meeting the deficit challenge strategies for fiscal sustainability

8/3/2019 Meeting the Deficit Challenge Strategies for Fiscal Sustainability

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Meeting the Deicit ChallengeStrategies or Fiscal Sustainability

KPMG INTERNATIONAL

GOVERNMENT


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2 Strategies or Fiscal Sustainabil ity

2010 KPMG International Cooperative (KPMG International), a Swiss entity. Member irms o the KPMG network o independent irms are ailiated with KPMG International. KPMG International provides no client services. All rights reserved.


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Strategies or Fiscal Sustainabil ity 3


Contents

Foreword 5

Executive summary 6

The deicit challenge 8

Lessons rom previous iscal adjustments 12

Moving towards iscal sustainability 18

Re-engineering government 20

Conclusion 25

Appendix 1 Case studies on deicit reduction 26

Appendix 2 Detailed tables 28

Reerences 30


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John Herhalt

Global Head o Government Sector

KPMG in Canada

Alan Downey

Head o KPMGs Global Government

Committee on Perormance

KPMG in the UK


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Foreword

It is time or governments to address the challenge o high debt and budget

deicits. The need to prepare or uture spending commitments to manage

demographic changes, clean energy/climate change goals and required

inrastructure investments make meeting these iscal challenges all the more

diicult and critical. Governments should develop detailed deicit recovery

strategies and plans or ongoing iscal sustainability. Now is the time to act to

meet that challenge.

The objective o this report is to examine approaches and discuss options or

deicit reduction, and to review strategies or ongoing iscal sustainability. Our

goal is to add to the conversation as our public sector peers evaluate their

options, build their strategy and potentially re-engineer their sector. We draw

on international data rom previous experiences o iscal adjustment, economic

research, insights rom KPMG partners and directors around the world, as well

as interviews with senior academics and public sector leaders in the US, UK,

Germany, Canada and Spain.

Meeting the Challenge: Strategies for Fiscal Sustainability is the third and

ollow-on report to Tough Choices Ahead: The Future of the Public Sector, and

The Wolfis at theDoorpublications. These previous reports were based on

insights rom a survey o public sector leaders around the world, along with

detailed in-depth interviews. This ollow-up research looks at the options acing

public sector leaders as they build strategies or iscal sustainability.


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Executive summary

The need or detailed deicit recovery strategies in the industrialized economies

has become a pressing one. Increasing concerns in inancial markets about debt

sustainability, the risks to growth rom high debt and deicits, and the need to

prepare or uture spending commitments, all point to the need or action.

Background

In2009theaveragedeficit/GDPratioexceeded10percentintheG7economies,

and the average debt/GDP ratio exceeded 100 percent. These are levels that may

put at risk signiicant long-term growth prospects.

Moreover,largeage-relatedspendingincreasesinthedecadesahead,

combined with the need to spend signiicant amounts to upgrade

inrastructure, add urther to the pressure or iscal change.

This Report

Seekstoexamineapproachestodeficitreductionandhighlightthechallenges.

It draws on international evidence rom previous experiences o iscaladjustment, economic research, insights rom KPMG partners and directors,

and interviews with senior academics and public sector leaders in the US, UK,

Germany, Canada and Spain.

Key Findings

Althoughthescaleofdeficitrecoverynecessary islarge,it isnot

unprecedented. Countries like Denmark, Sweden, Ireland and Canada have

achieved very large iscal turnarounds in recent years without major

damage to economic growth. However, conditions or deicit recovery may

be more challenging this time around, given that a large number o countries

are attempting to deal with deicits at the same time and the global growthbackdrop is more uncertain.


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Examinationofhistoricalbudgetconsolidationeffortssuggeststhatstrategies

based on spending cuts, especially cuts to current spending, tend to be more

successul than those centered on tax increases. Decisive, ront-loaded

eorts are also more likely to succeed than gradual ones.

Sometaxincreasesneverthelesslookinevitable,butthesecanbestructured

in a way to minimize the risks to growth.

Conventionaltaxandspendingmeasuresmaybeinsufficienttomeetthe

challenge o deicit recovery, especially over the long-term. Governments

may need to consider radically re-engineering the scope and scale o their

activities. This might include:

Reorms to drive up productivity growth in public services

Extendingprivateinvolvementdeeperintotheheartofgovernment

Privatization o inrastructure and other key assets

Fiscalruleswhichaimtobindgovernmentsintoresponsiblebehaviorprovide a possible approach to preventing deicit problems rom recurring,

but their record to date is mixed.

Therightapproachtofiscaladjustmentcouldbehardtosell,politically.

It may require an atmosphere o crisis to allow major cuts to government

payrolls or transers and pensions.

Buildingthenecessarysupportforfiscalchangewillrequiredifferent

approaches in dierent countries, depending on their social and political

structures. Historical experience suggests deicit reduction eorts can

succeed under a variety o political dispositions, implying that outlining

clear goals and ollowing through on them is a critical actor.


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1980 1984 1992 1996 2000 2004 20081988

12

10

8

6

4

2

0

Source: Oxford Economics/Haver Analytics

G7 Budget

deficit/GDP ratio

% of GDP

The deicit challenge

This report reviews options for deficit reduction and strategies for achievement of

fiscal sustainability. Drawing on lessons from previous fiscal retrenchments and

economic research, it identifies the key elements for successful and sustained

deficit reduction. Given the scale of adjustment needed, it also suggests an

agenda for a re-engineering of government, drawing on insights from a number

of roundtables and in-depth interviews with experts in the US, UK, Germany,

Canada and Spain. This first section sets out the deficit recovery challenge, and is

followed by sections looking at lessons from past fiscal turnarounds, options to

be considered for structuring deficit recovery strategies and the re-engineering of

government.

