Download Budget Process and Policy

Center for Policy Excellence: budget policy
Workshop eighteen
Budget process and policy: fiscal policy
Seminar notes for fellows
Prepared by Michel Marion
May 1999
CONTENTS
1.
Policy tools of government ..................................................................... 1
2.
What is fiscal policy? ............................................................................... 4
2.1 Instruments ................................................................................................. 4
2.2 Targets of fiscal policy .............................................................................. 4
2.3 Linkages between government balance and equilibrium
conditions in other sectors ............................................................................. 6
2.4 Financing the deficit ................................................................................ 6
2.5 Considerations of prudent fiscal deficit and debt level ..................... 7
2.6 Fiscal policy as part of “adjustment” strategy ..................................... 8
2.7 Short and long term focus of fiscal policy measures .......................... 8
Tax structure ..................................................................................................... 8
2.8 Expenditure policy .................................................................................... 9
2.9 Other topics related to fiscal-tax-expenditure policy ....................... 10
2.10 References ........................................................................................... 10
3.
Tax policy: Issues and Considerations ................................................ 11
3.1 Introduction ............................................................................................. 11
3.2 1. Types of Taxes ...................................................................................... 11
3.3 Desired characteristics of tax structure ............................................... 11
3.4 Tax policy revisited .................................................................................. 12
3.5 Conclusions: broad IMF perspective ................................................... 20
3.6 Concluding comments .......................................................................... 21
3.7 References ............................................................................................... 22
4.
Expenditure policy: issues and considerations .................................. 23
4.1 Context and overview ........................................................................... 23
4.2 Inherent challenges ................................................................................ 23
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4.3 Size of government ................................................................................. 24
4.4 Allocation of expenditures .................................................................... 25
4.5 Examples of alternative delivery modes ............................................. 27
4.6 Guidelines in allocation across “economic” components .............. 28
4.7 Guidelines in allocation across “functional” components .............. 29
4.8 References ............................................................................................... 29
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1. POLICY TOOLS OF GOVERNMENT
We have looked at a number of different policy tools the government has available over the last
few weeks. In this section we summarize the major tools. The rest of the course notes focuses on
fiscal policy.
1.1.1 Fiscal policy
A key tool the government has in playing each of the roles described above is fiscal policy. Indeed
a common measure of the size of government is the ratio of public expenditures to GDP. The
right size of government is a decision for society to take through the electoral process. Crosscountry comparisons show a wide range of government expenditures to GDP ratios. This attests
to the different choices that different countries make. However, policy analysts should be aware
that there are potential biases in political incentives that do not always promote optimal
expenditure decisions. These include:
The possibility of financing public deficits with long-term borrowing facilitates deferral of
difficult expenditure-reduction decisions.
The benefits of prudent and productivity-oriented expenditure policies may only show up in
the long run, beyond the term of office of the incumbent administration.
Even during periods of fiscal consolidation, it is easier to raise taxes than to cut programs;
Being seen to be doing new things – addressing emerging problems – may get elected officials
more visibility and political points than improving the administration of existing programs that
may have been put in place by predecessors (part of explanation for growth in size of
government).
Rising trend in expenditure-to-GDP ratio world-wide in 60s to mid to late 80s: alternative
theories: increasing complexity and changing values of society; “ratcheting”: increase during
periods of crisis but only partial decline subsequently; built-in incentives in the political process:
responding to pressure groups; empire-building by bureaucrats
Some things to consider when assessing the appropriate size of government:
Higher level of expenditures than necessary will have implications for debt and debt service or
tax burden.
Guiding principle for policy makers is to assess whether an increase in government spending
would be more helpful to economy than a reduction in spending which would reduce the
government’s claim on available savings and be available for use in the private economy.
Compare program expenditures and total expenditures to GDP ratio to neighbors, trading
partners, or other countries at similar stage in development: how do size and mix compare?
Can insights be drawn?
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Start with a fairly restrictive approach to allocative, distributional, and stabilization role of
government simply because however good the intentions, as we saw in course notes ten, it is
difficult to know how government interventions will work out. Also, once a program in place
there is often strong opposition to reduce it let alone dismantle it. Thus, it is prudent to adopt
a narrow perspective on what constitute pure public goods and to be very discriminating when
assessing prospects of addressing market failures in ways that will commit significant or
growing public resources.
Be realistic in assessment as to whether government can really do something about the issue at
that particular time.
Challenge the pressure for incrementalism: periodically question the basic value of programs in
place; when new priorities emerge, seek out ways to finance them internally, that is through
reductions in or elimination of existing programs rather than simply adding new to the existing
stock of programs.
Tax policy is also an important policy tool for government. We have looked at some of the ways
government can use taxes to correct market failure in course notes for workshop eight and nine.
We will look more fully at the impact of taxes on the economy in future course notes.
1.1.2 Monetary policy
Monetary policy can be used to smooth out cycles in economic activity. Most countries now see
the primary role of monetary policy as contributing to a stable macroeconomic environment by
controlling inflation. However, this approach indirectly tends to smooth out demand driven
cycles in economic activity.
1.1.3 Exchange rate policy
A government can choose between a floating or fixed exchange rate, or some mixture of the two
such as a crawling peg or trading band. Under a floating system, government only has indirect
influence on the exchange rate via monetary policy. However, even under a fixed regime,
government can not permanently sustain an exchange rate that is significantly different from the
level implied by the economic fundamentals. The exchange rate can influence real economic
activity through its impact on the competitiveness of exports and imports and import-competing
goods.
1.1.4 Trade and other supply side policies
A key policy choice for governments is the extent to which they open their economies to external
competition. Governments can protect domestic producers from competition through a number
of mechanisms including tariff and non-tariff barriers to trade.
The trend in many countries over the last decade has been to reduce barriers to trade. Tradepolicy has become a key supply-side policy, in that by removing this direct protection, domestic
producers must be more innovative, competitive and proactive if they want to keep their
traditional markets and more aggressive to open new ones. This greater dynamism leads to
improved production practices, reduced complacency of the work force and entrepreneurs.
In this new environment, what is government’s role? It may include:
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Assisting exporters to identify new markets or new product or service opportunities and
helping them to break into these markets with technical or marketing or market research
advice.
Removing impediments to investment, unnecessary regulations, restrictions on imported
inputs, red tape, and providing an environment that is supportive to the creation of new
ventures and business investment.
Infrastructural support.
More generally, supply-side policies focus on increasing output, in the short term, through better
allocation of resources and on pushing up the production potential or GDP growth track in the
longer term. Obstacles to utilizing available capacity often related to limited availability of foreign
exchange; obsolete technologies (industrial or agricultural sectors); deficiencies in working
capital; and lack of managerial or technical skills in the workforce.
It is usually difficult to reduce constraints to production due to these factors in the short term. In
the longer term, some direct measures can be taken to improve the skill levels of the workforce,
and improve the workings of the financial and exchange rate markets. Other measures include:
The removal of restrictions that distort prices and the allocation of resources.
Review the role and effectiveness of public enterprises.
Measures to increase savings and productive investment.
Stimulate competition; measures that reduce costs of production and remove restrictions to
market access; review credit controls and subsidization of credit to favored sectors; review
public enterprises and examine opportunities for privatization, improved management and
innovation.
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2. WHAT IS FISCAL POLICY?
The use of budget instruments (tax and non-tax revenue, expenditures and borrowing) to
influence some macroeconomic variables, and ultimately the sustained growth of output and
productivity in the economy, and the attendant steady progression in citizens’ standards of living.
Impact on:
Balance of payments/exchange rates: sustainable current account balance.
The level and growth of economic activity: demand management in the short term and
private sector investment-led supply expansion in the longer term.
Inflation and credit conditions (availability of savings for productive investment) in the
short and the long term.
