NUMBER 144 * ED Precis !17 Operations Evaluation Department A Fiscal Management in Adjustment Lending A recent OED study* confirms that goods and services, and indirectly, Patterns of deficit reductions fiscal deficit reduction leads to im- by affecting other macroeconomic proved external balances and eco- variables. Depending on how they Though poor data made country nomic growth. But the process takes are financed, fiscal deficits can lead comparisons difficult, the study sustained, long-term effort, and con- to inflation, distorted interest and found quite a strong correlation tinual vigilance against reversals. exchange rates, current account between central government fiscal Contrary to the view prevailing in the deficits, and poor external credit- balances, GDP growth, and exter- early years of adjustment operations, worthiness. The combination of nal balances. Fiscal adjustment the study suggests thatfiscal misman- these factors can crowd out private proved to be a long-term process, agement, not exogenous shocks, was investment and hurt growth. Fiscal more likely to succeed in regions the principal cause of persistent budget balance is thus central to the suc- and groups with a seven- to eight- deficits. Almost all of the 26 countries cess of adjustment. For this reason, year history in reducing fiscal defi- studied reduced tlheir deficits, mostly fiscal adjustment has formed a ma- cits. Although the average deficit by increasing revenue and, to a lesser jor part of the IMF's and the Bank's of the sample countries actually extent, by lowering capital spending. policy-based assistance. As many increased in the medium term, all Targeted cuts in current expenditures as 250 of the Bank's structural and countries studied (except for the proved more elusive. In recent years, sectoral adjustment loans approved unsuccessful adjusters) reduced however, budget deficits have grown in 1979-94 for 86 countries had fiscal their deficits in the long run. again in several countries, accompa- reform components. nied by rising external debt and a While most countries sustained growing ratio of debt to GDP. To review the Bank's assistance their lower deficits in the most re- for fiscal management, OED exam- cent period, significant reversals The study concludes thatfiscal mea- ined 134 completed and ongoing have occurred, particularly in Af- sures were not strong enough to sus- adjustment loans in 26 countries rica among low-income adjusters, tain solvency in many client countries with a long history of fiscal adjust- the severely indebted, and pri- for several reasons: (1) failure to ad- ment. The sample spanned five re- mary exporters. (See figure.) What dress the role of the state, a role critical gions and covered 59 percent of is more, deficits continue well in determining the level of publicfi- adjustment loans with fiscal reform above 3 percent of GDP in the nances; (2) treatment offiscal issues conditions. The study looked at the sample as a whole and in almost separately from other macroeconomic fiscal record of each country at four all country groups. And the aver- reforms; (3) scant attention to issues stages: four years before the first age ratio of external debt to GDP of fiscal deficit coverage, measurement, adjustment loan, the medium term (a traditional indicator of credit- and sustainability; and (4) condition- (four years following approval of worthiness) increased from 37 per- ality that was too soft, ambiguous, the first loan), the long term (five cent in the preloan period to about or inconsistent across loans to the to eight years following the first 64 percent in the most recent pe- same country. loan), and the two most recent years. The countries were grouped Why fiscal adjustment? by region, portfolio characteristics *Fiscal Management in Adjust- (OED ratings of country macroeco- ment Lending, A World Bank Management of the government nomic performance and frequency Operations Evaluation Study, by budget influences private economic of adjustment operations), and eco- Jayati Datta-Mitra, forthcoming. decisions both directly, through nomic traits (level of indebtedness, Precis written by Farah Ebrahimi, taxation and the pricing of public income, and type of exports). How were deficits reduced? Change in fiscal deficits by region and countnv group How countries address their fis- 9 cal deficit problems-with tax in- 8 creases, expenditure cuts, or a 7 combination-matters because the choice affects incentives to save, 6 s s o | d invest, and produce. Fiscal adjust- ments were not sustained in coun- 4 l ] | | | 11 tries that reduced their deficits .E 3 through short run shifts in revenue z 2 ] | | | | ] ] | | ll or expenditure. Over the long term I 1 [ | s | 1l i1 1 1 | | I | | 11 and during the most recent period, O Ir tr - l