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FISCAL STANDARDS AND ECONOMIC DEVELOPMENT Leszek Balcerowicz National Bank of Poland World Bank Workshop 3 April 2006 Agenda: I. Public finance and short-term economic growth II. Public finance and long-term economic growth 1. General government balance 2. Tax system 3. Public expenditure I. Public finance and short-term economic growth The tightening of fiscal policy does not have to lead to a fall in GDP growth in the short term because so-called non-Keynesian effects of fiscal tightening may occur. General government deficit (ESA’95, % of GDP, left scale) and GDP growth rate (%, right scale) in 1999-2004. Poland 6 4.5 5.3 4.8 4.2 3.9 3.7 4 3.3 6 4 3.8 2 1.4 1.4 1.1 2 0.7 0 0 1999 Lithuania 5.6 2000 2001 10.5 12 2002 2003 2004 Slovakia 16 4.6 12.3 7.2 5 7.0 6.8 8 3.9 4 3 2.5 -1.7 2.0 0 1.4 1.2 -4 2000 2001 2002 2003 2004 4.5 3.8 8 7.8 6.4 2.0 6.6 3.8 4 3.1 2 1.5 0 0 1999 General Government budget deficit (ESA’95, in % of GDP) Source: Eurostat. 6 4 1.4 1 1999 12 5.5 2000 2001 2002 2003 2004 GDP growth rate (in %) 3 I. Public finance and short-term economic growth Non-Keynesian effect Output increase Change of private demand bigger and stronger than change of government demand rigid prices Net export increase Depreciation of domestic currency Increase of interest rates sensitive private expenditure Output increase in long term Increase of cumulated disposable income expected in a horizon of utility maximization Dispelling of concerns for government solvency Drop in interest rates Increase of enterprise capability and propensity to invest Positive supply shock (cost fall) Budget deficit reduction flexible prices Improvement in external competitiveness Keynesian approach Non-Keynesian approach Source: Rzońca A., Ciżkowicz P., Non-Keynesian Effects of Fiscal Contraction in New Member States, ECB Working Paper, No. 519, September, 2005. 4 I. Public finance and short-term economic growth Selected conclusions on the non-Keynesian contraction drawn from empirical studies: effects of fiscal • Non-Keynesian effects occur more often when fiscal adjustment is large (see e.g. Francesco Giavazzi and Marco Pagano, 1996) and lasting (see e.g. Alberto Alesina and Roberto Perotti, 1996) rather than small or transitory. • Fiscal adjustments are more lasting and lead more often to non-Keynesian effects if they are caused by curtailment of expenditures rather than by tax increases (see e.g. Alberto Alesina, Roberto Perotti and Jose Tavares, 1998). Some studies show an opposite relationship, but they mainly deal with the response of private consumption to negative fiscal impulses (see e.g. Francesco Giavazzi, Tullio Jappelli and Marco Pagano, 1999). • The manner of fiscal policy tightening is of far greater importance in terms of its aftermath than the scale of deficit reduction. Among the successful fiscal adjustments, those that focus on cuts in public sector wage expenditure and in transfers to households are particularly frequent (see e.g. Alberto Alesina, Silvia Ardagna, Roberto Perotti and Fabio Schiantarelli, 1999). • The probability of the effects’ occurrence is greater when public debt is high (Rina Bhattacharya, 1999) or fast growing (see e.g. Francesco Giavazzi, Tullio Jappelli and Marco Pagano, 2000) rather than low, and, at most, slowly growing. Source: Rzońca A., Ciżkowicz P., Non-Keynesian Effects of Fiscal Contraction in New Member States, ECB Working Paper, No. 519, September, 2005. 5 I. Public finance and short-term economic growth According to recent research carried out at the National Bank of Poland fiscal consolidation in the NMS in 1993-2002 triggered nonKeynesian mechanisms, and as a result, was almost always accompanied by an acceleration in output momentum. ‘‘In six out of the seven episodes of fiscal adjustment, output changed in the opposite direction than a Keynesian approach would predict, that is to say, one observed an acceleration in output momentum in comparison with the previous period instead of its slowdown. GDP growth was, on average, faster by 4.9 during and 4.2 a year after consolidation respectively, than a year before the fiscal adjustment. Moreover, actual GDP momentum during the tightening of fiscal policy was almost twice as strong as generally expected at the onset of the fiscal adjustment, although forecasts of GDP momentum were usually built under the assumption of a far more lax fiscal policy than what was actually implemented.” Source: Rzońca A., Ciżkowicz P., Non-Keynesian Effects of Fiscal Contraction in New Member States, ECB Working Paper, No. 519, September, 2005. 