The keys to fiscal sanity

Countries around the world have significantly improved their fiscal positions since the early 1990s. A defining characteristic of recent fiscal adjustments is that they have been based primarily on expenditure restraint rather than on a rising share of revenue in GDP. Recent fiscal developments have also been accompanied by widespread reforms directed at strengthening fiscal frameworks.

Several factors may have underpinned this general strengthening of fiscal positions and fiscal institutions. Many countries have shown a marked preference for a more limited role of government, reflecting doubts about the extent to which governments can correct the effects of market failure and improve income distribution. In addition, there may have been increased recognition of potential distortions arising from high rates of taxation and from public sector competition for economic resources.

While in the budget speech Prime Minister Lawrence Gonzi was able to announce that the structural deficit in 2004 was reduced by Lm11.5 million to Lm93.9 million (4.9 per cent of GDP), this was by dint of a further rise in revenue (Lm85 million or 11.5 per cent), more than half of which from taxes. In fact, the tax take as a percentage of GDP has risen again from 36.2 per cent of GDP to 37.4 per cent. There was no sight of the hoped-for reductions in recurrent expenditure which, on the contrary, increased by Lm61.2 million (or nine per cent).

A key issue in fiscal adjustments is always whether they can endure or whether they may be reversed during some future economic slowdown. On the positive side, many governments in the OECD area have focused on expenditure reductions rather than tax increases, cuts in transfer spending and in the public sector wage bill and an urgent need to address high levels of public debt.

As a further note of caution, lower interest payments and capital outlays have made an important contribution to the recent decline in expenditure, most significantly in Europe. However, substantial additional fiscal improvements from lower interest rates cannot be expected and further reductions in capital outlays are not necessarily desirable.

Looking to the longer term, the pressures of ageing populations on pension, health and other areas of public spending will impose a challenge to fiscal positions in many economies. While some countries, such as the UK, Canada, and Sweden, have reformed their public pension systems to improve significantly their financial viability, others still have a long way to go. The challenge of ageing populations need not be insurmountable, however, if timely and wide-ranging policy measures are taken.

The most striking feature of the recent fiscal consolidation has been the downtrend in government expenditure. In the advanced economies (excluding Japan) this declined by close to six per cent of GDP during 1993-2000, with the sharpest reduction in the northern European countries (10.5 per cent of GDP). The bulk of adjustment has fallen on expenditure categories that contributed to the earlier long upward trend in the expenditure ratio: wages and salaries, current transfers and interest payments.

In Malta, this has not been the case. Even the government's latest projections for the next three years reveal that, while the structural deficit is targeted to decline from 5.7 per cent of GDP in 2003 to 1.6 per cent in 2007, recurrent expenditure is set to rise by 16 per cent. It is only by cutting some 18.5 per cent from the capital expenditure programme that the Prime Minister was able to contain total expenditure. Moreover, the tax take is set to expand. Only 82 per cent of the increased tax take is attributable to GDP growth while the other 18 per cent will come from additional taxation.

In other countries, reforms in public expenditure management, including mechanisms to strengthen budgetary procedures and to enhance budget flexibility while strengthening expenditure control, have contributed significantly to expenditure restraint. Furthermore, emphasis has been made on an expanded role for markets in the provision of public goods and services, including contracting out of government services, liberalising public procurement, introducing user charges and using vouchers in the distribution of merit goods and services.

Several forces, such as privatisation and tax amnesties, that may not be repeated in the future have helped to drive the recent fiscal adjustment.

While there is widespread agreement that a sound fiscal position is conducive to improved economic performance over the medium to long term, the impact of fiscal consolidation on output in the short term is an area of some dispute. The standard Keynesian analysis suggests, and our experience in Malta confirms, that fiscal contraction will result in lower employment and output over the short term, as it reduces aggregate demand.

Reductions in public expenditure and the associated public wage compression (which can impact private sector wages) can reduce production costs, which raises profitability and competitiveness, thus stimulating investment and exports. Reducing public spending can also raise the confidence of the business sector. There is also some evidence that reductions in government spending have a strong positive effect on investment spending.

As I mentioned earlier, various institutional reforms have contributed to achieving and maintaining fiscal consolidation while continuing to leave room for fiscal policy to dampen the business cycle through automatic stabilisers and (if necessary) policy actions.

Recent institutional reforms can be classified into three broad, but not mutually exclusive, groups.

¤ Formal deficit and debt rules. The main examples of this approach are the countries of the euro area, which are bound by the Maastricht Treaty and subsequent Stability and Growth Pact limit of three per cent of GDP on the deficit; and the United Kingdom, which since 1997 has operated a golden rule (borrowing only to finance capital spending) and a sustainable investment rule, which limits net debt to 40 per cent of GDP over the cycle.

¤ Expenditure limits. Other countries, such as the US, as well as Finland and the Netherlands in the euro area, have put more emphasis on expenditure limits, whereby overruns in certain expenditure areas must be accompanied by offsetting expenditure cuts elsewhere or by revenue increases.

¤ Transparency. New Zealand, Australia and the UK have adopted a fiscal management approach that places primary emphasis on transparency in the structure and functions of government, public sector accounts and fiscal policy intentions and projections.

The advantage of deficit rules is that they are clear and focus on a generally well-understood macroeconomic aggregate. The main criticism of deficit rules in general, and balanced budget rules in particular, is that they are inflexible and therefore tend to be procyclical. As a result, deficit rules have increasingly been refined to apply either to a cyclically adjusted deficit measure or an average over the economic cycle.

Debt ceilings can be a useful adjunct to deficit rules, although the definition of an appropriate ceiling is difficult.

Expenditure rules typically impose ceilings on specific areas of expenditure; for example, discretionary as opposed to non-discretionary programmes. The principal advantage of capping expenditure is that it tackles deficit bias by addressing the principal source of rising deficits, namely political and institutional pressures to increase expenditure.

While we are seeing elements of all this filtering through to policy-making in Malta, we still have a long way to go.