By Vitor Gaspar, director of the Fiscal Affairs Department of the International Monetary Fund, and Luc Eyraud, deputy division chief in the IMF's Fiscal Affairs Department.
Public finances have had a rough year. A new reality is emerging. Against this backdrop, countries need to act now to boost growth and build resilience. They must also be prepared to act together to fend off global risks.
Worsening public finances
The April 2016 Fiscal Monitor shows that public debt continues to rise in every corner of the world. Fiscal deficits have also gone up in many countries. In advanced economies, once again we will have to wait another year for debt ratios to decline. On average, public debt now exceeds the level observed during the Great Depression and is approaching the level immediately seen after World War II (Chart 1).
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In emerging markets and low-income countries, fiscal deficits in 2016 are projected to be even higher than in 2009 during the global financial crisis. This represents a big shift compared to what we expected about a year ago; there's been a large jump in future public debt ratios (Chart 2). The fiscal positions of commodity exporters have been especially hard hit because of the collapse in revenues. In the Middle East and North Africa, the cumulative fiscal balances of oil exporters alone are set to deteriorate by a staggering $2 trillion in the next five years compared to the pre-crisis period 2004-08 (Chart 3).
Fundamental and far-reaching trends of the global economy are affecting public finances everywhere. These transformations include continued weakness in global activity and entrenched low inflation pressures in advanced economies, the decline in commodity prices (about 35 percent in the past 12 months and 65 percent since mid-2014 for oil), and the slowdown in trade. Emerging market and developing economies are also facing higher interest rates and dwindling capital inflows. Risks are also rising almost everywhere. These changes look like they are here to stay, at least for some time.
Countries need to adapt to these new realities, but "no one size fits all." The appropriate policy response varies across countries, but the exact mix of measures depends on the nature of the fiscal challenge they face. We identify three main challenges.
Challenge 1: Avoiding the low growth-low inflation trap
Advanced economies are facing the triple threat of low growth, low inflation and high public debt. This combination of factors could create self-reinforcing downward spirals. By this, we mean that continuous downward revisions in growth and inflation are associated with upward revisions in public and private debt as a share of GDP. This may lead governments, firms and households to cut spending in order to lower debt, depressing further economic activity and inflation.
To avert falling into such a trap, countries should follow a three-pronged approach based on expansionary monetary policy, growth-friendly fiscal policy and productivity-enhancing structural reforms. By growth-friendly fiscal policy, we mean measures that boost growth both in the short and the medium term (such as higher infrastructure investment) and policy actions that support the implementation of structural reforms. One example of this is using public funds to compensate those that lose from reforms (such as reforms promoting greater competition) and who could block their adoption.
In countries with fiscal space, the budget could also do more to support aggregate demand. Many countries lack this fiscal space, and of course, how much countries can do to support demand will depend on individual country circumstances - particularly on their debt levels and current and future borrowing costs. In some cases, countries will not be able to slow down fiscal adjustment. But even in these circumstances, governments should protect growth by avoiding cuts to highly productive public spending and scaling down less efficient programs instead.
And what if the macroeconomic situation gets worse? What should countries do if there is a large slowdown in global growth and intensifying deflationary pressures which could precipitate the world economy into the downward spirals that we have just described? Then, individual countries' responses would not be sufficient. Policymakers should act quickly and act together to fight the stagnation forces and deploy coordinated policies across the major economies of the world. The international response should combine growth-friendly policies on the demand and supply sides. It is particularly important that countries act simultaneously, because the beneficial effects from each country's policies would be amplified. Of course, some economies would not be able to participate in the coordinated policy response, in particular those under market pressure. But they would still benefit indirectly from higher growth elsewhere through stronger trade and improved global stability.
Challenge 2: Addressing the big and lasting drop in revenues
Between 2014 and 2016, about two-thirds of all countries experienced a decline in their revenue-to-GDP ratios (Chart 4). Commodity exporters saw the largest revenue shortfalls - an average of 7 percent of GDP for oil exporters. As commodity prices are likely to remain low for some time, producers have no choice but to reduce public spending and align it with lower revenues. Nonetheless, this unavoidable adjustment can be made less painful by mobilizing non-commodity revenues and cutting poorly targeted and wasteful spending, including reforming fuel subsidies. Countries that have accumulated financial assets in the past and are under less pressure from the financial markets will be able to consolidate at a more gradual pace.
Challenge 3: Achieving development goals with constrained budgetary resources
Almost half of the low-income developing countries have a tax ratio below 15 percent of GDP. Low revenue mobilization is an important impediment to economic development not only because it limits the ability to fund pro-growth spending, but also because a low tax ratio is often associated with a lack of institutional capacity, which is essential for growth to take off. Thus, adequate revenue mobilization is a fundamental component of a growth and development strategy.
Building up a minimum tax capacity can support and complement broader state and legal capacity. In particular, stable taxation that is broad-based and governed by clear rules is necessary for an effective budget process. Combined with improvements in expenditure efficiency, better revenue mobilization can help achieve the Sustainable Development Goals, including by enhancing the provision of health and education services and developing infrastructure. In practice, low-income countries should explore possibilities for raising new forms of revenue (for instance, by introducing or expanding the value added tax or the property tax) and strengthening tax compliance - two areas in which the IMF provides extensive technical assistance.
Beyond the country-specific immediate policy responses outlined above, there are two main objectives that all countries should pursue over the medium term:
- Enhancing the resilience of public finances. In a risky environment, a key objective of fiscal policy is to make public finances less sensitive to shocks, such as a drop in commodity prices or a currency depreciation. But how can government reduce vulnerabilities? Principally by working on three fronts. First, countries can improve how they disclose and analyze risks. A comprehensive, reliable, and timely public reporting on the state of public finances can reduce the likelihood and magnitude of negative surprises. Such events are not uncommon. For instance, governments often provide guarantees to the private sector that may prove very costly when they are exercised. It is very important to disclose such guarantees so that they do not pop up unexpectedly. Second, countries should take concrete measures to mitigate the risks they have identified. Very few countries have developed risk management strategies that actively reduce the probability that risks may occur and limit the government's exposure to risk. Taking our previous example, countries could introduce caps to the amount of guarantees provided by the government. Third, governments should create adequate cushions to absorb the remaining risks that cannot be mitigated. For instance, budgets should include adequate "provisions," which are safety margins to cope with unexpected events.
- Promoting sustainable growth. Raising medium-term growth is necessary in all countries. In advanced economies, a lasting solution to the high debt problem is not possible without higher growth. In fact, a sustained increase in growth of 1 percentage point could bring debt ratios in advanced economies to their pre-crisis levels within a decade. In emerging and developing countries, strong growth is also warranted to raise living standards and finance development strategies. How do we increase growth? An IMF study suggests reforms of tax and expenditure policies could lift medium- to long-term growth by ¾ of a percentage point in advanced economies and even more in developing economies. The analysis in Chapter 2 of the Fiscal Monitor shows that some fiscal measures are very powerful tools for fostering innovation and productivity. In particular, fiscal support to private research and development (in the form of research and development tax credits or subsidies) costing 0.4 percent of GDP to the budget - less than half a percent of GDP - can deliver 5 percent higher GDP in advanced economies in the long run.
In sum, countries face big challenges in restoring vigorous growth, and healthy and resilient public finances. But the good news is that policymakers, individually and in concert, still have adequate policy tools to address these challenges and adapt to the new realities.