Trade policy: availability of capital for exporters, and deficit impact of reduced duties
This impact is felt through transmission mechanisms (often two-way linkages) operating through
the various markets and with impacts on public and private sector economic agents. Assessment of
impact is judgmental; what is presented here is based on personal experience in my country and
on results of IMF research – based on various cross-sectional and historical studies of countries,
where IMF assistance was provided, and where Financial Programs were put in place
2.1 Instruments
Expenditures: current, capital (PSIP), subsidies (to individuals, other levels of government, firms
and public sector enterprises) tax expenditures, concessional financing, loan guarantees.
Taxes: direct (e.g. corporate, personal, wealth), indirect (consumption, import duties) royalties.
Non-tax revenue: fees, licenses, and fines.
Borrowing sourcing (domestic versus foreign, market versus concessional, maturity structure of
debt and interest rate and exchange rate risks).
2.2 Targets of fiscal policy
While the focus is on macro variables, the instruments themselves have large direct microeconomic
impacts: on sectors, particular groups or individuals; through the structure of taxation and priority
setting in expenditures.
Impact on the macro variables less direct and maybe less immediately visible but real; so fiscal
actions taken by authorities have to be analyzed and understood properly not just their immediate
and obvious effect but to ensure that done in the right context and will be consistent with all
macro objectives; so need information to assess not only direct effect but also the cumulative and
indirect effects.
Assessing the “fiscal stance” in the short term (stabilization function):
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Expansionary: government adding stimulus to aggregate demand.
Contractionary: government holding back aggregate demand.
Neutral stance.
How to assess fiscal stance: (important dynamic properties, so look at movements and not just
levels in certain variables):
Deficit and deficit to GDP.
Ratio of government expenditures to GDP.
More sophisticated measures: movements in the government’s primary balance (total
deficit less interest payments); or total program expenditures less current revenues-to
exclude privatization receipts and foreign grants).
Even more sophisticated measures: cyclically-adjusted budget balance (CABB) or primary
CABB; although the latter require considerable information on the state of labor markets
and industrial sector capacity utilization rates, not readily available).
2.2.1 Government sector universe
Central government, ministries and parliamentary institutions.
General Government: includes also other areas within close circle of influence:
Hospitals, school boards, commissions, regional governments.
Public sector enterprises: financial and non-financial; subsidies, special exemptions,
concessional financing, preferential tax rates of import duties on inputs.
Other special funds or accounts, like pension plans or public service pension plans that may
generate windfalls to the central government or liabilities.
Classification of government sector transactions:
Above the line: on the expenditure side: reflects purchases of goods services and capital,
interest payments, as well as equity investments in public sector enterprises; on the
revenue side, includes tax and non-tax revenues used to pay for current expenditures, as
well as grants from foreign governments or international financial institutions (although in
latter case, must be cognizant that they are determined by outside authority and may not be
prudent to plan on the basis that they will be forthcoming on an ongoing basis); includes
also receipts from sales of assets or from privatizations (here again a one-shot inflow of
cash).
Below the line: other transactions that affect the government’s net worth position: debt
repayment and new borrowings, including from foreign governments or international
financial institutions.
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2.3 Linkages between government balance and equilibrium
conditions in other sectors
First set out a few System of National Accounts (SNA) identities.
Y  C + I + G + (X – M)
(Eq. 1)
( Means the two sides of the equation are necessarily equal since the equation depicts an
identity).
Where Y is GDP, C is private consumption, I is private capital formation, G is total government
expenditures; X, and M are total exports and imports respectively of goods and services.
Subtracting T (government revenues) from each side of equation 1 yields:
Y – T  C + I + (G – T) + (X – M)
(Eq. 2)
Y – T  income after tax, that is, available to consume or to save. Thus:
Y – T – C  SA (savings)
(Eq. 3)
Thus, subtracting C from each side of Eq. 2 yields:
Y – T – C  I + (G – T) + (X – M), and after substituting Eq. 3, and rearranging, becomes:
(SA – I) – (X – M)  (G – T) or,
(SA – I) (G – T) + (X – M) or,
(SA – I) – (G –T)  (X – M), or
(I – SA) + (G – T)  (M – X)
(Eq. 4)
Eq. 4 presents the accounting relationship between the private sector’s net excess savings (the 1st
expression), the current account balance of the balance of payments (2nd expression), and the
overall balance in the government sector (fiscal deficit).
While this simple set of equations does not provide us with the transmission mechanisms,
nonetheless, they indicate that a non-zero balance in one account has to be offset by a non-zero
balance in one or both of the other balances so that the identity still holds. This holds true also of
changes in these balances having to be offset by an offsetting change in one or both of the other
balances.
An overall fiscal deficit must be matched by a domestic private sector that saves more than it
invests or by an external current account deficit.
Considerable examples of situations where prolonged periods of fiscal deficits have been reflected
in deteriorating external current account balances. How the government finances the fiscal deficit
(or net “dissaving” in the model above) is one of the key considerations.
2.4 Financing the deficit
Borrowing from the Central Bank: the central bank buys debt instruments from the government and
deposits corresponding amounts of credits in its government account. The government pays for
expenditures and uses up the amounts credited. This is called monetising the debt as the monetary
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base and money supply are increased. Reliance on the commercial banking sector will have similar
effects if borrowing by government does not constrain lending to the private sector.
Borrowing from the non bank sector: corporations or individuals purchasing government bonds or
treasury bills. This may affect the allocation of resources in the economy, as this capital will not
then be put to productive uses. During periods of economic downturns, when there is excess
liquidity, hence private sector investment is low and credit is available, government investment
projects initiated in part for counter-cyclical reasons will make use of this credit to boost GDP,
with no adverse effects on private sector investment. In other words, from Eq. 4 above, if SA
greater than I, this excess savings can be offset by an increase in G. In other circumstances, an
increase in G can lead to crowding out of private sector investment, especially if foreign capital
inflows are not available to finance private sector investment.
Borrowing from abroad: in developing countries, this may come mainly from international financial
institutions, such as the IMF, the World Bank, the IDB, etc, as private sector financing
Accumulation of arrears: not paying the bills on time is one way to finance debt: debt service, or
goods and services purchases. Very negative impact on creditworthiness and country risk
assessment, hence as a result, increasing difficulty in securing market financing.
2.4.1 Impact of fiscal policy on macroeconomic variables
Inflation: if government spending financed by the creation of money: inflation tax; some room to
do this as money supply has to increase to accommodate rise in economic activity and increased
monetisation (exchanges done using money instead of barter).
External current account: government increases in spending without corresponding increase in
revenues will lead to increase in aggregate demand and imports.
Generally, no obvious reason to expect offsetting increase in exports so can expect deterioration
in the current account component of the balance of payments with the rest of the world. – Not a
simple linkage, since will depend on how deficit is financed and current economic conditions; if
leads to crowding out of private sector investment, and rise in interest rates, the result could be a
corresponding reduction in private sector investment or consumer durables purchases, and an
increase in private savings, with less effect on the external balance. But negative longer-term
impact on growth of output, and perhaps potential to increase exports or to substitute imports,
with the negative implications for the current account balance.
Growth: if deficit comes from current consumption component of government expenditures, and
not the production of human capital or maintenance of public infrastructure, then adverse effect
on growth (since hindering the domestic savings-investment balance); also possible impact on the
allocation of resources if, for example government resorts to excessive marginal income tax rates
or to subsidies of inefficient firms.
2.5 Considerations of prudent fiscal deficit and debt level
Debt is the accumulation of past deficits less accumulated surpluses. Sustainability is an issue.
Fiscal deficits of government sector dissavings must be made up by savings from the private sector
or foreign inflows and fiscal deficit impacts on these other sectors.
Interest must be paid on this debt; a high debt level implies that every year, a large proportion of
revenues go out as debt interest and so cannot be used to finance priority programs. This means
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that the government must run large primary balances just to not risk running arrears, which
means that taxpayers see a large part of taxes paid not reflected in programs. Risk of rising taxes
at the same time as program spending is curtailed. If this debt was used on investment in human
capital or productive infrastructure, then generating incomes and taxes so fiscal payback.