Many o the industrialized countries1 currently ace a major challenge o potential

iscal adjustment to reverse the huge expansion in budget deicits that has

resultedfromtheglobalfinancialcrisisandrecession.In2009,theaverage

budgetdeficitintheG7countriesreached10percentofGDPfivetimeshigher

thanin2007anditisexpectedtoremainclosetothatin2010(seechart1).

And government debt exceeded 100 percent o GDP on average across the

G7countriesin2009(seechart2).Againstthisbackground,therecentG20

summit meeting eatured a commitment by the participating countries to halve

budget deicits over three years.

Chart 1: G7 Budget deficit

1ThetermindustrializedeconomiesinthisreportreferstotheUS,Canada,Australia,thewestEuropeaneconomiesand

Japan


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Chart 2: G7 Government debt ratio

1950 1958 1974 1982 1990 1998 20061966

140

120

100

80

60

40

0

20


G7 Governmentdebt/GDP ratio

% of GDP

Widening deicits resulted in part rom government stimulus eorts in the ace

ofweakeninggrowthandthecostoffinancialsectorsupport.Butcompelling

strategies to achieve deicit recovery without undermining the recovery are a

priority because the conclusion o stimulus packages and a return to economic

growth will not be suicient to restore the public inances. The average structural

primary deicit (i.e. adjusted or the eects o the economic cycle and netting out

interest costs) is expected by the International Monetary Fund (IMF) to be

overfivepercentofGDPintheG7thisyear 2, with especially large deicits in the

US,JapanandtheUK(seechart3).TheBankforInternationalSettlements(BIS)

estimates suggest that, on unchanged policies, debt/GDP ratios could rise to

150200percentofGDPintheG7countriesoverthenext10years,andover300 percent in Japan.3

2IMFTheStateofPublicFinancesCross-CountryFiscalMonitor:November2009IMF Staff Position Note,November20093Cecchetti,S,Mohanty,M&Zampolli,FTheFutureofpublicdebt:prospectsandimplicationsBISWorkingPapers

No. 300, 2010


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Further rises in debt levels pose considerable risks in the broader political and

socio-economic landscape, as clearly demonstrated by the iscal crisis in the

Eurozone. Rising costs o inancing government debt not only exacerbate the

iscal challenge acing governments, they also have adverse impacts on economic

growth. It is particularly worrying that an increasing number o industrialized

economiesnowhavegovernmentdebtoverorapproachingthe90percentof

GDP threshold, beyond which research by Reinhart and Rogo suggests there

is a risk o a marked downward eect on GDP growth.4

To reduce the debt/GDP ratio to 60 percent by 2030, the IMF estimates theG20 countries would, on average, need to improve their structural primary budget

balances by over nine percent o GDP rom 2010 20 and then maintain this

improvement or a urther decade. Even just stabilizing the debt/GDP ratio at the

2014 projected level which is still expected to be very high in many cases

would require an improvement in the budget balance o over our percent o GDP.5

Chart 3: World Budget deficit 2010F GDP by country

0 2 4 6 8 10 12 14

Source: IMFNote: Primary deficit is deficit excluding interest payments

Primary budget deficit

Total budget deficit

% of GDP

G-20 advanced

US

UK

Sweden

Spain

Portugal

Japan

Italy

Ireland

Greece

Germany

France

Canada

Belgium

Australia

4Reinhart,C&Rogoff,KGrowthinatimeofdebtAmerican Economic Review Papers & Proceedings,December20095IMFop.cit.(2009)


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Moreover, the challenge acing governments is even greater than headline debt

and deicit igures imply. Spending on pensions and health is expected to have to

rise a urther ive percent o GDP by 2030 in the advanced G20 economies (see

chart 4), as populations age.6Also,OECDestimatessuggestthatUS$3.7trillion

will be needed over the next 20 years to upgrade inrastructure across the

OECD countries.7

Chart 4: World age-related spending pressures

Source: IMF

Projected rise in spending to 2030, % of GDP

-2 0 2 4 6 8

G-20 advanced

US

UK

Sweden

Spain

Portugal

Japan

Italy

Ireland

Greece

Germany

France

Canada

Belgium

Australia

Pensions

Health

The analysis above makes clear the scale o the deicit recovery challenge acing

governments, and also the importance o designing credible and comprehensive

strategies to meet it. The next section draws on lessons rom past iscal turnarounds

in order to help elaborate how such deicit recovery strategies could be structured.

6IMFop.cit.(2009)7OECD Infrastructure to 2030


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Change in structural primary

balance, % of GDP

Time to complete adjustment

(years)

Ireland 1989 20.0 11

Sweden 2000 13.3 7

Finland 2000 13.3 7

Denmark 1986 12.3 4

Israel 1983 11.1 3

Belgium 1998 11.1 15

Canada 1999 10.4 14

Cyprus 2007 8.5 4

UK 2000 8.3 7

Japan 1990 8.1 12

Portugal 1985 7.5 4

Netherlands 2000 6.3 10

Australia 1988 5.8 4

Lessons rom previous iscaladjustments

Although the scale o the necessary budgetary adjustment appears daunting,

it is not unprecedented. Large debt/GDP ratios were cut rapidly in the period ater

WorldWarII(thanksinparttothePeaceDividend),andoverthelastfourdecades the IMF has identiied around twenty cases o advanced economies

improving their structural primary balances by more than ive percent o GDP

and nine cases o improvements exceeding 10 percent o GDP (see Table 1).

Table 1: Notable previous fiscal adjustments

Source:IMFTheStateofPublicFinancesCrossCountryFiscalMonitor(2009)

Note: Year next to country indicates inal year o adjustment


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Agreatdealofevidenceexistsonwhatmightbetermedleadingpractice

approaches to reducing budget deicits, based on cross-country empirical studies

and individual country eorts. These studies, combined with the key lessons rom

previous periods o large-scale adjustment in countries like Sweden, Canada and

Ireland (see Appendix 1), suggest eight key lessons:

1) A crisis can be an opportunity to challenge fiscal taboos.

