FISCAL ISSUES IN ADJUSTMENT IN DEVELOPING COUNTRIES Fiscal Issues in Adjustment in Developing Countries Edited by Riccardo Faini Professor of Economics University ofB rescia and Jaime de Melo Division Chief, The World Bank, Washington, DC Professor of Economics, University of Genoa lSOtb YEAR M St. Martin's Press © Riccardo Faini and Jaime de Melo 1993 Softcover reprint of the hardcover 3rd edition 1993 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tonenham Court Road, London WlP 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published in Great Britain 1993 by THE MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 2XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 978-1-349-22792-1 ISBN 978-1-349-22790-7 (eBook) DOI 10.1007/978-1-349-22790-7 Frrst published in the United States of America 1993 by Scholarly and Reference Division, ST. MARTIN'S PRESS, INC., 175 Fifth Avenue, New York, N.Y. 10010 ISBN 978-0-312-09470-6 Library of Congress Cataloging-in-Publication Data Fiscal issues in adjustment in developing countries I edited by Riccardo Faini and Jaime de Melo. p. em. ISBN 978-0-312-09470-6 1. Fiscal policy-Developing countrie~ongresses. 2. Economic stabilization-Developing countri~ongresses. 3. Structural adjustment (Economics)-Developing countri~ongresses. I. Faini, Riccardo. II. De Melo, Jaime. HJ1620.F55 1993 336.3'09172'4-dc20 92-36200 CIP Contents Fiscal Issues in Adjustment: An Introduction Riccardo Faini and Jaime de Melo 1 Fiscal Issues in Adjustment Programs Vito Tanzi 21 Orthodox Models fur Adjustment and Growth Peter J. Montiel 43 Fiscal Issues in Macroeconomic Stabilization: A Structuralist Perspective Lance Taylor 61 The Transfer Problem in Small Open Economies: Exchange Rate and Fiscal Policies for Debt Service Dani Rodrik 19 Fiscal Adjustment in High-Debt Countries Martha de Melo 99 Fiscal Policy and Private Investment in Developing Countries: Recent Evidence on Key Selected Issues Ajay Chhibber and Mansoor Dailami 121 Prices. Taxes and Planning Nicholas Stern 151 Recent Experience with Tax Reform in Developing Countries Wayne R. Thirsk 169 The Fiscal System. Adjustment and the Poor Giovanni Andrea Cornia and Frances Stewart 197 Index 227 FISCAL ISSUES IN ADJUSTMENT: AN INTRODUCTION RICCARDO FA INI Universita di Brescia and Centre for Economic Policy Research }AIME DE MELO World Bank, University of Geneva, and Centre/or Economic Policy Research 1. Introduction (*) Rising international interest rates, falling terms of trade, and the foreclosing of commercial credit, forced the majority of developing coun tries to pursue drastic adjustment policies. In spite of differences in initial conditions and in ideological predilections, common adjustment patterns were observed across many countries. Initially the focus was on short-run stabilization, in particular on restoring a viable balance of payments and on servicing the external debt. Soon it became apparent that short-run measures alone would be insufficient to restore sustainable long-run growth. Short-run measures were thus complemented by structural reforms aimed at increasing the efficiency of resource use. Yet, for many observers, the success of adjustment has been limited to containing the debt crisis. Growth has only resumed in a handful of countries. Severe macroeconomic im balances subsist in the remainder. It is now widely recognized that adjustment was least successful on the fiscal front. Dealing with fiscal deficits remains today one of the most vexing problem for the majority of developing countries. For many, grow ing fiscal deficits led to money creation as the main source of financing follow ed by spiralling inflation, an erosion of the tax base, and even larger fiscal Received September 1990. (*) Partial funding from RPO 675-32 at the World Bank is gratefully acknowledged. We thank Rebecca Sugui and Julie Stanton for logistic support. The views are those of the authors, not those of their respective affiliations. 2 imbalances. Even countries that contained their fiscal deficits usually did so at great costs mainly by indiscriminate expenditure cutting. The inability to raise taxes made apparent many inherent flaws in their tax systems. Thus, to successfully cope with the fiscal crisis, short-run fiscal measures had to be accompanied by major overhauls of the tax system. The origins of the fiscal crisis are well-known. For countries that had access to borrowing on private capital markets, the recycling of petrodollars at low borrowing costs opened the door to ambitious investment program mes. The average private investment rate for a sample of middle-income countries (public investment rates in parenthesis) rose from 