Some would argue that debt eventually has to be repaid and so intergenerational transfer of debt:
folks in the past received the benefit of the program spending which gave rise to the debt, and
folks now or in the future have to pay the bill for past spending, for which they may not be
reaping the benefits.
If past spending went on infrastructure, which is resulting in increased domestic activity (income)
or export earnings, then justified. So must look at the qualitative side of the expenditures, which
led to the debt increase.
In a world of constrained resources, what one sector uses up, the other sector does not have
available. Is the share of economic resources going to the public sector too large – one indicator
will be the sustainability of the present fiscal course? Are most expenditures key and critical
current expenditures to strengthen health and human resource capital or to rebuild the capital
infrastructure, which will contribute to future growth.
2.6 Fiscal policy as part of “adjustment” strategy
So, in a financial programming environment, that is when the IMF is asked to support a country’s
balance of payments problems over the Program period, there will be generally be a fiscal policy
component in the set of policy recommendations.
In most instances, the balance of payments problems result from a large proportion of revenues
that go as debt interest on external debt and this in turn leads to current account problems.
2.7 Short and long term focus of fiscal policy measures
Short term: limitations of excess demand: deficit reduction measures warranted.
Longer term: supply-side measures to reallocate resources to more productive uses and hence
boost growth of output and of export earnings. This has structural implications, not only fiscal
implications, which refer to measures to improve the quality of the revenue and expenditure structure
Tax structure
Issues:
Distortionary impact on relative prices with possible adverse effects on incentives and
inappropriate price signals; largely from too high commodity taxes and duties; and too
much reliance on taxes levied on large corporations.
Import duties with high and variables rates give unintended effective protection and
encourage inefficient import substitution.
High nominal direct tax rates (applied to incomes) combined with ad hoc exemptions will
affect the level and pattern of investment, saving, work, work effort and capital flows.
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Complementary issue: overvalued exchange rates are disincentives to domestic production and
export
Desired characteristics of tax structure:
Revenue-generating capacity: ability to raise revenues and growth at least in line with respect
to incomes, so that don’t need frequent rate adjustments or introduction of new rates;
avoid “specific” in favor of “ad valorem” and go for bases that are not shrinking in relation to
the rest of the economy (elasticity concept); remember taxes typically go to finance an
increasing level of expenditures, so don’t want shrinking revenues.
Efficiency: minimize impact on relative prices, so that least disturbance of what the
allocation of resources would be in the economy in the absence of taxes: in practice as
general rule avoid excessive reliance on high rates applied to few commodities in favor of
low uniform rates applied to a broad base; implies keeping tax exemptions to a minimum
since they reduce effective tax rates and distort market signals.
Equity: fair and equitable, based on ability to pay (progressive taxes such that as income
rises a greater proportion of marginal income goes in taxes, and high excise taxes on luxury
goods to encourage savings; equity also across sectors s that burden reasonably uniform
treatment within cohorts or across sectors; to affect income distribution, targeted transfers
my be more effective policy than tax system (complexity, incentives to avoid paying taxes).
Transparency: clearly drafted tax codes, well defined, simple to understand; stable or
predictable tax rates, infrequent changes.
Reasonable overall tax burden: ratio of tax to GDP that society accepts and which is consistent
with high compliance and self-assessment.
To that must be added sound tax administration.
2.8 Expenditure policy
Need to encourage productive government investment: passes economic tests in terms of
payback; complements rather than competes with market-determined activities (back to our little
matrix of when and when not is government intervention to be considered).
Funding operations and maintenance: critical to success and ongoing productivity of capital;
otherwise low levels of effectiveness (schools and hospitals) and rapid deterioration; thus if need
to reduce current expenditures, avoid if possible simply applying across-the-board reductions, even
if might look easier in a first instance and impact may not show up for some time, when the
damage is done and the cost becomes astronomical; other implication is only do the capital
investment for which you have assessed the ongoing O&M costs and have ascertained that
can maintain the capital.
Addressing sources of low productivity in government: low pay and inadequate salary differentials for
skilled managerial and technical staff may discourage work effort and productivity; government as
employer of last resort means bloated payroll.
Cost-effective expenditure policies: intended objectives of expenditures relate to allocative,
distributive or stabilization functions; expenditure measures must be properly targeted and seek
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cost-effectiveness: “maximum bang for minimum dollars”; for example, avoid generalized subsidies;
if decide must intervene in markets, see if can accomplish task using enforced regulations instead
of expenditure program; and be very selective before resort to instituting public sector
enterprise, since experience around the world demonstrates not nearly as effective in delivering
cost-effectively as intended and tough to dismantle or to sell off once in place; one guide is to
search out alternative service delivery mechanisms.
Limiting government consumption: within total program expenditures, examine the split
between current and capital expenditures and consider that reduction in spending means lower
claim on available savings, possibly available for more productive uses and hence contributing to
raise the sustainable growth path or output and resources.
2.8.1 Suggested ways to rationalise expenditures
Short term; quick hits: may be some obvious candidates for reductions, but mostly need analytical
approach based on government priorities; avoid across-the board; controversy over
appropriateness of action on the wage bill.
Medium term: fundamental review of priorities to help identify lower-priority activities; examine
broad coverage of activities and modes of delivery; use zero-based program budgeting; apply user
fees in programs that are not pure public goods, or other market-simulating methods to
rationalize demand or costs; target subsidies; incentives for managers to achieve greater costeffectiveness in program design and delivery.
2.9 Other topics related to fiscal-tax-expenditure policy
Experience of other countries.
“Governance”, administrative, institutional, and “process” dimensions or requirements for
effective formulation and execution.
Develop analytical framework for expenditures and revenues.
2.10 References
Davis (Ed.), Macroeconomic Adjustment: Policy instruments and Issues, IMF Institute: 1992, Ch.
III.
IMF, Fiscal Affairs Department, (# 49 pamphlet series) Guidelines for Fiscal Adjustment, 1995.
IMF, Occasional Paper # 149, The Composition of Fiscal Adjustment and Growth – Lessons
from Fiscal Reform in Eight Countries, 1997.
Shome, P (ed.) Tax Policy Handbook, IMF, 1995.
Chu and Hemming (ed.) Public Expenditure Handbook – A Guide to Public Policy Issues in
Developing Countries, IMF, 1991.
IMF, Fiscal Affairs Department, (#48 pamphlet series) Unproductive Public Expenditures – A
Pragmatic Approach to Policy Analysis, 1997.
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3. TAX POLICY: ISSUES AND CONSIDERATIONS
3.1 Introduction
Will look more deeply into revenue side of budget, the major issues in tax design and the
desirable characteristics of tax structure; then draw out the less obvious but no less important
impacts of various types of taxes on how people or firms react and how some taxes affect relative
prices and influence people’s decisions in various ways, and in ways that can affect the economy’s
growth path as well as the revenues themselves.
Caveats: Obviously, in one lecture, we can only cover some elements and skim them at best. But
as in the other lectures and indeed as for this entire project, the objective is to step back and
develop an analytical framework and give ourselves some guide posts to look at our respective
country’s reality with a fresh pair of eyes and more analytically. Other major point is that as in all
policy issues, deal with normative issues not just positive or analytical – but requiring judgement
about social values and relative priorities. In the tax policy area, no perfect system, all taxes have
pros and cons and so boils down to trade-offs among second best options.
3.2 1. Types of Taxes
Can look at taxes as whether they are levied on the “source” side (on the income side) or on the
“use” side (or expenditure side).
Source side taxes include all incomes levied on factor incomes: personal income tax, payroll tax
(such as unemployment insurance premiums); taxes on the income of firms, taxes on property
and wealth, or on inheritances
Use-side taxes include: taxes on the purchases of households and firms (general sales tax, specific
excise taxes, taxes on imports (tariffs or duties) and taxes on be bequests.
