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January 25, 2012

What Shapes the Structural Fiscal Balance?

Posted by Iva Petrova and Marcos Poplawski-Ribeiro

In recent years, policymakers have increasingly turned their attention to the structural fiscal balance as an important indicator of fiscal policy. The structural fiscal balance filters out from the overall balance cyclical movements in output and other temporary factors that are out of the reach of policy-makers. Hence, the structural balance tends to be smoother than the overall balance. At the peak of the business (or other type of) cycle the structural balance is lower than the nominal balance as unadjusted revenues are higher and (social) spending is lower. In a recession the situation is reversed, assuming that the so called automatic stabilizers are allowed to function. The structural balance is an important indicator because it shows whether fiscal policy is countercyclical and whether the fiscal balance is in line with long-term fiscal sustainability.

Estimating the structural fiscal balance is not without difficulties, however, especially in developing countries. Adjusting for the output cycle is an important but only a first step in identifying the temporary factors affecting government revenues and expenditures. There are quite a few temporary factors that can potentially influence the fiscal position. In countries with sophisticated financial markets, growing share prices could boost corporate and capital income taxes. They could also create a wealth effect that could give a temporary rise to consumption and taxes on goods and services. In resource producing low-income countries similar sizeable windfall effects could occur because of commodity exports. In emerging market economies the fiscal balance could be influenced by booming real estate prices.

In some emerging markets, especially where tax revenues contain a large share of taxes on goods and services, strong domestic consumption may raise government revenues. However, if it is coupled with a large trade deficit, an eventual rebalancing of the current account could cause an abrupt reversal in government revenues. All these examples show that even after correcting for the business cycle, one needs to exercise caution about other temporary effects that could mask the true state of the fiscal aggregates.

Adjusting government revenues and expenditures for temporary effects is country-specific, as it depends on the structure of the economy and the elasticity with which revenues and expenditures respond to different temporary factors. An IMF technical note by Bornhorst et al. (2011) explains several approaches that can be used to make such adjustments. The note was recently supplemented with an excel tool, which provides a quick and easy “first cut” in this process. The tool contains default revenue and expenditure elasticities based on estimates derived from relevant studies, and modular spreadsheets allowing each adjustment approach to be used independently. This provides flexibility to make adjustments only for those factors that are relevant for the country under consideration. Further customization of the tool is possible and encouraged, especially in those cases where the template default elasticities are significantly different from the observed response of government revenues and expenditures to temporary factors.

The technical note, the excel tool, and further background information are available on a newly established website.

An IMF FAD team is available at FADF1SFB@imf.org to respond to further requests regarding the tool and the information provided on the website.

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.


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