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Fiscal Policy and Public Expenditure Santiago Herrera PUBLIC EXPENDITURE ANALYSIS AND MANAGEMENT COURSE March 2005 Outline I. The Government’s budget identity II. Expenditure: composition, efficiency and growth impact III. Taxes and growth-optimal size of the expenditure IV. Financing the budget-debt sustainability analysis in practice V. Policy coordination: fiscal, monetary, exchange rate and public debt policies I. The Government’s Budget Identity Uses = Sources Gt it Bt 1 Et i Ft 1 * Uses : Sources: Tt Bt Bt 1 E t Ft Ft 1 M t M t 1 Government’s Inter-temporal Budget Constraint Today’s debt stock = NPV of (primary surplus + seigniorage revenue) Dt ( St i M t i ) / i 1 where St i Tt i Gt i Dt Bt Et Ft i 1 Rt II. Public spending:composition, efficiency, and growth impact Objectives of public expenditure: Efficiency in resource utilization Economic growth Equity of income distribution and social stability A. Cost-Benefit analysis B. Measuring effciency C. Growth impact A. Costs Benefits Analysis • Rationale for public intervention – Redistribute income – Correct market failure/positive externality – Greater supply of goods than private-sector provision • Objectives and Targets • Valuing costs – Additional fiscal burden • Source of funds to cover costs – borrowing vs. taxation • Marginal cost of public funds – Sustainability – Macroeconomic Stability • Valuing benefits – Comparing with a counterfactual Net present value of geothermal project in the Philippines with different marginal cost of funds NPV 40 US m 29.7 20 0 1.0 -20 1.20 1.40 1.60 -11.3 -40 -60 -52.3 -80 -100 Source: Devarajan, et.al. (1997) -93.3 BOX 2: ROAMEF CYCLE Source: The Green Book, HM Treasury B. Measuring Efficiency of Public Spending • Nonparametric Approaches: (Deterministic or Stochastic) – FDH (Free Disposable Hull) – DEA (Data Envelopment Analysis) • Parametric Approaches: (Deterministic or Stochastic) – Corrected OLS – Stochastic Frontier Parametric Approach: Stochastic Frontier - An Illustration 140 Primary Enrollment vs Education Expenditure BRA CPVGAB GNQ PER 120 MWI 60 80 100 UGAT GO CHN BLZ KNA ARG ZAF FJ I NAM NPL T UN LAO DOM PHL RWA LSO LCA RUS MEX COL T ON PRY GUY BOL IDN URY LKA KHM VNM PAN DZA SWZ HND BLR VUT MUS LBN CRI SLV SYR ZWE T J KKGZNIC ROM HUNBWACZE CHL SVK BHR T T O VCT BGRWSM LT U MKD MAC EST DMA POL IND J AM LVA MYS MDG SLB AZE KOR KAZ MNG BGD GT M BHS MAR J OR GRD IRN GEO CMR ARMUZB T HA HRV ARE BENKEN MDA MOZ MRT OMN COM UKR ZMBGMB COG GHA PNG YEM CIV SEN PAK GNB T CD SLE TCAF ZA AGO GIN BDI ERI SDN ET H MLI BRB KWT SAU 40 BFA DJ I NER 0 200 400 600 Public Expenditure on Education Inefficiency Data Source: World Bank WDI 800 Efficiency Frontier 1000 Methodology: Concept of Efficiency X2/Y Y T R P S Y’ O • Technical Efficiency: TE = OR/OP • Allocative Efficiency: AE = OS/OP X1/Y Methodology: FDH D Output E C A YA YB B O XA XB Input Input Efficiency for country B: XA/XB Output Efficiency for country B: YB/YA Non-parametric Approach: FDH – An Illustration 140 Primary Enrollment vs Education Expenditure BRA CPVGAB MWI 120 GNQ 60 80 100 PER UGAT GO CHN BLZ KNA ARG ZAF FJI NAM NPL T UN LAO DOM PHL PRY RWA LSO RUS COL T ONMEXLCA IDN LKA BOL GUY URY PAN KHM VNM DZA SWZ HND BLR VUT MUS LBN CRI SLV SYR ZWE T JKKGZNIC ROM HUNBWACZE CHL SVK BHR T T O VCT BGR MKD LT U MAC EST WSM DMA POL IND JAM LVA MYS MDG SLB AZE KOR KAZ MNG GT M BGD BHS MAR JORIRN GRDT HA HRV GEO CMR ARM UZB ARE BENKEN MDA MOZ MRT OMN UKR ZMB COM COG GMB GHA PNG YEM CIV SEN PAK GNB T CD SLE TCAF ZA AGO GIN BDI ERI SDN ET H MLI BRB KWT SAU 40 BFA DJI NER 0 200 400 600 Public Expenditure on Education Data Source: World Bank WDI 800 1000 Methodology: DEA CRS F D Output N Y VRS V C A B VRS O X Input Country C: Efficient by FDH, but inefficient by DEA Peers of country C: A