Other classifications:
Ad valorem (tax is expressed as a percent of the selling price of a good or service) versus
specific taxes (tax is expressed as a fixed dollar amount).
Personal taxes (levied on a specific individual such as the personal income tax) versus in rem
taxes (imposed on an impersonal transaction such as the sale of a commodity, and do not
discriminate among individuals and thus apply at the same rate to all)
3.3 Desired characteristics of tax structure
Are:
Revenue-generating capacity: ability to raise revenues; growth in revenue keeps pace with
economy (since typically need to finance an increasing level of expenditures); don’t want
shrinking revenues so don’t go for bases that are shrinking in relation to the rest of the
economy (review elasticity concept); and avoid frequent rate adjustments or introduction
of new rates or new taxes; avoid “specific” (fixed dollar values) in favor of “ad valorem”
(percent of selling price).
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Efficiency (neutrality): minimize impact on relative prices, so that least disturbance of what
the allocation of resources would be in the economy in the absence of taxes: in practice as
general rule avoid excessive reliance on high rates applied to few commodities in favor of
low uniform rates applied to a broad base; implies keeping tax exemptions to a minimum
since they reduce effective tax rates and distort market signals.
Equity: fair and equitable, based on ability to pay (progressive taxes such that as income
rises a greater proportion of marginal income goes in taxes, and high excise taxes on luxury
goods to encourage savings; equity also horizontally so that burden reasonably similar for
individuals in similar economic circumstances or across sectors; to affect income
distribution, targeted transfers my be more effective policy than tax system (complexity,
incentives to avoid paying taxes).
Transparency: clearly drafted tax codes, well defined, simple to understand; stable or
predictable tax rates, infrequent changes.
Reasonable overall tax burden: ratio of tax to GDP that society accepts and which is consistent
with high compliance and self-assessment.
Sound tax administration also key requirement.
3.4 Tax policy revisited
Government needs taxes to carry out its essential functions (fall-out from allocative function).
Up to the point where signs of tax fatigue (e.g. increased complaints of excessive tax burden, or
increased incidence of avoidance), taxes are first place government typically have turned to, to
address fiscal deficit or to finance higher spending. Action on taxes is more direct, easier to
implement “path of least resistance” since expenditure cuts are often more politically difficult.
Will focus on four inter-related issues: equity, efficiency, incidence and incentives effects of taxes
3.4.1 Equity
Two approaches:
Application of Benefit Principle Dates back to Adam Smith: each taxpayer contributes
according to the degree in which they make use of the output of society; a variation on that
principle specifies also that payment should correspond to the benefits that he or she
derives from the provision of public services (thus the tax structure would be designed in
tandem with the structure of public expenditures).
Under this principle, taxes applied on an individual’s (or household’s) consumption or
expenditures – what the individual takes from and not what he or she contributes to
national output. This contribution or value added comes in the form of labor income or
compensation for risk taking (profits, dividends, and interest payments). Would also argue
for earmarked taxes (like oil products taxes going to fix roads or build new ones), and user
charging (tuition fees in schools, health care user fees, entrance fees to public facilities.
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Under this approach, there is no obvious redistributive role for tax policy. Of course this is
not generally how the real world works, which brings us to the other equity principle, that
which is more generally applied.
Application of the Ability-to-Pay Principle. Here the focus is on which individuals are most able
to pay for public services and public sector spending, not on the basis of the benefits
individuals derive from the system.
How to raise revenue and who is to pay are questions addressed independently of the
question of what activities government should be engaged in and how the government
budget should be allocated.
(Of course, in the aggregate, the revenue and expenditure totals are determined
simultaneously in the Fiscal Plan, but the decisions on the individual tax and expenditure
measures are not co-dependent.
Application of this principle would point to the appropriateness of taxes on incomes and
wealth, since these variables affect an individual or household’s ability to consume, and
therefore potential economic wellbeing.
Application of the “ability-to-pay” equity principle leads naturally to an explicit
redistributive role for the tax regime (through progressive tax rates, and thresholds for
taxable income) and for expenditures (transfers or publicly funded social programs or equal
access to health and education services).
Indeed, a tax is judged to have positive equity effect when the post tax distribution is more
even that the pre-tax distribution.
There are two dimensions to the equity issue: horizontal and vertical equity:
Horizontal equity refers to equal tax treatment of equal economic agents, that is individuals
in identical situations in terms of wealth of income, should be asked to pay the same
amount of tax, so one is not penalized if he receives his income from one source rather than
another.
Vertical equity refers to unequal tax treatment of unequal economic agents: this has to do
with ability to pay: the individual who earns more or who is wealthier is in a position to pay
more and the tax system should be so organized.
While intuitively appealing, these concepts are hard to apply since they raise a number of difficult
practical issues: how to measure “equality” or “inequality” among individuals; and how to define
“equal” or “unequal” tax treatment
a) How to define “equality” among individuals
Subjectively: by focusing on what is important to each individual’s welfare or sense of well-being
and measuring each individual’s welfare; or
Objectively: by assuming that economic wellbeing is linked directly to ability to consume, and
assess welfare through measures of income or wealth; even here the issue becomes over what
timeframe should wellbeing be measured. This is an issue since wealth and income will be a
function - at least in part - of initial endowments, and lifetime earnings. There is a temporal
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dimension: where individuals are by the time they are fifty or seventy five will nor be the same as
when they were twenty. In practice, taxes are levied on annual incomes – but there are often
deductions from taxable income for prior-year losses or income averaging provisions in the event
of windfalls, etc.
In practice, the latter approach is used: there is a more straightforward way to measure incomes
than “happiness”
b) Measures of relative equalities in the distribution of income
Different measures of degrees of equality (or inequality) have been devised using income data.
The oldest and more often quoted index is the Gini coefficient (see workshop thirteen).
To be effective in our previous model – unequal treatment to unequal individuals – an effective
redistributive measure is one that results in reduced inequality.
But will society’s welfare really be improved by lowering the Gini coefficient to as near zero as
possible? Alternative views on how best to aggregate over individuals’ welfare to obtain society’s
total welfare. Here in particular, the analysis is normative, as economists reflect and comment on
social values. For a discussion of different philosophical approaches to viewing equity see course
notes on workshop thirteen.
c) Equity Issues in the Choice of a Tax Base
Capital gains: Makes sense that they be included in a comprehensive income base, since represent
increases in net worth. But should the tax be applied on accrued or realized gains. Each approach
has its problems. Accrued: costly and difficult to value certain assets periodically; also some
element off arbitrariness.
Realization: then incentive to defer conversion to cash, in order to postpone tax liability (lock-in
effect), with associated distortion since holder of some assets may in absence of taxes move capital
around to seek maximum return; this way would ensure that society places resources where most
productive.
Inflation raises two tax-related problems:
Illusory capital gain – part of return is simply to compensate asset owner for increase in
price when time to replace asset.
Other relates to the progressivity of the tax structure in nominal terms (assuming
deductions, thresholds, and tax brackets are not indexed): leads to bracket creep: as higher
proportion of income is paid in taxes even if purchasing power of that income has not
changed.
Fluctuating incomes. Unless tax regime has income-averaging provisions or loss carry-forward
provisions (where losses one year can be applied to reduce tax liabilities in years where income
earned is positive) then a person who receives a steady income will pay less taxes over a period of
years than a person who receives the same cumulative income over those years but whose annual
income fluctuates.
Explicit form of income tax averaging exists when can deduct a certain amount of savings from
taxable income in working years, but then counted as taxable income in retirement years.
