September 19, 1997
Fiscal Affairs Department
International Monetary Fund
Washington D.C.
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Contents | |||
| I. | Fiscal Policy, Sustainable Growth, and Macroeconomic Adjustment: Evolving Policy Objectives | ||
|
A. |
From Macroeconomic Stabilization to Sustainable Growth | ||
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B. |
From Sustainable Growth to Growth with Equity | ||
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II. |
Fiscal Policy to Achieve Growth with Equity | ||
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A. |
Efficient Expenditure Policy: Reducing Unproductive Expenditures | ||
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B. |
Expenditure Composition | ||
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Social expenditures | |||
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Military expenditures | |||
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Expenditure composition in ESAF countries | |||
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C. |
Other Social Aspects of Fiscal Policy | ||
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Social safety nets | |||
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Income distribution | |||
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D. |
Implementation in the Fund’s Other Core Activities | ||
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III. |
Conclusions | ||
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Tables | |||
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1. |
Benefit Incidence of Public Spending on Education in Selected African Countries | ||
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2. |
Benefit Incidence of Public Spending on Health in Selected African Countries | ||
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3. |
Benefit Incidence of Social Expenditures on Lowest Quintile in Selected Latin American Countries, 1980-93 | ||
| Figures | |||
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1. |
Annual Average Change in Real Per Capita Education and Health Spending Under SAF/ESAF Programs | ||
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2. |
Average Annual Change in Enrollment and Infant Mortality Rates Under SAF/ESAF Programs | ||
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References | |||
Over the past two decades, the Fund’s policy advice has gradually evolved. Before the late 1970s, policy advice focused on macroeconomic issues; fiscal policy in Fund-supported programs was predominantly viewed as an instrument for influencing aggregate demand and establishing macroeconomic equilibria. In more recent years, however, the structural and social aspects of fiscal policy have become prominent, both in Fund programs and in its general policy advice to countries. This paper traces the evolution of the Fund’s approach to fiscal policy, in particular its social aspects, against the background of its mandate. 1
A. From Macroeconomic Stabilization to Sustainable Growth
The increased financing needs of the developing countries in the 1970s prompted a number of developing countries to seek financing from the Fund and from other multilateral agencies.2 The increased use of Fund resources by developing countries coincided with the virtual termination of the Fund’s role in financing the industrial countries; by the end of the 1970s, developing countries accounted for practically all of the use of Fund resources. The Fund’s involvement in developing countries was further deepened after the debt crisis of 1982, when private credit flows to these countries were reduced significantly. The debt crisis also underscored the need to increase economic growth rates in developing countries, so as to reduce the burden of high levels of external debt.
The shift in emphasis to the developing countries, together with the new thinking which came with supply side economics, drew the Fund’s attention to the structural problems of these countries. It came to be recognized that sustainable macroeconomic stabilization required policies to address not only macroeconomic imbalances, but the structural rigidities that impeded an improved supply-side response of the economy (Tanzi, 1987). Given that structural reforms often take a number of years to implement, many Fund-supported programs began to be designed in a multi-year context, with financial support provided by the Extended Fund Facility (EFF) and two new concessional lending facilities for low income countries—the Structural Adjustment Facility (SAF) and the Enhanced Structural Adjustment Facility (ESAF).
The increased focus of policy advice on supply side issues required the Fund to adopt what I have called the "microeconomic" approach to stabilization and fiscal policy, in recognition of the fact that fiscal policy changes often affect not only aggregate demand, but aggregate supply as well. Fiscal policy was thus seen as affecting growth not only through its contribution to macroeconomic stabilization, but through its supply side effects. Growth-promoting fiscal policy requires that adjustment is efficient—having the smallest adverse effect on long-term growth prospects of the country; and durable—having a lasting impact on the fiscal balance over the medium term. Efficient fiscal adjustment necessitates that close attention must be paid to the specific policy mix used to reduce the deficit. For example, the long term growth prospects of a country will differ greatly if it achieves a lower deficit by reducing unproductive expenditure or if it raises a tax that has strong disincentive effects. Efficient adjustment, by raising growth rates, can also help achieve lower inflation rates for a given monetary policy. Durable fiscal adjustment entails that measures have an impact on fiscal balances beyond the short-term; for example, a reduction in public sector employment could be a durable measure, while temporary surtaxes and tax amnesties are not durable.