Crisis conditions can create the opportunity to challenge long-standing iscal

taboos.Thiswastheexperienceofsuccessfullyadjustingcountriesinthe1980sand1990ssuchasIrelandandSweden,whichwereforcedbycircumstancesto

radically re-evaluate the priorities o the public sector and tackle previously

politically diicult areas including pension reorm.

2) Healthy growth is possible while achieving fiscal adjustment.

Successul iscal turnarounds in countries like Ireland, Canada, and the Nordic

countriesinthe1980sand1990s,wereachievedwhilemaintaininghealthy

growth (see chart 5). Repeating this will be more challenging now, however, given

the scale o public deicits and the need or simultaneous retrenchment across

almost all major economies. Only China among the major economies, has a

suiciently robust iscal position to act as a sustained support or global demand.

There is a risk that simultaneous iscal adjustment across the major economies

could damage global growth and reduce the scope or a cyclical recovery in

government revenues.

Chart 5: Growth during successful fiscal adjustments

Ireland

1987 1989

Sweden

1994 1998

Finland

1996 2000

Denmark

1983 1986

Canada

1994 1997

12

10

8

6

4

2

0


GDP Investment Consumption

% year, average


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3) Build a political and social consensus around the need for adjustment.

As well as acilitating the necessary tax and spending measures to restore public

inances, building a broad social and political consensus around the need or

adjustment can result in other agreements (e.g. wage moderation in both the

public and private sectors) which help to mitigate the economic impact o

retrenchment.

4) Choose decisive cuts over gradual fiscal strategies.

Gradual spending cuts tend to be inerior to decisive, ront-loaded ones becausethey can run out o steam in the ace o social and political opposition.8 In

addition,theydonotdeliverthepositiveshocktoconsumerandbusiness

confidencewhichcanbeexperiencedinadecisiveadjustment.Byprolonging

uncertainty about uture tax levels, they can induce higher precautionary saving

by the private sector.

5) Focus fiscal strategy on spending cuts rather than tax increases.

Historically, most successul iscal turnarounds have ocused on the spending

rather than the revenue side. Examples o successul spending-driven adjust-

mentsincludeIrelandinthelate1980s,andSwedenandCanadainthemid-

1990s.Thereisalsoevidencethatexpenditure-drivenadjustmentsaremorebenign in terms o their eects on growth and in the right conditions such

adjustments can actually be expansionary. This latter eect comes as a result

o deicit reductions improving business and consumer conidence, reducing

interest rates by lowering risk premiums (thus boosting interest-sensitive private

spending), raising asset prices and in some cases weakening the exchange rate. 9

In addition, cuts to public sector jobs and wages can help hold down unit labor

costs in the wider economy, boosting corporate competitiveness. Examination

o past successul spending-driven adjustment experiences suggests particularly

strong positive eects on private investment, resulting rom reduced interest

rates and improved business expectations.

8SeeAlesina,A&Perotti,RFiscaladjustmentsinOECDcountries:MacroeconomicEffectsNBERWorkingPaper5730,19969SeeAlesina,A&Ardagna,SLargechangesinfiscalpolicy:taxesversusspendingTaxPolicy&theEconomy,2010,and

Alesina,A&Perotti,Rop.cit.(1996)


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Bycontrast,tax-drivenadjustmentshavetendedtohaveamoredepressiveimpact

on growth, raising the chances o ultimate ailure. The Organisation or Economic

Co-operation and Development (OECD) reports that successul iscal consolidations

have typically been comprised o around 80 percent spending cuts and 20 percent

tax increases.10 In the industrialized economies, where pre-existing tax burdens

were oten relatively high, the risks to growth associated with a tax-driven approach

are likely to be especially signiicant. In the words o a senior UK policymaker,

Fiscal tightening should not be a business burden.

6) Concentrate on cutting current spending not capital spending.

Past experience o successul adjustments suggests governments should

aim to concentrate spending cuts on current government spending; transers,

social security and government wages and employment. One advantage o

concentrating on areas like government wages and welare programs (including

pensions)isthatitmeansattackingtheareaswhichhavethestrongestnatural

tendency to increase.

Tackling these areas, which account on average or around two-thirds o

government spending in the industrialized economies,11 also increases the

chances a iscal adjustment will prove durable, and be seen as such by inancial

markets and the domestic private sector. Reorms that reduce long-term costsin areas like health and pensions could be especially useul given the pressures

in these areas (e.g. rom aging populations). Successul iscal turnarounds in

Canada, Ireland, Finland and Sweden were mostly based on cuts to current

spending(seechart6)andAlesina&Perottis1996studyofabroadersampleof

successul adjustments over the last our decades inds 60 percent o spending

cuts were in current spending.12

10OECDPreparingFiscalConsolidation,201011See Appendix 2, Table 312Alesina&Perotti,op.cit.(1996)


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Chart 6: Structure of successful adjustments

Finland

1996 2000

Sweden

1994 1998

Ireland

1987 1989

Denmark

1983 1986

Canada

1994 1997

12

10

8

6

4

2

0

14


Improvement in structural deficit

% of GDP

Reduction in current spending

Bycontrast,cuttinggovernmentinvestment,oftenarelativelyeasyoption(e.g. by postponing/canceling large projects) is less optimal. It can have a negative

impact on growth, reducing revenues and undermining attempts at adjustment.