19.0 (6.2) per cent of GDP during 1970-74 to 22.6 (7.9) percent during 1975-82. A similar pattern was observed for low-income countries which also experienced a rise in public and private-investment rates (see Faini and de Melo 1990, Table 4). For borrowers in capital markets, the crisis occurred when they could no longer borrow while being concurrently faced with higher interest rates on their external debt. For low-income countries, the fiscal crisis was exacerbated by deteriorating terms of trade. The papers in this symposium deal with issues raised by the fiscal crisis. In Section 2, we discuss the relationship between the external debt and the fiscal crisis and take a look at recent trends in fiscal deficits, govern ment expenditures and fiscal revenues. The next two sections review briefly the main themes covered by the papers in this symposium: Section 3 covers the macroeconomics of fiscal deficits and Section 4 covers issues of fiscal system reforms. Finally Section 5 suggests news areas of research. 2. Fiscal Trends: A Look at the Evidence The immediate origins of the fiscal crisis was the assumption by govern ments - under strong external pressure - of privately contracted debt. Governments also faced internal pressures caused by the effects of short run adjustment policies involving sharp devaluations required to raise foreign exchange to service the external debt. The ensuing sharp depreciations of the real exchange rate helped generate the needed foreign exchange, but resulted in capital losses for foreign-denominated debt holders. Thus, in addition to guaranteeing the privately contracted external debt, govern ments faced increasing budgetary pressures as they often had to grant preferential exchange rates to holders of foreign debt to cushion capital losses. As a result the external debt problem became first and foremost a fiscal problem. Real exchange rate depreciation and aggregate demand contrac tion would succeed in improving the current account and would help the economy service its external debt. But, typically, foreign exchange earn- 3 ings were in private hands, while foreign exchange obligations were publicly held. A way had to be found to transfer foreign exchange earnings from the private sector to the government. This dual need to transfer resources abroad and, internally, from the private to the public sector, has become known as the "twin transfer problem". How important has been this fiscal crisis and how have countries reacted to it? To answer properly this question requires comparable data on the consolidated public sector (inclusive of the Central Bank, local govern ments and public enterprises). As mentioned earlier, many fiscal operations like foreign exchange subsidies were undertaken by the Central Bank. These operations often amounted to a sizable percentage of GDP. Unfortunate ly, they do not figure in the widely available data sets like the Interna tional Monetary Fund's Government Financial Statistics (GFS) which only report Central Government operations. Still, these statistics are useful to indicate broad trends for the universe of developing countries and are used in the tables that follow. Tables 1 and 2 give averages for middle and low-income countries be tween 1975 and 1988. The breakdown into period averages is to smooth out year-to-year fluctuations, and to try to capture the effects of signifi cant changes in the external environment. The breakdown into two coun try groupings reflects the widely held view that low-income countries have less resilience in their fiscal systems and a different tax revenue structure because of a larger share of agriculture in GDP (a sector difficult to tax) and because of less-developed administrative capabilities(!). The two tables suggest several stylized developments. Start with fiscal deficit and expenditure trends in Table 1(2). First, the overall deficit showed a worsening trend during the period of easy money (1979-81) and during the aftermath of the debt crisis (1982-85) for both low-income and middle-income countries. This worsening trend was only arrested for middle income countries in the last period (1986-88) when the overall deficit was, on average, reduced by two percentage points of GDP. During the first sub-period this trend reflected expansionary fiscal policies, as indicated by the evolution of total expenditures in column 3. Starting in 1982, with the onset of the debt crisis, higher interest payments (column 4 in Table 1) account significantly for increasing budget imbalances. The primary deficit, which excludes interest payments and is largely outside the con trol of fiscal authorities, may therefore provide a better indicator of the governments' efforts to reduce fiscal imbalances. The trend revealed by (1) For a review of the literature on tax revenue and issues of tax reform in develop ing countries see Ahmad and Stern (1989). (2) In principle, the fiscal deficit includes all central government's operations, but comparability across countries is flawed by the fact that the definition of what is included in tfie central government differs across countries. See Blejer and Chu (1989) for further discussion. 