1
Portugal Coping with Fiscal Policy
Challenges in the 21st Century Peter S. Heller
International Monetary Fund December
13, 2004(Presentation to the Budget Control
Committee of the Portuguese Parliament)
This Presentation should not be reported as
representing the views of the IMF. The views
expressed in this presentation are those of the
speaker and do not necessarily represent those of
the IMF or IMF policy.
.
2
Introductory remarks

• This conference is noteworthy, reflecting
  recognition by the Parliament of the need to take
  account of long-term issues in budget
  formulation.
• Critical that such a perspective is shared both
  by executive and legislative branches.

3
Principal Messages

• As with most other industrial countries, Portugal
  needs to take account of potential long term
  structural developments and risks.
• There are fiscal dimensions to many of these
  risks.
• Dealing with problems for which there are
  fundamental uncertainties
• A multi-pronged approach is necessary to deal
  with issues of the long-run, involving
  strengthened policy analysis, reforms of the
  budget process, sustained fiscal consolidation,
  and sectoral policy reforms.

4
Motivation for considering LT fiscal risk issues
what are some of the key long-term challenges
confronting Portugal?

• 1. Demographic factors
• Fertility rate low (at 1.53) Eurostat
  projections suggest a rise to only 1.6 by
  mid-century.
• Increasing life expectancy by 2050
• males 72 to 78 females 79 to 84.
• Dependency rate will double by 2050 from 23
  percent to 46 percent.
• Population will peak in 2040.

5
(No Transcript)
6

• Potential fiscal impact of aging population
  well-recognized
• General system pension (GSP) costs will rise,
  even under new 2000 Framework law
• From 6 of GDP in 2000 to 8 in 2075
• GSP revenue to decline by 1.5 of GDP in same
  period system in deficit by 2016 zero balance
  in reserve fund by 2029.
• Civil Service Pension scheme costs projected to
  rise from 3.6 to 5.0 during same period.

7
(No Transcript)
8

• Medical care impact of aging population
• Caldes and Rodriguez aging alone will lead to
  increase in spending from 5.3 of GDP in 2000 to
  6.4 to 7.2 by 2050.
• Bronchi (OECD, 2003) suggests even larger
  increase of about 3 of GDP by 2030.
• With increasing elderly dependency rates,
  long-term care will also be a challenge, with
  Portugal now poorly positioned relative to other
  European countries.

9

• 2. Medical costs may increase further due to
  technology-induced cost pressures
• Between 1970 and 2000/01, health care costs in
  Portugal rose from 2.7 of GDP to over 6,
  independent of aging-related pressures parallel
  experience to US Note standard of technological
  equipment in Portugal still much below OECD
  average high cost equipment (e.g., imaging
  devices) still in short supply.

10
3. Global Climate Change

• For Portugal, most Global Climate Change
  Models (GCMs) project a temperature increase in
  interval
• 4-7º C by 2100 (SIAM Model). Climate change
  will also be reflected in
• Increased frequency and intensity of extreme
  weather events.
• Reduced precipitation in many regions
  substantial declines in spring (by 30) and
  autumn (35-60) an increase in winter months.
• Increased probability of flooding episodes with
  accumulated precipitation in heavy rainy periods.
  

11
Alternative GCM Model Projections of Climate
Change in Portugal through 2100
12
Potential impact of Climate Change

• Agricultural sector net adverse effects
• Negative impact of temperature change and from
  pressures on available water supply positive
  impact from CO2 change
• Differential impact across regions, with shifting
  to different crops in different zones
• Coastal zones increase in sea levelneed for
  protective actions to minimize impact,
  particularly in regions of high development and
  high population density
• Increasing energy demands in summer months
• No estimates made by SIAM GCM of impact on
  insurance or tourism sectors, urban centres, or
  soil and land resources.

13

• 4. Supply-side challenges
• Pressure to upgrade human capital skills
• Portugal suffers from competitive disadvantage
  in terms of quality of its human capital, its
  investment in RD, and ICT penetration.
• Portugal will need to increase investments and
  quality of spending in education and bolster
  spending on RD.

14

• 5. Contingent Risks associated with commitments
  on PPPs (in transport, water, energy, hospital
  sector) akin to debt, but not reflected in
  budget.
• 6. Globalization tax competition pressures
  fiscal policy constraints associated with
  membership in Eurozone.
• 7. Global pressures on energy supplies and
  prices.
• 8. Other potential risk factors terrorism, WMD,
  possible global systemic viruses.

15
9. Risks associated with present fiscal position

• Portugals current debt to GDP ratioclose to 60
  percent.
• Present fiscal position, while consistent with
  Stability and Growth Programme, still too reliant
  on one-off measures and imbalanced in terms of
  share of wages and salaries
• Failure to bring down primary deficit in line
  with SGP and sustain it at lower level (exclusive
  of aging-related fiscal pressures) would put
  Portugal on unsustainable fiscal track in terms
  of its projected debt growth.
• Sensitivity to adverse interest rate scenarios.
• Scale of continued EU assistance through
  Community Support Framework. Presently about 3
  of GDP.

