Budgeting for Fiscal Space

1
Budgeting for Fiscal Space

• Allen Schick
• Annual Meeting Senior Budget Officials
• Organization for Economic Co-operation and
  Development
• Vienna, 2-3 June 2008

2
The Contemporary Interest in Fiscal Space

• The prospect of a constrained fiscal environment
  has spurred interest in fiscal space
• Governments are not concerned about fiscal space
  when resources suffice to finance existing
  programs and policy initiatives
• OECD governments have vastly more to spend than
  in the past, but their budget options have
  narrowed
• The increments available for policy initiatives
  tend to be small
• Demographic trends will intensify budget stress
  in many OECD countries
• The impact of these trends will depend on the age
  structure of the population and the means of
  financing pensions and health care
• The possibility that budgeting will become a
  decremental process that allocates losses rather
  than gains
• Budgeting would be more contentious and
  politicians would have difficulty financing new
  policies

3
How the Fiscal Space Concept is Applied

• All Countries
• To measure the money available for policy
  innovation consistent with medium to long term
  fiscal sustainability
• Low Income Countries
• To assess the opportunity for additional spending
  to promote development, thereby stimulating
  economic growth and increases in government
  revenue
• Middle Income/Developmental Countries
• To promote rapid development without undue risk
  to the governments future fiscal position
• Highly Developed Countries
• To assess the resources available for allocation
  through annual or medium-term budget decisions

4
Budgeting for Fiscal Space is Incremental

• Fiscal Space recognizes that budgeting is
  inherently incremental
• Past efforts to uproot incrementalism (such as
  PPBS and ZBB) failed
• Incremental budgeting focuses on allocating
  additional resources and on marginal adjustments
  in ongoing programs
• Over time, incremental decisions can aggregate to
  major changes in budget policy
• Baseline projections are the starting point in
  budgeting for fiscal space
• The baseline projects future budgets assuming no
  change in current policy
• The Medium-Term Expenditure Framework (MTEF)
  institutionalizes incremental budgeting
• This may be why MTEF, in contrast to previous
  reforms, has survived

5
The Four Determinants of Fiscal Space

• The composition and trend of public expenditure
• How large is public spending relative to GDP and
  how sticky is it?
• The propensity to tax
• What is the share of GDP extracted in taxes and
  can this share increase?
• The propensity to borrow
• Can government finance spending ambitions by
  borrowing more?
• The performance of the economy
• Will economic growth provide sufficient
  increments?

6
The Shrinkage of Fiscal Space Public Expenditures

• After decades of steep increases, public spending
  as a share of GDP has stabilized in most OECD
  countries
• In view of its relative size, public expenditure
  is not likely to rise much in the decades ahead
• Public expenditures are sticky
• They do not readily adjust to changes in
  political/economic conditions or to changes in
  national priorities
• Expenditures are sticky even for programs that
  are not effective
• In fact, governments often spend more for
  programs that are not performing well
• National governments have become holders of
  costly risks
• Government must give priority to these risks
  (ageing, illness, unemployment, natural
  disasters)
• Entitlements that establish a legal right to
  payment from government will claim a rising share
  of most national budgets
• Demographic trends will compel national
  governments to allocate incremental resources to
  entitlements

7
The Shrinkage of Fiscal Space Revenues

• The era of large tax increases has ended in most
  OECD countries
• It appears that many OECD countries are competing
  to reduce tax rates on individual and corporate
  income
• Governments with large tax expenditures will try
  to curtail these preferences
• In some countries, reducing tax expenditures will
  facilitate reductions in tax rates in others,
  doing so will provide modest increments for
  expenditure
• Fiscal decentralization has led some countries to
  assign a substantial share of their revenue to
  sub-national governments
• The impetus for decentralization has slowed, but
  has not been reversed
• Pressure will likely increase in decades ahead
  for taxes to finance international activities
• These demands will influence the capacity of
  national governments to generate additional
  review for their own purposes