6 II. Public finance and long-term economic growth The impact of fiscal policy on long-term economic growth may be underestimated... Fraser Institute Economic Freedom of the World Index Fiscal Position of Government Regulation of Credit, Labor and Business Freedom to Trade Internationally Legal System and Property Rights Sound Money The Fiscal Position of the Government (Size of Government) index consists of: • The share of general government consumption in total consumption; • Transfers and subsidies as a share of GDP; • Government investment as investment; enterprises a share of and gross • Top marginal tax rate. Developed countries Transition countries Asian Tigers The poorest countries The higher the value of the index, the more limited the size of the government. Source: Fraser Institute. For instance, it is not commonly known that one of the main differences between the Asian Tigers and other countries is that the former successfully restrained government expansion. 7 II. Public finance and long-term economic growth ...and under-researched. ‘‘The recent growth literature makes relatively few references to public finance even though some empirical work by Baro, Gordon and others has isolated variables such as government consumption, the corporate tax rate, and others that are found to retard growth.” Source: Tanzi V., Public Finances and Long-Term Economic Growth: Toward a Warsaw Consensus?, Paper presented at the Conference on „Fiscal Policy and the Road to the Euro”, Warsaw, 30 June – 1 July 2005. 8 II. Public finance and long-term economic growth 1. General government balance GENERAL GOVERNMENT DEFICIT PUBLIC DEBT Crisis ‘‘When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having fairly and completely paid. The liberation of the public revenue, if it has ever been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment. The raising of the denomination of the coin has been the most usual expedient by which a real public bankruptcy has been disguised under the appearance of a pretended payment.” Adam Smith, An Inquiry Into The Nature and Causes of The Wealth of Nations, Vol. 2, Methuen & CO. LTD., London. Crowding out of investment Fall in the growth rate or in the level of output ‘‘the evidence appears to show that, on average, deficits do “crowd out” investment, including investment in plant and equipment in particular.” Benjamin M. Friedman, Deficits and Debt in the Short and Long Run, NBER Working Paper No. 11630, 2005. 9 II. Public finance and long-term economic growth 1. General government balance In the long term, a high budget deficit hampers economic growth. General government deficit in the years 1970-98 (% of GDP) 6 5.2 5 4.8 4 3 2 2.3 0.7 0 1 Countries at medium income level with Countries at low income level with fast convergence divergence or slow growth fast convergence divergence or slow growth Source: World Economic Outlook, May 2000, IMF. 10 II. Public finance and long-term economic growth 1. General government balance There are also other important channels through which public finance affects long-term economic growth. Long-term economic growth TAX SYSTEM Level of taxes Structure of taxes PUBLIC EXPENDITURE Level of public expenditure Structure of public expenditure 11 II. Public finance and long-term economic growth 2. Tax system TAX SYSTEM Level of taxes (tax burden) Structure of taxes (% of GDP) - official taxes; - taxes on labour; - ‘‘corruption taxes”. - taxes on capital; - taxes on consumption. The problem of failed states. 12 II. Public finance and long-term economic growth 2. Tax system Empirical research confirms the negative impact of high taxes on economic growth. Authors Publication Research area Extent of impact Willi Leibfritz, John Thornton, Alexandra Bibbee. Taxation and Economic Performance, OECD WP 176, 1997. OECD countries in the years 19651995. 10 pp increase of taxesto-GDP ratio lowers GDP growth by 0.51.0%. Michael F. Bleaney, Norman Gemmell., Richard Kneller. Fiscal policy and growth: evidence from OECD countries, Journal of Public Economics, 74, 1999. 