The broadening of the Fund’s focus to structural issues also called further attention to the linkages between economic and social issues. While macroeconomic and structural reforms, such as devaluation, fiscal adjustment, and privatization can enhance long-run growth, in the short run they can also have potentially adverse effects on the poor or a disproportionately large effect on some groups. This indicates the need for well-designed social safety nets to mitigate the adverse effects of economic reform measures on the poor or groups that disproportionately suffer from economic reform measures. These social safety nets not only help protect the living standards of these groups, but also enhance the political viability of reform efforts. The wider scope of the Fund’s work also called for closer collaboration among international agencies, as these institutions—such as the World Bank, UNDP, and ILO—have specific expertise in social and sectoral issues that can be incorporated into macroeconomic and structural adjustment programs.
The transition from a command to a market economy in many countries in the early 1990s, coinciding with the increased emphasis of the Fund on structural issues, posed major challenges to reform policies (Tanzi, 1992). The Fund was called on to provide advice to countries on how to implement the broad and profound changes necessary to accomplish the transition, including the creation of institutions necessary for a market economy. The transition also involved the creation of fiscal and monetary institutions, such as a central bank, a treasury, and a tax administration. Policy advice was also needed to guide the transition in a number of areas, including social safety nets.
In recent years, the increase in income inequality in some countries has given rise to the realization that growth does not automatically lead to sizeable improvements in the living standards of the poor. Income inequality remains particularly high in Latin America and Sub-Saharan Africa. In Eastern Europe, the former Soviet Union and far Eastern transition economies (China and Vietnam), inequality has generally been on an upward trend. There is some evidence that the increase in inequality in these countries resulted from the growth of income at the upper end of the income scale, and to some extent from the fall in the real incomes of pensioners (Milanovic, 1996). The higher share enjoyed by upper income groups in transition countries has been perceived by some as resulting from rents created by the sale of state assets at prices much below their market values. The increase in economic power of these groups has thus been seen as highly unfair.
The relationship between economic growth and income inequality continues to attract much professional attention. Recent evidence—presented at a major conference at the IMF in 1995 on income distribution and sustainable growth—indicates that there is no systematic impact of growth on inequality, and thus there is now little support for the Kuznets hypothesis (Bruno, Ravallion, and Squire, 1998).3 This view is supported by the comprehensive empirical study conducted by Deininger and Squire (1996). This study shows that the variation of inequality within countries over time is quite small compared to the variation across countries. The use of cross-country data to assess the relationship between growth and inequality gives a misleading picture of the growth/inequality nexus for a given country. There is little reason to expect that in a given country growth will necessarily be associated with rising inequality. Recent research also shows that growth reduces the incidence of poverty, although the extent to which this happens is influenced by the existing degree of inequality (World Bank, 1990; Squire, 1993; Ravallion and Chen, 1996). This implies that while growth matters for poverty reduction, there is considerable scope for social policy to better channel the fruits of growth to lower-income groups (Tanzi and Chu, 1992). This is a conclusion that has been progressively internalized in the operational work of the Fund.
A substantial body of work on the effect of inequality on growth has also emerged in recent years. The new thinking of the profession in this area has been influenced by both new empirical research and theoretical modeling efforts which attempt to capture the complex relationships between income inequality, the political process, economic policy choices, and growth.4 The main conclusion from the theoretical studies is that inequality can be harmful to growth, as it leads to pressures for populist policies. Inequality may also lower growth by increasing political instability or by leading to pressures to postpone needed adjustment efforts.5 It can also curtail productive expenditure by the poor given capital market imperfections.6 These works imply that public expenditures that improve the human capital of low-income groups, such as those for primary education and health, can augment growth. The potentially positive effect of public outlays on health and education targeted to the poor on growth is underscored in Blejer and Chu (1990) and Tanzi and Chu (1992).
