Download Long-Term Fiscal Challenges for Portugal

“Portugal: Coping with Fiscal Policy
Challenges in the 21st Century
Peter S. Heller
International Monetary Fund
December 13, 2004
(Presentation to the Budget Control
Committee of the Portuguese
Parliament)
This Presentation should not be reported as representing the views of the
IMF. The views expressed in this presentation are those of the speaker and
do not necessarily represent those of the IMF or IMF policy.
1
.
Introductory remarks
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This conference is noteworthy,
reflecting recognition by the Parliament
of the need to take account of longterm issues in budget formulation.
Critical that such a perspective is shared
both by executive and legislative
branches.
2
Principal Messages
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As with most other industrial countries, Portugal
needs to take account of potential long term
structural developments and risks.
There are fiscal dimensions to many of these risks.
Dealing with problems for which there are
fundamental uncertainties
A multi-pronged approach is necessary to deal with
issues of the long-run, involving strengthened policy
analysis, reforms of the budget process, sustained
fiscal consolidation, and sectoral policy reforms.
3
Motivation for considering LT fiscal risk
issues: what are some of the key longterm challenges confronting Portugal?
1. Demographic factors

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Fertility rate low (at 1.53); Eurostat
projections suggest a rise to only 1.6 by
mid-century.
Increasing life expectancy by 2050:
males 72 to 78; females: 79 to 84.
Dependency rate will double by 2050:
from 23 percent to 46 percent.
Population will peak in 2040.
4
Figure 1. Portugal: Trends in Old-Age Dependency Ratios, 2000-50
70
70
Rapidly-Ageing Economies
60
60
50
50
40
40
Italy
Spain
30
30
Greece
Austria
20
20
Germany
EU-15 average
10
10
0
0
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
60
60
Moderately-Ageing Economies
50
50
40
40
EU-15 average
30
30
France
Belgium
Portugal
20
20
Finland
Sweden
10
10
0
0
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
60
60
Slowly-Ageing Economies
50
50
40
40
30
30
EU-15 average
United Kingdom
Netherlands
Ireland
Luxembourg
Denmark
20
10
20
10
0
0
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
Sources: Eurostat, as cited in Economic Policy Committee, European Commission (2001).
5
Potential fiscal impact of aging
population well-recognized
General system pension (GSP) costs
will rise, even under new 2000
Framework law:
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From 6% of GDP in 2000 to 8% in 2075;
GSP revenue to decline: by 1.5% of GDP in
same period; system in deficit by 2016;
zero balance in reserve fund by 2029.
Civil Service Pension scheme: costs
projected to rise from 3.6% to 5.0%
during same period.
6
Figure 3. Portugal: Public Pension Expenditures, 2000-50
(In percent of GDP)
14
14
Total
12
12
10
10
SS
8
6
8
6
CGA
4
4
2
2
0
0
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
15
15
14
14
lower productivity
lower partic. & prod.
lower participation
13
13
baseline
12
12
11
11
10
10
9
9
8
8
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
Sources: Fund staff simulations.
7
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Medical care: impact of aging
population
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Caldes and Rodriguez: aging alone will lead
to increase in spending from 5.3% of GDP
in 2000 to 6.4 to 7.2% by 2050.
Bronchi (OECD, 2003) suggests even larger
increase of about 3% of GDP by 2030.
With increasing elderly dependency rates,
long-term care will also be a challenge,
with Portugal now poorly positioned
relative to other European countries.
8
2. Medical costs may increase further due
to technology-induced cost pressures
Between 1970 and 2000/01, health care
costs in Portugal rose from 2.7% of
GDP to over 6%, independent of agingrelated pressures; parallel experience to
US; Note: standard of technological
equipment in Portugal still much below
OECD average ; high cost equipment
(e.g., imaging devices) still in short
supply.
9
3. Global Climate Change
For Portugal, most Global Climate Change Models
(GCMs) project a temperature increase in interval
4-7º C by 2100 (SIAM Model). Climate change will
also be reflected in:
 Increased frequency and intensity of extreme
weather events.
 Reduced precipitation in many regions: substantial
declines in spring (by 30%) and autumn (3560%); an increase in winter months.
 Increased probability of flooding episodes with
accumulated precipitation in heavy rainy periods.
10
Alternative GCM Model Projections of
Climate Change in Portugal through 2100
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Potential impact of Climate Change