17 OECD countries in the years 19701994. 1 pp increase in the distorting-tax revenuesto-GDP* ratio lowers GDP per capita growth by 0.4 pp. Stefan Folster, Magnus Henrekson. Growth Effects of Government Expenditure and Taxation in Rich Countries, European Economic Review, 45, 2001. Sample of most affluent countries of OECD and outside OECD in the years 1970-1995. 10 pp increase in the taxes-to-GDP ratio lowers GDP growth by about 1%. 2.5 pp increase in the Eric M. Engen, Taxation and Economic Growth, NBER taxes-to-GDP ratio Jonathan Skinner. WO 5826, Cambridge 1996. reduces economic growth by 0.2-0.3% * distorting tax revenue – revenue from taxes on income and profit, social security contribution, tax on payroll, tax on property. Source: Skrok E., Taxation and Long-Term Economic Growth: Analysis of Poland’s Tax Policy Against the Background of International Theory and Experience, 2004. United States and a sample from OECD countries. 13 II. Public finance and long-term economic growth 2. Tax system The structure of taxes matters because taxes differ in their contribution to distorting incentives: • to work ‘‘If direct taxes upon the wages of labour have not always occasioned a proportionable rise in those wages, it is because they have generally occasioned a considerable fall in the demand for labour. The declension of industry, the decrease of employment for the poor, the diminution of the annual produce of the land and labour of the country, have generally been the effects of such taxes.” • to invest ‘‘The proprietor of stock is properly a citizen of the world, and is not necessarily attached to any particular country. He would be apt to abandon the country in which he was exposed to a vexatious inquisition, in order to be assessed to a burdensome tax, and would remove his stock to some other country where he could either carry on his business, or enjoy his fortune more at his ease. By removing his stock he would put an end to all the industry which it had maintained in the country which he left.” Source: Smith A., An Inquiry Into The Nature and Causes of The Wealth of Nations, Vol. 2, Methuen & CO. LTD., London. 14 II. Public finance and long-term economic growth 2. Tax system Empirical research confirms the negative impact of high taxes on employment... Taxes and Unemployment, Kluwer Academics, Boston, 2002. Taxes have a negative impact on employment. The magnitude of the tax policy’s influence on employment depends on the labour market’s institutional conditions. Vincent Hogan Do Taxes Cause Unemployment?, University College Dublin, 2001. The burden of higher taxes is spread among employees and employers, and in turn leads to higher unemployment. Even a temporary (up to 1 year) tax increase leads to higher unemployment which persists for several years. Edward C. Prescott Tax Not Culture Explains Why Europeans Work Less, The Wall Street Journal, 21 Oct 2004. ‘‘I determine the importance of tax rates in accounting for (...) differences in labor supply for the major advanced industrial countries and find that tax rates alone account for most of these differences in labor supply.” Laszlo Goerke 15 II. Public finance and long-term economic growth 2. Tax system ...and investment. Determining the taxation and investment impacts of Estonia’s 2000 income tax reform, Bank of Finland Working Paper no. 15, 2000. Differences in tax systems explain a large proportion of differences in economic growth. The tax reduction in Estonia in 2000 will lead in the long run to a 6% increase in the capital stock. Robert Douglas, HoltzEakin, Mark Rider, Harvey S. Rosen Entrepreneurs, Income Taxes, and Investment, NBER Working Paper No. 6374, 1998. The level of corporate income tax has a significant influence on companies’ investment decisions. A 5 percentage point increase in the marginal rate of taxation in the USA would lead to a 10 per cent decrease in investment. Eric M. Engen, Jonathan Skinner Taxation and Economic Growth, NBER Working Paper No. 5826, 1996. Reint Gropp, Kristina Kostial The Disappearing Tax Base: Is Foreign Direct Investment (FDI) Eroding Corporate Income Taxes?, IMF Working Paper No. 173, 2000. Michael Funke In the USA an average tax-rate change of 2.5 percentage points leads, by means of a positive impact on employment, investment and productivity