and D Country D: inefficient by CRS DEA, but efficient by VRS DEA DEA Efficient Frontier: Primary Enrollment 140 Primary Enrollment vs Education Expenditure BRA CPVGAB MWI 120 GNQ 60 80 100 PER UGAT GO CHN BLZ KNA ARG ZAF FJI NAM NPL T UN LAO DOM PHL RWA LSO LCA RUS MEX PRY COL T ON IDN LKA BOL GUY URY PAN KHM VNM DZA SWZ HND BLR VUT MUS LBN CRI SLV SYR ZWE T JKKGZNIC ROM HUNBWACZE CHL SVK BHR T T O VCT BGR MKD LT U MAC EST WSM DMA POL JAM LVA MYS MDG IND SLB AZE KOR KAZ MNG GT M BGD BHS MAR JORIRN GRDT HA HRV GEO CMR ARM UZB ARE BENKEN MDA MOZ MRT OMN UKR ZMB COM COG GMB GHA PNG YEM CIV SEN PAK GNB T CD SLE TCAF ZA AGO GIN BDI ERI SDN ET H MLI BRB KWT SAU 40 BFA DJI NER 0 200 400 600 Public Expenditure on Education Data Source: World Bank WDI 800 1000 An important factor of production (public spending) is used more intensively in the relatively richer countries 8 Edcation Spending vs GDP per capita 2 4 6 KWT SAU BRB MAC EST CZE ZAF HUN BWA KOR ARG POL NAM LVA MYS KNA BHS SVK OMN BHR T UN LCA ARE LT U CRI HRV VCT MUS MEX DMA T ON TGRD HA O AT G ZWE BLZ PAN BRAT TCHL FJI IRN VUT JOR COL SWZ MKD DZA BLR RUS URY LSO JAM PRY GAB WSM ROM CPV GUY BGR MARUKR KAZ PER PHL GNQ BOL SYR LBN SLV DOM HND UZB SDN MDA MNG NIC AZE IND LKACHN GHA SLBARM CIV T GO DJI COM MRT YEM KEN GT M SENGMB KGZ CMR PNG AGO VNM IDN GEO PAK NPL BGD GIN LAO KHM ERI UGA ET H BENRWA MWI BDI CAF MOZ MLI MDG T CD NER TZMB JK GNB BFA T ZA SLE 0 COG 6 7 8 lgdp ledu 9 10 Linear prediction Public Expenditure on Education and GDP per capita (both in logs) 600 Correlation: Learning Scores and Average Years of School SGP T WN 500 SVN MYS CUB 400 KEN T ZA MOZ 300 Learning Scores T HA ARG CHL PER PRY KWT PHL MUS ZWE CMR UGA ROM MEX T T O JOR T UN IRN BRAT UR IDN BOL COL DOM HND KOR HKG HUN SVK CZE BGR POL SWZ BWA ZAF MLI LSO 200 SEN ZMB MWI NER 0 2 4 6 Average Years of School 8 10 600 Data Source: World Bank WDI & Crouch and Fasih (2004) Correlation: Learning Scores and Net Secondary Enrollment KOR CUB ROM MDA T T O MKD J OR T UN IRN BRAALB ARG 400 MEX DOM IDN PRY T UR BOL CHL COL PER KW T VUT SYC KEN 300 T ZA MAR SW Z MOZ MDG PHL ZW E BLZ MUS BW A BFA ZAF LSO NAM 200 Learning Scores 500 SVK MYS HUN CZESVN BGR LVA POL LT U NER 0 20 40 60 Net Secondary Enrollment Data Source: World Bank WDI & Crouch and Fasih (2004) 80 100 600 Learning Scores vs Education Expenditure HUN SVK RUS CZE 500 BGR POL LVAMYS LT U ROM TT O 400 IDN CHL MDA J OR IRN T UR ARG BRA PER T HA MEX MKD PRY COL HND T UN BOL KWT VUT 300 MUS KEN BLZ SWZ PHL T ZAMAR CMR MOZ MDG UGA BFA BWA CIV MLI ZMB SEN MWI 200 ZWE ZAF LSO NAM NER 0 100 200 300 Orthogonalized Public Expditure on Education Data Source: World Bank WDI & Crouch and Fasih (2004) 400 600 500 NLD HUN SVK AUS CZE RUS GBR DEU BGRUSA ESP 400 GRC 300 CAN CHE MYS POLLVA AUT FRA SWE FIN ISL NZL NOR IT A LT U T HA PRT ROM MDACYP T T OMEX MKD J OR T UN ARG TBRA UR IRN IDN CHL COLPRYBOL KWT DOM PER HND VUT MUS KEN BLZ MAR T ZA CMR MOZ MDGSWZ UGA ISR PHL BFA CIV MLI ZMB SEN MWI 200 Learning Scores Learning Scores vs Education Expenditure ZWE BWA ZAF LSO NAM NER 600 800 1000 1200 1400 Orthogonalized Public Expditure on Education Data Source: World Bank WDI & Crouch and Fasih (2004) 1600 DNK C. Public Expenditure Composition and Growth Question – What’s impact of public spending composition on growth? • Re-allocation decisions among Infrastructure, Education, Health, and Transfers • Financing decisions for expenditure change – debt or tax, or or different types of tax instruments • Permanent vs. transitory expenditure changes Modeling approach • Question: Effect of public expenditure on growth • Building blocks of the model economy based on some principles that allow replication of key features (growth, transfers, debt accumulation) • Experiments a. Allocation decisions: Change compositions and compare with SS