Revenue and Spending Policies for Fiscal Consolidation

Anita Tuladhar

May 24, 2010

Posted by Anita Tuladhar 

The past year has required extraordinary global effort by fiscal and monetary policies to support economic activity in the wake of the financial crisis. A key challenge now facing the world economy is to ensure that economic growth resumes in a strong, sustained, and balanced way. As the recovery becomes entrenched, policymakers will need to start reducing public debt ratios to more prudent levels. This is a daunting challenge: in the advanced economies, restoring debt from post-crisis levels to an indicative 60 percent of GDP by 2030 would require on average an adjustment of almost 9 percent of GDP over the next ten years and this does not include measures needed to offset higher spending on health and pensions, which is projected at about 4-5 percentage points of GDP over the next 20 years. A recent policy paper from the Fiscal Affairs Department (FAD) examined options for revenue and spending measures that could be considered in the advanced and emerging economies to achieve this fiscal adjustment. This paper complements earlier efforts from FAD that provided assessments of the size and composition of the needed fiscal adjustment.

Fiscal consolidations of this magnitude are not unprecedented, but are obviously not common, and not easy. This will, however, be the first time that most advanced economies will have to undertake a simultaneous adjustment of such a large magnitude. Moreover, while past adjustments have benefited from the favorable evolution of interest and exchange rates and strong export growth, these conditions may not prevail now. It is thus imperative that consolidation is achieved in a way that does not penalize growth potential: spending cuts should be consistent with the provision of efficient public services; tax measures should improve economic incentives.

For the advanced economies, the paper recommends a strategy for fiscal consolidation that rests on three pillars: first, it should seek to stabilize age-related spending—health and pensions—as a share of GDP (going beyond this is unlikely to be possible given demographic trends); second, it should reduce other non-age related spending items in relation to GDP; and finally, it should seek to raise additional revenues in an efficient and equitable manner. The balance among these components would depend on country circumstances, but, with public spending already high in advanced countries, a larger share of the adjustment will have to be on the spending side.

In the area of age-related spending, the paper highlights the challenge arising in particular from health care spending. Projected pension spending increases of about 1 percentage point of GDP between 2010 and 2030 is modest compared to projected increases of 3 to 4 percentage points of GDP in health care spending. This primarily reflects the fact that non-demographic factors, such as technological progress, play a key role in driving health care costs. Furthermore, in contrast to pensions, no major reforms—aimed primarily at reducing healthcare costs over the long run— have yet been agreed. Indeed, while concerns about the sustainability of publicly-financed health systems have featured prominently in the United States, this has been less the case in Europe. Reforming healthcare will be politically difficult and will entail difficult tradeoffs between containing growth in spending and maintaining broad access to high-quality health care. Lessons from past reforms will be crucial here. The paper discusses some of these measures emphasizing both supply-side incentives for cost-containment and demand-side measures to limit excessive use.

To achieve the reductions in non-age related spending ratios, the paper emphasizes reforms improving the composition and efficiency of spending, while ensuring the provision of key public services. Here the focus will have to be on rationalizing public wage bill, subsidies, and transfers. This approach has been conducive to catalyzing growth during previous consolidation efforts.  Reversing recent increases in military spending could also yield substantial savings. Better targeting of social welfare spending could provide fiscal savings while maintaining equity. Generalized subsidies, such as those for energy and agriculture, could be replaced with more targeted instruments.

While fiscal adjustments based on expenditure reductions should be preferred in countries where spending and tax burdens are already high, expenditure measures alone may not be enough, given the large size of adjustment needed. Even if the advanced economies were to freeze aggregate non-age related spending in real per capita terms over the next decade, for example, it would only yield around 3-3½ percent of GDP in savings. The paper thus also focuses on tax policies that can help raise revenues in the most efficient and equitable manner. 

In a globalized economy, efforts to raise revenues should center on strengthening broad-based taxes on relatively immobile bases. These include, mainly, consumption taxes and externality correcting taxes, such as those applied to petroleum products. More specifically, there is substantial scope for improving the revenue performance of the VAT in almost all countries through the reform of exemptions and the elimination of reduced rates. Many countries have scope to increase significantly revenues from excises on tobacco and alcohol, and fuel taxes. Property taxes are also an efficient source of revenues with a benign impact on growth. Pricing greenhouse gas emissions—either by taxing carbon or by auctioning emissions permits—could raise large sums. Altogether, appropriately designed and relatively efficient revenue measures with regard to these taxes in the G-7 economies could raise revenues of close to 3 percent of GDP, on average. And this does not take into account a menu of new measures in this area—for instance, introducing VAT in the United States, and doubling the very low VAT rate in Japan—which could contribute substantially to revenue.

The paper also notes the increasing importance of international coordination in policy and administration. Tax compliance gaps are large in many countries, and the crisis has likely aggravated tax compliance problems. In order to avoid further erosion, increased international coordination in policy as well as tax administration is likely needed. International collaboration in tax information exchange and transparency can help strengthen tax compliance.

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