinforce each other in a destabilizing manner as happened in the case of Zambia, Sierra Leone and Bolivia where - 25 - black market premia accrued to the governmentbefore the devaluation and, correspondingly,the fiscal situation deterioratedfollowing the 11 devaluation. In this case, a series of managed exchange rate changes programmedwith an overall reduction in the budget deticit may be a much safer alternative;with some priority in sequencing given to deficit reduction. 29. Consistencywith Other Policies. Consistencyissues also arise with respect to trade policy. The first stage of the Bank's trade reform recommendationsusually involve a shift from QR's to tariffs which improve the fiscal position of the government. Subsequent reductionsin the tariff rate involve the need for compensatingfiscal measures. In general the Bank's tariff reform recommendationshave focussed on this problem. The danger arises when governmentsdo not implement compensatoryfiscal measures, which then can lead to policy reversalsas happened in the case of Morocco. 30. budget. Sectoral price liberalizationusually benefits the government In many cases the benefit comes from a decline in state enterprise losses. However, if a sector is a net taxpayer, price decontrolscan have adverse fiscal impact. This is often the case for the agricultural sector where prices paid to farmers are kept low through export taxes and below market procurement prices. Price increases to the farm sector unless compensated by removal of input subsidies affect the budget. A comprehensive price liberalization 1J/See Brian Pinto (1987): "Black Market Premia, Exchange Rate Unificationand Inflationin Sub-SaharanAfrica",Mimeo, World Bank, Washington,DC. - 26 - involving several sectors would have less problems as the government's losses in one sector would be made up by gains in others. Individual sector adjustmentloans would, however,need to direct attentionon this issue. 31. An issue of great concern to many governmentsis the short-run inflationary consequences of price liberalization--the release of repressed inflation.1 2 The predominant approach to assessment of inflationin adjustmentprogramsis a straightforwardmacroeconomicone, that runs through the relationship between fiscal deficits, the financialprogram and targettedinflationrates. However, the immediate burst in prices following decontrol and liberalization can lead to policy reversals if the impact of deficit reductionson inflationtakes effect over a longer period. This is often a key reason for the reluctanceof many countries to adopt Bank/Fundprograms. Much greater care is needed in coordinationof public enterprise price policy and fiscal policy. Fiscal Deficits.Public Sector Size and Growth 32. Longer term structural adjustmentquestions deal with issues about the role and the relative size of the public sector. Long-run trends indicate that the size of the public sector increases with ja/ See for an empirical illustration: Feltenstein, A and Ziba Farhadian (1987) "Fiscal Policy, Monetary Targets and the Price Level in a CentrallyControlledEconomy: An Applicationto the Case of China",Journal of Money. Credit and Banking 19,2 (May): 137-56. - 27 economic development.1 3 Contrary to a widespread belief, the governmentdominates to a far greater extent resource mobilizationand its allocation in the more developed countries. On the expenditure side, richer countries appear to spend a lot more on health, social securityand welfare. On the revenue side the more developedan economy the more revenue (as a share of GNP) it collects from income and wealth taxes, social security contributionsand domestic indirect taxes. The only category which declines with development is taxation on internationaltrade. Governmentsalso play a supportingor restrictive role through a myriad of rules, procedures and regulations. No direct evidence on these is available. The notion that the public sector has become too large in many developingcountriescannot thereforebe based on historical trends. Rather, it emanates from the view that in many developingcountries,governmentexpenditurepoliciesare often wasteful and budgetary deficits put excessive pressure on underdeveloped financialmarkets. 33. In the adjustmentperiod consideredhere, i.e., post 1980, the adjustmentto lower budget deficitshave come primarily from expenditure cuts. Increases in revenues have been difficult to achieve especially since import cuts have led to reductionsin revenue from import duties as for example in Malawi. The expenditurereductionshave cut heavily into public investment (which have faced the largest percentage j/ See Appendix A, Figures A.1 and A.2 for detailed figures derived from Lindbeck, A. (1986): "Public Finance for Market Oriented DevelopingCountries",Mimeo, World Bank. - 28 14 reductions) and the non-interest component of current expenditure. These have affectedsocial and economicservicesand subsidies,and have 15 major implicationsfor future growth and equity requiring careful considerationof alternativepolicies. The reductionin expenditurehas not always been rational and efficient because of a variety of social and politicalpressureson the government. 34. When a choice is available between expenditurereduction or a revenue increase some important macroeconomicimplicationsneed to be kept in mind. One example of the differential impact of revenue increases versus expenditure reductions is the possibility that an increasein revenueswould lead to a reduction in the aggregate sav-ings rate of the economy. This is known as the Please effect and arises from the proposition that the public sector's propensity to save is lower 16 than that of the private sector. Of course the opposite is also possible. Many Asian economieshave raised taxation to finance public investment and thereby raise savings and investment rates in the 14/ Detailed figuresare provided in Section III. l_/ In the SAL countriesconsidered,negativeGDP per capita growth was observed in Jamaica, Malawi, Mexico, Cote d'Ivoire, Chile, Philippines and Zambia, between 1980-86. Only Pakistan, Turkey, Thailand, Korea and Morocco (marginally)showed positive GDP per capita growth. li/ Please, S., "SavingsThrough Taxation: Reality or Mirage, Finance 1967. For an empiricalverificationof the Please and Developmelit, Effect see Chhibber, A. (1985): "Taxationand Aggregate Savings: An Econometric Analysis for Three Sub-SaharanAfrican Countries", CPD DiscussionPaper 1985-35,Washington,DC, World Bank. - 29 - 1 7 correlation economy. However, a recent study shows a negative between GDP growth and the share of public consumptionin GDP. The choices made in cutting expenditures or raising resources also have wide-ranging effects on trade balances and the distributionof income. Who benefits and who loses from governmentexpenditureand the manner in which it is financed is a key factor in the ability or inabilityof the government to undertake reforms. 