fiscal policy and economic growth: lessons for eastern europe and central asia
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Fiscal Policy and Economic Growth:Lessons for Eastern Europe and Central Asia
Key questions How do broad public finance patterns and
trends affect economic growth? Fiscal balance Size of government Patterns of spending and taxation
How can the efficiency of spending and taxation be increased? Infrastructure Education Health Pensions Flat income taxes Labor taxes
Key messageso The impact of fiscal policies on growth
depends on the quality of governance.o Government size and expenditure composition matter most
when governance is weak; Tax composition also matters when governance is strong
o High fiscal deficits reduce growth in both cases
o In most ECA countries fiscal space needs to be created through efficiency gains rather than increased spending.
There are opportunities for efficiency gains in infrastructure, education, health, and pensions.
o Recent reforms in income taxation are welcome but do not adequately address the high labor tax wedge.
Public Finance and Economic Growth:Trends and Interrelationships
Growth in ECA has been rapid in recent years after initial collapse.
-25
-20
-15
-10
-5
0
5
10
15
1990
1991
199
2
199
3
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Annual real GDP growth, in %
SE Europe
Middle income CIS
Low income CISEU3 Baltics
EU5 Central Europe
Fiscal balances have improved in recent years in most ECA countries.
…but further fiscal adjustment is still needed in some settings.
Primary fiscal balance (average 2002-04, in % of GDP)
-8
-6
-4
-2
0
2
4
6
8
Successful fiscal adjustments have been stronger than unsuccessful ones and have been driven mainly by broad-based expenditure cuts
Characteristics of fiscal adjustments in ECA
-5
-4
-3
-2
-1
0
1
2
3
4
5
fiscal balance 1year before
fiscal balance 2years after
expenditurecuts
revenueincreases
in %
of G
DP
successful unsuccessful
Composition of fiscal adjustments
Growth has been higher when fiscal adjustment has been successful…
GDP growth before, during, and after fiscal adjustment in ECA, 1996-2004, in % per year
0
1
2
3
4
5
6
7
8
Year before During adjustment Over 2 years after adjustment
Successful adjustments Unsuccessful adjustments
0.36
0.38
0.4
0.42
0.44
0.46
0.48
0.5
decrease in nonproductivespending
increase in nondistorting taxes
increase indistorting taxes
decrease inproductivespending
Impact on the annual growth rate of an increase in the fiscal surplus of 1% of GDP
Increase in fiscal surplus financed by:
…and adjustments financed by “non directly productive” expenditure cuts have had higher growth impact
Most ECA governments are larger than in comparator high-growth countries
10
15
20
25
30
35
40
45
50
55
60
6 7 8 9 10 11
LN GDP per capita, PPP
Prim
ary
Exp
Per
cent
of G
DP
ECA countries High growth comparator countries
ECA countries correlation
International correlation
Thailand
ChileUganda
VietnamKorea
Ireland
Spain
Croatia
Primary Public Expenditures and Per capita Incomes (PPP)(average 2000-2004)
Large size tends to reflect large spending for social transfers
05
1015202530354045
EU8 SEE Turkey MIC CIS Lowincome
CIS
Perc
ent o
f GD
P
Other
Economic Affairs
General Public Services
Defense & Public Order
Education
Health
Social Security
Large government size is associated with slower growth in poorly-governed countries
-50
-25
025
50Ec
onom
ic G
rowt
h
0 20 40 60 80Size of Government
Less Effective Governments
-50
-25
025
50Ec
onom
ic G
row
th
0 20 40 60 80Size of Government
More Effective Governments
… but not in well-governed countries
Why might “big governments”, beyond a certain size, adversely affect growth?
Misallocation of expenditures: Big governments may spend more on less productive functions
Low efficiency: Weak administrative capacity may be more of a binding constraint when public responsibilities are large
High taxes: Financing of high levels of public spending requires high taxes that can distort incentives for saving, investment, and work effort
…and the negative effect of these factors tends to be stronger when governance is poor
The impacts on growth of public spending and revenues also depend on the quality of governance.
Size of government and spending mix matter most when governance is poor; Spending and revenue mix matters more when governance is good.