Recent empirical work casts doubt on the notion that income inequality has a systematic effect on growth across all countries, either positive or negative (Deininger and Squire, 1996). However, there is some evidence to support the notion that inequality in the initial distribution of assets can be detrimental to growth. Empirical work has also underscored the importance of primary and secondary educational attainment levels on growth (Barro, 1991; Easterly and Rebelo, 1993), indicating that public outlays that help increase educational attainment levels can potentially help achieve both improved equity and growth.
The Fund’s own work in evaluating the effects of Fund programs on poverty and income distribution has also contributed to the evolution of its thinking. In the mid-1980s, the Fiscal Affairs Department undertook a study of the distributional effects of adjustment programs, based on the experience of 78 countries (Staff of the International Monetary Fund, 1986). The conclusion of the study was that although there was no evidence that IMF programs were damaging to income inequality, the distributional incidence of different policy measures varied considerably. Measures that tended to make the distribution of income more equal include devaluing the exchange rate in countries where small farmers are dependent on agricultural exports; eliminating exchange controls; expanding access to credit markets; expanding the tax base for property and income taxes; and reallocating expenditure toward basic health and education. Measures with adverse distributional effects include increases in indirect taxes, in particular those on goods and services. A follow-up study which focused on seven countries (Heller and others, 1988) concluded that the distributive effect of Fund programs was dependent on the policy mix employed to achieve fiscal adjustment.
Since the late 1980s research has continued inside the Fund to contribute to the design of equitable and sustainable fiscal adjustment, including in the areas of unproductive expenditures and social safety nets.7 The deepening interest of the Fund in income distribution issues is also evidenced by its hosting of the forementioned major conference on income distribution and sustainable development in 1995, which brought together a number of prominent scholars and government officials to assess the interrelationship between income distribution and high quality growth.8
The new thinking has three major implications for fiscal policy, particularly as it is viewed in the Fund: (1) policies that promote equity can enhance growth prospects. For instance, policies that promote the accumulation of human capital by low-income groups—such as the expansion of primary education—promote economic growth; (2) economic growth may not necessarily lead to a strong reduction in poverty, particularly in the short run, unless supported by appropriate policies and institutions that incorporate the poor in the growth process; and (3) the provision of social safety nets may be conducive to long-term growth, given that the protection of vulnerable groups from the potentially adverse effects of economic reform may help garner political support for economic reforms. These conclusions are affecting the current work of the Fund.
The new view implies that economic policy should contribute not only to macroeconomic adjustment, but to higher growth and greater equity. The Managing Director has expressed this view in a number of different fora throughout the 1990s.9
Achieving these multiple objectives of stabilization, growth and equity requires not only reducing expenditures, where necessary, but improving the efficiency and composition of public expenditures.10 This can be achieved by reducing unproductive expenditures while shifting budgetary resources toward areas that support the development of essential physical infrastructure and human capital, including basic health and primary education. Another key element of the new role of fiscal policy is the incorporation of social safety nets in the budget.
The IMF has attempted to incorporate this new thinking in the fiscal policy advice it provides to countries through its three core activities: financial assistance to member countries, surveillance, and technical assistance. In what follows, the central elements of the new approach, as well as how the Fund has incorporated these considerations in its work, are described.
A key element of fiscal reform is the reduction of unproductive expenditures. By "unproductive public expenditures," it is meant public outlays that can be reduced without affecting government outputs or objectives, such as the provision of law and order and basic education and health services. Unproductive expenditures stem from a number of political and economic influences, including the pursuit of multiple objectives in public expenditure programs (e.g., using the public sector as the employer of last resort), the absence of a well-trained and motivated civil service, inadequate budgetary institutions and processes, and corruption. Unproductive spending can generate large fiscal deficits, a correspondingly lower level of effective public sector output, and a tax burden heavier than necessary.