35. SustainableFiscal Deficits. A related issue of more immediate concern is how much should the budget deficit be cut, or put differently,what is the sustainablelevel of the fiscal deficit? While in general there are close links between the size of the fiscal deficit and the externalaccount, the nature of fiscal conditionalityneeds to be carefullyassessedas regards its impact on internaladjustment. How the private sector adjusts to changes in fiscal policy influences its impact on externalbalances. If a reductionin the fiscal deficit leads to lower private savings, its effectivenessin terms of lowering the current account is reduced. Conversely,a country can run higher budget deficitswithout affectingthe current accountadversely,if the private sector is willing to generate additional net savings surpluses at reasonablerates of inflationand real interestrates, as is the case in Thailand and Malaysia. Moreover,whether the improvementin the current account is brought above by a reductionin investmentor an increase in savings is fundamental to the medium-term success of the adjustment program. This is where potentialconflictsarise between stabilization 11/ B. Balassa (1988): "Public Finance and Economic Development"PPR Working Paper WPS31, July 1988. - 30 and adjustment. There is little merit in having a close correlation between the budget deficit and the externalaccount if the outcome is a low level of savings and investmentin the economy. Thus, the quality of fiscal adjustmentis as importantas the quantity. The government's tax and credit policy, and the compositionof public expendituresare key factors determiningthe outcome and are addressedin more detail in Sections III & IV. 36. The 'sustainable'level of the fiscal deficit thereforedepends on a number of factors such as the cost and availabilityof externaland internal finance, the quality and composition of the public resource mobilization and use, accompanying adjustment measures and the behavioral responses of the rest of the economy. Turkey provides an interestingexample of the need to make a careful assessmentof these factors in judging the sustainability of fiscal policy. Turkey repeatedly exceeded Fund fiscal targets. Undoubtedly, the financing needs commensuratewith larger public sector deficits generated higher medium term inflation and real interest rates. But the thrust of the program was growth-orientedcentering around export performanceand the ability to keep savings and investmentrates up. Fiscal policy played a key role in the process through an increase in a well-directedpublic expenditureprogram (and recommendedby the Bank) which supported the private sector through special incentivesand credit for export and investment and a substantial reduction in the losses of state enterprises. A key contributing factor was the substantial excess capacity inherited from the heavy investmentsmade in the 1970s which allowed for a quick improvementin output and exports once the exchange -31- rate was aligned. A recent study1 8 argues that the cost of a more conservativefiscal policy on growth may have been high, in the early stages of the adjustmentprogram. 37. Turkey's fiscal deficitswere sustainableupto a point because their impact was growth-oriented. In the last two years additional increases in public investmentand rising interest payments on past borrowing have led to very high fiscal deficits and threaten macrostability,requiringcorrectiveaction. The importantpoint to keep in mind is that as shown in a previous section, while macroeconomic stability is central to successfuladjustment, in a period of sharply reduced external resources,a country may need to live with a degree of mild inflation and high interest rates in order to raise savings and growth. This is especiallytrue when the economy is saddledwith excess capacity and is coming out of a recession. Designing an appropriate growth-orientedfiscal policy will requiremore careful country-specific quantitativeanalysis of the issues raised here. Because, of the much wider range of objectivesit considers,the Bank will need to take on a much more active role in the design of macro-fiscalconditionality. I/ See R. Anand, A. Chhibberand S. van Wijnbergen (1988): "External Balance,Fiscal Policy and Growth in Turkey",PPR Working Paper No. WPS86, August 1988. - 32 - III. Public Sector ResourceAllocationand Use 38. programs The previous section showed that stabilizationand adjustment typically require considerable changes in government expenditurepolicy aimed at both reducingunsustainablefiscal deficits and enhancing the growth and distributionalimpact of public spending. In principle, revenue-increasingmeasures can be used to reduce the fiscal deficit. However, given the difficulties of increasing tax revenuesin the short run and possibleconcernsabout the over-expansion of the public Factor and "crowdingout" of private activity,expenditure reductions are often heavily relied upon to redress fiscal deficits. With reduced or tightly controlled real public spending, there is greater need to ensure that scarce public funds are allocatedto highest priorityareas and used more efficiently. 39. Adjustmentprograms and the Bank's lending in support of them devote considerableattention to public expenditureissues. Four broad areas are generally addressed: (i) the level and composition of recurrent expenditures; (ii) the size and allocation of public investment;(iii) institutionalprocessesand mechanismsfor budgetting; and (iv) the fiscal consequencesof public enterpriseoperations. Each of these areas are discussed in brief in the remainderof this section. RecurrentExpenditures 40. As noted earlier,budget deficit reductionis a major focus of the Fund standby and EFF lending. Inasmuchas Bank SALs have typically been extended concurrentlywith a Fund Program, the Bank has generally - 33 been guided by Fund conditionalitywith respect to the fiscal deficit 19 target and the associatedrevenuesand expenditureindicators. Only occassionally do SALs contain specific targets for overall recurrent expenditures (e.g., SAL I for Ghana or SAL II for the Philippines). More often, however, subceilingsor targetsfor particularcomponentsof the current budget are specified. These generally relate to subsidies and spendingon social sectors. 