SPENDING Good governance
Poor governance
“Unproductive” expenditures
No measurable impact
Negative impact
“Productive” expenditures
Positive impact No measurable impact
TAXATION“Distorting” taxes Negative impact No measurable
impact
“Non distorting” taxes
Positive impact No measurable impact
The Challenge of Improving Public Spending Efficiency
Few ECA countries have fiscal space for additional spending
Infrastructure: Policy reforms are high priority-- and maintenance, private sector participation, some new investment
Total Hidden Costs - Percentage of GDP(2000-2005)
0
5
10
15
20
25
30
2000 2001 2002 2003 2004 2005
Education and health: ECA has good outcomes given its level of income…
…but these results come at a high cost.
Example: Input efficiency
score for life expectancy at birth
0.38
0.46
0.55
0.56
0.63
0.65
0.65
0.65
0.68
0.69
0.69
0.70
0.79
0.92
1.00
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
HRV
SVK
POL
ROM
TUR
UGA
UKR
KGZ
VNM
ARM
GEO
ALB
THA
CHL
KOR
Reforms can increase efficiency in education and health
Education Allocate financing on a per student basis Move to more efficient (generally larger) class sizes Reduce emphasis on expensive vocational education Enhance private financing, particularly at tertiary level
Health Consolidate hospitals to improve efficiency Strengthen incentives for cost saving by providers and
consumers (e.g. co-payments, basic benefits package) Address high out-of-pocket payments (often informal) Improve transparency and accountability at all levels
Pensions are a particular challenge in ECA
Situation different than in comparators Legacy of generous pension coverage Falling employment levels (exacerbated by high labor taxes) Aging populations
0
20
40
60
80
100
120
140
0 20 40 60 80 100 120 140
% of elderly receving pensions
% o
f w
ork
ing
ag
e co
ntr
ibut
ing
ALBANIAGEORGIA
SLOVAKIA
KYRGYZ REP
POLAND
ROMANIACROATIA
UKRAINE
TURKEY
CHILE
VIETNAMVIETNAM
UGANDA
THAILAND
KOREA
IRELAND
SPAIN
Share of elderly receiving pensions exceeds percentage of working-age population making contributions
A two-pronged approach for pension reform?
MICs: public/private contributory systems + means-tested social assistance
LICs: universal low-rate pension (financed from general revenues)
All contributory systems should be entirely self-financing
In many cases financial sustainability will require benefits to be tightened
How can Distortions in the Tax System be Reduced?
ECA leads the world in flat-rate income tax reforms…
Revenue, incentive, equity, and growth effects have generally been positive.
PIT Revenue Collections as % of GDP
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
Lithuania RussianFederation
Slovakia Ukraine
before 1 year after 2 years after
…but complementary policies are needed to enhance the impact of flat-income taxes
Closing tax loopholes and ad hoc exemptions
Maintaining appropriate tax allowances to enhance equity
Strengthening tax administration
Reforming payroll taxes and social insurance
Labor taxes are still too high…
Tax Wedge on Labor: ECA against Selected Comparator Countries, 2006
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
50.0%
Turk
ey
EU
-11
SE
E
Mid
dle
-incom
e
CIS
Low
-incom
e C
IS
EU
-15
Denm
ark
Neth
erlands
Spain
UK
US
A
Irela
nd
Kore
a
Vie
tnam
ECA Comparators
…and are associated with low labor force participation in ECA
ECA countries need to streamline social benefits and move to general revenue financing of health and some social transfers to help spur employment
Labor Force Participation Rate by Quartiles of Tax Wedge, 200428 ECA countries
62
63
64
65
66
67
68
69
70
bottom quartile 2nd quartile 3rd quartile top quartile
Tax Wedge
Lab
or
forc
e p
arti
cip
atio
n r
ate,
%
Summing up
The impact of fiscal policies on growth depends on the quality of governance.
Government size and expenditure composition matter most when governance is weak; Tax composition also matters when governance is strong
High fiscal deficits reduce growth in both cases
In most ECA countries fiscal space needs to be created through efficiency gains rather than increased spending.
There are opportunities for efficiency gains in infrastructure, education, health, and pensions.
Recent reforms in income taxation are welcome but do not adequately address the high labor tax wedge.
Thank you.
Report available in English and Russian at www.worldbank.org/eca/fiscal
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