4 TABLE 1. - Fiscal deficits and expenditure trends: period averages for low-income (LY) and middle-income (MY) countries Overall Primary Total Interest Capital deficit/GOP deficit/GOP expenditure payments/TE expenditure (TE) / GDP I TE Period averages LY MY LY MY LY MY LY MY LY MY 1975 to 1978 -3.2-1.7-3.2 0.0 19.1 19.5 5.4 6.3 22.8 25.7 1979 to 1981 -3.8 -2.1 -2.9 0.0 20.0 21.3 7.2 8.8 22.3 22.4 1982 to 1985 -4.3 -4.0 -2.5 -1.1 20.5 23.0 11.7 14.9 20.8 17.4 1986 to 1988 -4.3-2.1-1.5 1.4 21.0 21.7 13.5 17.8 24.7 15.3 Notes: Low-income (LY) countries (36) are countries with a 1980 income per capita below $500. Middle income (MY) countries (45) include countries with an income per capita above $500 and below $4,000. Data sources: Government Financial Statistics of the IMF deficit refers to the deficit of the central government. TABLE 2. -Fiscal revenue trends: period averages for low-income (LY) and middle-income (MY) countries Total revenue Income Domestic International (TR)/GDP tax/(TR) tax/(TR) tax/(TR) Grants/(TR) Period averages LY MY LY MY LY MY LY MY LY MY 1975 to 1978 16.1 17.5 23.2 25.0 24.1 30.9 32.3 23.8 8.0 4.3 1979 to 1981 15.8 19.3 22.4 28.3 27.9 35.1 35.1 21.6 10.2 4.0 1982 to 1985 17.0 20.4 23.2 28.3 29.1 40.9 29.2 19.8 8.3 3.1 1985 to 1988 16.3 20.8 22.4 26.7 27.3 37.7 30.9 17.6 9.9 3.4 Notes: Same definitions and same sample as in Table 1. Data sources: Same as Table 1. 5 the period averages in Table 1 suggests that it is only since 1986 that an improvement is noticeable in the primary deficit, especially among middle income countries which managed a swing of 2.5 percentage points of GDP to produce a primary surplus. Not surprisingly, the brunt of adjustment among middle-income countries fell on capital rather than on current ex penditures. Somewhat surprisingly, the data indicate an increase in capital expenditures for the low-income group since 1986. However, overall, the figures in Table 1 indicate a great insensitivity of total government expend itures to the fiscal crisis. Turning to fiscal revenues, they too, have been insensitive to the fiscal crisis (Table 2). Since the onset of the crisis, neither group has been able to raise significantly fiscal revenues. Moreover, both groups have registered a declining share of income taxes in total revenues. Direct taxes being typically the most progressive and buoyant component of the tax system, this trend may signal both, efficiency loss, and equity deterioration. For low-income countries, trade tax revenues continue to be the most impor tant source of tax revenue. With import growth effectively constrained by foreign exchange earnings, the reliance on trade taxes further reduces the buoyancy of the tax system for this group of countries. At the same time, the role of foreign grants in helping alleviate the crisis has been relative ly small, even for low income countries. Stagnant fiscal revenues coupled with difficulties in compressing ex penditures, implies limited progress towards reducing fiscal imbalances(3). With foreign borrowing foreclosed, this meant that governments had to rely on domestic sources of financing. For countries with relatively underdeveloped capital markets, borrowing from the Central Bank was the only remaining option. The ensuing increase in liquidity could only result either in run-away inflation, or in capital flight, or in a combination of both. Countries with more developed financial markets, could rely on non inflationary sources of finance at the cost of higher interest rates, and possibly unstable debt dynamics. 3. The Macroeconomics of Fiscal Adiustment The debt and fiscal crises combined to force many developing coun tries to undertake adjustment programs, often with the support of inter national organizations like the IMF and the World Bank. The immediate aim of these programs was to stabilize the economy by eliminating the main sources of macroeconomic imbalances. To help restore growth, these pro grams included structural reforms in the areas of trade, financial, agricultural (3) In Section 5, we suggest that a political economy perspective is useful in understanding the insensitivity of fiscal expenditures and revenues.