41. Figure 5 shows the changes in real expenditures across functional sectoral categories for 34 developingcountries (unweighted average) during 1982-85. It indicates cuts in every category of expenditure with the exception of housing and other social services. Increasingly,there is concern that budgetaryallocationsfor operations and maintenance are inadequate. Based on its detailed sectoral knowledge,the Bank at times has set specifictargets for increasesin O&M expendituresin the belief that the payoff to such outlays would be high. In some cases, SALs have stipulateda target for increased real spending on social sectors even when there has been a condition requiring a reduction in the overall deficit and/or recurrent expenditures. 19/ With the advent of the StructuralAdjustment Facility and Policy Framework Papers, there is, however, greater interactionamong the Bank and Fund staff in devisingand agreeingupon program targets. Figure Percent Change (Unweighted 5 in Real Average Current Exp. 1982-85) 40 30 20 u 10 General DefensEducationHealth 1/ Tncludes interest na"rients. Soc.Sec.HousingSoc.Ser.Eco.Ser. Other i/ - 42. 35 - Among the recurrent expenditurecategoriesmost often subject to scrutiny in adjustmentprograms are subsidiesbecause of the large amounts that are involved. Both explicit and implicit subsidies are covered and involve a wide range of items, including foodstuffs. The 20 relevance, effectiveness and costs of the subsidies are examined. For most products,eventualeliminationof the subsidiesinvolvedshould be a policy goal. Where appropriate,subsidiesand cost recoveryought to be handled jointly. For some items, particularly foodstuffs, however, it may be justified to focus on better targetting of the beneficiaries both to improve the distributional reduce/restrainthe budgetary outlays. impact and The Bank's adjustment lending often contains conditionalityon the reduction in, and rationalization of, subsidies. 43. Analysis of recurrent expendituresother than those mentioned earlier has received mueh less attention in adjustmentprograms. The general focus of the analysis is on the impact of recurrent spendingon resource use, i.e., on public savings and investment, the underlying notion being that physical investmenthas higher priority. The fact that returns to some recurrentexpenditurecan be higher than returns to investmentand that expenditureswhlch contributeto human capital are as importantis being increasinglyrecognized. 2Q/ See World Bank, Bank Treatmentog Subsidies,January 15, 1987. - 36 Public Investment 44. A key aspect of fiscal adjustmentin many developingcountries relates to the level, compositionand institutionalprocesses of public investment. Resource constraints often dictate a relatively sharp cutback in the magnitude of public investment (see Figure 6 and Table 7), which generally has a significant balance of payments impact inasmuchas the import content of such spendingexceeds that of current expenditures. Within a reduced public investmentprogram, priority is given to projectswith shorter gestation,higher rates of return. Many developing countries have, however, lacked a systematic process for evaluating public projects and for establishingmulti-year budgetting requirements. 45. In recent years, the Bank has carried out numerous public investment(or, sometimesmore broadly, public expenditure)reviews. A major objective of these studies has been to strengthen the Bank's ability to advise governments on the adjustments needed in their investment programs and how to improve the processes for planning, evaluating and monitoring public projects. It is, therefore, not surprisingthat adjustmentlending, both SALs and SECALs, has embodied 21 numerousconditions,many of a qualitativenature, on public investment. 46. In the early phases of the adjustmentprocess, the emphasis is generallyon scaling down the size of the public investmentprogram and shifting the focus away from the manufacturingsector to infrastructure 1/ Some 22 Public Investment/ExpenditureReviews were carried out during FY84-86,nearly all serving as inputs into adjustmentloans. I- Capital and 6 Current Shares 35- Expenditure-" of GDP 30 - 25- 20- 15- 10. 0 --- a- 1980 1//1 Capital Expenditure 1/ 1: SL countries. 1982 1983 1984 C&9 Current 1985 Expenditure 1986 - 38 - Table 7 Comjositionof GovernmentExpenditures (As % of Total GovernmentExpenditure) Countrv Wages and Salaries Subsidies and other Other current transfers Expenditure Interest Pavments Capital Expenditure . 7.6 6.0 8.4 40.0 20.5 17.6 20.0 32.5 34.8 32.2 41.0 39.3 24.3 23.0 17.9 8.3 8.2 36.3 14.9 12.8 7.6 42.6 45.9 29.5 9.9 10.2 8.7 35.0 32.2 20.3 9.6 2.9 5.4 8.2 5.4 11.7 36.1 47.4 50.5 11.2 12.1 12.1 25.7 19.6 20.3 3.3 3.7 10.0 48.1 50.2 49.6 5.8 14.9 10.6 17.1 11.7 9.6 17.0 16.0 13.1 4.7 6.6 7.9 15.8 14.1 14.2 31.7 34.2 37.9 30.9 29.1 26.8 . 9.2 8.0 28.9 22.7 35.4 23.2 23.4 21.3 19.9 44.8 35.2 28.0 26.1 33.1 33.2 3.8 7.2 15.9 49.4 31.2 19.3 10.2 14.7 15.2 10.6 13.8 16.5 . . 11.1 11.9 17.0 21.4 17.4 11.9 15.6 23.3 15.3 52.0 47.4 55.9 22.9 21.3 29.0 6.5 7.8 14.2 26.5 23.2 19.2 15.3 14.3 7.8 28.7 33.4 29.9 34.5 30.2 26.6 1.4 1.6 8.4 24.5 17.3 16.7 37.8 43.0 40.8 1.9 7.9 7.4 Argentina 1977 1980 1984 Brazil 1978 1980 1985 Chile 1977 1980 1986 . . Iiidonesia 1977 1980 1986 Korea S/ 1977 1980 1987 dexico 1977 1980 1984 Morocco,/ 1977 1980 1985 Pakistan 1977 1980 1985 Thailandif 1977 1980 1985 . . . Uruguay 1977 1980 1984 Al Countrieswith data on central governmentonly. Source: World Bank Data. - 39 and social sectors. A "core" investmentprogram consistingof a smaller number of projects which can be completed speedily is often devised. Pakistanand Turkey are two countrieswhere the Bank has been successful in persuading the government to increase the emphasis towards infrastructure (see Figure 7), which has important complementary linkages with private sector productivity. Some S&Ls contain highly specificquantitativeconditionson public investment. For example,SAL IV for Turkey required that (a) the public investoent/savingsgap be limited to 4.1% of GNP in 1983, (b) the 1983 growth of public investment be constrainedto 5.2% in real terms as an upper limit, and (c) number of projects in the program be reduced to 6,600 witl.85% of funds focused on 112 of 187 large projects. Generally, however, no exglicit quantitative target for public investment is put forward in SALs. Rather, conditionalitytakes the form of review and agreement on the program at a specifiedtime. It is in the course of the review process that agreementis reached on the appropriateslze and compositionof the program. 