b. Financing decisions: debt vs. taxes; or different types of tax instruments c. Permanent vs. transitory expenditure changes Building blocks • Preferences (types of agents, consumption, unproductive government expenditure) • Technology- Explicit relationship between inputs and output; productive government expenditure) • Resource constraints (public and private sectors) Building blocks (Glomm-Rioja)–Preferences Individual s live 2 periods : Work in period 1. Retired in period 2. • Consumer’s utility maximization problem max s.t. ln( 1 nt ) ln ct ,t ln ct ,t 1 ct , t st (1 L, t ) wt ht ct , t 1 (1 (1 K , t )rt 1 ) st Tt 1 Solution leads to optimal savings and labor supply decisions. Building blocks -Technology Production Function : Yt 1 AGt K t H t Y : Output A : Productivity parameter G : Public capital K : Private physical capital H : human capital Building blocks-productive government expenditure • Human capital production function ht Bnt Et 1ht 1 Laws of motion: H t Bnt Et 1H t 1 Gt 1 G ,tYt Building blocks-Fiscal policy Dt 1 L, t wt H t K , t rt K t ( G, t E , t T , t P, t )Yt (1 rt (1 K , t )) Dt where public expenditure (as % of GDP) - on infrastructure on education on transfers on other non-utility enhancing public service Tax rate - on labor income - on capital (interest) income rt rt Dt R( Y t ) G ,t E ,t T ,t P,t L ,t K ,t Building blocks- The steady state • Competitive equilibrium conditions – – – – – The household utility maximization problem is solved. The representative firm’s profits maximization problem is solved. The government budget constraint is satisfied. The goods market clears The competitive input markets clear – Permanent increase in expenditure financed by debt Increase in expenditure (Perm anent 1% of GDP, financed by debt) GDP growth rate (%) 3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 0 1 2 3 Period Benchmark Transfer Education Infrastructure –Temporary increase in expenditure financed by debt Increase in expenditure (Tem porary 1% of GDP, financed by debt) GDP growth rate (%) 3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 0 1 2 3 Period Benchmark Transfer Education Infrastructure – Permanent increase in expenditure financed by tax Increase in expenditure (Perm anent 1% of GDP, Financed by tax) GDP growth rate (%) 3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 0 1 2 3 Period Benchmark Transfer Education Infrastructure Income per capita - Permanent Expenditure Reallocation (1% of GDP) Reallocation in expenditure (Permanent 1% of GDP) 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 0 1 2 3 Period Benchmark From Transfers to Education From Transfers to Infrastructure From Education to Infrastructure Income in base year: $4500 for Brazil, constant 1995 III. How much government expenditure? a simple model and international comparison • The model (Barro and Sala-I-Martin, 1995) • Production function of the economy : Yt= AtF(K, N, G) or Y=AL1-KG1- • Government Budget constraint : G=Y • Representative individual maximizes a utility function subject to a budget restriction Public expenditure has two opposite effects on growth rate of consumption of • One positive effect derived from larger government services • One negative effect due to the after-tax marginal product of capital The simple estimate of the optimal size of government expenditure g From this simple model we obtain: • The maximum growth rate is achieved for = G/Y=1- • Indicators of productiveness or unproductiveness of government services ( dy/dg>0 ?) • The degree of over-provisioning or underprovisioning of public capital Atf1< r+d+n Implications of Maintenance in Public Capital • • • • • • • Aggregate Production Y=AL1-KG1- Kt I t (1 k ) Kt 1 Private capital M Gt I Gt [1 G ( )]Gt 1 Public capital Y Maintenance expenditure M Y I g (1 )Y New public investment