Reducing unproductive expenditure is an important element of the Fund’s fiscal policy advice. A recent Fund study of 17 countries (11 of which had Fund-supported adjustment programs) for various periods over 1990-95 revealed that IMF policy advice, as reported in Fund documents, was directed to several major spending components such as wages and salaries, social expenditures, military outlays, and transfers to inefficient public enterprises (International Monetary Fund, 1997). IMF policy advice generally covered a significantly broader range of areas in countries with IMF-supported programs than in nonprogram countries. Other areas where the Fund frequently provides advice on reducing unproductive spending include public investment programs and extrabudgetary spending.
The record of the program countries in the sample in implementing the Fund’s advice on reducing unproductive outlays has been mixed; while almost all countries implemented some of the advice, significant slippages occurred in civil service reform, public investment programs, and public enterprise reform. The picture is also mixed in the nonprogram countries, as many had difficulty in fully implementing Fund advice on subsidies and social security reform.
As mentioned, unproductive expenditure can be promoted by corruption, defined as the abuse of public power for personal advantage. The lack of corruption is essential for the efficient functioning of markets and for the efficient use of public resources. More often than not pervasive corruption is associated with a large state. A reduction in the scope of corruption can come mainly from a drastic reduction of the pervasive role of the state in the economy and from a significant modernization of the public institutions. In this respect, policies seeking a leaner and more efficient government and more effective public expenditures are consistent with a policy environment conducive to lower corruption.
Despite the progress that has been made in reducing unproductive outlays, there is considerable scope for further improvements, including in the industrial countries. As I have demonstrated elsewhere (Tanzi and Schuknecht, 1997), the large increase in expenditures in recent decades in some industrial countries was not accompanied by significant improvements in social indicators, implying that much of the increased expenditure could be viewed as unproductive.
Social expenditures
Public expenditures on health and education have the potential to both increase growth, improve equity and reduce poverty over the long run, through their favorable effects on the accumulation of human capital. The productivity and benefit incidence of this spending is highly dependent, however, on its intrasectoral distribution; studies have consistently shown higher rates of return and a more favorable distributive incidence for primary education and preventative health, in contrast to outlays for higher education and curative, hospital-based and largely urban health care.
Building on these insights, in some countries with Fund-supported adjustment programs, the Fund has recommended a shift in the pattern of expenditure to accommodate increased spending in primary health and education. Fund policy advice to many low-income countries has stressed the importance of increasing both the level and the efficiency of social expenditure as part of the country’s effort to improve the composition of public expenditure. Often simply spending more without an increase in the efficiency of spending is not a good policy. Many programs have sought increases in real health and education spending and a larger share for the social sectors in total public expenditure especially in countries where this spending was very low.
Based on evidence for 23 countries for which data are available over the 1986-95 period and contrary to the claims of some Fund critics, social spending in ESAF countries has, on average, fared reasonably well, although substantially less so in CFA franc zone countries (Fiscal Affairs Department, 1997; Gupta, Clements, and Verhoeven, 1997). Social indicators also improved, although their performance varied considerably from country to country. Comparing the last year for which data are available and the preprogram year (a period that averaged six years), real public education spending climbed by 46 percent. This implied an average annual growth of spending of 6.4 percent, or 3.8 percent on a per capita basis (Figure 1). 17 of the 23 countries in the sample increased real spending on education. African countries, however, increased spending by less than other ESAF countries, as education spending in real terms rose only 2.4 percent per year, compared with 11 percent per annum in other SAF/ESAF countries. This and the high demographic growth in Africa resulted in an actual decline in per capita education spending in Africa by 0.4 percent per year, compared with a rise of more than 9 percent per year elsewhere.11 Similarly, health spending increased in real terms in all but three SAF/ESAF countries, with per capita spending increasing on average by almost 6 percent per year. Again, African countries increased their outlays by less, with their per capita health spending increasing annually at 1.7 percent, compared with 11 percent elsewhere. For both health and education, their shares in total spending increased, indicating that these sectors became higher priorities under SAF/ESAF programs.
