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Fiscal Policy and Economic Growth: Lessons for Eastern Europe and Central Asia Key questions How do broad public finance patterns and trends affect economic growth? Fiscal balance Size of government Patterns of spending and taxation How can the efficiency of spending and taxation be increased? Infrastructure Education Health Pensions Flat income taxes Labor taxes Key messages o The impact of fiscal policies on growth depends on the quality of governance. o o o In most ECA countries fiscal space needs to be created through efficiency gains rather than increased spending. o Government size and expenditure composition matter most when governance is weak; Tax composition also matters when governance is strong High fiscal deficits reduce growth in both cases There are opportunities for efficiency gains in infrastructure, education, health, and pensions. Recent reforms in income taxation are welcome but do not adequately address the high labor tax wedge. Public Finance and Economic Growth: Trends and Interrelationships Growth in ECA has been rapid in recent years after initial collapse. Annual real GDP growth, in % 15 Low income CIS EU3 Baltics SE Europe 10 5 EU5 Central Europe 0 -5 Middle income CIS -10 -15 -20 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 -25 R ke y us sia B Ka os za nia kh st M an ol d Bu o va lg a G ri a eo rg Es ia Az ton er i a ba ij Be an la R rus om a FY S ni a l R ov M en ac i ed a on i La a tv ia Sa Ta M jik ist Al an ba Li ni a th ua Ar nia m en C ia ro at i Sl a ov a Po k la H nd un Ky g a rg ry yz re C p ze c U h kr ai ne Tu r Fiscal balances have improved in recent years in most ECA countries. …but further fiscal adjustment is still needed in some settings. Primary fiscal balance (average 2002-04, in % of GDP) 8 6 4 2 0 -2 -4 -6 -8 Successful fiscal adjustments have been stronger than unsuccessful ones and have been driven mainly by broad-based expenditure cuts Characteristics of fiscal adjustments in ECA 5 4 3 successful unsuccessful in % of GDP 2 1 0 Composition of fiscal adjustments -1 -2 -3 -4 -5 fiscal balance 1 fiscal balance 2 year before years after expenditure cuts revenue increases Growth has been higher when fiscal adjustment has been successful… 8 7 GDP growth before, during, and after fiscal adjustment in ECA, 1996-2004, in % per year Successful adjustments Unsuccessful adjustments 6 5 4 3 2 1 0 Year before During adjustment Over 2 years after adjustment …and adjustments financed by “non directly productive” expenditure cuts have had higher growth impact Impact on the annual growth rate of an increase in the fiscal surplus of 1% of GDP 0.5 0.48 0.46 0.44 0.42 0.4 0.38 0.36 decrease in non productive spending increase in non distorting taxes increase in distorting taxes Increase in fiscal surplus financed by: decrease in productive spending Most ECA governments are larger than in comparator high-growth countries Primary Public Expenditures and Per capita Incomes (PPP) (average 2000-2004) 60 Primary Exp Percent of GDP 55 Croatia 50 45 International correlation 40 35 ECA countries correlation 30 Spain Ireland 25 Korea Vietnam 20 Chile Uganda 15 Thailand 10 6 7 8 9 LN GDP per capita, PPP ECA countries High growth comparator countries 10 11 Percent of GDP Large size tends to reflect large spending for social transfers 45 40 35 30 25 20 15 10 5 0 Other Economic Affairs General Public Services Defense & Public Order Education Health EU8 SEE Turkey MIC CIS Low income CIS Social Security Large government size is associated with slower growth in poorly-governed countries More Effective Governments 0 -50 -50 -25 -25 0 Economic Growth 25 25 50 50 Less Effective Governments 0 20 40 Size of Government 60 80 0 20 40 Size of Government … but not in well-governed countries 60 80 Why might “big governments”, beyond a certain size, adversely affect growth? Misallocation of expenditures: Big Low efficiency: Weak administrative capacity High taxes: Financing of high levels of public governments may spend more on less productive functions may be more of a binding constraint when public responsibilities are large spending requires high taxes that can distort incentives for saving, investment, and work effort …and the negative effect of these factors tends to be stronger when governance is poor The impacts on growth of public spending and revenues also depend on the quality of governance. Size of government and spending mix matter most when governance is poor; Spending