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3.4.2 Efficiency
Government needs to collect taxes if it is to have the means to deliver the programs that society
has asked for - through the political process. But there are “costs” associated with taxes, three
facets, and each successive one is a bit less tractable than the previous but no less important:
Administrative costs: how much it costs to collect one dollar of revenue; based on the
wages and other operating costs of revenue authorities; the employees’ time and other
costs spent on assessment, audit, collection, court proceedings; costs also include
administrative or information support, etc. The costs will be higher when the tax system is
complicated – with multiple rates and exemptions, and when voluntary compliance is low.
Compliance costs: costs to taxpayers, out of pocket, and time; time it takes taxpayers to
file, and the costs they incur when hiring accountants to prepare the documentation, and to
advise on how to legally minimize their tax bill. These costs would depend on the
complexity of the tax code; the pieces of supporting information that are to be included in
the filing, etc. The higher the costs, the greater the incentive for non-compliance and for
moving to the informal economy. Since this would be more feasible for upper or high
middle income earners, this shift of non-compliance would result in significant loss of
equity – based on ability-to-pay equity principle.
Efficiency cost: borne by taxpayers, and citizens. This is over and above the cost to
individuals associated with transferring some of their purchasing power to the government.
Taxes impose varying degrees of distortions on the workings of the private economy. They
may result in changes in individuals’ purchasing patterns or their work-leisure mix or their
consumption-savings choices. These distortions impose a dead-weight loss, or the “social
welfare cost. Indeed, a desirable characteristic of a tax regime is neutrality, characterized
as a tax regime that results in no material change in any relative prices and therefore not
influencing taxpayers’ expenditure, work or savings behavior.
Will focus here on the latter element of efficiency, by looking at incentives effects of various tax
forms and at tax incidence.
a) Tax incidence
This looks into which individuals or groups of individuals pay the tax. Ultimately it is individuals
or households who bear the ultimate burden of all taxes, since corporations or firms are owned by
shareholders – thus when a corporation pays income taxes this represents a tax on dividends
(since there is less income to return to shareholders).
Tax incidence analysis focuses on which economic agents (persons) ultimately bear the burden of
a tax or of a system of taxation. The concern is on the impact of taxes on the well being of persons
in their economic roles: as consumers, producers, and providers of factors (labor or capital).
We will look at examples where the actual burden will not rest on the agents, upon whom the tax
is levied, in that in certain conditions, the burden is shifted onto others.
Discussion of this dimension of taxation follows naturally from the discussion of the efficiency
costs, and consumer and producers surpluses and ties in not only with tax efficiency but also with
tax equity
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To do tax incidence analysis well, need keen understanding of how the economy works, how
economic agents and firms behave, how quickly, how sharply and in what way they respond to
price changes or changes in incentives.
Different points of reference to assess incidence: budget incidence (according to level of income);
by region; according to level in production-consumption process (i.e. suppliers of factorsproducers-consumers):
Budget incidence: This approach assesses the impact of a tax measure on the distribution of
income: incidence is measured with respect to how individuals at different points in the
income distribution are impacted. In this classification a tax is regressive or progressive if
the burden tends to fall more heavily on the lower or higher income groups, respectively,
and proportional in the case of a fairly uniform pattern of incidence.
Regional incidence: Some activities or factors of production may be concentrated in
particular geographical areas of the country. Thus the impact of some tax measures may not
be evenly distributed across regions.
b) Partial or general equilibrium analysis:
The focus of analysis may be on an individual market or commodity; this is satisfactory in the case
of a relatively minor tax measure or a market or commodity of secondary importance in the
economy.
Otherwise, what is missed by partial equilibrium analysis may be quite significant by assuming away
any full economy-wide impacts, – especially the feedback effects. In these circumstances, general
equilibrium analysis is warranted. (This broadens the analysis to encompass also the secondary
markets or commodities that would be impacted by a measure in another sector/market.) But the
spillover effects cannot be disregarded in the case of major tax changes affecting a major sector,
significant base broadening, or a broad-based tax on factors (e.g. capital).
c) Partial Equilibrium
This approach focuses on how a tax will affect economic agents in a particular market where a tax
is contemplated or has been applied. Here the issue is in what proportion will producers,
consumers, or suppliers of factors ultimately bear the tax.
In some situations a tax applied to a producer may be borne by him through lower profit income.
In other circumstances part or all of it may be transferred to (and borne by) suppliers of factors to
the producers in this industry (through a reduction in the prices paid for their factors) which then
means lower incomes to factor suppliers.
Yet another possibility is that it may be transferred downstream and borne by consumers of the
industry’s products, through higher prices and lower consumers’ surplus.
Example 1: excise tax applied to a commodity.
Draw typical supply and demand curves, describe equilibrium price and quantity before tax is
applied and identify consumers’ and producers’ surplus; then draw tax wedge and describe the
new equilibrium price and quantities and lost surpluses: shared tax burden.
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In markets, prices determine quantity demanded and supplied, and the determining factor in the
incidence is the magnitude of the wedge and the elasticities in the demand and supply functions.
Which agent is responsible to remit the tax is of very secondary importance in assessment of
whom will bear the tax burden.
Note how different shapes in the supply and demand curves affect incidence:
Burden falls on low elasticity agents, those who cannot easily adjust; indeed, if unable to adjust at
all – most likely that this would be observed in the short term – then they bear the full impact.
If consumers find substitutes, firms bear the burden. If firms can leave the industry then
consumers (or the producers’ suppliers) bear the burden.
To assess the impact need data on elasticity of demand and supply.
Numerous extensions of this analysis:
Can use it to analyze incidence of a subsidy: who are the ultimate beneficiaries are not
necessarily those to whom the subsidy is paid, thus irrelevant whether the subsidy is paid to
producers or to consumers. The benefit is distributed among consumers and producers
according to the elasticities of supply and demand.
Incidence of a tax on labor (payroll tax). If the supply of labor (number of hours a week
workers are prepared to work at each wage point) is relatively inelastic (doesn’t change
much at different wage points), most of the tax falls on them.
d) General Equilibrium Incidence Analysis
This focuses on the spillover incidence, not just on particular market of commodity on which tax
is applied; focus is on economy-wide impact on factors of production, capital and labor.
In the analysis of the impact of applying an excise tax on a commodity above, we noted how the
incidence differed if consumers or firms could find substitute goods or activities respectively. This
opened the door to the issue of cross-commodity or cross-sector impacts.
So need to broaden the universe of analysis in the case of taxes on commodities that will induce
significant flows of resources between markets. Conversely, the industry being analyzed can be
affected by changes in the tax treatment in other sectors
If there are factor price changes, this would mean cost changes for industries using these factors;
this in turn may lead to lower output prices, in which case the wellbeing of consumers of these
commodities would increase.
Numerous scenarios are possible, and in the end who pays the tax and how factor or commodity
prices change will depend on the short term and on the long term elasticities – on how close to
horizontal (elastic) or vertical (inelastic) the various demand and supply functions are.
We also know that these price changes will affect the wellbeing of the owners of the factors, the
producers, or the consumers.
In considering these types of tax measures, there will serious equity considerations.
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There will also be important efficiency considerations. We know that the more elastic the
functions, the larger the deadweight loss, or efficiency cost of the tax measure. One objective of a
sound tax regime is a minimal efficiency cost.
3.4.3 Incentives effects of taxation
This section examines how taxes affect the behavior of households and firms.
a) Tax on capital income: impact on savings, investment and human capital
Tax on capital income can have major impact on the accumulation of capital and on savings
patterns. The tax creates a wedge between the pre-tax and after-tax return, thereby lowering the
after-tax interest rate. For the individual, foregoing current consumption affords a lower amount
of future consumption relative to what it would be in the absence of the tax. Thus there is an
increase in the relative price of future vis-à-vis current consumption. This tax-induced distortion
in these relative prices becomes larger the farther into the future is the intended consumption.
This is due to the compound effect of many periods of reduced interest rates.