8
The Shrinkage of Fiscal Space Deficit Financing

• During the postwar growth spurt, many governments
  borrowed to finance current expenditure
• Deficit financing occurred despite sharply rising
  revenue due to economic growth and tax increases
• Deficit financing was accommodated by a shift
  from balanced budget norms to demand management
• It was deemed more important to balance the
  economy than the budget
• The advent of fixed fiscal targets and rules
  limits the capacity of most OECD governments to
  borrow
• Fiscal rules such as the Stability and Growth
  Pact limit the deficits and debt of many OECD
  countries
• Even when they are not fully effective, fiscal
  rules inhibit public borrowing
• Net borrowing by OECD countries has declined
  during the past decade

9
The Shrinkage of Fiscal Space Economic
Performance

• Economic growth is a necessary condition for
  incremental budgeting
• Growth not only gave governments more money to
  spend, but it induced them to boost the portion
  of the economy allocated to public consumption,
  investment and transfers
• In most OECD countries the potential for growth
  will be less robust in the future than in the
  past
• Potential output is a function of the size of the
  work force, which will likely grow more slowly in
  the future, and of productivity, which is
  difficult to predict
• Built in stabilizers protect fiscal space when
  the economy is weak
• When the economy recovers, government may be
  pressured to stabilize its fiscal position

10
Protecting Fiscal Space

• Governments often engage in budget practices that
  significantly reduce future space
• Space-robbing behavior occurs in both affluent
  and poor countries
• Policy changes that have modest short-term costs,
  but generate large downstream expenditures
• This practice can be mitigated by having an
  effective MTEF, including baseline projections
• Ad-hoc spending decisions made outside the
  regular budget framework curtail fiscal space
• In some countries, decisions made between budgets
  have become as important as decisions made in the
  budget

11
Protecting Fiscal Space, continued

• Spending units do not often propose significant
  reallocations
• Governments can stimulate reallocation by
  increasing baseline expenditures by less than the
  rate of inflation or by reducing them for
  expected productivity gains, or by making
  across-the-board cuts and setting aside the
  savings in a bidding fund for policy initiatives
• When fiscal space is tight, investment
  expenditure may be curtailed
• One remedy is to finance investments through
  public-private partnerships, provided downstream
  costs and risks are prudently assessed
• Fiscal space is narrowed when risks become due
• Space can be protected by shifting risks to
  households or enterprises by imposing
  risk-sensitive premiums, increasing copayments
  and deductibles, and by shifting to defined
  contribution pensions

12
Adjusting the Budget Process

• The primary role of the modernized central budget
  office should be to guard and allocate fiscal
  space
• Performing this role requires that it manage
  baseline projections, assure that proposed and
  adopted program savings and initiatives are
  accurately costed, and shift from an annual to a
  multiyear horizon
• To the extent politically feasible, the budget
  office should uphold the disciplined framework
  for compiling the budget
• The capacity of the budget office to perform its
  responsibilities is greatly diminished by ad-hoc
  decisions

13
Adjusting the Budget Process, continued

• Governments that incorporate future price changes
  in baseline projections should reconsider this
  practice
• Protecting existing programs against future price
  changes greatly diminishes fiscal space and
  distorts perceptions of budget actions
• The Medium-term (3-5 years ahead) may be an
  insufficient frame for protecting fiscal space
• Budget offices that have well-running MTEFs
  should introduce longer-term perspectives into
  budgeting
• An improperly operated MTEF can significantly
  reduce fiscal space by legitimizing larger claims
  on future budgets
• The MTEF should be fully integrated into annual
  budgeting and should have a firm constraint

14

• THE BUDGET OFFICE SHOULD REGARD FISCAL SPACE AS
  ITS SPACE.
• OFTEN IT IS THE ONLY PORTION OF THE BUDGET OVER
  WHICH IT HAS SIGNIFICANT INFLUENCE.