Iff f ~ Ir 11 __ s _ fiscal improvements were achieved 1I primarily through revenue in- -2 creases. All regions and country -3 groups except the Middle East and ;AFR EAP LAC NIN3- §AS lI FR SAS '1.FR EA.P LAC SASI AFR LAC NINA jAFR LACj North Africa and middle-income I Riali:'ajiee L't. .u,onte Unica-hdt Sever¸iwo1ebt,d Prninanm countries increased current expen- ; ditures, and all groups except East ;li Medium term * Long tenr * N1ost recent h%o sveals Asia and the Pacific pruned capital expenditures relative to the preloan - - - - __ __ __ period. Targeted reductions in cur- rent expenditures, while considered riod, signaling reduced creditwor- vency in many countries. The rea- necessary in many cases, proved thiness. Given the persistence of sons for the limited success of fis- elusive. Countries with worsening high deficits, financial solvency cal adjustment were as follows: fiscal deficits generally increased and sustainability of fiscal adjust- current expenditures without in- ment continue to pose serious con- * Most operations paid little at- creasing revenue. cerns for a range of countries. tention to the role of the public sector (a critical factor determining How was revenue increased? What were the constraints on the level of public finances), or to fiscal adjustment? the coverage and measurement of Although Bank conditions calling the deficit. specifically for increases in tax rates Fiscal mismanagement, not ex- were rare, the ratio of tax revenue ogenous shocks, was the source of * The sustainability of deficits to GDP rose in 17 (65 percent) of the persistently high deficits. For was also ignored, and planners the 26 countries that adopted rev- example, except among primary tended to ignore the relationship enue reform. Tax reforms sup- exporters in Africa, there was little between fiscal deficits (and the in- ported by the Bank followed best evidence of a link between declines struments for reducing them) and practices specified in the Bank's in terms of trade and fiscal prob- the other macroeconomic variables 1991 policy paper Lessons of Tax Re- lems. In Latin America and the and structural reforms underway form: Loan conditions aimed to Caribbean and South Asia, fiscal or planned. broaden tax bases and make tax deficits fell as a percentage of GDP systems simpler, more efficient, despite deteriorating terms of * The complex issues related to and easier to administer. The shifts trade. Similarly, long-term foreign budgetary process reform were in tax structure that followed were interest payments-which at 1.5 handled through an ad hoc rather generally consistent with reform percent to 3 percent of GDP were than an integrated approach (for objectives. In 26 countries that clearly burdensome-did not un- example, combining mechanisms adopted tax reforms, overall reli- equivocally constrain fiscal adjust- for enforcing budgetary discipline, ance on trade taxes diminished, ment. In fact, several country setting strategic priorities, build- from 27 to 25 percent, while reli- groups were able to reduce their ing technical efficiency, and ensur- ance on domestic indirect taxes deficits despite high foreign inter- ing transparency through periodic increased, from 41 to 43 percent. est obligations. budgetary reporting). Weaknesses in tax administration Nevertheless, the growing ratio * The Bank's loan conditions partly explain why revenues fell in of external debt to GDP across were inconsistent across loans to some countries (Bulgaria, C6te most regions indicates that im- the same country or too vague and d'Ivoire, Hungary, Senegal, Ven- provements in fiscal management general, making implementation ezuela) and why revenue increases, were not sufficient to sustain sol- and monitoring difficult. where they occurred, failed to have April 1997 the desired fiscal impact (Bang- pressures often held up trade re- equal ratios of total expenditures ladesh, Pakistan, Uganda). Re- form, as did insufficient progress to GDP). Attempts to restructure forms of tax administration, on stabilization. current expenditures away from neglected in early structural ad- wages and subsidies to nonwage justment loans, have increasingly Expenditure reform operations and maintenance and become a part of Bank adjustment to cut public employment were programs since 1987. But the ap- To encourage expenditure re- generally short-lived or modest. proaches have been piecemeal in- form, loan conditions focused on Moreover, countries with capital stead of comprehensive. Bank the size and composition of spend- expenditure conditions ended the conditions have lacked precision, ing. Conditions focused on reduc- period with relatively large un- and thus have been difficult to ing and restructuring capital ex- sustainable cuts in infrastruc- monitor. penditures, removing