47. As the process of adjustmentand expenditure compressionhas continued,there has been, however, concern about the insufficiencyof public investment,particularlyfor infrastructuraland social sectors. Thus, some recent adjustment loans have specified conditionality in terms of an increase in, or a minimum level of, public investment. SAL I for Chile and the Reconstruction Import Credit II for Ghana are examples. A reduction in the share of public investmentallocated to the manufacturingsector so as to free up resources for other sectors has been another featureof SAL conditionality. -40Figure 7 SECTORALPUBLIC INVESTMENT (as share of GNP) TURKEY '13 12 s1'0 '2 I tso"1 1 . "3 s" I 3S arI tv PAKISTAN 2 2 6*- 195 -- 19; a 9419- Year aaInfrastructure Other Mitbanufact. h Minning - 41 - InstitutionalProcessesfor ExpenditurePolicy 48. Budgetaryreforms in general and improvementsin the investment planning and priority-settingprocess as well as in capital budgetting and control in particularare widely emphasized in adjustmentprograms and loans. For example,the Ghana SAL I requiredthat the IMF technical assistance recommendations on budgetting and expenditure control be implemented. It also stipulated further measures for strengthening institutional capacity for budgetting. SAL III for C6te d'Ivoire contained provisions for a program to strengthencapacity for project identification, economic evaluation and supervision in technical ministries as well as the use of "agreed criteria" for appraisal of economic and social projects. This focus on the institutionalissues in the budget area arises from the belief that expenditure reforms are unlikely to be durable unless the related institutionalcapacity is strengthened. This type of change is often a difficult one to effect given the shortage of skilled personnel and governmentpay scales in most developing countries, and would, therefore, have to have an appropriatelylong time horizon for implementation. 22 Fiscal Conseguencesof Public EnterpriseOverations 49. In many developing countries, the financial performance of public enterpriseshas a major bearing on the governmentbudget and the tJ/This discussion is limited to fiscal issues only. A separate background paper treats the issues related to public enterprise reform in more depth. - 42 - allocation of resources between the public and private sectors. Budgetary transfers to finance the investment outlays of public enterprisesor their operatinglosses often constitutea major drain on public finances. Moreover, public enterprisedemands on resources are widely believed to "crowd out" private investment. There is a general presumption that successful fiscal adjustment and enhanced overall economic performance often requires not only improved efficiency of public enterprises but also a reduction in the size of the public enterprisesector. These considerationsare incorporatedin the design of the adjustmentprogramssupportedby the Bank. 50. Public enterpriseconditionalitygenerallycovers a broad range of issues, including investment size and its financing, budgetary transfers,pricing, personnel,and divestiture. Sometimes the targets relate to the state enterprisesas a whole, while in other cases, the conditions may pertain to one or a few major enterprises. Explicit quantitative conditions are particularly common with respect to the investment level for public enterprises and the contributionof the general budget to its financing (e.g., SAL II for the Philippines; various SALs for Turkey). 51. Price and rate increases constitute a major area of public enterprise conditionality. The intent is to phase out subsidies, particularlycommon for petroleumproducts,electricityand fertilizers. Border pricing for petroleum products and other homogeneous tradeables is generally the rule followed. Considerableprogresshas been made in - 43 raising domesticpetroleum prices to internationallevels. However, it has proved to be more difficult to phase out fertilizer subsidies (Pakistan,Turkey). 52. The financialperformanceof public enterprises,often measured as a rate of return target or a given level of self-financing,is a common focus of conditionality. What seems to receive less emphasis is the possibilitythat price/rateincreasesby public enterprisesenjcying market power may even be counterproductiveto efficiency improvements. This issue particularlyarises in the context of electricutilitiesand other natural monopolies. Efforts to improve resource utilizationby the utility companies have proved elusive (e.g., Bangladesh, Colombia and Indonesiawhere power "loss" rates remain very high). IV. Reform of Taxation 53. Many developing countries have tax systems which generate distortionsin incentivesthrough their influenceon relativeprices (of both commoditiesand factorsof production). Moreover, tax revenuesare often not sufficientlybuoyant with respect to growth of output and incomes and may not adequatelyserve equity objectives. Typically, a large proportion of tax revenues is raised through taxes on internationaltrade, particularlyimports,and excises. For example, in 1985 in low-incomecountries,38 percent of tax revenuesoriginatedfrom taxes on international trade, with another 13 percent derived from excises (Table 8). - 44 - Table 8 Compositionof Tax Revenues for Countries Grouoedby Income. 1975 and 1983 -/ Low-income£/ 1985 1975 Tax CategoryhI Domesticincome Individual Corporate Other direct taxes Social security Property Domesticcommodity Sales, VAT, turnover Excises Internationaltrade Import Export LI hi .q/ I/ e/ Middle-IncomeA/ 1985 1975 Industriale/ 1975 1985 28 9 18 26 9 15 30 8 17 2 10 17 35 27 7 35 27 7 5 4 18 la 33 34 1 2 28 13 13 39 25 11 1 1 3 17 13 38 28 8 12 3 27 9 12 25 20 4 11 2 29 2 29 16 10 4 4 0 31 2 29 17 10 i1 13 12 19 17 1 2 0 Figures are unweightedrepresentingthe averagepatternlfor countries in the sample. Figures for subcategoriesdo not add up to the figure for each categorydue to the presenceof smallerunallocatedtaxes. Low-incomesample includes11 countries. Middle-incomesample includes36 countries. Industrialmarket includes19 countries. Source: World DevelogmentReport: 1988. 54. 