16
(No Transcript)
17
Uncertain Certainties

• Most of these structural developments will
  happen most likely concurrently.
• But still much uncertainty nature of change
  degree of predictability size of potential
  impact.
• Different processes different time paths.
• On demography will fertility rise? Greater
  improvement in life expectancy? What migration
  level? Impact of HIV/AIDS?
• Still a wide band of uncertainty on the amount of
  possible climate change.
• Obvious uncertainties on security risks, etc.
• Inevitable surprise factor shocks that are
  difficult to predict for which fiscal leeway
  required.

18
Many issues pose fiscal risks. Why?

• Explicit, legislated, government commitments--
  some linked to demographic variables
• Pre-commitment of budgetary resources in
  pensions, medical care welfare assistance
  education.
• On political economy grounds, hard to change
  these commitments now even harder in future,
  with prospect of rising share of elderly in
  electorate.
• Implicit fiscal commitments? flowing from
  perceived role of government (e.g. Govt backup
  for failure of private occupational pension
  schemes? dealing with effects of sea level rise?
  sectoral adjustments in agriculture flooding,
  etc.)?

19
Should one tighten the fiscal policy framework
further to take account of these long-term
issues? Arguments Con

• Unpredictability of future events.
• Poor past records of forecasting.
• Future generations likely to be better off.
• Costs of addressing these long-term issues
  prematurely
• Higher taxes in the short term.
• Additional burden on households in responding to
  reduced long-term promises.
• Higher costs of adapting to uncertain climate
  change.

20
Arguments Pro

• Pressure for increased fiscal outlays will rise
  over time could lead to politically unfeasible
  tax burden, even with higher per capita income.
• Deferring action may increase cost of solutions
  (e.g., higher cost of tax smoothing or policy
  reform costs).
• Unfair burdens shifted to future generations.
• High potential welfare costs if abrupt benefit
  cuts.
• Reduced capacity of government to respond to new
  challenges.

21
Arguments Pro

• Failure to address LT risk factors may also
  constrain short/medium-term policy options
• Markets may require higher risk premia on
  government borrowing may constrain capacity for
  appropriate macro- economic policy stance. Recent
  SP study (Kremer, 2004) suggests that Portugals
  rating could deteriorate substantially, even as
  early as 2010.
• May induce Ricardian effects, as private sector
  agents respond to perceived failure of
  governments to actreducing potential impact of
  countercyclical fiscal policy measures.

22
What to do? Not easy issues

• Dealing with problems for which there are
  fundamental uncertainties policies imply
  significant short-run costs to taxpayers with
  uncertain scale of actions required and uncertain
  benefits to future generations. Climate change as
  example.
• Need to decide how much risk aversion is
  acceptable in judging sustainability of policies?
  What probability of LT fiscal sustainability
  desirable? What are losses if action not taken?
• Social time preference rates matter
  intergenerational welfare choices defining
  generations.
• There are allocative efficiency costs associated
  with tax smoothing.

23
What to do? A multi-pronged strategy is
required to take LT fiscal concerns into account
in short to medium-term

• A budget process and framework more clearly
  recognizing LT fiscal risksbuilding on existing
  work.
• Strengthened analytic approaches.
• A blend of
• aggregate fiscal policy consolidation.
• accompanied by further sectoral policy reforms.

24
Need for strengthened analytic approaches

• Formalize periodic long-term projections
  sustainability indicators scenario analyses tax
  or primary gap analyses.
• Alternative demographic scenarios.
• Carry out demographic-based stochastic forecasts
  taking multiple risk factors into account.

25
Possible sensitivity analyses

• Alternative non-aging cost pressures in medical
  care (e.g., US Long Term Budget Outlook, Dec.
  2003)
• In assessing future cost burden of pension
  system, examine alternative assumptions suppose
  less optimistic productivity assumptions (e.g.
  lower than 2.5 p.a.) lower labor force
  participation rates.
• Risks of any failure to meet the SGP adjustment
  path.
• Indexation assumptions for civil service pension
  scheme.
• Potential costs of climate changesea level rise,
  higher flooding levels.
• Alternative demographic assumptions (fertility
  LE).

26
Recognize limits on relevance of formal
Government balance sheet or measures of
Government debt

• Excludes significant potential implicit
  commitments and risk exposures.
• Hard to determine how to treat constructive
  budget obligations.
• Excludes potential revenue assets
• What is politically viable revenue share in
  future?
• Suggests there is a spectrum of Government debt
  and risk exposure.

27
Chart 1 Illustrative spectrum of Government debt
and risk exposures
Off-Balance Sheet
On Balance Sheet (As Liability or Provision)
Risk exposures derived from Role of Govt
Other types of Guarantees
Constructive Budget Obligations
Explicit Debt
Public Guarantees (provisioned)
Public Guarantees (not provisioned)
Implicit Contingent obligations Hard Soft
costs of climate change adaptation
Contractual
Noncontractualmedical care ---long term
care ---strengthening educational system
PPPs
Explicit contingent liabilities
28
Spectrum of debt and risk Exposures

• The softer the risk exposure, the
• Greater the potential flexibility of government
  in meeting an obligation
• Political economy factors weigh more heavily
• Greater indeterminacy on nature of governments
  commitment and
• The more relevant moral hazard considerations.