and revenue mix matters more when governance is good. SPENDING Good governance Poor governance “Unproductive” expenditures No measurable impact Negative impact “Productive” expenditures Positive impact No measurable impact “Distorting” taxes Negative impact No measurable impact “Non distorting” taxes Positive impact No measurable impact TAXATION The Challenge of Improving Public Spending Efficiency Few ECA countries have fiscal space for additional spending Infrastructure: Policy reforms are high priority -- and maintenance, private sector participation, some new investment Total Hidden Costs - Percentage of GDP (2000-2005) 30 25 20 15 10 5 2000 2001 2002 2003 2004 2005 kr ai ne U Tu rk ey om an ia R Po la nd R gy z Ky r G eo rg ia ro at ia C a Ar m en i Al ba ni a 0 Education and health: ECA has good outcomes given its level of income… …but these results come at a high cost. KOR 1.00 CHL 0.92 THA Example: Input efficiency score for life expectancy at birth 0.79 ALB 0.70 GEO 0.69 ARM 0.69 VNM 0.68 KGZ 0.65 UKR 0.65 UGA 0.65 TUR 0.63 ROM 0.56 POL 0.55 SVK 0.46 HRV 0.00 0.38 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 Reforms can increase efficiency in education and health Education Allocate financing on a per student basis Move to more efficient (generally larger) class sizes Reduce emphasis on expensive vocational education Enhance private financing, particularly at tertiary level Health Consolidate hospitals to improve efficiency Strengthen incentives for cost saving by providers and consumers (e.g. co-payments, basic benefits package) Address high out-of-pocket payments (often informal) Improve transparency and accountability at all levels Pensions are a particular challenge in ECA Situation different than in comparators Legacy of generous pension coverage Falling employment levels (exacerbated by high labor taxes) Aging populations 140 Share of elderly receiving pensions exceeds percentage of working-age population making contributions % of working age contributing 120 100 IRELAND 80 SPAIN 60 UKRAINE POLAND CHILE KOREA SLOVAKIA CROATIA ROMANIA 40 THAILAND 20 ALBANIA VIETNAM VIETNAM UGANDA 0 0 KYRGYZ REP GEORGIA TURKEY 20 40 60 80 % of elderly receving pensions 100 120 140 A two-pronged approach for pension reform? MICs: public/private contributory systems + means-tested social assistance LICs: universal low-rate pension (financed from general revenues) All contributory systems should be entirely self-financing In many cases financial sustainability will require benefits to be tightened How can Distortions in the Tax System be Reduced? ECA leads the world in flat-rate income tax reforms… Revenue, incentive, equity, and growth effects have generally been positive. PIT Revenue Collections as % of GDP 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 Lithuania Russian Federation before 1 year after Slovakia 2 years after Ukraine …but complementary policies are needed to enhance the impact of flat-income taxes Closing tax loopholes and ad hoc exemptions Maintaining appropriate tax allowances to enhance equity Strengthening tax administration Reforming payroll taxes and social insurance Labor taxes are still too high… Tax Wedge on Labor: ECA against Selected Comparator Countries, 2006 50.0% 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% ECA Comparators Vietnam Korea Ireland USA UK Spain Netherlands Denmark EU-15 Low-income CIS Middle-income CIS SEE EU-11 Turkey 0.0% …and are associated with low labor force participation in ECA ECA countries need to streamline social benefits and move to general revenue financing of health and some social transfers to help spur employment Labor Force Participation Rate by Quartiles of Tax Wedge, 2004 28 ECA countries 70 Labor force participation rate, % 69 68 67 66 65 64 63 62 bottom quartile 2nd quartile 3rd quartile Tax Wedge top quartile Summing up The impact of fiscal policies on growth depends on the quality of governance. In most ECA countries fiscal space needs to be created through efficiency gains rather than increased spending. Government size and expenditure composition matter most when governance is weak; Tax composition also matters when governance is strong High fiscal deficits reduce growth in both cases There are opportunities for efficiency gains in infrastructure, education, health, and pensions. Recent reforms in income taxation are welcome but do not adequately address the high labor tax wedge. Thank you. Report available in English and Russian at www.worldbank.org/eca/fiscal