2 Changes in tax systems which reduce distortionsin production and improve investment/savings incentivescan go a long way in effecting structuraladjustmentand contributingto economicgrowth. Moreover, by broadening the tax base, simplification, and strengthening tax administration,revenue elasticityand equity aspects of the tax system could be enhanced. Thus, adjustment programs increasingly include elements of tax reform. In designinga tax reform package, there are inevitably tradeoffs among various objectives -- revenue generation, efficiency, equity, and administrative simplicity. Administrative constraintsoften pose significantlimitationson the overall design and - 45 - the pace of reform implementation. Nevertheless,theoretical insights and experienceprovide broad guidelinesfor reformingtax systems. The contoursof desirablechange include the following: Shifting away from taxation of production to taxing consumptionin the form of a value added tax, coupled with a few excises on luxury items so as to achieve greater equity. Broadening of personal income taxation to include income from all sources with a top marginal rate significantlybelow those found in many industrial and developing countries;very few exemptions and rates. Simplifyingand rationalizingof corporate taxationso as to have a relatively low marginal effective rate and neutrality with respect to the choice of sectors, assets and the financing compositionof investment; very few rates; elimination of double taxation of dividends. Inflationaccountingfor both personaland corporate taxes. A reductionand simplificationof tariffsbased on ad-valoremrates and which serve protectiverather than revenue purposes;replacement of high tariffson luxury goods by excise taxes. A major strengtheningof tax administrationsystem. - 46 - 55. While few countries have carried out successfulcomprehensivetax reforms, it is important that partial reforms be based on a sound overall design of the tax system. In particular,the reforms of internationaltrade taxes need to be closelycoordinatedwith that of domestictrade taxes. Experiencewith Tax Reform in AdiustmentPrograms 56. Faced with large and unsustainablefiscal deficits, fundamentaltax reform in many developing countries has been temperedby short-run revenue considerations. Indeed, given the urgency of fiscal deficit reduction,nearmeasutes have often tended to dominate tax policy term revenue-enhancement initiativesin recent years. This has often involvedan increase in excise and internationaltrade taxes, because of the ease with which such taxes can be administered. In Malawi, for example, import duties and excises on selective goods were increased in the early 1980s. Other countries with similar experiences have included Argentina, Bangladesh, Philippines,and Thailand and more recently, Morocco, where a special surtax on imports is being increased. These ad hoc changes, however, have adverse incentive implicationsthrough increasedprotectionand cascadingeffects, and tend to further complicatethe tax structure. 57. The trend in tax revenuesfor a selectedgroup of countries is shown in Table 9. With few exceptions,there has not been a significantincrease in the tax/GDP ratio, further underscoring the earlier observation that expenditures have borne the main brunt of fiscal deficit reduction. Maintainingthe tax/GDP ratio has often been achievedby the introductionof - 47 - Table 9 GovernmentRevenuesby Broad Categories (Percentageof GDP) Domestic Int'l Indirect Trade Taxes Taxes Total TIaz Non LM Total Revenue Country Domestic Direct Taxes Chile 1982 1986 9.0 6.3 12.3 14.1 1.4 3.0 22.7 23.4 9.0 5.6 31.7 28.9 Colombia 1982 1986 2.6 3.3 2.8 3.5 1.8 2.2 7.4 9.6 0.9 0.5 8.3 10.1 C6te d'voire 1982 1986 4.1 3.7 5.6 5.7 10.1 9.6 21.3 20.3 6.4 11.4 27.7 31.7 Jamaica 1982 1986 11.9 11.9 8.9 11.1 3.0 5.2 23.9 28.4 0.9 1.0 24.8 29.4 1982 1986 6.5 6.8 8.2 9.9 5.0 4.4 19.7 21.4 3.4 3.2 23.1 24.6 M1ala-i 1982 1986 6.4 7.1 5.9 6.4 4.2 3.5 16.7 17.1 2.9 4.5 19.6 21.6 1983 1986 10.6 8.0 5.6 6.1 0.5 0.9 16.8 15.0 1.0 1.0 17.8 16.0 Morocco 1982 1986 4.6 5.0 8.7 8.1 6.4 4.2 20.1 17.9 2.6 3.8 22.7 21.7 Pakista 1982 1986 2.9 2.2 4.9 5.8 5.9 5.8 13.6 13.8 2.9 3.7 16.5 17.5 Thailand 1983 1986 3.6 3.4 6.7 7.9 3.7 3.5 14.6 15.6 1.5 1.5 16.1 17.1 Mexico Source: World Bank and IMF Data. - 48 - ad hoc measures, as noted above. Inelasticity of tax systems in many developingcountries gives rise to the need for frequent, ad hoc changes in the taxes rates and/or base to ensure that tax revenues increasein line with GDP. 58. As part of trade liberalizationprograms, reform of international trade taxes has been the most common feature of tax changes aimed at improving resource allocation. Generally, the focus has been on converting specific duties to ad-valoremrates and reducing the level and variation in tariff rates. ConvertingQRs to tariffs has typicallybeen an accompanying measure. Virtually all SALs and trade/industrysector adjustmentloans have contained considerableconditionalitywith respect to tariff regimes and, by and large, significantprogress has been made on this front. However, in some cases (e.g., Kenya in 1983), trade liberalizationhas sufferedsetbacks in part because of the negative revenue consequencesof reduced tariffs at a time when importswere decliningbecause of a foreign exchange shortage. In the case of Kenya, while tariff reductions and rationalization were initiated,compensatoryrevenuemeasureswere not instituted. In other cases (e.g., Philippinesand Thailand),tariff reform was not undertakenbecause of negative revenue consequences. Removal of export taxes on agriculturesis at times impeded by revenue consequences,particularlyas the impositionof a land tax as a substitute encounters powerful political opposition (e.g., Argentina). 59. Reform of domestic indirect taxes has been less extensive than in the case of tariffs. Several countries, including Indonesia, Korea and Turkey, have in recent years introduceda VAT as the main instrument for rationalizingtheir system of indirect taxation. By now, more than thirty developing countries have some form of VAT. Some VATs apply to the - 49 manufacturing/import stage (e.g., Indonesia) while others extend to wholesale/retailstage (e.g., Korea, Turkey). The experiencewith VAT has been favorable,even in terms of short run revenue response. While the Fund has long advocated the introductionof a VAT as the most desirable broadbased, efficient form of commodity taxation,the Bank has generally accorded very limited attention to commodity taxation issues, except tariffs, in its economic work and adjustmentlending. An important exceptionhas been the case of Turkey where the introductionof VAT was explicitlysupportedin the SALs to that country as early as in 1981. Beginning in the mid-1980s, the Bank has taken a more active role in advocatingVATs (e.g., the Malawi Tax Study of 1985; Bangladesh: Adjustmentin the 80s and Short-termProspects, 1988; Tunisia SAL I). 60. Progress in reforming personal and corporate income taxation has been very limited. Two broad problem areas exist in most income tax systems of developingcountries. First is the presenceof numerousexemptionsand/or incentiveswhich are often intendedto stimulateinvestment/savings or serve other policy objectives. Such provisionsreduce the tax base and revenuesto an extent often unknown and, in the case of investmentincentiveswhich are pervasive in some countries (e.g., Morocco, Turkey), there is very little empirical evidence that they produce sociallydesirableresults. The second aspect of income taxation where reform is warranted, particularly in high inflation countries, relates to the absence or inadequacyof indexationof both income and assets. The impact of high inflationon revenue can also be negative through collectionlags and full deductabilityof interestexpenses. The low share of income taxes in overall tax revenues, enforcement difficulties,powerful vested interests,and a genuine desire to influence saving/investmentdecisions account for the inertia in streamliningincome taxation. - 61. 