Agricultural sector: net adverse effects
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Negative impact of temperature change and from pressures
on available water supply; positive impact from CO2 change;
Differential impact across regions, with shifting to different
crops in different zones
Coastal zones: increase in sea level—need for
protective actions to minimize impact, particularly in
regions of high development and high population
density
Increasing energy demands in summer months
No estimates made by SIAM GCM of impact on
insurance or tourism sectors, urban centres, or soil
and land resources.
12
4. Supply-side challenges
Pressure to upgrade human capital skills
• Portugal suffers from competitive
disadvantage in terms of quality of its
human capital, its investment in R&D,
and ICT penetration.
• Portugal will need to increase
investments and quality of spending in
education and bolster spending on
R&D.
13
5. Contingent Risks associated with commitments on
PPPs (in transport, water, energy, hospital sector):
akin to debt, but not reflected in budget.
6. Globalization: tax competition pressures; fiscal
policy constraints associated with membership in
Eurozone.
7. Global pressures on energy supplies and prices.
8. Other potential risk factors: terrorism, WMD,
possible global systemic “viruses.”
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9. Risks associated with present fiscal
position
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Portugal’s current debt to GDP ratio—close to 60
percent.
Present fiscal position, while consistent with
Stability and Growth Programme, still too reliant
on one-off measures and imbalanced in terms of
share of wages and salaries;
Failure to bring down primary deficit in line
with SGP and sustain it at lower level (exclusive of
aging-related fiscal pressures) would put Portugal
on unsustainable fiscal track in terms of its
projected debt growth.
Sensitivity to adverse interest rate scenarios.
Scale of continued EU assistance through Community
Support Framework. Presently about 3% of GDP.
15
Figure 2. Portugal: Long-Term Aging-Related Fiscal Projections, 2000-50
(In percent of GDP)
160
160
Public Debt Dynamics
140
140
120
120
100
100
80
80
60
60
40
40
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
-2
-2
Fiscal Balance
-3
-3
-4
-4
-5
-5
-6
-6
-7
-7
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
25
25
Ageing-Related Spending
20
20
Total
15
15
Pensions
10
10
Healthcare 1/
5
5
0
0
2000
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
Sources: Portuguese authorities; and Fund staff calculations.
1/ Excludes long-term care.
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“Uncertain” Certainties
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Most of these structural developments
will happen; most likely concurrently.
But still much uncertainty: nature of
change; degree of predictability; size of
potential impact.
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Different processes; different time paths.
On demography: will fertility rise? Greater
improvement in life expectancy? What
migration level?; Impact of HIV/AIDS?
Still a wide band of uncertainty on the amount
of possible climate change.
Obvious uncertainties on security risks, etc.
“Inevitable surprise” factor: shocks that
are difficult to predict for which fiscal
leeway required.
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Many issues pose fiscal risks. Why?
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Explicit, legislated, government commitments-some linked to demographic variables
 Pre-commitment of budgetary resources: in
pensions, medical care; welfare assistance;
education.
 On political economy grounds, hard to change
these commitments now; even harder in future,
with prospect of rising share of elderly in
electorate.
Implicit fiscal commitments? flowing from
perceived role of government (e.g. Gov’t backup for
failure of private occupational pension schemes?
dealing with effects of sea level rise? sectoral
adjustments in agriculture; flooding, etc.)?
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Should one tighten the fiscal policy framework
further to take account of these long-term
issues?
Arguments Con:
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Unpredictability of future events.
Poor past records of forecasting.
Future generations likely to be better off.
Costs of addressing these long-term issues
prematurely:
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Higher taxes in the short term.
Additional burden on households in responding to
reduced long-term promises.
Higher costs of adapting to uncertain climate change.
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Arguments Pro:
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Pressure for increased fiscal outlays will rise
over time: could lead to politically unfeasible
tax burden, even with higher per capita
income.
Deferring action may increase cost of
solutions (e.g., higher cost of tax smoothing
or policy reform costs).
Unfair burdens shifted to future generations.
High potential welfare costs if abrupt benefit
cuts.
Reduced capacity of government to respond
to new challenges.
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Arguments Pro
•
Failure to address LT risk factors may
also constrain short/medium-term
policy options
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Markets may require higher risk premia on
government borrowing; may constrain capacity
for appropriate macro- economic policy stance.
Recent S&P study (Kremer, 2004) suggests that
Portugal’s rating could deteriorate substantially,
even as early as 2010.
May induce Ricardian effects, as private sector
agents respond to perceived failure of
governments to act—reducing potential impact
of countercyclical fiscal policy measures.
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What to do? Not easy issues
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Dealing with problems for which there are
fundamental uncertainties; policies imply
significant short-run costs to taxpayers with
uncertain scale of actions required and
uncertain benefits to future generations.
Climate change as example.
Need to decide how much risk aversion is
acceptable in judging sustainability of
policies? What probability of LT fiscal
sustainability desirable? What are losses if
action not taken?
Social time preference rates matter:
intergenerational welfare choices: defining
generations.
There are allocative efficiency costs
associated with tax smoothing.
22
What to do? A “multi-pronged” strategy
is required to take LT fiscal concerns into
account in short to medium-term
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A budget process and framework more
clearly recognizing LT fiscal risks—building
on existing work.
Strengthened analytic approaches.
A blend of
 aggregate fiscal policy consolidation.
 accompanied by further sectoral policy
reforms.
23
Need for strengthened analytic
approaches