Thus a tax on capital income discourages long-term savings more than short-term savings. Thus
while the short-term impact on capital may be small, in the long term, with long periods of lower
savings, there will be significantly smaller capital stock base than it would be in the absence of a
tax. Since productivity growth is in part the result of technological advances embodied in the new
capital stock, this may prompt a slowdown in productivity growth, hinder economic growth and
living standards, with adverse consequences on both savings and consumption.
Taxation of capital income reduces the net rate of return on physical capital and makes human
capital a relatively more attractive investment. The reduction of capital in the long run lowers the
demand for labor services putting downward pressure on wages, which in turn lowers the return
to investment in human capital. Thus there will be effects in opposing directions, which may or
may not cancel out. Taxation of labour income lowers the wage, which means reductions in both
the costs of investing in human capital and in the return on human capital investment. Reduced
social investment in infrastructure designed to enrich human capital – schools, universities or
laboratories – can limit the ability to accumulate human capital, with the associated negative
impact on long term growth potential.
b) Impact of consumption taxes versus income taxes
The consumption tax reduces real income by increasing the price of any given amount of
consumption by the extent of the tax liability. But the consumption tax is neutral with respect to
the decision to consume now versus in the future since it taxes consumption expenditures
independently of their timing. It does not penalize deferral of consumption. Indeed, by not
reducing after tax interest rates, and by being applied to consumption rather than savings, these
taxes promote savings and therefore growth, and may engender an efficiency gain.
Consumption taxes are more efficient than income taxes as they result in a smaller loss of
consumer or producer surplus. That is one of their main advantages. The reason for this advantage
relates to the double taxation of to which investment returns are subjected: first when the income
is earned, and secondly, on the return on the amount saved. Thus there is a double disincentive to
save. Since savings decisions are usually motivated on the basis of long-term motives, there is a
long-term impact to this distortionary effect.
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General consumption taxes have the opposite effect. Indeed their distortionary effect is to
increase the price of consumables vis-à-vis investments in human and physical capital. Thus,
relative to other forms of taxation, it would tend to result in an increase in the stock of productive
resources and thus the economy’s growth rate.
The problem with consumption taxes is their possible negative equity implications.
Income taxes reduce the return to supplying labor, and tax may motivate the individual to work less
and spend more time at leisure and less at work (substitution effect); alternatively, given that the
same amount of labor now yields a smaller return, the individual’s consumption habits may
dictate that the individual work more in order to maintain his lifestyle (income effect). Thus
offsetting substitution and income effects.
Income tax has another less obvious effect: it alters the relative price of future consumption with
respect to present consumption by decreasing the after-tax interest rate earned on savings. Thus
the income tax makes it necessary to forego more present consumption to obtain any given future
consumption.
Savings represent resources freed up by society that can be used for the production of capital
goods that increase the economy’s productive capacity, employment possibilities and future
incomes. Also productivity-enhancing advances are often embodied in capital, which adds to the
promise of future income gains. A tax on wage income reduces after tax income and thus
consumption or savings.
Reduced savings effects on growth have already been discussed. However, to the extent that
revenues go to public sector investment in infrastructure, education, protection of persons and
property, etc. – all are a requirement for private sector investment – then the society’s welfare
will be positively impacted by this transfer of resources to the public sector).
3.4.4 Intertemporal effects of taxation
The impact of a projected tax measure may vary over time. We have alluded to this in referring to
the need for policy action that promote an increase in the economy’s output and productivity
growth path – since these are key to the sustained increase in the sustained progress in the
population’s standard of living.
This dimension of tax analysis is most important for taxation on interest rates, savings and
investment in capital, because these variables have an important impact on growth – eventually
this may feed back onto revenues.
For example, an inefficient tax (say on savings account balances) with high deadweight loss, may
result in an increase in revenues initially but at the expense of a subsequent reduction in savings
and investment, causing a slowdown in economic growth, and ultimately in revenue. The longterm yield of this tax may be much lower than its short-term yield.
Also, expectations of future tax events can affect the present behavior of economic agents. As an
example let’s consider the impact of a temporary tax cut. In static analysis under the Keynesian
model, if such a tax cut occurs for stabilization reasons – to stimulate demand during a period of
economic downturn – economic agents use their increased disposable incomes to increase their
consumption, and through the multiplier effect, the economy recovers by an amount greater than
the value of the tax cut. In turn, the foregone revenue to the government is partly offset by the
increase in economic activity.
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The analysis can lead to very different results once the time frame is broadened. The reduction in
taxes – without a corresponding decline in expenditures – means a higher level of debt. If
households assume that this debt will eventually have to be repaid, they will conclude that this
temporary tax reduction will lead to a higher tax level sometime in the future.
So instead of going out to spend the windfall, they may decide to save it, in which case the tax cut
will have no stimulative impact on aggregate demand.
So the stabilization measure will not be successful and at the same time, the amount of foregone
government revenue will be significantly greater than in the previous scenario.
Some economists (Ricardo and Barro in particular) have argued that a current tax cut financed by
increased government debt has no real effects and does not change either the present or the future
path of the economy. The reason for this is that economic agents offset the impact of the fiscal
policy measure by increasing their savings in anticipation of a future (and more than offsetting) tax
increase.
Two factors that will impinge on the incentives effects of an income tax reduction:
The planning horizon of economic agents: life-cycle hypothesis posits that individuals save
during the first part of their working life to finance their retirement, and they dissave in the
latter part of their life. If this is the main motive for savings, then, a tax cut financed by
higher taxes well into the future – to the next generation or beyond – may indeed stimulate
consumption. Thus the increase in savings may not be enough to absorb the issue of debt in
the future and public debt will tend to crowd out private investment. In this scenario,
future generations may inherit a lower stock of capital, higher debt and higher interest
rates. If altruistic intergenerational transfers motivate private savings, then household
reaction will be in line with Ricardo’s thesis.
Liquidity Constraints: Assume that households want to borrow and consume currently and
to sacrifice future consumption (since they would be compelled to repay the debt incurred)
but they are unable to do so because of constraints in the credit markets. In that context, a
tax cut will be used to finance an increased in current consumption. Thus in a way,
government is borrowing on their behalf, and the tax cut will have real effects.
3.5 Conclusions: broad IMF perspective
Start from a rather restrictive view of government’s role in a market economy, thus low tax
burden: keep as much resources as possible in the private sector.
Structural shift in tax structures, with increasing shares for consumption taxes relative to taxes on
incomes and wealth taxes and import duties.
“Tax neutrality”, “revenue generation” and “lessened demands on tax administration” are
increasingly prime objectives underlying tax design.
Recognition that high nominal direct tax rates (applied to incomes) combined with ad hoc
exemptions affect the level and pattern of investment, saving, work, work effort and capital
flows, and encourage tax evasion.
Recognition also that overly complicated tax systems (trying to achieve too many goals) tend to
generate inefficiencies, inequities, high compliance costs and tax evasion.
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Personal income tax remains major revenue source and instrument to achieve equity (ability-topay perspective); the move has been to a comprehensive base (inclusion of non-cash benefits from
employment as well as capital gains), few exemptions; progressive marginal rate structure
retained, but few rates, with top marginal rate in line with corporate rate (to reduce disincentives
and associated scope for tax avoidance); also index deductions for price-level increases to avoid
bracket creep impact of inflation.
Corporate tax: single rate; trend to link taxation of corporations and their shareholders (e.g.
exempt dividends from taxation at the corporate level and tax it at the recipient’s level); trend to
increased provisions for loss carry forward, and to recognize inflation in valuation of assets and in
deductible amortization expenses; same treatment for private and public sector firms.
Recognition that need more than just low corporate tax rate to promote domestic and foreign
investment; need the combination of a single-rate low corporate tax; a well-educated and trained
(but not over-paid) workforce; political stability; and good infrastructure.
VAT (consumption-type, destination-based and invoice-backed credit-based) increasingly viewed
as preferred tax on consumption: minimal exemptions, few rates, applied to imports but zerorated exports; adverse redistributive consequences addressed by exemptions of foodstuffs.