Cuts to public investment may also be unsustainable and can only tackle the

deicit problem to a limited extent as government capital spending accounts or

an average o only two percent o GDP in the advanced G20 countries. 13 More

generally, spending cuts with a permanent lavor (e.g. welare cuts obtained by

changesineligibilityrules)arepreferabletoone-offmeasures,eveniftheinitial

magnitude o adjustments is similar.

7) Structure tax increases in ways that minimize growth risks.

Tax increases have also played important parts in past deicit recovery eorts.Although they risk damaging growth through reducing incentives to work and

harming business and consumer conidence, they can also have a beneicial

eect in the right circumstances or example i they help reduce the perceived

risk o bigger and more disruptive tax rises later.

ThesuccessfulDanishfiscaladjustmentof198386isoneexampleofa

program that had a substantial tax-raising element. The International Monetary

Fund(IMF)hasidentified29episodesoverthelast30yearswhererevenuesrose

more than three percent o GDP or two consecutive years, o which 14 episodes

saw this gain maintained or a decade.14 Four o these latter episodes involved

natural resource taxes, however, and others relied on comprehensive tax reorms

including the introduction o VAT.

13SeeAppendix2,Table3basedonIMFop.cit.(2009)14IMFFromStimulustoConsolidation:RevenueandExpenditurePoliciesinAdvancedandEmergingEconomies2010


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OECD research suggests taxes on corporate and personal income are most

damaging or growth, with taxes on immovable property the least damaging.15

SuccessfuladjustmentsstudiedbyAlesina&Perotti(1996)alsotendedtofeature

a low share o tax rises on households and low social security tax rises. 16 Within

income taxes, there is, however, also scope or action which is relatively benign

or growth. For example, some countries allow substantial deductions or items

such as mortgage interest (e.g. the US and the Netherlands) which arguably have

a distorting eect on those markets.

The IMF estimates substantial extra revenues can be raised rom indirect taxes intheG7economies,worth46percentofGDP.Afurther0.51percentofGDP

could come rom higher carbon taxes (see Annex 3).17

8) Fiscal Rules have a mixed record.

Fiscalrulesaimtobindgovernmentsintoresponsiblefuturebudgetarypolicies

and secure iscal sustainability through caps on the size o deicits, spending or

bond issuance, mandated by statute or in some cases constitutional amendment.

AnIMFstudyoffiscaladjustmentepisodessince1980,arguesthatadjust-ments

in countries with rules were on average larger and more ront-loaded than in

those without. The OECD has also argued that rules can aid iscal adjustment

eorts.18

One senior German public officialreers to good iscal rules as, Thealpha and omega o successul long-term policymaking and aformer senior

US policymakeralso sees statutory spending controls as, The only way to

contain elected oicials.

The eectiveness o such rules is nevertheless controversial and the case or

them has been damaged by recent events. In particular, iscal rules in the

Eurozone (the Stability and Growth Pact) and the UK (the Code or Fiscal Stability)

ailed to prevent either the build up o large structural deicits prior to the onset o

the global recession or the massive rises in deicits seen since.

Atypicalproblemisthatsuchruleshaveget-outclausesthatallowthemtobe

circumvented relatively easily in diicult times. As such, iscal rules seem unlikely

to directly rein in government behavior unless they are very rigid, in which case

political opposition to their introduction is likely to be very strong. Fiscal rules are

morelikelytoworkbyraisingthereputationalcosttogovernmentofdiverging

rom a sustainable iscal policy. This appears to be the thinking behind the new

OfficeforBudgetResponsibilityintheUK,whichwillproduceindependent

orecasts o growth and iscal trends.19

15Heady,C,Johansson,A,Arnold,J,Brys,B&VartiaLTaxationandEconomicGrowthOECD Economics Department

No. 620, 200816Alesina&Perotti,op.cit.(1996)17IMFop.cit.(2009)18IMFop.cit.(2010),OECDFiscalsustainability:thecontributionofrulesinOECDEconomicOutlookNo.72,200219SeeUKOfficeofBudgetResponsibility,TermsofReference,June2010

Working Papers


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Moving towards iscalsustainability

The previous section laid out some important lessons based on previous

experience, which should be considered in designing a deicit recovery strategy.

In addition, a number o other issues need to be considered by policymakers

acing the challenge o reining in large iscal deicits and achieving iscal

sustainability:

Inflationofferslittlescopetoreducedeficits.

An alternative approach sometimes suggested or reducing government

indebtedness is allowing inlation to rise signiicantly. In the right conditions

(e.g. when the average debt maturity is long and debt is largely in domestic

currency), this approach can cut the debt/GDP ratio. However, in current

circumstances this approach looks to be a non-starter. The IMF estimates that

raising inlation to six percent per annum or ive years would erode less than

a quarter o the rise in the debt ratio which it projects or the G20 economies

up to 2014.20

There are other drawbacks. I a country has a short average debt maturity,

attempts to erode the debt burden by inlation will be ineective as interest

payments will tend to rise sharply. Among the G20 this approach would be

especially challenging or the US, with an average debt maturity o just our years.

Attempting to engineer a sustained high inlation could also prove diicult giventhe institutional context (i.e. the existence o legislatively or constitutionally

protected independent central banks). Finally, such an inlationary period would

eventually have to be brought to an end, a process that would entail substantial

outputcoststhelessonofthe1970sandearly1980s.

Monetarypolicyoflimitedusetooffsetthegrowthimpactsoffiscal

tightening.

Fiscal adjustment eorts in the past have been helped by aggressive use o

monetary and exchange rate policy to cushion the negative eects on growth.

A problem aced by governments today, however, is that typically there is very

little room or monetary policy to loosen urther oicial interest rates in mostmajor economies are already at record lows. For the economies in the Eurozone,

exchange rate adjustment is also not an option. Regardless, with sizeable iscal

retrenchment required in almost all countries, currency depreciation is not

possible or all.