Formalize periodic long-term
projections & sustainability
indicators: scenario analyses; tax
or primary gap analyses.
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Alternative demographic scenarios.
Carry out demographic-based
stochastic forecasts: taking multiple
risk factors into account.
24
Possible sensitivity analyses
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Alternative non-aging cost pressures in medical care
(e.g., US Long Term Budget Outlook, Dec. 2003)
In assessing future cost burden of pension system,
examine alternative assumptions: suppose less
optimistic productivity assumptions (e.g. lower than
2.5% p.a.); lower labor force participation rates.
Risks of any failure to meet the SGP adjustment path.
Indexation assumptions for civil service pension
scheme.
Potential costs of climate change—sea level rise,
higher flooding levels.
Alternative demographic assumptions (fertility; LE).
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Recognize limits on relevance of formal
Government balance sheet or measures of
Government debt
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Excludes significant potential implicit
commitments and risk exposures.
Hard to determine how to treat constructive
budget obligations.
Excludes potential revenue assets
 What is politically viable revenue share in
future?
Suggests there is a spectrum of Government
debt and risk exposure.
26
Chart 1: Illustrative spectrum of
Government debt and risk exposures
On Balance Sheet
Off-Balance Sheet
(As Liability or
Other types
of
Provision)
Constructive Budget
Guarantees
Obligations
Public
Guarantees
(provisioned) Public
Guarantees
Contractual Noncontractual
(not
—medical care
provisioned)
---long term
PPPs
care
--Explicit
strengthening
contingent
educational
liabilities
system
Risk exposures
derived from
Role of Gov’t
Implicit Contingent
obligations
Hard
Soft
costs of climate
change adaptation
27
Spectrum of debt and risk Exposures
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The softer the risk exposure, the:
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Greater the potential flexibility of
government in meeting an obligation;
Political economy factors weigh more
heavily;
Greater indeterminacy on nature of
government’s commitment; and
The more relevant moral hazard
considerations.
28
Need to obtain greater clarity on the risks to
which the public sector is exposed
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Clarifying potential costs of different risk factors:
simple first step in process of judging when policy
adjustment is necessary:
 Aging-related costs (pensions, medical care, longterm care; cost of climate change vulnerabilities).
 Carry out sensitivity analyses.
Becomes exercise in
 analyzing prospects for fiscal sustainability.
 considering scale of necessary policy actions.
 Assessing which policy alternatives limit risk
exposure.
29
Portugal is relatively advanced in
considering long-term issues through its
involvement in EU/OECD work programs
on aging populations