VAT preferred to turnover since the latter has “cascading effect”; also preferred to retail sales tax
which are more prone to tax evasion.
Continued role for excise taxes – low excess burden – correcting for negative externalities and
enhancing vertical equity: traditional categories of goods: tobacco, alcohol and other beverages,
petroleum products.
No role for export taxes – almost always shifted back to producers – perhaps appropriate as proxy
for income tax in some areas of agriculture that are difficult to tax, and capturing windfall gains
on oil or minerals.
Lesser role for import duties; role for temporary protection of domestic infant or restructuring
industries: simplify and rationalize the structure of import duties and eliminate ad hoc
exemptions.
On the issue of tax administration, there is trend to more open relationship between taxpayers
representing the private sector and tax administrations representing the public sector:
government recognizes that tax system works only if large segment of the population respect and
comply with its obligations under the tax code.
3.6 Concluding comments
The objective here has not been to make generalizations regarding the appropriateness or not of
various tax measures. We have presented, in skeleton form, a framework for the analysis of taxes;
we have raised a good sample of the key issues and considerations; and perhaps more importantly,
we have emphasized the need for broad-based analysis.
A few observations:
Different places in the system to apply taxes; they will have different effects.
Properly designed consumption or expenditure taxes are said to be more efficient than
taxes on factor inputs: wages, profits, and interest.
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Taxes on incomes reduce the return to work or investment and may affect people’s choices
in ways that reduce economic growth (and maybe even revenues) in the long term.
Taxes on incomes may be better at addressing equity issues; indeed, taxes applied to sales,
consumption, and the like have an inherent downside from an equity point of view since
they are inherently regressive (they have a proportionally bigger impact on the poor); and
may require some offsets I the form of income tax concessions or direct transfers.
Governments tap into both the “sources” and “uses” sides of income flows to generate
revenues, because of the massive revenue requirements and also because no perfect tax;
some countries also use presumptive taxes (e.g. a relatively small broad-based turnover
tax) to get some revenue from harder to reach sectors.
3.7 References
Shome, Tax Policy Handbook, IMF - FAD, 1995, Parts I & II, (Pg. 3 – 69); and Part VII, (Pg.
275 – 284).
Musgrave, Musgrave and Bird, Public Finance in Theory and Practice, 1987, Ch. 10 – 14
(Pg. 202 – 294).
Boadway & Wildasin, Public Sector Economics, 1984, Ch. 9 – 12, (Pg. 223 – 412).
Davis (Ed.), Macroeconomic Adjustment: Policy Instruments and Issues, IMF Institute,
1992, Ch. III, (Pg. 25 – 28).
Davis & Daniel (et al.) Guidelines for Fiscal Adjustment, IMF – FAD, 1995, (Pg. 26 – 32).
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4. EXPENDITURE POLICY: ISSUES AND
CONSIDERATIONS
4.1 Context and overview
Purpose is to present analytical framework: raise some key macro and micro considerations:
objective is to make most informed judgement as to the right size of government and best mix of
programs (i.e. best use made of taxpayer dollars)
Approach here is to focus on the economics of expenditures:
Why it is not possible to base decisions only on objective facts and guidelines.
Dos and don’ts in order to promote sustained growth in employment and living standards
Guidelines on when and how to intrude in private economy to address problems caused by
market failure and distributional (poverty) problems
There are macro and micro considerations in expenditure policy:
Size of government raises macro issues.
Allocation of spending raises micro issues. It also raises macro issues if, for example, some
elements distort market signals in ways that lessen work effort, private investment and
therefore long term growth (An example may be generalized consumer subsidies, which
encourage over-consumption or discourage domestic production if financed by taxes on
producers; in turn this creates excessive import demand and a drain on foreign exchange).
Begin with a listing of the major challenges; then focus on “size of government” issues, then on the
effectiveness and efficiency requirements of judicious budget allocations.
4.2 Inherent challenges
Greater normative element than on the revenue side and public sector economics offers fewer
objectives “rules”. Thus recommendations are less clear cut than on revenue-side, and more
country-specific: in a sense more difficult process: particularly when in retrenchment mode; no
substitute for having to make difficult value judgements in the decision process leading up to level
and composition;
Potential bias in political incentives: not always in the direction of promoting optimal expenditure
decisions:
Possibility of financing deficit with long-term borrowing facilitates deferral of difficult
expenditure-reduction decisions.
Benefits of prudent and productivity-oriented expenditure policies may only show up in the
long run, beyond the term of office of the incumbent administration.
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Even during periods of fiscal consolidation, easier to raise taxes than to cut programs.
Being seen to be doing new things – addressing emerging problems – may get elected
officials more visibility and political points than improving administration of existing
programs that may have been put in place by predecessors ( part of explanation for growth
in size of government)
Nonetheless, some principles and guidelines can be applied to ensure sound expenditure policy
4.3 Size of government
Macro-issues regarding expenditure level:
Consistency of total expenditures with deficit target.
Consistency of program expenditures with ability to service the public debt.
Consistency with targeted external sector balance and external debt service.
Crowding out: how total and composition fit in with stabilization function
Sustainability.
Consistency with reasonable tax burden.
Right size of government is decision for society to take through the electoral process. Crosscountry comparisons show wide range of government expenditures to GDP ratios or program
expenditures to GDP: attests to different choices that different countries make.
Rising trend in expenditure-to-GDP ratio worldwide in 60s to mid to late 80s: alternative theories:
increasing complexity and changing values of society; “ratcheting”: increase during periods of
crisis but only partial decline subsequently; built-in incentives in the political process: responding
to pressure groups; empire-building by bureaucrats.
4.3.1 Guidelines
Higher level of expenditures than necessary will have implications for debt and debt service or tax
burden.
Guiding principle for policy makers is to assess whether an increase in government spending
would be more helpful to economy than a reduction in spending which would reduce the
government’s claim on available savings and be available for use in the private economy.
Compare program expenditures and total expenditures to GDP ratio to neighbors, trading
partners, or other countries at similar stage in development: how do size and mix compare? Can
insights be drawn?
Start with a fairly restrictive approach to allocative, distributional, and stabilization role of
government simply because:
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However good the intentions, difficult to achieve the results for a number of unanticipated
reasons.
Better to avoid creating unrealistic expectations.
Once a program in place strong opposition to reduce it let alone dismantle it
Thus it is prudent to adopt a narrow perspective on what constitute pure public goods and to be
very discriminating when assessing prospects of addressing market failures in ways that will
commit significant or growing public resources; as starting point, recall the criteria for public
goods and see how bad the implications are for society at large, or for particular groups.
Be realistic in assessment as to whether government can really do something about the issue at
that particular time
Challenge the pressure for incrementalism: periodically question basic value of programs in place;
when new priorities emerge, seek out ways to finance them internally, that is through reductions
in or elimination of existing programs rather than simply adding new to the existing stock of
programs (advise government to resist ratcheting; they may decide not to).
4.4 Allocation of expenditures
4.4.1 Challenges
Difficult to compare the value to society of various programs in absence of “market” prices: e.g.
how to weigh objectively the relative merits of economic-military-social objectives.
Serving more than one objective makes assessment even more difficult: positive externality
effects: e.g. infrastructure project which promotes private sector investment; complementarity of
programs (e.g. joint benefits of health and education programs).
4.4.2 Guidelines
Take a comprehensive approach in examination of the government universe.
Retain a modest view as to what government really can achieve.
Then in determining proper mix of expenditures, place priority on areas where government
action is complementing rather than competing with market-determined activities.
Recall that some public programs are not very visible: e.g. pension schemes; loan guarantees
which may not involve cash outlays at the outset but which may expose the government to large
contingent liabilities.
Apply vigilance over activities of central banks or other public financial institutions performing
quasi-fiscal functions:
Inefficient or inequitable social security programs.
