Fiscal Issues in Adjustment in Developing Countries

232 Pages·1993·24.81 MB·English

by  Riccardo Faini

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
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First published in Great Britain 1993 by
THE MACMILLAN PRESS LTD
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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.