Chapter 3 Fiscal Deficits, Public Debt, and The Current Account

1. The World Bank Chapter 3Fiscal Deficits, Public Debt, and The Current Account © Pierre-Richard Agénor

2. Structure of Public Finances • The Government Budget Constraint • Assessing the Stance of Fiscal Policy • Fiscal Imbalances and External Deficits • Consistency and Sustainability • Sustainability and the Solvency Constraint • Commodity Price Shocks and Fiscal Deficits • Public Debt and Fiscal Austerity

3. Constraints on fiscal policy and macroeconomic management: • inadequate tax base and limited ability to collect taxes (result in tax evasion and a growing informal sector); • reliance on money financing (result in macroeconomic instability, capital flight, and currency crises); • high levels of public debt (cause a pressure on real interest rates and financial volatility and macroeconomic instability).

4. Structure of Public Finances • Conventional Sources of Revenue and Expenditure • Seigniorage and Inflationary Finance • Quasi-Fiscal Activities and Contingent Liabilities

5. Conventional Sources of Revenue and Expenditure • Figure 3.1: Public revenue and expenditure patterns vary across developing countries. • Structure of conventional sources of revenue and expenditure differs significantly between industrial and developing countries.

8. Main differences (Burgess and Stern (1993)): • Shares of total tax revenue and total central government expenditure in output are larger in industrial countries (Figure 3.2 and Figure 3.3). • Explanation: increased need for risk insurance as the degree of openness and exposure to large external shocks increase. (Rodrik, 1998b). • Composition of spending: Developing countries devote a substantially larger fraction of expenditures to general public services, defense, education, and other economic services. Industrial countries spend more on health and social security.

14. Main source of central government revenue: in both groups is taxation; however, the share of nontax revenue in total revenue is much higher in developing countries. • Within total tax revenue, the relative shares of direct taxes, taxes on domestic goods and services, and taxes on foreign trade vary across developing countries and over time (Figure 3.4). In industrial countries, income taxes account for the largest share of tax revenue. • There has been a gradual move away from trade taxes to taxes on domestic sales as economies develop and their domestic production and consumption bases expand.

17. Within direct taxes, the share of tax revenue raised from individual incomes is much larger than that from corporations in developing countries, while the reverse is true in industrial countries. • Need for revenue in developing countries is large. Reasons: • Need for the government to invest in infrastructure, foster the development of market institutions, and encourage employment creation in order to reduce poverty.

18. Deficit bias: due to the fact that although fiscal policy is decided collectively, the parties involved do not fully recognize the full social cost of the programs they support (commons problem). • Taxation systems in many developing countries remain highly inefficient. • Key reason: severe administrative and political constraints on the ability of tax authorities to collect revenue. • Consequences: direct taxation plays a much more limited role in developing countries and high tax rates tend to be levied on a narrow base (encourage tax evasion and lead to a high degree of reliance on monetary financing).

19. Seigniorage and Inflationary Finance • Developing countries tend to rely more on seigniorage than industrial countries. Reasons: • limited administrative capacity and political constraints hinder the collection of tax revenue in developing countries; • limited scope for issuing of domestic debt. • Seigniorage consists of the amount of real resources extracted by the government by means of base money creation.

20. Seigniorage revenue (conventional measure): (M/P) = (M/P) -(P-1/P)(M-1/P-1) = (M/P) + [(P - P-1)/P-1](M-1/P) = m + [/(1+ )]m-1 (1) M : nominal base money stock; P : price level; m  M/P;   P/P-1 .

21. Equation (1): seigniorage is the sum of the increase in the real stock of money, m, and the change in the real money stock that would have occurred with a constant nominal stock because of inflation, /(1+)]m-1. • Second term represents the inflation tax, with [/(1+)]denoting the tax rate and m-1, tax base. • When m = 0 (stationary state), seigniorage is equal to the inflation tax. • If monetary base is bearing any interest, Equation (1) overstate seigniorage revenue and a correction must be made to obtain an appropriate measure.

22. Alternative seigniorage definition: interest burden foregone by the government through its ability to issue non-interest-bearing liabilities. • This is private sector's revenue loss from foregone interest earnings (opportunity cost of money) corresponds to an equivalent revenue gain for the government from issuing money, iM/P, where i is the nominal short-term interest rate. • Figure 3.5: differences across countries in the use of seigniorage---from almost 12% in Yemen to less than 1% in Tunisia. • Figure 3.6: reliance on seigniorage tends to be associated with large fiscal deficits.

