Composition of Fiscal Adjustment Is Critical to Its Long-Term Success

• Pages: 17-25

Page 17

Budget deficits and government debt rose sharply in most industrial countries during the 1980s and early 1990s, posing a potentially serious destabilizing and disruptive threat to the economy. And policymakers, worried about the effects of a cutback in spending on short-term growth, often delayed making the necessary adjustments. Experience over the past several years, however, has demonstrated that strong budget-reducing actions-sufficiently large and properly targeted and timed-can sometimes boost demand and growth, even during the fiscal consolidation.

The ingredients for successful fiscal adjustment are analyzed in two recent IMF Working Papers-An Empirical Analysis of Fiscal Adjustment, by C. John McDermott and Robert F. Wescott; and Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects, by Alberto Alesina and Roberto Perotti.

In their study, McDermott and Wescott use the fiscal expansion and consolidation experiences of the industrial countries during 1970-95 to examine the interplay between fiscal changes and economic performance. Their analysis attempts to find answers to the following questions:

* Can fiscal consolidations be good for growth?

* Does the composition of the fiscal consolidation influence the likelihood of success (where success is defined as putting a country's public-debt-to-GDP ratio on a sustained downward trajectory)?

* Does the world economic environment matter for the success or failure of fiscal consolidation?

Page 24

The widening of fiscal imbalances in industrial countries over the past 25 years, according to McDermott and Wescott, comes from rising government spending that has exceeded economic growth and left revenue growth lagging behind. From 1960 to 1994, the average ratio of tax revenue to GDP in these countries rose to 44 percent from 28 percent, compared with a rise in the ratio of expenditures to GDP to 50 percent from 28 percent. Further rises in taxation would lead not only to distortions but to considerable political resistance. As the authors note, however, whether deficit reduction will raise or lower demand and output and which instruments are best suited to achieving a consolidation that reduces the ratio of debt to GDP are open questions requiring empirical analysis.

For their examination of fiscal adjustment episodes, the authors analyze annual data from 1970 to 1995 for the primary structural (that is, cyclically adjusted) balances of 20...