Taxmeasureswillneedtoreflectcountry-specificfeatures.

Looking at the structure o government revenues in the industrialized economies,

there is considerable variance, implying that dierent countries may have to take

dierent approaches to increasing taxation. The share o income taxes in GDP is

generally quite high, averaging nine percent and much higher in some countries

such as Canada and the Scandinavian states. Exceptions include Japan and Greece,

where revenues are well below average, suggesting scope or increases. Social

security taxes are also relatively high at 10 percent o GDP, while corporate tax

20IMFop.cit.(2009)


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Re-engineering government

The scale o the iscal adjustment needed in the industrialized economies

raisesseriousquestionsaboutwhetherconventionaltaxandspending

changes will be enough to eectively address the deicit problem. Do the

authorities need to go further and consider a radical re-engineering of

government?

Thereisacertainamountoflowhangingfruitintheareaofdeficitrecovery.

Governments can move quickly to halt capital spending projects, impose wage

freezesonpublicservantsorshedmarginalpublicsectorheadcount.Butsomeof

these approaches are only temporary in nature or could prove unsustainable beyondthe short-term.Bycontrast,there-engineeringagendafocusesontransforming

the delivery o public services in a way that can reduce the uture burden on the

government budget and yield signiicant eiciency gains.

In this section, we examine this question by drawing on the results o a series

o roundtables, expert panels and interviews with public sector oicials and

representatives to provide additional insights.

The re-engineering agenda encompasses a number o components:

Efficiencyandproductivitygains

The problem o rising long-term costs in key areas o spending partly relectspoor productivity perormance in the public sector. For example, in the UK, public

sectorproductivityactuallyfellin19972007by0.3percent(seechart7)per

annum while private service sector productivity rose two percent per annum.22

Paul Kirby, Partner at KPMG in the UK, notes that Had public sector productivity

grown at even hal the pace seen in the private sector, public spending could

have been lowered by as much as 30 billion or two percent o GDP.

Developing a culture of cost control is also important. In Canada, a senior

public servantnotes that, The burden o eiciency savings in coming years will

be placed on individual departments, which will have to identiy ive percent o

their programs that are currently under-perorming and should be reviewed or

scrapped.

The same senior Canadian oicial also sees considerable scope or strategic

transormation in areas such as consolidating unctions such as human resources,

inance and data collection as well as back oice and administrative sta. In his

view, Canada has too many service delivery networks that could be consolidated

relatively easily. This kind of focus on control of overhead costs is common

in the private sector and needs to be rolled out in the public sector as well.

A senior UK policymakersuggests, Public sector managers should be given the

target o achieving the same level o service or unchanged cash budgets

implying a signiicant squeeze over time.

22Reorm Public Sector Productivity brieing note, April 2010


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Chart 7: UK public and private sector productivity

4

3

2

1

0

-1

-2


Public sector

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Private sector

% year

Paul Kirby of KPMG in the UK,furtherarguesthatWeareenteringtheageof

the unit cost. He suggests that examination o a number o public sector areas

in the UK reveals substantial variations in cost perormance across dierent units,

with the top 25 percent o units having costs 20 25 percent lower than average.

Kirbyurther notes that plans are aoot in the UK health sector to set payments

to hospitals or acute treatment at the level o the top perorming 25 percent

rather than the average. This could cut 11 12 billion from the 40 billion

annual care cost. This kind o unit-cost based analysis also could be rolled out

across other parts o the public sector.

Rethinkingtheroleofgovernment

According to a former senior US policymaker, Most o the existing US Federal

government programs are based on conditions that existed 50 years ago. The

same observation can be made o other industrialized economies. The role o

government needs to be reassessed and re-ocused, with the emphasis on

makingitfuture-focusedandresults-oriented.Paul Kirby of KPMG in the UK

echoesthesepoints,pointingtotheneedto,Shiftfromtraditionalpublicsector

budgeting to payment o public sector bodies on the basis o results.

As part o the process o re-ocusing government, Paul Kirbyargues that,

Private involvement may need to go deeper into the heart o government.

Thiscouldinvolveaswitchfromaprovidingstatetoanenablingstate

which helps und but does not directly provide services. Private sector

involvementintheprovisionofservicescouldgobeyondtraditionalareas

to encompass activities such as registration and licensing, and the ownership

or management o schools.


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Developingnewrevenuestreams

Raising substantial additional revenues may require governments to look or new

revenue sources. Possible target areas include energy, environmental taxes, land

value taxes or national resource taxes such as those being contemplated in some

resource-rich countries. Also worthy o consideration are increased co-payments or

publicservicesorchargingforpreviouslyfreeitemssuchasroaduse.

Empoweringpublicserviceprovidersandreceivers

Existingpublicsectormanagementsandworkforcescouldproveanobstacle to radical reforms, but this problem could be sidestepped by

making empowerment of service providers part of the reform package.

Devolution o operational decision-making to public sector managers and workers

canbepartofthereform,aswellasmoreradicallyshiftingtheownershipof

services, or example by creating employee co-ops and giving well-perorming

units the possibility to expand. As well as helping service providers buy into the

reorm process by giving them a stake in successul outcomes, this process

could help develop a culture o continuous improvement in the public sector

and get away rom a situation where, in the words o asenior US public official,

Muchofthepublicsectorcurrentlyhasnoincentivetosavemoney.

Putting the recipients of public services in charge of their own dedicatedbudgets could yield substantial savings. For example, in the UK social care

sector, Paul Kirbystates that one pound in every three o the 12 billion budget

is spent on deciding internally in government how to spend the other two. Giving

individuals their own budget to spend as they see it could thus eliminate a large

portion o current spending.