50 - There have been only a few developingcountries that have attempted comprehensivetax reforms. Colombia has had two major episodes (1974 and 1986). More recently,Indonesiaand Mexico have had major overhaulsof their tax systems. Indonesia'sreform was particularlynoteworthy in that it was n= motivatedby a fiscal crisis but was induced largely by the government's effort to reduce the dependence of its revenue base on oil income and increase the low share (about 8 percent) of non-oil taxes to GNP over the medium to longer term. The reform, introduced in 1983-84, completely overhauledincome and domestic trade taxation. Not only does the new system have a broader base and is more neutral and simpler to administer,it has also produced significantrevenue gains, which in turn have helped to keep the fiscal deficit within manageable limits following the sharp decline in oil prices in 1986. Indonesia'stax reform was very much undertakenon its own initiative and did not form any part of explicit or implicit conditionalityin its dealingwith the Bank (or the Fund). V. Growth-OrientedFiscal Programs: Lessons of Experience 62. Fiscal adjustmentand reform are by nature difficult to design and implement given the complexityof the underlyingeconomic and institutional factors as well as social and politicalsensitivities. The discussionin the previous section points to several broad conclusionsas to the nature and extent of fiscal adjustmentin the developingcountriesin this decade: 51 - Fiscal policy reforms have often been triggered by actual or impending budgetary and balance of payment crises. Under such circumstances,short run considerationshave dominated the policy measures introduced. For a number of countries,considerableadjustmenthas occurredwith respect to reducing the fiscal deficit and the external deficit, althoughseveralcountriesexperienceda reversalon the budget side after 1985. As expected, the short run impact of budgetary retrenchment has generally been recessionary with a fall in investmentand growth. Reduction of the fiscal deficit has been achievedprimarily through expenditurecutbacks,particularlyin public investment. Expenditurecutbacksrelativeto GDP have been accompaniedby a more focussedpublic investmentprograms, often in the form of a "core" set of projects and activities in high priority, areas such as infrastructure. Improved allocationof recurrent expenditureshas also been achieved although the reduction and eliminationof some subsidies (e.g., fertilizers)has proven to be more difficult. With a few exceptions, revenue enhancement has not been very significantbecause the tax systems often lack a sufficientdegree of elasticityand the reductionof imports due to foreign exchange constraints has resulted in losses of tariff revenues--a main - 52 - component of tax receipts. Indeed,many countries have introduced ad hoc tax measures of an undesirable nature (on efficiency and incentive grounds) to maintain or modestly increase their tax/GDP ratios. Fundamental tax reform, except for tariffs, has not been a significantaspect of fiscal adjustment. 63. Growth-oriented adjustment programs entail an approach to fiscal reforma which goes considerably beyond the purview of the traditional stabilization approach which emphasizes measures aimed at reducing the aggregate demand. By definition,fiscal policy changes aimed at augmenting aggregate supply take longer to bring about the desired results. Consequently,adjustmentpoliciesaccentingfulndamental fiscal reform require a medium term perspective. Countries suffering from severe macroeconomic imbalances need, of course, to restore a reasonable degree of stability before structural measures can be put in place and expected to elicit the desired responses. However, what constitutes a "reasonable degree" of macroeconomic correction depends on a number of factors, including the availability of external finance to support an appropriate adjustment program. Countriescommitted to fundamentalfiscal reform--aswell as other key policy areas--should be able to avail themselves of the necessary - 53 financial support within a time frame that allows them to initiate and sustain the process of change. In this context, the tradeoffbetween a rigid 23 focus on stabilizationand adjustmentshould be recognizedand considered. 64. SALs remain the most appropriate vehicle for supporting fiscal reform because of their economy-wideapproach. In principle, there is no reason why a series of fiscal-basedSALs could not be designed for a country willing to undertake structural and institutionalreforms in the areas of expenditure policy, taxation, and public sector pricing. Considerable preparation in the form of studies with a policy focus would, however, need to precede such lendingoperationsfor them to be effective. The Bank has in recent years carried out many "Public Investment(Expenditure)Reviews", some of which have served, as noted earlier, as inputs into SALs. More sharply focussed studies of this type, including those on the revenue side, would need to be undertaken to underpin carefully the adjustment programs and lending. SAL conditionalitywould need to be geared towards reform actions as opposed to necessarilyshort-run improvementsin key macro targets (e.g., the budget deficit). In countries where there is an acute stabilization problem, aggregatedemand reductionmeasureswould also need to be included. In any event, multi-year financing commitmentwould be required to help persuadegovernmentsto undertakethe reforms and to sustain them.24 2./ The World Bank and IMF are increasingly recognizing the need folrefocussing fiscal reform packages to include supply-sidemeasures .an, are proposing a change in its policy in this direction as evidenced i:. recent internalpolicy documents. 24/ See S. Fischer, "Issues in Medium-Term MacroeconomicAdjustment", Th1 World Bank ResearchObserver,VL.1, July 1986, for a discussionof multiyear structuraladjustmentprogramsand financing. - 65. 