Increased spending on education and health coincided with or led to improvements in social indicators. The illiteracy rate was reduced by some 3 percent annually since the start of the first program, although its level remained high. Gains in literacy were comparatively lower in Africa. Gross primary enrollment rates also rose by 1.1 percent annually (Figure 2). Access to health care improved from 46 to 64 percent of the population, and immunization rates and access to safe water and sanitation were sharply increased. However, health status indicators rose more slowly: life expectancy increased by just 0.3 percent per year and infant mortality fell by only 2.1 percent per year (Figure 2). Gains in health status in Africa were smaller than in other countries, reflecting partly the adverse effect of AIDS on these indicators.
Less progress was made in ESAF countries in improving the distributive incidence of social spending. Based on an assessment of eight ESAF countries for which data are available, the evidence indicates that the distribution of benefits still disproportionately favors the well to do in ESAF countries (Tables 1 and 2). This mirrors the empirical results (Table 3) that others have found in a number of studies of the distributive incidence of public expenditure. The regressive incidence of this spending is due largely to the intra-sectoral allocation of these outlays in favor of curative health care and higher education. The ability of upper-income groups to capture a disproportionate share of the benefits of this spending may also be due to the urban bias in the provision of social services.12 See Tanzi (1974).
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Table 1. Benefit Incidence of Public Spending on
Education in Selected African Countries | ||||||||||
|
Quintile shares of |
Total subsidy as percent of p.c. expenditure | |||||||||
|
Primary Subsidy |
Secondary Subsidy |
Tertiary Subsidy |
Total Subsidy | |||||||
|
Poorest |
Richest |
Poorest |
Richest |
Poorest |
Richest |
Poorest |
Richest |
Poorest |
Richest | |
|
Côte d’Ivoire (1995) |
19 |
14 |
7 |
37 |
12 |
71 |
13 |
35 |
12.5 |
4.6 |
|
Ghana (1992) |
22 |
14 |
15 |
19 |
6 |
45 |
16 |
21 |
13.4 |
3.1 |
|
Guinea (1994) |
11 |
21 |
4 |
39 |
1 |
65 |
5 |
44 | ||
|
Kenya (1992) |
22 |
15 |
7 |
30 |
2 |
44 |
17 |
21 |
27.8 |
1.9 |
|
Malawi |
20 |
16 |
9 |
40 |
1 |
59 |
16 |
25 |
2.3 |
1.4 |
|
Madagascar (1993) |
17 |
14 |
2 |
41 |
0 |
89 |
8 |
41 |
7.2 |
3.4 |
|
South Africa (1994) |
19 |
28 |
11 |
39 |
6 |
47 |
14 |
35 |
42.1 |
5.1 |
|
Tanzania (1992/93) |
20 |
19 |
8 |
34 |
0 |
100 |
14 |
37 | ||
|
Uganda (1992) |
19 |
18 |
4 |
49 |
6 |
47 |
13 |
32 |
4.3 |
1.5 |
|
Source: Castro-Leal, and others (1997). | ||||||||||
|
Table 2. Benefit Incidence of Public Spending on
Health in Selected African Countries | ||||||||||
|
Quintile shares of |
Total subsidy as percent of p.c. expenditure | |||||||||
|
Primary Facilities |
Hospital Outpatient |
Hospital Inpatient |
All Health | |||||||
|
Poorest |
Richest |
Poorest |
Richest |
Poorest |
Richest |
Poorest |
Richest |
Poorest |
Richest | |
|
Côte d’Ivoire (1995) |
14 |
22 |
8 |
39 |
11 |
32 |
2.0 |
1.3 | ||
|
Ghana (1992) |
10 |
31 |
13 |
35 |
11 |
32 |
12 |
33 |
3.5 |