Infrastructureprivatization

KPMGs John Herhalt of KPMG in Canada, emphasizes the signiicant opportunities

in the sphere o inrastructure privatization, Investment requirements in the

decades ahead are substantial. In the transport sector, congestion charges, toll

roads and contracts to build, operate and maintain highways have all been usedin recent years. Private involvement in the highway network is substantial in a

number o European countries (see chart 8), and has in part been driven by

financialpressuresongovernment.Bycontrast,intheUKandGermany,private

sector involvement in this area is very modest. The potential sums involved are

large for the UK, it is estimated that privatization of the motorway

network could raise 100 billion.23 Involving the private sector more in

inrastructure also meets a growing demand or access to the stable revenue

streams inrastructure assets can generate.

23SundayTimes,London,UK,August30,2009.


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Chart8:PrivatesectorinvolvementinEuropeanhighways

90

50

60

70

80

40

30

20

10

0

Source: Albalte, Bel & Fageda, Oxford Economics

Portugal France Italy Spain UK Finland Denmark Netherlands Germany

% of motorway network run under private concession, 2004

Radical transormational change in the public sector aces practical barriers. As

a senior German public officialstates, A radical rethinking and reshaping o the

public sector is unlikely at the political level. Implementing incremental changes

in the right areas is probably the only way to get it done. Many iscal adjustments

are, in the words o Alan Downey of KPMG in the UK, Managerially easy, but

politically hard, such as curbing welare spending. Improving public service

productivityisbycontrastpoliticallyeasybutmanageriallyhard.Successful

outsourcing or public-private contracts can be hard to manage and the public

sector may lack the skills and competencies needed to design and deliver radical

changes so these skills and competencies need to be embedded to ensure

success.

Creating an environment where competitive or managerial structures exist that

will drive continuous improvements in productivity may also take time and

involve substantial set-up costs. As a result, governments may have to ride

two horses at once,engaginginsignificantconventionalfiscaladjustments

while also laying the oundations or a step-change in uture productivity

perormance in the public sector which will support the public inances in the

medium-term. In the opinion o a former seniorUS policymaker, the long-term

re-engineering o government needs to be a separate process [to conventional

deicit reduction] run by respected and non-government igures with experience

in transorming organizations.


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Conclusion

The problem o large budget deicits and rising debt levels is widespread among

industrialized economies, although problems are clearly more severe in some

countries than others. In many cases, governments ace a dual challenge: cutting

expenses and raising revenues in the near-term, and tackling the rising pressures

rom age-related spending and the need or inrastructure investment in the

long-term while laying the oundation or iscal sustainability.

Examination o historical episodes in deicit recovery conirms that large

adjustments can be made, and i well-structured, need not be harmul to

economic growth. Successul adjustment eorts have generally ocused on theexpenditure-side, but tax increases probably need to be part o the package

too. Large increases in revenue may be hard to achieve without signiicant tax

reorms, or tapping new streams o revenues. The picture varies across dierent

countries and each will need to consider its individual circumstances in designing

recovery strategies.

In many cases, conventional tax and spending measures may not be enough to

ensuremedium-termfiscalsustainability,andgovernmentsmayhavetoridetwo

horses at once, squeezing budgets today while also putting in place plans to

re-engineer the public sector in order to support the public inances in the

medium-term.

This involves pursuing options including orcing up productivity growth in

the public sector, taking private sector involvement deeper into the heart o

government activity, and exploring new opportunities in areas like inrastructure

privatization.

Thepoliticalchallengeofsellingtheneedformajorfiscalcutbacksissignificant,as

is the practical challenge o designing and carrying through radical transormational

changeinpublicservices.Butthecurrentatmosphereofdeepconcernoverthe

trajectory o public inances may provide the opportunity to cut through traditional

political and social taboos in the iscal sphere in order to make a real dierence.


25/32



Appendix 1 Case studies in deicit reduction

Ireland(198789)

Irelandhadaseriousfiscalproblematthestartofthe1980s,withadouble-digit

deicit/GDP ratio and a steeply rising debt/GDP ratio which reached 120 percent

in1987.Thesefiscalproblemsweighedheavilyongrowth,whichaveragedonly

1.5percentofGDPfrom198087 24 despite a avourable global backdrop. Also

contributing to this weak growth was a ailed attempt at iscal adjustment in the

early1980swhichfocusedontherevenuesideandhadsignificantcontractionary

eects on domestic demand.

In1987,anewadjustmentprogrambeganbasedonexpenditure-sidemeasures.This program improved the structural primary balance by ive percent o GDP

over198789,withthewholeimprovementduetoreductionsincurrent

primary spending. Cuts ocused on transer payments, government consumption,

and government wages, with only education excluded. Government employment

fell10percentfrom198689.Thedebt/GDPratiofellsharplyto90percent

o GDP ater ive years, and despite the spending cuts, GDP growth averaged

ive percent per annum, well above the OECD average.25 This was helped by

substantial exchange rate depreciation.

The Irish experience yields a number o lessons. The irst is that it may take a

crisis to orce governments into taking the necessary measures. The emphasis o

the198789programonspendingcutswastheresultofthefailureofprevious

eorts and growing problems o raising inancing in bond markets. The Irish

experience also shows the value o building political and social consensus. A key

eature o the programs success was that wage moderation was achieved via an

agreement between government and unions. This helped bring down labor costs

and boost investment and exports.

Sweden(199498)

Intheearly1990s,Swedensufferedacollapseintherealestatemarket,a

banking crisis and a deep recession, all o which let the public inances in a poor

state. With international conidence in the Swedish economy at an all time low,

the authorities were orced into a severe iscal adjustment which proved

remarkablysuccessfulturningabudgetdeficitof11percentofGDPin1993

intoasurplusofonepercentofGDPby1998.Thedebt/GDPratio,whichhad

risensteeplyintheprecedingyears,wasstabilizedataround70percent.

