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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 CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN II 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 CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN III 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? CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 1 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: CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 2 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 3 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): CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 4 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 5 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 CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 6 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 CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 7 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 8 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 CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 9 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 10 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). CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 11 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 12 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 CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 13 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 14 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 CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 15 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 16 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 17 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 18 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 19 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 20 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 21 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). CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 22 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 23 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: CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 24 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 25 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 26 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 27 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 28 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. CENTERS OF POLICY EXCELLENCE/BUDGET POLICY – WORKSHOP EIGHTEEN 29