54- Greater Bank involvement in adjustment lending based on fiscal reform and the Fund's growing concern with growth-oriented adjustment programs imply a greater need for coordinationand collaborationbetween the two institutions in designing mutually-reinforcingoperations. In this context, there should be a clear understandingthat fiscal policy issues are a matter of concern for both institutionsand could be the basis for the lending operationsof either entity. The increasedawarenessof the need for growth-oriented adjustment programs in general, and the central role of fiscal policy in their design implies that the Bank will be required to take a much more active role in this area. - 55 BOX Tarzettingthe Budaet Deficit: ClarifvingConcepts The fiscal deficit is a very important component of the policy package in adjustment programs. In order to monitor its size, adjustment programs usually set targets on net domesticcredit to the governmentor the private sector as well as on commercial borrowing by the government (or public sector) from abroad. To avoid the possibility of the government borrowing excessively from the non-bank public, adjustment programs often also include targets on the size of the deficit, thereby limiting the need for such borrowing. This is done in order to ensure that the private sector is not crowded-outfor financialresources. In designing adjustmentprograms, do the commonly used concepts of the budget deficitprovide an accurateindicationof the fiscal stance of the public sector viz-a-vis the rest of the economy or are they misleading? Would it be useful to complement the standard budget deficit with other measures? These issues are often decidedby the availabilityof data. But, the discussionson these questionshave improvedunderstandingof the impact of the government on the economy; and have shown that it is important to understandthe limitationsof the commonlyused measures. Earlier programs often only look at the public finances of the central government. The central government'sdeficit or its net borrowing requirement was defined as central government expenditure net of central government revenue. This was obviously an insufficient measure as a substantialpart of governmentactivity consists of public enterprises and state of local governments. It is now common to measure the net financing requirementof the entire public sector called the consolidatedpublic sector - 56 - deficit or the public sector borrowingrequirement(PSBR). This measures the net use of financial resources by the public sector and consequently its impact on the balance of payments, inflation,credit to the private sector and domestic interestrates. In dealing with high inflation countries the concept of the operational deficit or inflation-correcteddeficit is very useful. The operational deficit is defined as the PSBR minus the inflation correction part of interestpayments. This is necessarybecause with high inflationthe real value of the government'sdebt has fallen, and a part of the interest payments (which should be deducted) only compensates debt-holders for inflation. A few recent programs have used this as a supplementary criterion. In countrieswith a large debt overhang it is useful to measure the non-interest or primary deficit. This is ar.indicator of the impact of fiscal policy in a particularyear on the public sector's net indebtedness; and providesan assessmentof trends in underlyinggovernmentaccountsnet of the inheriteddebt problem. Another concept sometimes found useful is the structuraldeficit. This concept is suggested in cases where temporary factors such as fluctuationsin commodity prices, sale of public assets (privatization), a tax amnesty or for that manner any fluctuationin GDP from trend values leads to a temporarychange in public financeswithout changing underlyingtrends in government expenditure or revenue. It can be particularlyuseful in avoiding a commonly observed problem in many developing countries of increasingexpendituresduring a commodityboom followed by large deficits when prices fall. Automatic adjustors are often specified to the overall deficit or credit ceilingsto account for unexpectedshortfallsor a bonanza. * 57 A more difficult issue associated with targetting arises from distinguishing ex-ante between what will be called here the first order deficit and the subsequentincrease in the deficit brought about by changes in inflation and domestic interest rates or for that matter other channels which affect the budget deficit. For example,acceleratinginflationerodes revenues because of collection lags, tax evasion or lack of indexation, creating even larger deficits. This is known as the Tanzi effect. Studies show that the impact of these lags can be large in high inflationcountries. A similar situation arises when the governmentfinances its deficit through domestic borrowing. Now interest rates rise due to inflationary expectations,resulting in large interestpayments, which in turn raise the deficit even further. Turkey, and Brazil providesa strikingexample of this type of vicious spiral in domesticinterestrates, domestic interestpayments and the deficit. What does this imply for targettingbudget deficits? The firstorder deficit reduction required for macro-stabilityis smaller than the deficit shown by the PSBR. This is because a part of the deficit reduction will come automaticallyas the rate of interest and inflation fall with an initial reduction in first-orderdeficit (Note that a fall in inflationwill have other consequencessuch as a fall in revenue from the inflation tax). The PSBR can over-estimatethe reduction in the fiscal deficit required to correct macro imbalances. It can therefore lead to recommendationswhich require larger expenditurereductionand revenue enhancingmeasures than are warranted. 58 - A final measure of the deficit that is often used in evaluating government finances is the current deficit i.e. current expenditurenet of current revenues. A surplus on this account shows that the governmentis a net saver. A deficit shows that the governmentis using a part of the taxed savings of the private sactor for its current expenditureneeds. In general it is desirable to increase government savings (reduce current deficit). However, one must be careful. If this is brought about for example by reducing maintenance expenditures to increase investments or by reducing current outlays on public health services to build a hospital its overall impact may not be beneficial. - 59 Table 1 Definitionsof the Budget Deficit Central Government Deficit - Central Government Expenditure - Central Government Revenue Public Sector Borrowing Requirements(PSBR) - Total Public Expenditure - Total Public OperationDeficit (inflationcorrected deficit) - PSBR - Inflationcorrected part of interest-payment Primary Deficit (nun-interestdeficit) - PSBR - interest-payments Structural Deficit - PSBR - temporaryfactors (commoditybooms or busts, droughts sale