Government Financial Management : Issues and Country Studies

INTERNATIONAL MONETARY FUND

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1990
• eBook ISBN: 9781557751492

NONE

Part I: Issues

1 Fiscal Policy for Growth and Stability in Developing Countries: Selected Issues

VITO TANZI

INTRODUCTION

Over the past decade two major intellectual developments (some would call them revolutions) have had a major impact on how economists and policymakers think about the way policies affect economies. The first of these revolutions is associated with a growing body of literature that goes under the name of “public choice.” In 1986 James Buchanan received a Nobel Prize in economics for his seminal contributions to this literature. The second is the less unified, but highly influential, thinking that goes under the name of supply-side economics. Supply-side economics had its major expression in the United States under the Reagan Administration. Its influence has progressively spread to other countries, both developed and developing.

Major recent changes in tax reform, in privatization, and in deregulation have been facilitated, and perhaps even promoted, by these two major developments. The present paper discusses some of the implications of these developments for fiscal policy in developing countries. It does this in part by focusing on some of the basic but implicit assumptions that guided fiscal policies in the past and that still guide many current policies. The two developments mentioned above have had powerful implications for fiscal policy. In general they have tended to reduce the desired role of the government in the economy.

HISTORICAL BACKGROUND

The term “fiscal policy” applies to the use of public finance instruments to influence the working of the economic system to maximize economic welfare. However, this is too vague a concept to be the focus of specific policy measures. For this reason, policymakers concentrate on more specific objectives, such as reduction of the rate of inflation, acceleration of the rate of growth, and redistribution of income. The activities of the public finance authorities are generally classified under four broad functions: allocation of resources, redistribution of income, stabilization of the economy, and the promotion of economic growth.

The allocation of resources is the function that has been emphasized for the longest period of time. At least since Adam Smith wrote the Wealth of Nations in 1776 it has been recognized by economists that an organized society requires certain goods and services whose technical characteristics (indivisibility, jointness of production, etc.) make their provision by the private sector unprofitable. These so-called public goods include defense, law and order, justice, basic education, and provision of roads.

Early in this century the need to redistribute income began to attract the attention of economists and governments. It was realized that the distribution of income that would result from the working of the economy might not be the one desired by society. Governments began to worry about the disabled, the old, the very young, the unemployed, and other particular groups that, without government assistance, might end up with incomes below some poverty line. In recent decades, governments have taken upon themselves the responsibility of supporting the consumption of various groups and, as a consequence, public spending for transfer payments has grown at a very fast pace. The concern for redistribution is largely a product of this century. Today some societies pay more attention to the distribution of income than others and are more willing to sacrifice other objectives (such as efficiency) to pursue the objective of a better distribution of income.

The third function, stabilization, is even more recent than redistribution as a legitimate objective of the government. The idea that the government could and should explicitly try to stabilize the level of aggregate demand through its own public finance activities originated with the writing of John Maynard Keynes in the 1930s. It implies that government revenue and expenditure should be used as instruments to reduce cyclical variations in economic activity.

In industrial countries the role of the public finances encompasses the foregoing, since growth is generally expected to follow automatically from the proper pursuit of those three functions. However, in developing countries, with income levels much below those of the industrial countries, it has often been argued that growth should be an explicit and separate objective of policy. It is argued that the government cannot passively accept the rate of growth that automatically results from the activities of the private sector but should actively pursue policies aimed at accelerating that rate.

The role of the government can be evaluated from two different angles: One focuses on what the government should do to promote the rate of growth of the economy; the other focuses on what the government should not do to avoid becoming itself an obstacle to growth. The first aspect emphasizes the potential or theoretical role of the government in mobilizing resources, in raising investment, in creating social and economic infrastructure, and so forth. The second, more passive, and more realistic aspect emphasizes the limitations of that role and the risk that when the government attempts to do too much it may create obstacles and difficulties. This second aspect is influenced by recent writing on “public choice” and on supply-side economics. It is an aspect that emphasizes the need to pursue policies that are more market oriented and that do not replace the judgment of the market with that of civil servants except where this replacement is justified by the presence of public goods and exceptional externalities. It is also an aspect that brings greater realism in economic policy.

Until the recent emphasis on supply-side economics, the governments of the developing countries were advised: (a) to increase tax revenue to mobilize more resources; (b) to increase public investment; (c) to promote private capital accumulation through investment incentives; (d) to take over many economic activities, especially through the creation of public enterprises, thus providing capital and managerial skills assumed to be lacking in the private sector. With increasing frequency governments are now (a) reducing tax-created disincentives; (b) privatizing public enterprises; and (c) reducing those regulations and policies that give much discretion to some public employees, such as those, for example, that grant import permits, tax incentives, and so forth. The recent tax reforms reflect a realization that the government should play a more neutral role in the economy.

INSTRUMENTS OF FISCAL POLICY

In their pursuit of economic objectives, the authorities rely on a variety of policy instruments which, at least in theory, can be manipulated to achieve particular social objectives. These instruments can be classified into broad categories or can be identified in terms of the specific characteristics of each category. For the broad categories there are the revenue and expenditure instruments. Among the revenue instruments, the most important role is played by taxes; however, governments rely also on fees, on the prices of public utilities, and on sales of assets. In addition to providing revenue, each tax can also be used to achieve particular goals. For example, import duties can be used to influence the balance of payments; excise taxes can be used to influence consumption patterns, and so on.