Subsidized credit advanced to selected enterprises.
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Provision of foreign exchange at below-market rates to certain users.
Adopt a broad approach in assessing the impact of government actions: do not ignore international
ramifications; for example:
High military expenditures in one country may lead to higher military spending in other
countries.
Subsidizing exports may have international price and supply effects, and may lead to
retaliatory action by other countries.
4.4.3 Effectiveness
Criteria for sound allocation of government expenditures: effectiveness and efficiency.
Effectiveness has to do with ensuring expenditures achieve their intended objective; best use
possible of taxpayers dollars, “maximum bang for minimum dollars”; for example, avoid
generalized subsidies.
Within a restrictive perspective on the role of government, maximize the chances that once a
decision to do something, it will work. Once a decision to intervene is made, then the next step is
to ensure that program is properly targeted, designed and costed out, so that it will work and can
be sustained.
This will ensure that the intended redress measure for the market-failure or distributional
problem will be done right and there will be enough resources for sustainability.
Good planning is required in the design and program start up and once it is up and running, need
periodic performance assessment: involving feedback from clients. Also need good assessment of
cost drivers to anticipate future cost pressures.
4.4.4 Efficiency
Efficiency has to do with “how” the job will get done, who will pay for it; how long the involvement of
government should be - whether it should have a built-in sunset clause (a date at which the program
ends naturally), or ongoing timeframe: address stabilization problem with temporary action not
permanent.
The objective is to achieve the intended results at the least possible cost to the government. There
are many dimensions in the quest for efficiency and the task begins as government intervention is
being contemplated, even before a decision is made to institute a program, let alone when the
program is being designed.
Challenges:
Lack of competent, well-trained and motivated administrators may lead to bad
management, poor service delivery and waste or corruption.
There may be bureaucratic incentives to build empires; this too may lead to waste, bloated
payrolls and poorly targeted programs.
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4.4.5 Guidelines
Seek best program delivery mechanisms:
See if can accomplish task using enforced regulations instead of expenditure program.
Seek out lowest possible costs and appropriate mix of inputs.
Consider of user fees where not a pure public good and where equity issues (regressive
aspect) can be addressed.
Institute proper systems and incentives to promote sound management and achievement of
intended objectives.
Institute good budgetary controls, good charts of accounts, good procurement systems,
competent project management, and sound auditing procedures.
Be very selective before resort to instituting public sector enterprise, since experience
around the world demonstrates not nearly as effective in delivering cost-effectively as
intended and tough to dismantle or to sell off once in place; one guide is to search out
alternative service delivery mechanisms.
Indeed be very selective before concluding that delivery must be achieved through a public
institution.
Indeed, the first question is who should deliver the program. (Note the distinction between who
finances the program and who delivers it.)
4.5 Examples of alternative delivery modes
Partnerships or contracting out: objective here is to determine if a group other than government
can deliver the program, and to engage others in the solution.
If the objective is to alleviate the poverty or social problem, or even to build a social, cultural,
leisure or sport facility or provide equipment and furnishings, look to see if a partnership can be
struck with a non-profit group or organization. (They are sometimes called “non-governmental
organizations” (NGOs)).
On occasions, depending on the amount of volunteer time and effort required, the government
can best its role by being a catalyst or using transfers rather than direct program delivery: by
appealing to concerned citizens or NGOs. The government’s role may include sponsoring this
group or association or providing office space. The point is that the government need not always
institute a new department or head, hire public servants etc and take on the full task of delivering
the service.
An important benefit in the partnership approach is that it engages those who are lobbying for
government intervention in the solution if the cause is dear enough to them. Important incentive
issue. Also good governance as does not allow pressure groups to leave the full onus of a solution
on the government’s doorstep.
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The partnership model can be extended to many country-specific situations, for example a
significant infrastructure investment – a road or bridge for example. The analysis made by
government leading to a positive recommendation that a project should be undertaken will have
identified the major beneficiaries of this investment. Their willingness to provide tangible support
for the project - in some form or another - would be a further test of the merits of the
investment. At the same time it would alleviate the financial burden on the general taxpayer.
Of course, the analysis would also have shown the project passing the economic test in terms of
social payback (including the return to the taxpayers from the higher tax collections flowing from
the higher level of exports, which the project permitted and would not likely have materialized
without the investment).
The partnership can take different forms: if a capital investment is required, perhaps its ownership
can remain in private sector hands, with government helping to defray ongoing Operating &
Maintenance costs; perhaps government retains ownership but contracts out operations, with or
without subsidies; perhaps maintenance costs are assumed by the private sector, etc.
To ensure enlightened allocation of funds across economic and functional categories, need
historical data series for expenditures by function and across economic categories
4.6 Guidelines in allocation across “economic” components
1. Operations and maintenance: critical to ongoing productivity of capital even though not as visible
or politically rewarding as new projects); complementarity of expenditures on textbooks, and
other school supplies, qualified teachers, a good curriculum etc on quality of education (like a
production process sometimes, no trade-off possible.
If need to reduce current expenditures, look for alternatives to across-the-board reductions,
even if might look easier in a first instance and impact may not show up for some time, when
the costs become astronomical. Better to maintain smaller stock of key programs that are
adequately funded.
2. Wage bill: Addressing sources of low productivity in government: low pay and inadequate salary
differentials for skilled managerial and technical staff may discourage work effort and
productivity and encourage corruption; inability to attract and retain qualified personnel;
government as employer of last resort means bloated payroll:
Overstaffing can mean inadequate wages to contain overall wage bill
Is composition consistent with effective management and client service?
Need comprehensive measure of labor costs: include the value of “in-kind entitlements
such as travel, transportation, housing allowances, subsidized loans, privileged access to
free of subsidized goods or services, or to tax exemptions.
3. Capital: need maintenance otherwise rapid deterioration and shortened useful life; tendency
for donor agencies to focus on capital projects with ongoing expenditures not properly
anticipated. Apply principles of social cost-benefit analysis to public investment; avoid “white
elephants”; conduct proper needs assessment.
Only do the capital investment for which you have assessed the ongoing O&M costs and have
ascertained that can maintain the capital.
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4
Transfers must be properly targeted: if too broad, then too costly and often benefits do not
reach intended individuals - particularly the very poor; public works programs with low
wages may be better way to target assistance to poor than food subsidies.
4.7 Guidelines in allocation across “functional” components
Sometimes can make use of some output indicators to guide budget allocation decisions: level and
trend in infant mortality rates or in life expectancy or incidence of certain diseases as gauge of
adequacy of health care spending; literacy rates and scores on international exams as indicators in
the education system; comparing own-country results to other countries for these indicators can
also be helpful.
It is well established that economic growth depends on good infrastructure, healthy and welleducated workforce and client-focused and competent public administration and provision of
public services.
Nutrition, health and education: very productive as develop human capital; high rate of return on
preventive health care; high complementarity.
Know the cost drivers and examine the economic components of the key functional groups, their
trend, and cross-program comparisons: can some efficiencies gained in one program be applied
elsewhere?
Application of user fees with offsets for regressive aspects may be judicious.
Military spending: sensitive issue since it involves national security and multi-country dynamics.
4.8 References
Chu and Hemming (ed.) Public Expenditure Handbook – A Guide to Public Policy Issues in
Developing Countries, IMF, 1991
IMF, Fiscal Affairs Department, (#48 pamphlet series) Unproductive Public Expenditures – A
Pragmatic Approach to Policy Analysis, 1997
IMF, Fiscal Affairs Department, (# 49 pamphlet series) Guidelines for Fiscal Adjustment, 1995
Davis (Ed.), Macroeconomic Adjustment: Policy instruments and Issues, IMF Institute: 1992, Ch.
III, Pg. 29, 30
IMF, Occasional Paper # 149, The Composition of Fiscal Adjustment and Growth – Lessons
from Fiscal Reform in Eight Countries, 1997.
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