25. Quasi_Fiscal Activities and Contingent Liabilities • Quasi-fiscal activities: operations whose effect can in principle be duplicated by budgetary measures in the form of an explicit tax, subsidy, or direct expenditure. • Carried out by the country's central bank, by public sector banks and other public financial institutions, such as development banks. Main examples of quasi-fiscal activities: • Subsidized credit: lending at preferential rates by the central bank to the government or other public entities, or subsidized lending by specialized public sector financial institutions to the private sector.

26. Manipulation of reserve and statutory liquidity requirements, through, for instance, central bank regulations requiring commercial banks to hold large reserves. • Multiple exchange rate practices: it may be a surrender requirement on export proceeds at a rate that is more appreciated than the market rate. This implicit tax on exports may have potentially large distortionary effects on trade flows and production patterns. • Exchange rate guarantees: given by the central bank on the repayment of principal and interest on foreign-currency denominated debt of other public sector or private sector entities.

27. Bailout of troubled commercial banks: central bank provides an infusion of capital in troubled banks, or directly takes control of some of the nonperforming assets of problem banks. • Sterilization operations : central bank pays interest on its liabilities at a rate higher than the one earned on the foreign exchange reserves that it chose to accumulate. Examples of the importance of quasi-fiscal deficits: Chile and Argentina. • Monetary authorities in both countries extended emergency loans to financial institutions and suffered large losses from exchange rate guarantee programs.

28. Consolidated quasi-fiscal deficits averaged more than 10% of GDP a year in Chile. • In Argentina, quasi-fiscal deficits of the consolidated public sector were roughly as large as conventionally-measured deficits; together they averaged 25% of GDP a year. • Quasi-fiscal activities lead to the creation of contingent implicit liabilities (obligations that the government is expected to fulfill, although required outlays are typically uncertain before a failure occurs).

29. Contingent explicit fiscal liabilities: obligations that the government is legally compelled to honor if the entity that incurred them in the first place cannot do. • Because of severe distortionary effects of contingent liabilities together with direct liabilities on the allocation of resources, eliminating or reducing the scope of quasi-fiscal activities is a key objective of macroeconomic management.

30. The Government Budget Constraint

31. Budget constraint: G - (TT+TN) + iB-1+ i*EBg-1 = Lg + B + EBg * * (2) G: public spending on goods and services; TT: tax revenue ; TN: non-tax revenue; B: end-of-period stock of domestic public debt (bears interest at the market-determined rate i); * Bg: end-of-period stock of foreign-currency-denominated public debt (bears interest at i*); E: nominal exchange rate; Lg: nominal stock of credit allocated by the central bank.

32. Left-hand side of Equation (2): components of the budget deficit; spending on goods and services and debt service, net of taxes (conventional fiscal balance). • Right-hand side: government finances its budget deficit by either issuing domestic bonds, borrowing abroad, or borrowing from the central bank. • Primary fiscal balance: D = G - T where T = TN + TT .

33. * * D + iB-1 + i*EBg-1 = Lg + B + EBg (3) • Then (2): • Conventional fiscal deficit can be sensitive to inflation. • Key reason: effect of inflation on nominal interest payments on the public debt. Limitations of conventional deficit under inflation: • No longer a reliable indicator of sustainability of fiscal stance (issuance of public debt occurs at a rate in excess of the growth rate of the resources available for eventual debt service).

34. No longer provide an adequate measure of fiscal effort by policymakers. • Primary balance is a more reliable measure. • Economists often use an alternative to conventional balance, operational balance (defined in real terms).

35. Difference between conventional balance and operational balance: • Assume B* = 0. Equation (3) becomes: D + iB-1 = Lg + B. • Divide both sides by P: d + i(P-1/P)b-1 = (Lg/P) + (P-1/P)(B/P-1), (4) d: real primary deficit; b: real stock of government bonds.

36. After some calculations: d + rb-1 = (Lg/P) + b, (5) r = [(1+i)/(1+)] - 1: real interest rate. • Left hand side of (4): nominal deficit deflated by the price level P. • Left hand side of (5): total deficit in real terms. • Comparing these two: simply deflating the conventional fiscal balance by current prices leads to an overestimation of the real deficit by the amount: [/(1+)]b-1.