of assets) First-OrderDeficit - PSBR - Tanzi Effect - effect of inflationaryexpectations on interestrates CurrentDeficit - Current Expenditure - Total Revenue Revenue - 60 AppendixA: Table A.1 Effutlvw Rserve Rsstr.nts an Oposits In DOUsticBualng Wsyt a/ 1981 1982 1983 1984 198S 1988 0.148 0.085 0.422 0.473 0.154 0.467 0.317 0.158 0.51 0.178 0.398 0.438 0.152 0.609 0.27 0.024 0.797 0.422 0.359 0.454 0.141 0.632 0.304 0.118 O.5S 0.341 0.351 0.830 0.284 0.566 0.294 0.270 0.483 0.333 0.34 0.501 0.308 0.413 0.257 0.278 0.222 0.348 NA 0.m 0.484 0.302 0.215 0.393 BrazIl Baglad.ah Indormsla Nigeria ivory Cost I(Mys PakIstan Phllppilus Zabla 0.185 0.10 0.205 0.137 0.081 0.085 0.101 0.114 0.177 0.210 0.098 0.248 0.175 0.048 0.105 0.091 0.090 0.148 0.167 0.150 0.106 0.161 0.070 0.072 0.077 0.121 0.132 0.195 0.159 0.0a0 0.124 0.098 0.105 0.139 0.211 0.185 0.091 NA 0.Ot8 0.140 0.116 0.100 0.193 0.284 Tunisia Korea MDrooco 0.039 0.054 0.023 0.023 0.069 0.018 0.028 0.033 0.056 0.040 0.015 0.025 0.028 0.040 0.017 0.018 0.043 0.048 Thai lad 0.048 0.041 0.039 0.030 0.040 Hlgh ArgutIra uruImy Colomia iOu Iblawl &bxlao Turkey _uIca Moderate Source:Intnatinal 0.093 O.94 0.0 0.163 0.098 0.058 0.071 0.089 0.108 0.162 Filncial Statistics a/ Line 20 divided by sum of Line 24 & 25. 0.037 - 61 - Appendix A: Table A.2 AVERAGE INTEREST RATE ON PUBLIC-SECTOR DOMESTIC DEBT Per cent per annum 1980 1981 1982 1983 1984 1985 19.9 100.8 30.9 104.5 19.2 104.5 10.4 343.8 7.2 626.7 11.2 673.4 Brazil Interest rates Consumer prices 35.4 92.8 89.0 98.6 131.3 100.4 136.7 133.4 250.2 188.8 270.4 224.6 High Inflation Mexico Interest rate Consumer prices 10.8 26.3 16.9 27.9 21.7 58.9 28.5 101.9 37.3 645.4 32.6 57.7 Philippines Intereat rate Consumer prices 12.0 18.2 11.9 13.1 13.8 10.2 14.2 10.0 28.5 50.4 33.2 21.7 III. Low Inflation Indonesia Interest rate Consumer prices 9.0 18.5 9.0 12.2 9.0 9.5 9.0 11.8 9.0 10.4 9.0 3.7 Korea Interest rate Consumer prices 11.6 28.7 10.5 21.3 8.8 7.3 7.2 3.4 9.1 2.3 7.8 1.7 Venezuela Interest rate Consumer prices 7.1 21.5 8.4 16.2 11.8 9.5 13.2 6.2 13.5 12.2 13.0 10.7 I. II. A/ k Hyperinflation Argentina Interest rate A/ Consumer prices k/ Derived from comparing the annual interest expense on domestic indebtedness incurred by the non-financial public sector with the estimated mid-year stock of its domestic debt. Annual increase as a percentage. Source: Helmut Reisen and A. van Trotsenburg "Developing Country Debt: The Budgetary and Transfer Problem," OECD, Paris, 1988. Appendix A: Figure A.1 CENTRALGOVERNMENTEXPENDITURE FOR , LWER-MIDLER -DDLE, & INTWS ECONOMES 40- 30 - 0 20 -. io- 0%_ 10 DE ZZ DE ED HE SS ES - Ew ED HE SS ES, AF iC OP 1E S 136 i L Iw Up-Mid Defence Education Health Social Security and Welfare Economic Services -. AF TC OP TE SD "n = - Indust Agriculture,Forestry, Fishing, and Hunting Transportationand Communication Other Purposes Total Expenditure Overall Surplus/Deficit iket Oriented Developing A: CURRENTREVENUE CENTRALGOVERNMENT UIR-MI.& FORLW, LUMER-MIDOL ECOOME NR 35. 30- - 25 IL z 20 - IL 0 K 15 10 .0 IPC SSC DCS IIT CNR *T CTR TCR 1983 gZo ' Low-Mid LOW 1 and IPC = Taxes on income, profit, gains capital contributions Social security SSC DCS - Domestic taxes on goods and services ITT - Taxes on internationaltrade and transactions Up-Mid OT CNR CTR TCR - Indust Other taxes Current nontax revenue Current tax revenue revenue Total current Source: See Lindbeck, Assar (1986): "Public Finance for Market Oriented Developing Countries," Mimeo, The World Bank, Washington,D.C. - 64 BIBLIOGRAPHY Anand, R., Chhibber,A., van Wijnbergen,S. 1988. "ExternalBalance,Fiscal Policy and Growth in Turkey",PPR Working Paper No. WPS86, August 1988. Balassa, B. 1988. "Public Financeand EconomicDevelopment". 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Low Inflation Countries 170 160 150 - 140- 0~ 120110 9U10 100 -1 901980 a 1981 BA 1983 1982 + IN 0 Year TU 1985 1984 A MO v TH 1986 High Inflation Countries 120- 110 - 100 I LU 90 0. so -- 70 - ' 60 1980 1981 0 ARGENTlNA 1982 1983 Year + GHANA 1984 O 1985 MEXICO 1986 PPR WorkingPaper Series Title WPS107 A Review of World Bank Lending for ElectricPower Author L. Leltmann WPS109 ImprovingPower System EfficiencyIn the DevelopingCountriesThrough PerformanceContracting Philip Yates WPSIII Recent World Bank Activitiesin Energy WPS112 A Visual Overview of the World Oil Markets WPS113 Public Sector Pay and Employment Reform Contact Mohan Munasinghe JosephGilling Melody Mason WPS108 Some ConsiderationsIn CollectingData on HouseholdEnergy Consumptlon WPSIIO Impactof Lower Oil Prices on RenewableEnergy Technologies Date E. Terrado M. Mendis K. Fitzgerald Industryand Energy Department Kay McKeough Jose Escay SompheapSem BarbaraNunberg October 1988 J. Cheeseman 61703 WPS114 Africa Region PopulationProjections 1988-89 edition My T. Vu EduardBos October1988 S. Ainsworth 31091 RodolfoA. Bulatao WPS115 Asia Region PopulationProjections 1988-89 edition My T. Vu Eduard Bos October1988 S. Ainsworth 31091 Rodolfo A. Bulatao WPS116 Latin America and the Caribbean Region PopulationProjections 1988-89 edition My T. Vu October1988 Eduard Bos Rodolfo A. Bulatao S. Ainsworth 31091 WPS117 Europe,Middle East, and North Africa (EMN)Region PopulationProjections 1988-89 edition My T. Vu Eduard Bos RodolfoA. Bulatao October1988 S. Ainsworth 31091 PPR Working Paper Series Title WPS118 Contract-Plansand Public EnterprisePerformance Author John Nellis Date October 1988 Contact R. Malcolm 61707 WPS119 Recent Developmentsin Commodity Modeling: A World Bank Focus Walter C. Labys October 1988 A. Daruwala 33716 WPS120 Public Policy and Private Investment In Turkey WPS121 CommercialBank ProvisioningAgainst Claims on DevelopingCountries WPS122 ImportDemand In Developing Countries WPS123 Export Supply,Capacityand Relative Prices Ajay Chhibber October 1988 Sweder van Wljnbergen A. 8halia 60359 Graaam Bird October 1988 1. Holloman-Will 33729 RiccardoFaini Lant Pritchett FernandoClavljo November 1988 K. Cabana 61539 RiccardoFainl November 1988 K. Cabana 61539 WPS124 InternationalMacroeconomic Adjustment,1987-1992: A World Model Approach WPS125 The Effectsof FinancialLiberalization on Thailand, Indonesiaand the Philippines Robert E. King Helena Tang November1988 K. Adams 33738 ChristopheChamley Qaizar Hussaln October 1988 A. Bhalla 60359 November 1988 E. Madrona 61711 November 1988 1. Diwan 33910 WPS126 EducatingManagers for Businessand Goverment: A Review of International Experience Samuel Paul John C. Ickis Jacob Levitsky WPS127 LinkingDevelopment,Trade, and Debt Strategiesin Highly Indebted Countries IshacDiwan WPS128 Public Finances in AdjustmentPrograms Ajay Chhibber December1988 J. Khalilzadeh-Shirazl A. Bhalla 60359