29
Need to obtain greater clarity on the risks to
which the public sector is exposed

• Clarifying potential costs of different risk
  factors simple first step in process of judging
  when policy adjustment is necessary
• Aging-related costs (pensions, medical care,
  long-term care cost of climate change
  vulnerabilities).
• Carry out sensitivity analyses.
• Becomes exercise in
• analyzing prospects for fiscal sustainability.
• considering scale of necessary policy actions.
• Assessing which policy alternatives limit risk
  exposure.

30
Portugal is relatively advanced in considering
long-term issues through its involvement in
EU/OECD work programs on aging populations

• Over time, Portugal should develop full-fledged
  medium term budget
• Incorporate into annual budget.
• Provide long-term cost implications of policy
  measures.
• But dont extend detailed budget beyond
  medium-term.
• Consider value of an additional fiscal rule on
  expenditure ceilings.

31

• Long-term annexes to budget should be prepared
• Clarifying potential cost of
• contingent liabilities
• Implicit debt
• Risk exposures on extended balance sheet.
• Providing long-term projections
• Clarify when additional RD needed before policy
  action.
• Providing stochastic analyses.
• Carrying out sensitivity analyses.

32
The political economy challenge of dealing with
long-term fiscal policy issuesNeed to provoke
public debate on long-term fiscal
challengesimplied intergenerational tradeoffs
degree of risk aversion

• Consider legislative procedural rules
• Require executive to provide long-term risk
  assessments as part of budget submission
• Require debate by Parliament
• Call for hearings by Parliament.
• Earmarking of social insurance funds could be
  considered?
• Emphasis on providing transparency on long-term
  risk exposure.

33

• A potential role for an autonomous agency charged
  with providing independent assessments of
  long-term fiscal risks
• Scrutinize assumptions in budget.
• Characterize adequacy of sensitivity assessments.
• Comment on cost of implied policy tradeoffs.
• Assess generational cost-sharing implications.

34
What policy changes required?

• Governments cannot wholly rely on an aggregative
  approach to meet higher prospective fiscal costs
  over long termRequires sectoral reforms as well.

35
Three Types of Aggregate approach possible

• Balancing budget, year by year, but not reducing
  debt/GDP ratio below present level.
• SGP approach rule which over time brings
  debt/GDP ratio to zero (EU-Portugal approach).
• Primary Gap fillingor tax smoothing
• But, there are limits to an aggregative approach.

36

• Balanced Budget approach responding annually to
  new expenditure pressures as they arise by
  reducing other expenditure or increasing
  aggregate tax burden
• But limits to increase in politically or
  economically feasible tax share
• Limits to feasible expenditure rationalizationgiv
  en Govts role in provision of public goods and
  other services and high share of wages and public
  transfers in total government expenditure.

37

• Primary Gap Filling (or Prefunding) approach?
  Increase and sustain a higher tax share, implying
  decumulation of debt and possiblynet asset
  accumulation
• How much net asset accumulation feasible?
  Political economy risks with increasing asset/GDP
  ratio (Norway case)
• Expenditure creep
• Pressures for tax reduction.
• Allocational efficiency costs of increased tax
  burden.
• Ricardian effects of prefunding strategy.
• Increases political economy costs of further
  Government policy changes.

38
As a minimum for Portugal, SGP implementation
must be high priority

• European Commission reports as well as SP
  assessment highlight fiscal risks associated with
  not implementing Stability and Growth Programme
  in coming three years.
• Requires sustaining that primary balance
  (independent of aging-related factors).
• Sufficiency? Ignores other forms of fiscal risk
  exposure of Portugal.
• Does not assess whether there is further
  revenue-raising potential.

39
Thus, need a balance between aggregate and
sectoral policy reforms

• Commitment and regulatory reform must be a
  critical component of policy mix.
• Requires commitment reform, affecting time path
  of pre-committed expenditures and reduced
  exposure by Govt to various fiscal risks.
• Critical to ensure adequate fiscal leeway is
  maintained.
• Critical to consider when there are important
  windows of opportunity for action.

40
Portugal has made important start in recent
years, with reform efforts in health and pension
areas. Reforms in public administration and
early efforts at developing a long-term care
network.

• Still, more effort needed in public pension
  reform
• May require further extension in retirement age
• Possibly reduced accrual rate of pension
  benefitslowering replacement rate.
• More targeting.
• Change in qualitative commitments further forms
  of cost sharing may require adopting Dutch type
  of limits on coverage for certain categories of
  medical care.
• Promote greater clarity on who will bear given
  risks.
• Government support for strengthening insurance
  markets.
• Clarify government role in addressing issues of
  climate change its adaptation role.

41
Commitment reform (continued)

• Transparency necessary on implied
  intergenerational burden sharing.
• Long lead time needed for some reforms.
• Need to clarify macroeconomic effects of reliance
  on sectoral policy reforms.
• Consider self-adjusting policy provisionsbuilt-i
  n flexibility with uncertain outcomes.
• How much risk reinsurance coverage should be
  provided by Government?