Next, governments can finance the part of their expenditure not covered by ordinary revenues (taxes and fees) through foreign borrowing, borrowing from domestic nonbanking sources, and borrowing from the domestic banking system. Depending on their particular situations and on the objectives they wish to pursue, countries rely more on some of these sources than on others.

An important classification for expenditures is that between real expenditures and transfers. Especially in industrial countries, much of the growth in public spending over the years has occurred in the form of transfers. Another classification considered important by some economists is that between capital and current expenditure, on the presumption that capital expenditure contributes to growth while current expenditure does not.

The traditional theory of public finance assumes that the government can manipulate these instruments, both those on the revenue side and those on the expenditure or financing side, to achieve particular objectives. This theory, which goes back to the work of both Keynes and Tinbergen, is based on a series of strong but unstated assumptions that, in all countries but especially in developing countries, are often not realistic. As already mentioned, public choice and supply-side economics present major implicit challenges to these assumptions.

The first assumption is the one that views the public sector as a monolithic entity. It is assumed that within the public sector there is a focus of decision making that controls all public finance decisions in the country. The reality is obviously different. The public sector is not made up of one entity but of many, and, in some cases, literally hundreds of separate entities. Some of these entities have enough political power and independence that they can go on “doing their own thing” even when contrasting signals are being sent by the central financial authorities, such as the treasury or ministry of finance. This is particularly true for some large public enterprises, for local governments, and even for some ministries and social security institutions. At times these entities have objectives or perceived responsibilities that in some ways diverge from those of the ministry of finance. They may also have enough political power to ignore, or at least to interpret in their own way, the instructions that they receive from the ministry of finance or the treasury. When this is so, the possibility of pursuing a rational and well-coordinated public finance policy to promote growth and stability is undoubtedly made much more difficult.

The second strong assumption made by the theory of public finance is that there is a clear and well-articulated public interest that is pursued by the individuals who make policy decisions, who interpret them, or carry them out. Unfortunately, the reality may sometimes be different. Policymakers, as well as the civil servants who must implement the decisions made at the highest level of government, may have their own interests. These interests may in part diverge from the public interests pursued through the chosen economic policy. This divergence is facilitated when, as is often true, the public interest is not well articulated. These private interests may originate from many sources: political or class affiliation, regional, racial, or tribal backgrounds, friendship or family ties, etc. When the divergence between the general interest and the private interests of those who must carry out the formal policy decision is substantial, the results of policies may differ from those anticipated. A common example of this divergence is provided by tax reforms that in some cases may not lead to major change in tax collection or tax incidence because the tax administration may de facto ignore the legislated changes.

The third assumption relates to the assumed superiority of information available to the government and to the presumed managerial superiority of public sector employees. Some of the original justification for expanding the role of the public sector was founded upon this assumption. The government was assumed to have access to information not available to the private sector. Furthermore, it was assumed that the government could provide managerial skills lacking in the private sector. Even if this assumption had some validity in earlier years, it is less valid today; first, because the information revolution has made much information available to everyone; and second, because in several countries (for reasons elaborated later), there has been a relative deterioration in the average quality of those who work in the public sector.

The fourth assumption is that the instruments of economic policy are highly controllable and that decisions can be easily reversed. In other words, the government will be able to increase or decrease particular taxes and particular types of spending as required by the evolving circumstances in the economy. However, some instruments are far more controllable than others, and some decisions can be made more easily when they require changes in some variables in one direction than in the opposite direction. For example, revenues from particular taxes may be influenced by factors (such as inflation, changes in world prices) that are beyond the immediate control of the government. Furthermore, it is much more difficult to reduce taxes or increase spending than to do the opposite.

In the traditional theory of public finance, it is assumed that the instruments used to pursue economic objectives will be public finance or monetary instruments. In practice, governments often pursue their objectives through regulations. To some extent, regulations can replace public finance instruments. For example, the consumption of an imported product can be subsidized either through the budget or by letting the exchange rate become overvalued. In many developing countries overvalued exchange rates conceal a lot of disguised redistributional activities on the part of the government. The production of a given product can be subsidized either directly through the budget or by restricting the importation of competing products.

Regulations have far less transparency than traditional public finance instruments and may involve very high but hidden efficiency costs. They are often justified in terms of some apparently worthwhile objective (protecting employment) and seem to be costless. Furthermore, they have a low direct cost of introduction, since they can often be introduced without formal legislative enactment. There has, thus, been a tendency in developing countries to rely excessively on them. The net result is a situation where the economy becomes overregulated and highly inefficient. Moreover, economic policy appears haphazard and without a clear sense of direction. One of the merits of public choice and supply-side literature has been to focus on these aspects of public policies that had received relatively little attention in the past. This literature has called attention to the efficiency costs of regulations and to the likely abuses that often accompany them.

TAXES AND ECONOMIC GROWTH

In recent years a tendency has arisen to advise countries to reduce the size of the public sector. But how does one measure the size of the public sector? Traditionally, the focus has been on tax levels. Studies of tax levels tried to develop norms that would indicate the tax level that a country was likely to have, given its level of economic development, or (in the more normative approaches) the tax level that it should have. However, the tax level is not a good measure of the size of the public sector and its impact on the economy because it may not be closely related to the level of public spending and because it does not reflect the impact of the public sector through...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Prefatory Note
• List of Contributors
• Introduction
• Part I—Issues
• Part II—Country Studies
• Footnotes