subsidies, ture spending. reducing public employment and Nontrade tax reform. In general, cutting the wage bill, emphasizing In countries whose operations nontrade tax conditions formed operations and maintenance of ex- contained conditions on health only a small component of adjust- isting facilities, and increasing and education spending, both sec- ment programs and (as with tax social sector spending (although tors increased their shares in total administration) were selective attention to poverty reduction was spending, though these shares rather than comprehensive. Politi- weak). The record shows only were only marginally better than cal constraints have generally stood modest performance. in countries without conditions. in the way of comprehensive tax Illiteracy rates declined in almost reform. Moreover, since the late Out of 27 countries studied, 22 all countries studied-particu- 1980s the Bank has deferred to required total spending cuts or re- larly for girls and women-as the IMF on tax reform, focusing straint. Of those, spending declined did infant mortality rates. instead on public expenditures. in only 14, and in 3 the cuts were Consequently, the Bank has tended smaller than targeted. In several Recommendations to piggyback on conditions already of the countries-C6te d'Ivoire, imposed by the IMF or other do- Kenya, and Tunisia-the decreases * Estimate the level of sustainable nors supporting government were achieved largely through re- deficitfor the country and provide reforms. ductions in capital spending rather guidelines for achieving it in Bank than through the current expendi- economic and sector work and adjust- How explicit were nontrade tax ture cuts called for in structural ment lending. Integrating fiscal ac- conditions? About 40 percent of adjustment programs. Although counts into the macroeconomic the conditions were quantitative all 27 countries attempted to lower framework of inquiry is essential and thus easily monitorable. The their current expenditures, only for identifying tradeoffs among other 60 percent either specified 10 countries actually did so. The fiscal variables and acceptable the direction of change in the tax reasons for poor performance were levels of borrowing and other code without stating how much several: (1) weak budgetary sys- macroeconomic variables, setting change was expected or lacked tems and processes; (2) inability quantitative targets for achieving both quantitative and qualitative of governments to reduce or sus- public sector solvency and fiscal criteria, leaving open the possibility tain cuts in employment (and thus sustainability, and for monitoring of poor outcomes. Finally, none of in public sector wages and sala- macroeconomic outcomes. At the the operations specified pre-reform ries); and (3) weaknesses in Bank same time, the coverage of the fis- benchmarks, such as marginal ef- conditions. cal accounts needs to be expanded fective tax rates, making it difficult and the transparency of accounts to evaluate the implementation Comparisons between countries improved. This implies a need to and outcome of the reform. with expenditure conditions and incorporate state, local, and mu- those without indicate that condi- nicipal accounts into the fiscal ac- Trade tax reform. In contrast tions were only marginally effec- counts, track quasi-fiscal deficits, to conditions on nontrade taxes, tive in improving spending patterns. and work out the implications of trade tax conditionality was spe- Countries with loan conditions on implicit taxes, subsidies, and gov- cific, and reform objectives were spending were more successful in ernment guarantees. Finally, the clearly outlined, with quantified increasing social spending and cut- appropriate measure of the deficit policy targets and deadlines speci- ting subsidies and defense spend- for tackling the problem at hand fied. Compliance was thus easy to ing, and they ended the period needs to be identified-whether monitor. The record shows high with lower wage bills than coun- it is the overall deficit or the pri- compliance, but the pace of reform tries without conditions. But these mary, the operational, or the struc- varied, often depending on how countries also had less success in tural deficit. All these tasks require well trade reform was synchro- cutting total expenditure (both improvement in the quality and nized with other reforms. Revenue groups started out with roughly coverage of fiscal data. OED Precis * Improve the sequencing of tax re- Performance indicators should in- economy. But management also noted form. If trade taxes contribute sig- clude marginal effective tax rates that OED's emphasis on estimating nificantly to revenue, nontrade tax and, for tax administration, cost the sustainable deficit deals with a