2.3 |
|
Guinea (1994) |
10 |
36 |
1 |
55 |
4 |
48 | ||||
|
Kenya (1992) |
13 |
26 |
23 |
15 |
14 |
24 |
6.0 |
1.1 | ||
|
Madagascar (1993) |
14 |
30 |
10 |
29 |
12 |
30 |
4.5 |
0.5 | ||
|
Tanzania (1992/93) |
18 |
21 |
11 |
37 |
20 |
36 |
17 |
29 | ||
|
South Africa (1994) |
18 |
10 |
15 |
17 |
16 |
17 |
28.2 |
1.5 | ||
|
Note: Hospital subsidies combine in- and out-patient spending in Côte d’Ivoire,
Madagascar, and Kenya. Source: Castro-Leal, and others (1997). | ||||||||||
- -
|
Table 3. Benefit Incidence of Social Expenditures
on Lowest Quintile in Selected Latin American Countries, 1980-93 | |||||||||
|
Argentina |
Costa Rica |
Chile |
Dominican Republic |
Uruguay | |||||
|
1980 |
1993 |
1980 |
1986 |
1980 |
1990 |
1980 |
1980 |
1989 | |
|
Total Social expenditure |
20.0 |
17.8 |
20.9 |
17.6 |
14.9 |
18.8 |
20.0 |
15.7 |
19.6 |
|
Total Education |
28.3 |
28.6 |
19.9 |
15.7 |
25.8 |
31.0 |
10.6 |
31.4 |
32.9 |
|
Primary education |
39.9 |
37.0 |
34.7 |
30.0 |
36.7 |
35.7 |
14.2 |
45.0 |
51.6 |
|
Secondary education |
26.4 |
22.0 |
18.6 |
17.8 |
21.0 |
26.8 |
9.4 |
24.7 |
30.3 |
|
Tertiary education |
8.3 |
8.3 |
4.1 |
1.7 |
5.5 |
22.8 |
-- |
7.2 |
5.4 |
|
Health |
51.2 |
53.2 |
30.0 |
27.7 |
22.3 |
24.5 |
41.3 |
34.0 |
34.8 |
|
Social security |
9.9 |
5.1 |
9.3 |
7.1 |
6.2 |
5.7 |
8.6 |
10.3 |
12.4 |
|
Public housing |
72.7 |
20.4 |
5.3 |
... |
42.8 |
16.5 |
2.7 |
7.0 |
15.7 |
|
Water and sanitation |
16.0 |
25.0 |
17.4 |
... |
14.6 |
... |
8.8 |
18.0 |
10.7 |
|
Sources: Petrei (1987 and 1995). | |||||||||
Military expenditures
Excessive military expenditures impose a heavy fiscal burden on developed and developing countries alike, absorbing 2.3 percent of world GDP in 1996. Recent research confirms the potentially adverse effects of military spending on growth (Knight and others, 1996), which can occur through the crowding out of private investment or high-productivity public expenditures. Recent research confirms that in countries where large increases in military expenditures occurred, there has been an increase in the budget deficit and a decline in public investment (Gupta, Schiff and Clements, 1996). The IMF’s advice on such spending often calls for reviewing military expenditures to identify potential fiscal savings, although the Fund is cautious not to claim expertise in evaluating the proper level of military spending in a given country.
Recent years have witnessed an encouraging decline in worldwide military outlays, including the developing countries. Progress has been even more rapid in developing countries with IMF-supported programs, although one should be cautious about attributing these more rapid declines to the existence of Fund-supported programs per se; in these countries military spending fell on average by 3 percentage points of GDP between 1990 and 1995, compared with 1.3 percentage points in nonprogram developing countries. These differences between program and nonprogram countries are largely due to the relatively more rapid decline in spending in transition countries with Fund-supported programs. Low-income countries with ESAF-supported programs have also made progress in trimming these outlays, which fell by 1.3 percent point of GDP between 1990 and 1995.