dynamics, to a 0.2-0.3 percentage point economic growth acceleration per year. The tax level has a significant impact on the value of foreign direct investment. Lower taxes are linked with a larger inflow of FDI. 16 II. Public finance and long-term economic growth 3. Public expenditure Public expenditure and long-run economic growth Level of expenditures Structure of expenditures expenditures on public goods other expenditures The theoretical concept of public goods is misused in its application to the real world - government consumption (Coase versus Stiglitz) - transfers - public investment 17 II. Public finance and long-term economic growth 3. Public expenditure It is a mistake to associate the fast development of many Western economies with their currently high public expenditure levels because they achieved their highest economic growth in years when their expenditures were low. The present level of public expenditure in Poland is much higher than it was in today’s highly developed countries in the middle of the 20th century. Public sector expenditure in West European countries in 1950 and in Poland in 2004 (% of GDP). 43.0 40 36.0 32.1 32.0 30 20 26.5 16.2 19.0 18.0 22.2 19.8 28.6 27.6 22.6 20 04 Po la nd Ki te d Fr an ce ng do m an y G er m nl an d Fi No rw ay Ne th er la nd s Be lg iu m ly Ita Sw it z er la nd ar k De nm Source: Middleton R., Britain’s economic problem: too small a public sector?, Centre for Contemporary British History, 1995. Eurostat. 18 Un i a Au st ri Sw ed en 10 II. Public finance and long-term economic growth 3. Public expenditure The increase of public expenditure at a pace exceeding the GDP growth rate has been an important source of GDP growth slowdown in OECD countries since the middle of the 20th century. Public expenditure and GDP per capita growth in OECD countries. 50 46.3 44.5 45 40 4 37.5 3 35 30.0 30 2.0 2 1.7 1.5 25 20 GDP per capita growth rate (in %) Public expenditure (in % of GDP) 4.0 1 1960s Public expenditure 1970s 1980s 1990s GDP per capita growth rate Source: Heitger B., The Scope of Government and Its Impact on Economic Growth in OECD Countries, Kiel Working Paper No. 1034, April 2001. 19 II. Public finance and long-term economic growth 3. Public expenditure Empirical research suggests that expanding general government expenditures in OECD countries have worsen the structure of expenditures. As Heitger states, in OECD countries the expenditure share in core categories* is about or below 14% of GDP. This is true even in countries where the scope of government is relatively large. ‘‘The empirical analysis of national accounts of the main OECD countries revealed that the supply of public goods in the 90s only accounted for about 14 percentage points of gross domestic product. Given the observation that the scope of government in European OECD countries, as measured by government shares, on average accounted for about 50 per cent of gross domestic product one may suggest that these countries have significantly surpassed the „optimum“ of government activities and thus, accordingly to the hypothesis, should have reduced the growth potential of their economies considerably.” * Core government expenditures consist of expenditures on public order and safety, national defence, education and transportation/communication. Source: Heitger B., The Scope of Government and Its Impact on Economic Growth in OECD Countries, Kiel Working Paper No. 1034, April 2001. 20 II. Public finance and long-term economic growth 3. Public expenditure It is a mistake to claim that a higher level of public expenditure is the cure for the societal problems and leads to higher well-being. ‘‘(...) the large increase in public spending (...) that occurred especially after 1960 does not seem to have contributed much to social welfare. This leads us to conclude that by the time countries reach the level of public spending shown by the small governments, namely, between 30 and 40 percent of GDP, much of the potential social gain from public spending has been obtained. Spending beyond that level does not contribute much.” Source: Tanzi V., Schuknecht L., Reconsidering the Fiscal Role of Government: The International Perspective, The American Economic Review, Vol. 87, No. 2, 1997. 