The Swedish adjustment was heavily weighted to the expenditure-side, with over

80 percent o the improvement in the deicit coming rom spending reductions.

CurrentspendingfellbyalmostninepercentofGDPfrom199498, 26 driven by

a large reduction in social transer payments linked to greatly tightened eligibility

criteria.

24Alesina&Perottiop.cit.(1996)25Alesina&Perottiop.cit.(1996)26Alesina&Perottiop.cit.(1996)


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Despite the scale o the adjustment, GDP growth averaged over three percent in

199498,27 above the OECD average. Exports and investment both perormed

very well, as a result o a weaker exchange rate but also because the iscal

adjustment appears to have boosted private sector activity by bringing down

interest rates and raising business and consumer conidence.

The Swedish experience once again suggests that crisis conditions can be the

catalyst or major breakthroughs in policy terms. The adjustment program tackled

head on the high-level o social spending that had been a eature o the country

and a politically sensitive area.

Canada(199497)

Canadasbudgetaryproblemsbecamesteadilyworseinthe1980sandearly1990s,

withthedeficitreaching9.2percentofGDPby1992. 28 A series o revenue-based

attemptstocontrolthedeficitfailedbeforeasuccessfuladjustmentbeganin1994

undertheleadershipofanewLiberalgovernmentelectedattheendof1993,

which ran explicitly on a ticket emphasising iscal reorm.

From199597thestructuralprimarydeficitimprovedbyoversixpercentof

GDP,withthebudgetbalancemovingintosurplusby1997.Onceagainthiswas

largely the result o expenditure-side measures, which accounted or around

80 percent o the improvement. Federal departmental budgets were cut back by

20 percent on average over our years. However, government investment was

protected, alling by only 0.5 percent o GDP. There was a large cut o 23 percent

in public sector employment, but despite this, overall employment rose. GDP

growth at 3.4 percent per annum was above the OECD average or the period.29

Like Ireland and Sweden, the growth perormance during adjustment was

helpedbyexchangeratedepreciation.Butanotherimportantfactorwasthatthe

adjustment program helped keep unit labor costs in the broader economy under

control, boosting corporate proitability and investment another example

ofthecrowdinginofprivatesectoractivity.TheCanadianexperienceagain

demonstrates that a suiciently negative starting point can allow the political

space or radical measures to be undertaken.

ItalyandArgentina

In contrast to the above examples, it is also worth noting some examples o

ailed adjustments. Italyin198993sawanattemptedadjustmentbased

on tax rises, which led to low growth and a collapse in private investment.

Thedebt/GDPratiocontinuedtoriseuntil1994,whenaprogramofspending

cuts was introduced. More dramatically, Argentina saw a series o revenue-led

attemptsatfiscaladjustmentin19992001failtostick, 30 draining market

credibility and contributing to the major debt deault at the start o 2002.

27OECD op. cit. 201028Alesina & Perotti op.cit. (2010)29Alesina & Perotti op.cit. (2010), OECD op. cit. (2010)30OECD op. cit. (2010)


27/32



Appendix 2 Detailed tables

Table 1: Debt and required fiscal adjustment in G-20 advanced economies

Gross debt,

% of GDP 2010F

Structural primary balance,

% of GDP 2010

Required adjustment for debt

sustainability 2010 2020

Australia 20 -4.6 5.2

Belgium 100 -1.1 4.7

Canada 83 -2.2 4.4

Denmark 51 -3.1 4.3

France 84 -4.6 8.3

Germany 77 -1.6 4.0

Greece 133 -2.4 9.2Ireland 79 -6.0 9.8

Italy 119 0.9 4.1

Japan 227 -6.5 13.1

Netherlands 64 -3.4 5.5

Spain 67 -5.8 9.4

Sweden 43 -1.6 2.3

UK 78 -5.4 9.0

US 93 -7.6 12.0

G-20 advanced 104 -5.3 9.3

Source:IMF,TheStateofPublicFinancesCross-CountryFiscalMonitor:November2009IMFStaffPositionNote,November2009

Table2:Industrializedeconomiesgrossfinancingneeds2010Maturing

debt

Budget

balance

Gross financing

need

Average debt

maturity (yrs)

Australia 2.0 -5.0 7.0 4.8

Belgium 20.8 -5.1 25.9 5.4

Canada 15.9 -5.3 21.2 5.6

France 16.9 -8.2 25.1 6.5

Germany 10.2 -5.7 15.9 6.0

Greece 13.4 -8.1 21.5 7.4

Ireland 7.7 -12.2 19.9 6.7

Italy 21.2 -5.2 26.4 6.7

Japan 54.2 -9.8 64.0 5.2

Portugal 13.0 -8.8 21.8 6.2Spain 10.3 -10.4 20.7 6.7

Sweden 6.8 -3.3 10.1 6.0

UK 8.6 -11.4 20.0 12.8

US 21.2 -11.0 32.2 4.4

Source:IMFFromStimulustoConsolidation:RevenueandExpenditurePoliciesinAdvancedandEmergingEconomies2010

Note: Column 3 is sum o columns 1 & 2.