37. This represents the compensation to creditors for the falling real value of their claims on government caused by inflation. • To see the difference: In Brazil, for example, conventional deficit 27.3%, operational deficit 4.5%, primary deficit -0.5% in 1988. • Figure 3.7: sharp differences between operational and primary balance. • Operational deficit becomes problematic when inflation is highly variable, because of difficulties in measuring and interpreting real interest payments. • Inflation may also affect noninterest expenditure and revenue, thus all three measures of fiscal deficits.

39. It can reduce real revenue in the presence of collection lags (Olivera-Tanzi effect). • Lag between the time tax payments are assessed and the time they are collected by the fiscal authorities. • If n is collection lag (in months),  monthly inflation rate, the amount by which real revenue drops is: (1+ )-n-1. • If n = 1 and  = 10%, drop in revenue = 9.1%. • In a high-inflation environment, the effect of inflation on the interest bill tends to exceed its effect on spending and revenue.

40. Assessing the Stance of Fiscal Policy

41. Tools for assessing the medium-term stance of fiscal policy are structural budget deficit and fiscal impulse measure. • Key idea to assess medium-term fiscal strategies properly: determine which changes in actual budget balances reflect structural factors, (discretionary fiscal policy action), rather than cyclical movements. • Changes in deficit attributable to the business cycle (or short-term fluctuations in aggregate demand) is self-correcting. • Changes in deficits attributable to structural factors can be offset only through discretionary measures.

42. Removing cyclical component from the observed budget balance provides a more accurate indication of medium-term fiscal positions : structural budget balance. First approach to calculate structural budget balances: • Budget elasticities are used to adjust revenues, TS , and total expenditures, GS , for movements in the cyclical output gap, GAP. • GAP: difference between actual and potential (or capacity) output, in proportion of potential output.

43. Structural budget deficit: DS = GS - TS = G(1 - GGAP) - T(1 - TGAP), G andT : elasticities of expenditure and revenue.

44. Second approach to calculate structural budget balances: • Used by IMF. • Cyclical revenue and expenditure components are expressed as ratios to GDP and estimated using parameters that describe the cyclical response of revenue and expenditure to movements in the cyclical output gap. • Budget deficit as a percentage of GDP: d = g - , g: observed total expenditure-to-GDP ratio; : observed total revenue-to-GDP ratio.

45. Decomposing the revenue and expenditure ratios into structural components (S and gS)and cyclical components (C and gC): d = (gS + gC) - (S + C). • Impact of cyclical component on budget deficit: dC = gC - C = GGAP - TGAP, G and T: cyclical response of expenditure and revenue ratios to an increase of 1 percentage point in cyclical output gap.

46. Overall effect of the business cycle on the budget: (G - T). • Structural budget deficit: dS = d - dC. • Two approaches are basically equivalent: T  (T -1)(T/Y); G  (G -1)(G/Y) T/Y, G/Y: revenue-to-GDP and expenditure-to-GDP ratios.

47. Presenting the estimates as ratios to GDP makes it easier to evaluate the sensitivity of estimates of structural budget balances to changes in assumptions about cyclical output gap and cyclical responsiveness of the budget. • Key aspect of the cyclical adjustment is the estimation of potential output. • Industrial countries: a common approach is first to estimate a production function linking output to capital, labor, and total factor productivity. Potential output is then estimated as the level of output that is consistent with normal capital utilization, and natural rate of unemployment.

48. Developing countries: Potential output is approximated by trend output, which can be estimated for instance by Hodrick-Prescott filter. Fiscal impulse measure: • First step: decomposition of the actual budget deficit into a cyclically neutral component and a fiscal stance component. • Cyclically neutral component: calculated by assuming that government expenditures increase proportionately to potential output and that revenues increase proportionately to actual output. • Fiscal stance: residual between the cyclically neutral and the actual budget deficits.

49. Second step: calculate the fiscal impulse as the annual change in the fiscal stance measure. • Negative value: contractionary demand impulse. • Positive value: expansionary demand impulse. • Fiscal stance was significantly more expansionary than what conventional indicators (such as the primary deficit) indicated. Limitations: • Beside to discretionary fiscal policy measures and business cycle, other factors can be important for movements in the structural components of revenues and expenditures:

50. Revenue side: changes in natural resource revenues, nonneutralities of the tax system with respect to inflation. • Expenditure side: changes in interest rates, changes in the demographic composition of the population. • Chand (1993): fiscal impulse measures do not include the effect of automatic stabilizers on aggregate demand. • Effects of fiscal policy on long-term interest rates and the distortions associated with tax and transfer programs on the supply side of the economy are not included.