Fiscal consolidation, a euphemism for government action to reduce fiscal deficits and hence public debt, is now on the policy agenda in many countries. Large spending increases in response to the Covid-19 pandemic and the shocks of the commodity prices and the war in Ukraine have led to acute pressures on public finances. According to an IMF assessment, about 60 percent of low-income developing countries and 30 percent of emerging market economies are in or near debt distress. Moreover, the need for fiscal consolidation is not limited to these countries, as many others, including advanced economies, will need to rebuild policy buffers to address infrastructure gaps, climate change, ageing populations as well as future shocks. Against this background, a team of IMF economists recently published a survey of the literature and provided some food for thought.
What is the chance of success?
History shows that fiscal consolidation is no easy task. The survey indicated that the success rate of consolidation programs varied widely across studies, ranging from one-fifth to two-thirds depending on the criteria used to define success. Apart from a good design, certain pre-existing conditions increase the chances of success. These include a high level of per capita income—which reflects a country’s greater overall capacity—broad political support, and strong fiscal institutions, such as sound public financial management and revenue administration.
A reality check – slower growth and higher inequality in the short term
Fiscal consolidation is expected to bring more sustainable growth in the long run, but when governments cut spending or hike taxes, they have to contend with temporary output losses and likely worsening income distribution as a result of an initial slowdown in economic growth.
The size of the losses depends on the so-called “cyclical conditions” and “structural characteristics” of the economy. For example, losses tend to be larger for economies that are in a downturn and slow to adjust because of greater labor market rigidities and a less flexible exchange rate. Fiscal consolidation also tends to widen income gaps as it often leads to disproportionally higher unemployment among poorer households.
How much, how fast and how long?
Historically, the size, pace and duration varied considerably depending on country circumstances, but most fiscal consolidation programs covered in the literature reduced fiscal deficits by 1-2 percent of GDP per year for about 3-4 years. A key lesson is that a gradual and backloaded approach tends to limit output losses and stabilizes debt more permanently by allowing more time for undertaking necessary structural reforms, albeit potentially at the cost of “adjustment fatigue” if extended for too long. On the other hand, large and frontloaded programs tend to occur when there is an upfront need to restore market access for financing or only a narrow window for reform exists.
What should be the policy mix?
Should countries cut spending or raise taxes to reduce their deficits and debts? The jury is still out on this question, but the general principle is that the mix of revenue and expenditure policies should reflect a country’s circumstances. For example, a country that has a low-revenue-to-GDP ratio may consider more revenue measures for consolidation while a country with a large government may prioritize reductions in untargeted subsidies and benefits. Countries should generally resist the temptation to cut capital investments and social spending, as these cuts hurt long-term growth.
Institutions and capacity development matter
Fiscal consolidation is easier when fiscal institutions are strong. Evidence highlights the importance of a credible medium-term fiscal framework, sound public financial management, as well as transparency and accountability. Fiscal rules can help too, but their effectiveness depends on countries’ ability to implement them, and they need to strike an appropriate balance between fiscal discipline and flexibility to accommodate extraordinary and unforeseen shocks such as the Covid-19 pandemic.
Capacity development plays a critical role in strengthening fiscal institutions, especially in low-income and emerging market economies. But such efforts take time to bear fruit and need to start early on and be tailored to country circumstances. For example, it is vital to focus on basic public financial management and information technology functions before proceeding to more challenging areas such as performance budgeting.
The bottom line
The key takeaway is that a well-designed fiscal consolidation program should consider a country’s socio- economic and political context and set clear and realistic objectives to increase its chance of success. This suggests that the policy measures must be credible and lasting whatever the size, pace and policy mix of fiscal consolidation may be to mitigate the short-term adverse impact on growth and income distribution. To this end, an effective communication strategy and capacity development to strengthen institutions can play a key role in helping design and implement reforms.