Expenditure composition in ESAF countries
Beyond increases in social expenditures and reductions in military spending, Fund program design in countries with ESAF-supported programs has also incorporated a number of other elements to improve the composition of public expenditure. Based on a review of 36 countries with ESAF-supported programs over the 1986-95 period, it was found that the programs have aimed, on average, to roughly maintain total expenditure constant as a share of GDP, while shifting expenditure from current to capital (Fiscal Affairs Department, 1997). Relative to the three-year preprogram average, an increase in capital expenditure and net lending of about 1½ percentage points of GDP was targeted, and a reduction in current spending of 2.2 percentage points of GDP was envisaged, on average, with budgetary savings anticipated to come from reductions in excessive public sector employment and inefficient subsidies and transfers. In the event, these countries made significant progress in changing the composition of expenditure, although by less than programmed; compared with the three year preprogram average and the last year for which data are available, the share of outlays devoted to capital and net lending rose by about 2½ percentage points, while the portion of expenditures absorbed by wages and salaries and subsidies and transfers declined. Significant changes in the shares of spending by function were also realized, with increased shares for the social sectors, and a decline in the portion of spending absorbed by defense outlays, general public services, and economic services.
Social safety nets
Reform measures, such as the removal of generalized price subsidies of basic necessities or exchange rate devaluation, can cause a decline in real income, including for the poor (Chu and Gupta, 1997a, 1997b). A reduction of budgetary subsidies to state enterprises, downsizing and lowering protection following trade liberalization may result in job losses. In these cases, IMF-supported programs have sought to mitigate the impact on the poor, bearing in mind the cost-effectiveness and financial viability of such safety net measures. Such measures include targeted subsidies (e.g., Jordan), cash compensation in lieu of subsidies (e.g., the Kyrgyz Republic), improved distribution of essentials such as medicine, temporary price controls for limited number of essential commodities, severance pay and retraining for retrenched public sector employees (e.g., Ghana and Sri Lanka), and employment through public works. Existing permanent social security arrangements (such as pensions and unemployment insurance) have also been adapted to shield pensioners and the unemployed from the adverse effects of economic reform; often this has been accompanied by a tightening of eligibility criteria and a restructuring of benefits, to ensure that the average benefit is not only fiscally sustainable but also fair and adequate (e.g., Latvia).
Income distribution
The Fund’s concern for securing economic growth, raising the living standards of the poor, and ensuring the political sustainability of economic reform imply that the Fund’s policy advice should incorporate the distributive consequences of different economic policies. These concerns go beyond an assessment of the impact of policies on the poor, as income distribution per se can also have an effect on the political sustainability of reforms.
The two key instruments of fiscal policy—tax policy and expenditure policy—have different roles in achieving distributive goals. In a nutshell, expenditure policy, rather than tax policy, should be the primary instrument to achieve distributive objectives.
Tax policy should aim at collecting revenues with relatively modest marginal tax rates and broad tax bases and minimum exemptions to ensure that rents are not created for powerful interest groups (Tanzi, 1998). For example, the VAT should ideally be a single-rate tax with very few exemptions and a broad base. And income taxes, both personal and corporate, should also limit special preferences and impose moderate marginal tax rates.
Tax policy alone cannot, in most cases, achieve distributional objectives (see Harberger, 1998). Even in the still high-tax transition economies the degree to which income taxes affect the pre-tax distribution of income has been found to be rather modest (Hassan and Bogetiæ, 1996). Thus, tax policy should be designed primarily with efficiency objectives in mind, with the burden of redistribution placedmore squarely on the shoulders of expenditure policy. 13The reform of tax policy and tax administration should aim at reducing or eliminating regressive taxes, imposing mildly progressive tax rates for some taxes, and improving compliance, to ensure that there is some progressivity to the tax system in practice, rather than just in a statutory sense (Tanzi, 1998).
Expenditure policy has the potential to help improve income distribution. Expenditure policy can shape both the distribution of pretax income—through its effect on human capital formation—and the posttax distribution of income through direct income transfers. In practice, as cited earlier, expenditure policy has tended to benefit upper-income groups. This however has been a sin of implementation. Policy options for improving the distributive incidence of social expenditures include the reallocation of outlays to primary education and preventative health care, and the imposition of user fees for those expenditures that benefit higher-income groups, such as higher education and curative health care.
Strengthening the design of equitable and efficient expenditure policies in Fund program will require an intensification of collaboration between the Fund and other international agencies that specialize in the assessment and design of social policies. At the same time, there is a need for additional research by the profession to help further identify policies in the social area that are most conducive to rapidly increasing the living standards of the poor.
