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