Over time, Portugal should develop fullfledged medium term budget:
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Incorporate into annual budget.
Provide long-term cost implications of policy
measures.
But don’t extend detailed budget beyond mediumterm.
Consider value of an additional fiscal rule on
expenditure ceilings.
30
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Long-term annexes to budget should be
prepared:
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Clarifying potential cost of:
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Providing long-term projections
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contingent liabilities;
Implicit debt;
Risk exposures on extended balance sheet.
Clarify when additional R&D needed before
policy action.
Providing stochastic analyses.
Carrying out sensitivity analyses.
31
The political economy challenge of dealing
with long-term fiscal policy issues:
Need to provoke public debate on long-term
fiscal challenges—implied intergenerational
tradeoffs; degree of risk aversion
 Consider legislative procedural rules:
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Require executive to provide long-term risk
assessments as part of budget submission;
Require debate by Parliament;
Call for hearings by Parliament.
Earmarking of social insurance funds could be
considered?
Emphasis on providing transparency on long32
term risk exposure.
A potential role for an autonomous
agency charged with providing
independent assessments of long-term
fiscal risks
 Scrutinize assumptions in budget.
 Characterize adequacy of sensitivity
assessments.
 Comment on cost of implied policy
tradeoffs.
 Assess generational cost-sharing
implications.
33
What policy changes required?
Governments cannot wholly rely on an
aggregative approach to meet higher
prospective fiscal costs over long term;
Requires sectoral reforms as well.
34
Three Types of Aggregate approach possible
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Balancing budget, year by year, but not reducing
debt/GDP ratio below present level.
SGP approach: rule which over time brings debt/GDP
ratio to zero (EU-Portugal approach).

Primary Gap filling—or tax smoothing

But, there are limits to an aggregative approach.
35
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Balanced Budget approach: responding
annually to new expenditure pressures as
they arise by reducing other expenditure or
increasing aggregate tax burden;
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But limits to increase in politically or
economically feasible tax share
Limits to feasible expenditure rationalization—
given Govt’s role in provision of public goods and
other services and high share of wages and
public transfers in total government expenditure.
36

Primary Gap Filling (or Prefunding)
approach? Increase and sustain a higher tax
share, implying decumulation of debt and
possiblynet asset accumulation

How much net asset accumulation feasible?
Political economy risks with increasing asset/GDP
ratio (Norway case):
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“Expenditure creep”;
Pressures for tax reduction.
Allocational efficiency costs of increased tax
burden.
Ricardian effects of prefunding strategy.
Increases political economy costs of further
Government policy changes.
37
As a minimum for Portugal, SGP
implementation must be high
priority
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European Commission reports as well as S&P
assessment highlight fiscal risks associated
with not implementing Stability and Growth
Programme in coming three years.
Requires sustaining that primary balance
(independent of aging-related factors).
Sufficiency? Ignores other forms of fiscal risk
exposure of Portugal.
Does not assess whether there is further
revenue-raising potential.
38
Thus, need a balance between aggregate
and sectoral policy reforms:
 Commitment and regulatory reform must
be a critical component of policy mix.
 Requires commitment reform, affecting
time path of pre-committed expenditures
and reduced exposure by Govt to various
fiscal risks.
 Critical to ensure adequate fiscal
leeway is maintained.
 Critical to consider when there are
important windows of opportunity
for action.
39
Portugal has made important start in recent
years, with reform efforts in health and pension areas.
Reforms in public administration and early efforts at
developing a long-term care network.

Still, more effort needed in public pension reform

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May require further extension in retirement age;
Possibly reduced accrual rate of pension benefits—lowering
replacement rate.
More targeting.
Change in qualitative commitments: further forms of cost
sharing; may require adopting Dutch type of limits on
coverage for certain categories of medical care.
Promote greater clarity on who will bear given risks.
Government support for strengthening insurance markets.
Clarify government role in addressing issues of climate
change: its adaptation role.
40
Commitment reform (continued)
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Transparency necessary on implied
intergenerational burden sharing.
Long lead time needed for some
reforms.
Need to clarify macroeconomic effects
of reliance on sectoral policy reforms.
Consider self-adjusting policy
provisions—”built-in flexibility with
uncertain outcomes.”
How much risk reinsurance coverage
should be provided by Government?
41