28/32



Table 3: Structure of industrialized country public spending 2007 2008

% of GDP

Public

spending

Employee

compensation

Social

benefits

Capital

spending

Other

spending

Australia 30.4 8.8 9.6 2.6 9.4

Belgium 46.2 12.1 23.3 1.7 9.1

Canada 36.1 11.6 7.5 1.4 15.6

Denmark 50.5 17.3 16.4 1.8 15.0

France 49.9 12.7 23.3 3.2 10.7

Germany 41.0 6.9 24.3 1.5 8.3Greece 43.7 11.5 19.1 2.9 10.2

Ireland 41.0 11.1 13.8 5.3 10.8

Italy 43.6 10.9 20.4 2.2 10.1

Japan 33.5 6.2 17.7 3.6 6.0

Netherlands 43.8 9.1 20.2 3.5 11.0

Spain 39.5 10.8 15.0 3.8 9.9

Sweden 51.3 14.9 18.2 3.3 14.9

UK 45.0 11.0 13.1 2.3 18.6

US 36.1 10.2 12.9 1.0 12.0

G-20 advanced 37.7 9.5 15.2 2.0 11.1


Table 4: Structure of industrialized country public revenues 2007 2008

% of GDP

Total Revenue Income taxes Corporate taxes Social security taxes Indirect taxes Property taxes

Australia 37.1 11.3 7.1 1.5 8.2 2.8

Belgium 48.1 6.2 10.2 13.6 11.0 2.3

Canada 40.5 12.4 3.7 5.5 7.9 3.3

Denmark 55.6 14.8 14.0 1.2 16.4 1.9

France 49.6 7.5 7.5 17.4 10.8 3.5

Germany 43.9 9.1 2.2 13.2 10.6 0.9

Greece 40.0 4.7 2.6 11.7 11.3 1.4

Ireland 35.8 8.7 3.4 4.9 10.9 2.5

Italy 46.9 11.1 3.8 13.0 11.0 2.1

Japan 31.1 5.5 4.8 10.3 4.9 2.6

Netherlands 45.8 7.7 3.3 13.6 11.0 1.2

Spain 41.0 4.6 7.5 12.1 9.5 3.0

Sweden 53.6 14.9 3.8 15.3 12.9 1.2

UK 37.8 10.9 3.4 6.6 10.5 4.5

US 29.9 10.8 3.1 6.6 4.7 3.1

Average 42.4 9.3 5.4 9.8 10.1 2.4



29/32



Table 5: Possible revenue gains from tax increases

Extend

VAT

Tobacco & alcohol

excise

Fuel

excise

Property

tax

VAT

at 10%

Full taxation of

carbon

Total

France 3.8 0.1 0.3 1.0 - 0.2 5.3

Germany 2.4 0.2 0.3 1.0 - 0.6 4.5

Italy 3.1 0.3 0.3 1.0 - 0.5 5.1

Japan 0.3 0.9 0.3 1.0 2.6 0.0 5.0

UK 3.3 0.0 0.2 0.0 - 0.5 4.0

US 0.0 0.3 0.6 0.0 4.5 0.8 6.1


VAT extension reduce current exemptions by hal

Excise taxes tobacco & alcohol excises raised to 2006 average level or the six, where existing level lower

Fuel excise raised by 10 cents per litre

Property taxes raise to average level (as % o GDP) in Canada, US, UK

Carbonbasedonfullauctioningortaxationofcarbonemissionson2007levelsofemission


30/32



Reerences

Albalate,DBel,G&Faged,X

PrivatizationandRegulationofToll

Motorways in Europe Research

InstituteofAppliedEconomics2007

Alesina,A&Ardagna,SLargechanges

in iscal policy: taxes versus spending

Tax Policy & the Economy, 2010

Alesina,A&Perotti,RFiscalexpansions

and adjustments in OECD countries:

EconomicPolicyNo.21,1995

Alesina,A&Perotti,RFiscal

adjustments in OECD countries:

MacroeconomicEffectsNBER

WorkingPaper5730,1996

American Society o Engineers Report

CardforAmericaInfrastructure2009

BundesministeriumderFinanzen

NachhaltigSparenGerectSparen:

DasSparpaketderBundesregierung

2010

CBOBudgetOptionsvol.2

August2009

Cecchetti, S, Mohanty, M & Zampolli,

FTheFutureofpublicdebt:prospects

andimplicationsBISWorkingPapers

No. 300, 2010

CentreforCitiesRegional

Development Agencies: the acts

December2009

Fuest,C&Thne,MErtragsabhngige

undertragsunabhngigeSteuern

University o Cologne July 2008

GAOTheFederalGovernments

Long-Term Fiscal Outlook January 2010

GAOStateandLocalGovernments

Fiscal Outlook March 2010

German Finance Ministry 22nd Report

onSubsidiesforyears20072010

Goldfinch,SEvaluatingPublicSector

Reorm in New Zealand: Have the

beneits been oversold? Asian Journal

ofPublicAdminstrationDecember1998

Hauner, D, Leigh, D & Skaarup, M

Ensuringfiscalsustainabilityin

G7countries, IMF Working Papers

07/187,2007

Heady,C,Johansson,A,Arnold,J,Brys,

B&Vartia,LTaxationandEconomic

Growth OECD Economics Department

Working PapersNo. 620, 2008

Henry Review o Australias Future Tax

System May 2010

IMF Global Financial Stability

Report, April 2010

IMFTheStateofPublicFinances

Cross-Country Fiscal Monitor:

November2009IMF Staff Position

Note,November2009

IMFFromStimulusto

Consolidation: Revenue and

Expenditure Policies in Advanced

and Emerging Economies 2010

IMF Fiscal Monitor May 2010

KPMGUKPaymentforSuccess

How to shit power rom Whitehall to

public service customers

OECDPreparingFiscal

Consolidation, 2010

OECDFiscalsustainability:the

contribution o rules in OECD

Economic OutlookNo.72,2002

OECD Inrastructure to 2030

Reorm Public Sector Productivity

brieing note April 2010

Reinhart,C&Rogoff,KGrowthina

time o debt American Economic

Review Papers & Proceedings,

December2009

TaxPolicyCenterDesperately

Seeking Revenue January 2010


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32/32


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Canada

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meeting the deficit challenge strategies for fiscal sustainability

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