21 II. Public finance and long-term economic growth 3. Public expenditure Especially destructive are the „welfare states” in less developed economies. • ‘‘(...) while governments devote about a third of their budgets to heath and education, they spend very little of it on poor people. (...) Public spending on health and education is typically enjoyed by the non-poor.” (World Bank, 2004). • Examples: Mexico In 1989 execution of the ‘‘National Solidarity Program” was started. The possible reduction of poverty was forecasted at 64%, but the real reduction had amounted only to 3% until 1995. The cost of the program came to 1.2% of GDP. The simple distribution of such an amount of money to all people (including wealthy people) would reduce poverty by 13%. Bangladesh 74% of teachers employed in public education system do not attend classes. Brazil The economic growth of Brazil is hampered by the high costs of doing business (including tax wedge) caused by the excessive welfare state. India The transfers originally directed to the poor peasants are taken over by wealthy farmers. The prohibition to fire the worker, even in private enterprise, leads to high unemployment in India. 22 Source: World Development Report: Making Services Work for Poor People, World Bank 2004. II. Public finance and long-term economic growth 3. Public expenditure A high level of social spending discourages people from active participation in the labour market (social traps). Fall in the labour supply caused by social traps depends on: • the level of social benefits • The cut of the replacement rate in unemployment insurance from 80 percent to 75 percent in Sweden in 1995 caused an increase in the transition rate of employment of roughly 10 percent. (Carling, Holmlund, Vejsiu 1999) • the entitlement period • The results of econometric analysis have shown that the prolongation of entitlement periods and its extension to successively younger age groups in West Germany in the 1980s has increased unemployment durations for males. (Steiner, 1997) Sources: Carling K., Holmlund B., Vejsiu A., Do benefit Cuts Boost Job Findings? Swedish Evidence from the 1990s, 1999. Steiner V., Extended Benefit – Entitlement Periods and the Duration of Unemployment in West Germany, 1997. 23 II. Public finance and long-term economic growth 3. Public expenditure • availability and conditions to exercise social benefits The extension of the number of weeks a person must work to become eligible for unemployment insurance benefits on the Swedish labour market from 80 days to 6 months between 1996 and 1998 caused an approximate 2.9-week extension in average employment duration. (Hagglund, 2000) Changes in the conditions to exercise social benefits in the United States in 1996 (obligatory to work or participate in training courses, eliminating part of the social programs, etc.) led to a 56% decrease in social benefits recipients in the years 1996-2001. Source: Hagglund P., Effects of Changes in the Unemployment Insurance Eligibility Requirement on Job Duration – Swedish Evidence, 2000. 24 II. Public finance and long-term economic growth 3. Public expenditure To conclude, an expansion of public expenditure from a relatively low level leads to a decline in the economic growth rate. As Schuknecht and Tanzi state, in the years 1980-2000 the expansion of public expenditure in relation to GDP led to lower values of the quality-of-life indicators, including the economic growth rate. 1.4 Public sector efficiency in 2000 * 1.26 1.2 1.03 1.0 0.90 0.8 "Small" governments "Medium" governments * Efficiency indicators for the public sectors of 23 industrialised OECD countries. • „small” governments: public spending less than 40% of GDP; • „medium” governments: public spending between 40% and 50% of GDP; • „big” governments: public spending greater than 50% of GDP. "Big" governments The average level of public sector performance was set to 1. The public sector performance indicator is based on measures of administrative performance of government, education, health performance, public infrastructure, income distribution, economic stability and economic performance. Sources: Afonso A., Schuknecht L., Tanzi V., Public sector efficiency: an international comparison, ECB Working Paper No. 242, 2003. A., Schuknecht L., Tanzi V., Public Spending in the 20th Century: A Global Perspective, Cambridge University Press, 2000. 25