still reforms to enhance revenue may and output measures. With regard unresolved theoretical issue-the de- need to precede trade tax reform. to expenditure reforms, perfor- termination of the sustainable deficit. Reforms in tax administration mance mon-itoring indicators need Management is planning to undertake should be closely sequenced with to show intermediate (short run) a study on the sustainable deficit, pos- tax structure reform. outputs and final (long run) out- sibly in collaboration with the IMF. comes as well as measures of the With regard to the study's recommen- * Consider the role of the state and level and composition of spending. dation for the Bank to strengthen tax the appropriate mix of public/private policy analysis, management noted that provision of services in recommend- * The Bank should strengthen its there is always room to improve Bank- ing public expenditure reform. What internal capabilityfor tax analysis to Fund collaboration, but the benefits is the specific mix of government- enhance Bank-Fund coordination. Both of investing resources in tax policy provided goods and services that the Bank and the IMF recognize analysis would have to be weighed suits a country's situation? Should the critical importance of fiscal re- against alternative uses of those re- the government assist the private form to macroeconomic stability sources, including investing in sector- sector with financing? In which and growth. While respecting the level public expenditures, where the areas should it withdraw to a Fund's lead role in giving fiscal ad- Fund is not doing any work. regulatory role? vice, the Bank needs to take a more hands-on-approach to the design of The Committee on Development * Include poverty alleviation and fiscal reform in adjustment lending, Effectiveness, in its discussion of the equity objectives in public expendi- particularly where the Fund may OED study, emphasized the needfor ture reform. Since expenditure so- not be directly involved. fiscal conditionality in adjustment op- lutions have greater potential erations to be more precise, supported than revenue reform in reducing Bank management, in its response by specific and monitorable perfor- poverty, expenditure programs that to the study, noted that the OED study mance indicators; the need to define improve the targeting of subsidies highlighted some importantfacts: that what is a sustainable deficit; the na- and the poor's access to basic ser- fiscal adjustment had generally been ture and causes of reversals in fiscal vices need to be in place. Basic attained by raising revenue than cut- reforms; and the appropriate role of the education and health services ting expenditure, that fiscal problems public sector. The committee believes might be provided free to ensure zvere due more to economic misman- that Bank-Fund collaboration on ex- universal coverage, and innova- agement and not necessarily to terms penditure policy and budget and tax tive cost-recovery solutions ex- of trade shocks or external indebted- reform proposals should be strength- plored to help finance tertiary ness, and that deficit reduction is ened. But it shares management's view education and health services. associated with improved external that the principle of selectivity and balances andfaster growth. Manage- partnership among internationalfi- Build better monitoring and per- ment agreed with many of the study's nance institutions arguefor the Bank formance indicatorsfor both tax and recommendations, such as making con- to assess carefully the work it assumes expenditure reforms. Building better ditions more specific and time bound, and what its comparative advantages performance indicators into tax sequencing reforms properly, ensuring are. Asfor the appropriate role of the and tax administration reform pro- transparency and extending coverage public sector, the committee said that grams benefits design, implemen- offiscal accounts, and basing public it is the prerogative of individual bor- tation, and evaluation and focuses expenditure reform on considerations rowers to decide what is appropriate attention on the goals of reform. of the role of government in the in the context of their local conditions. OED Precis is produced by the Operations Evaluation Department of the World Bank to help disseminate recent evaluation findings to development professionals within and outside the World Bank. The views here are those of the Operations Evaluation staff and should not be attributed to the World Bank or its affiliated organizations. This and other OED publications can be found on the Internet, at http:// www.worldbank.org/html/oed. Please address comments and inquiries to the managing editor, OED, tel: 1-202/458-4497, fax: 1-202/522- 3200, e-mail: eline@worldbank.org April 1997