The new approach has been incorporated not only in programs supported by the Fund, but also in its advice in two other core activities: surveillance and technical assistance. With respect to surveillance, the IMF provides advice on fiscal policy to member countries in the context of its regular article IV consultation discussions with all member countries, including the industrial countries. For example, policy advice to some European nations in the context of Article IV consultation missions has stressed the importance of labor market reforms to help reduce unemployment, and has also provided advice on the appropriate adjustments in tax and expenditure policies to address the social effects of these reforms. IMF advice has also focused on health and social security spending in industrial countries, where the rapid aging of the population implies that these expenditures will rise to unsustainable levels without reform.
The Fund’s technical assistance has also provided countries with advice on how to implement efficient and equitable tax and expenditure policies. Some of the areas where such assistance has been provided are tax policy and administration, public expenditure management, public expenditure policy, and social safety nets. Technical assistance in social safety nets has often been given in the context of Fund-supported adjustment programs, and has provided a key ingredient to the formulation of an adjustment program that helps protect the vulnerable from the potentially adverse effects of reform.
This paper has attempted to trace the evolution of the profession’s thinking and the Fund’s approach to fiscal policy, in particular its social aspects. Fiscal policy is no longer viewed as solely a macroeconomic policy tool. The distributional implications of fiscal policy, particularly during adjustment, are now understood to be important. But there is a need for further research by the profession on the linkages between social expenditures and social indicators, to provide guidelines for better targeting of social expenditures. The Fund, for its part, will continue to try to learn from the work done in the profession on the ties between economic policy and equity; toward this end, the Fund is organizing another conference on economic policy and income distribution, scheduled to take place in 1998. The Fund has also taken steps to further intensify its collaboration with other institutions on social issues.
The Fund can further strengthen its programs by more systematically following up on the effectiveness of social safety net policies and more systematically following up on the composition of expenditure. Recent guidelines issued to Fund staff to improve the monitoring of social expenditures and social indicators are a step in the right direction. Fund programs can also be further strengthened by more systematically addressing the distributive effects of policy measures and economic developments.
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*The views expressed in this paper are strictly those of the author. I wish to thank Ke-young Chu, Sanjeev Gupta, Benedict Clements, and Zeljko Bogetic; for substantial assistance in the preparation of this paper.
1The mandate of the IMF, as laid out in its Articles of Agreement, is to: (i) promote international monetary cooperation; (ii) facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income; (iii) promote exchange rate stability and maintain orderly exchange arrangements among members; (iv) assist in the establishment of a multilateral payments system; and (v) give confidence to members by providing temporary financial resources to help them correct balance of payments disequilibria.
2See Bernstein and Boughton (1993) for additional details.
3Based on his assessment of historical data, Kuznets (1955) advanced the hypothesis that at low levels of economic development, growth would be associated with increasing inequality, while sustained growth would eventually improve the distribution of income.
4See, for example, Ozler and Tabellini (1991); Perotti, (1992); Alesina and Rodrick (1992 and 1994); and Persson and Tabellini (1994).
5See, for example, Alesina and Drazen (1991); Laban and Struzenegger (1994); and Alesina and others (1996).
6See Bruno, Ravallion, and Squire (1997) for a description of models that support this conclusion.
7See, for example, Staffs of the International Monetary Fund and World Bank (1993); Chu and others (1995); and Chu and Gupta (1997a, 1997b).
8The papers presented at this conference are forthcoming in Tanzi and Chu (1998).
9See, for example, Camdessus (1990, 1997, 1998).
10The efficiency and the general quality of the tax system are also very important. However, in this paper we will focus on public expenditure which is the area in which Fund thinking has evolved especially.
11In some African countries such as Burkina Faso, Ghana, and Lesotho, real per capita education spending increased significantly.
12See Schwartz and Ter-Minassian (1995) for a recent review of the literature on the distributive incidence of public expenditure.
13See Tanzi (1974) for an explanation of the limited role, in practice, of the tax system in redistributing income in Latin America, as well as Harberger (1998) for a more general exposition on the topic.