Government Budget constraint M I g Y Optimal tax rate that maximizes growth 1 1 * * Does government expenditure (as a ratio to revenue) conform to international experience? The same holds when private investment is used as a metric Ratio of Public to Private Investment Ratio of Public to Private Investment 1 .20 1.04 Ratio of Public to Private Investment 1 .00 0 .8 1 0 .80 0 .6 7 0 .5 9 0 .60 0.45 0.40 0.3 9 0 .40 0 .36 0 .2 9 0 .22 0.2 1 0 .2 1 0.20 0.17 0 .20 0.2 4 0 .2 1 0.20 0.14 0 .10 0.09 0 .00 ARG BRA CHL COL CRI EST HRV IND LVA MDA PER PHL POL RUS SVN THA TUR URY VEN ZAF The ratio between capital and current expenditures. Expenditure composition is a matter of concern Ratio of Government Capital to Current Expenditure ARG Ratio of Capital to Currrent Expenditure (%) BHR BRA 80 .0 CAN CHL COL CRI 70 .0 67.1 CZE EST HRV 60 .0 HUN IND KAZ LTU 50 .0 46 .1 LVA MDA NZL 40 .0 PER PHL POL 29.7 30 .0 ROM 25 .5 RUS 22. 3 18 .9 20 .0 13. 0 11. 6 11.0 10.2 9. 9 9 .9 9.9 8.1 7 .2 7.7 7.2 SVK SVN 13 .2 THA 10 .7 1 0.1 TUR 8.7 7 .8 7 .3 URY 5 .0 4.7 4.7 2.7 2.5 1.7 5.1 USA VEN ZAF VNM VEN USA URY TUR THA SVN SVK SGP RUS ROM POL PHL PER MDA LVA LTU KAZ IND HUN HRV EST CZE CRI COL CHL CAN BRA VNM BHR 0 .0 SGP 17 .5 NZL 10 .0 ARG capcur (%) 44.5 ZAF IV. Debt sustainability and productivity of capital expenditures • The traditional debt dynamics equation e 1 e i rg bt 1 f t 1 st 1 g 1 1 g 1 * T b t 1. Debt targeting- S instrument of fiscal policy 2. “Fiscal space”-productivity of public capital Revised debt dynamics equation, with current and capital expenditures disaggregated T b t e 1 e i * (r d ) rg c k t 1 bt 1 f t 1 st 1 g 1 1 g 1 1 g r+d= rental price of public capital p = marginal productivity of public capital Policy coordination: fiscal, monetary, exchange rate and public debt management“fiscal space” considerations under liquidity constraints-Brazil 2002 • 1. 2. 3. Features of Brazilian public debt Mostly domestic Short maturity and duration Indexed to the exchange rate or to short term interest rates (Selic) 4. Concentrated holders (mutual funds, few banks) Public debt jumps in 2001 as currency depreciates (Argentina crisis unfolding) 4.0 68 3.6 64 3.2 60 2.8 56 2.4 Public Debt (right scale) 52 2.0 48 1.6 44 1999 2000 2001 2002 2003 % of GDP Reais/dollar Exchange Rate The primary surplus falls. The presidential campaign is no fertile ground for fiscal adjustments. Primary Fiscal Balance of the Public Sector 2000-2003 (as a percentage of GDP) 4.8 4.4 4.0 3.6 3.2 2000 2001 2002 2003 Brazilian Spreads and Exchange Rate Jan 2000 – April 2003 Capital Flows to Brazil (ratio to international reserves) B r a z i la i n S p r e a d s a n d E x c h a n g e R a t 4.0 .3 2800 $ R /U S E x c h a n g e r a te (left scale) 3.6 b ps .2 2400 .1 3.2 2000 .0 2.8 1600 -.1 2.4 1200 -.2 2.0 800 -.3 S o v e r e in g s p r e a d 1.6 2000 400 2001 2002 2003 96 97 98 99 00 01 02 03 Public debt sustainability concerns causes a run on mutual fund “deposits” Net Resource Flow to Mutual Funds (as a fraction of net worth) .06 .04 .02 .00 -.02 -.04 -.06 -.08 1998 1999 2000 2001 2002 2003 The central bank was forced to print money to redeem public debt Money Base as a Share of GDP (seasonally adjusted data Monetary Impact of Treasury’s Operations 1999- 2003 (ratio to the monetary base .4 5.0 .3 4.5 .2 4.0 .1 3.5 .0 3.0 -.1 2.5 -.2 2.0 -.3 95 96 97 98 99 00 01 02 03 1999 2000 2001 2002 2003 Monthly Inflation Rate in Brazil 20002003 6 Seignorage from Money Creation 2000-2003 (% of GDP) 2.5 5 2.0 4 1.5 3 1.0 2 0.5 1 0.0 0 -0.5 -1 2000 2001 2002 2003 2001 2002 2003 Exchange rate and interest rates adjust after the fiscal commitment is certain. 4.4 Reais/dollar 4.0 28 % 26 Exchange rate 3.6 24 3.2 22 2.8 20 2.4 Selic (right scale) 2.0 1.6 18 16 14 2000 2001 2002 2003
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