Slajd 1

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FISCAL STANDARDS AND ECONOMIC DEVELOPMENT
Leszek Balcerowicz National Bank of Poland
World Bank Workshop 3 April 2006
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Agenda

• Public finance and short-term economic growth
• Public finance and long-term economic growth
• General government balance
• Tax system
• Public expenditure

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I. Public finance and short-term economic growth
The tightening of fiscal policy does not have to
lead to a fall in GDP growth in the short term
because so-called non-Keynesian effects of fiscal
tightening may occur.
General government deficit (ESA95, of GDP,
left scale) and GDP growth rate (, right scale)
in 1999-2004.
Poland
Slovakia
Lithuania
Source Eurostat.
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I. Public finance and short-term economic growth
Non-Keynesian effect
Output increase
Change of private demand bigger and stronger than
change of government demand
Increase of cumulated disposable income expected
in a horizon of utility maximization
rigid prices
Increase of interest rates sensitive private
expenditure
Net export increase
Output increase in long term
Increase of enterprise capability and propensity
to invest
Drop in interest rates
Depreciation of domestic currency
Dispelling of concerns for government solvency
Positive supply shock (cost fall)
Budget deficit reduction
flexible prices
Improvement in external competitiveness
Keynesian approach
Non-Keynesian approach
Source Rzonca A., Cizkowicz P., Non-Keynesian
Effects of Fiscal Contraction in New Member
States, ECB Working Paper, No. 519, September,
2005.
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I. Public finance and short-term economic growth
Selected conclusions on the non-Keynesian effects
of fiscal contraction drawn from empirical
studies

• Non-Keynesian effects occur more often when
  fiscal adjustment is large (see e.g. Francesco
  Giavazzi and Marco Pagano, 1996) and lasting (see
  e.g. Alberto Alesina and Roberto Perotti, 1996)
  rather than small or transitory.
• Fiscal adjustments are more lasting and lead more
  often to non-Keynesian effects if they are caused
  by curtailment of expenditures rather than by tax
  increases (see e.g. Alberto Alesina, Roberto
  Perotti and Jose Tavares, 1998). Some studies
  show an opposite relationship, but they mainly
  deal with the response of private consumption to
  negative fiscal impulses (see e.g. Francesco
  Giavazzi, Tullio Jappelli and Marco Pagano,
  1999).
• The manner of fiscal policy tightening is of far
  greater importance in terms of its aftermath than
  the scale of deficit reduction. Among the
  successful fiscal adjustments, those that focus
  on cuts in public sector wage expenditure and in
  transfers to households are particularly frequent
  (see e.g. Alberto Alesina, Silvia Ardagna,
  Roberto Perotti and Fabio Schiantarelli, 1999).
• The probability of the effects occurrence is
  greater when public debt is high (Rina
  Bhattacharya, 1999) or fast growing (see e.g.
  Francesco Giavazzi, Tullio Jappelli and Marco
  Pagano, 2000) rather than low, and, at most,
  slowly growing.

Source Rzonca A., Cizkowicz P., Non-Keynesian
Effects of Fiscal Contraction in New Member
States, ECB Working Paper, No. 519, September,
2005.
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I. Public finance and short-term economic growth
According to recent research carried out at the
National Bank of Poland fiscal consolidation in
the NMS in 1993-2002 triggered non-Keynesian
mechanisms, and as a result, was almost always
accompanied by an acceleration in output momentum.
In six out of the seven episodes of fiscal
adjustment, output changed in the opposite
direction than a Keynesian approach would
predict, that is to say, one observed an
acceleration in output momentum in comparison
with the previous period instead of its slowdown.
GDP growth was, on average, faster by 4.9 during
and 4.2 a year after consolidation respectively,
than a year before the fiscal adjustment.
Moreover, actual GDP momentum during the
tightening of fiscal policy was almost twice as
strong as generally expected at the onset of the
fiscal adjustment, although forecasts of GDP
momentum were usually built under the assumption
of a far more lax fiscal policy than what was
actually implemented.
Source Rzonca A., Cizkowicz P., Non-Keynesian
Effects of Fiscal Contraction in New Member
States, ECB Working Paper, No. 519, September,
2005.
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II. Public finance and long-term economic growth
The impact of fiscal policy on long-term economic
growth may be underestimated...
Fraser Institute Economic Freedom of the World
Index

• The Fiscal Position of the Government (Size of
  Government) index consists of
• The share of general government consumption in
  total consumption
• Transfers and subsidies as a share of GDP
• Government enterprises and investment as a share
  of gross investment
• Top marginal tax rate.

The higher the value of the index, the more
limited the size of the government.
Source Fraser Institute.
For instance, it is not commonly known that one
of the main differences between the Asian Tigers
and other countries is that the former
successfully restrained government expansion.
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II. Public finance and long-term economic growth
...and under-researched.
The recent growth literature makes relatively
few references to public finance even though some
empirical work by Baro, Gordon and others has
isolated variables such as government
consumption, the corporate tax rate, and others
that are found to retard growth.
Source Tanzi V., Public Finances and Long-Term
Economic Growth Toward a Warsaw Consensus?,
Paper presented at the Conference on Fiscal
Policy and the Road to the Euro, Warsaw, 30 June
1 July 2005.
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II. Public finance and long-term economic growth
1. General government balance
GENERAL GOVERNMENT DEFICIT
PUBLIC DEBT
Crisis
Crowding out of investment
When national debts have once been accumulated
to a certain degree, there is scarce, I believe,
a single instance of their having fairly and
completely paid. The liberation of the public
revenue, if it has ever been brought about at
all, has always been brought about by a
bankruptcy sometimes by an avowed one, but
always by a real one, though frequently by a
pretended payment. The raising of the
denomination of the coin has been the most usual
expedient by which a real public bankruptcy has
been disguised under the appearance of a
pretended payment. Adam Smith, An Inquiry Into
The Nature and Causes of The Wealth of Nations,
Vol. 2, Methuen CO. LTD., London.
Fall in the growth rate or in the level of output
the evidence appears to show that, on average,
deficits do crowd out investment, including
investment in plant and equipment in
particular. Benjamin M. Friedman, Deficits and
Debt in the Short and Long Run, NBER Working
Paper No. 11630, 2005.
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II. Public finance and long-term economic growth
1. General government balance
In the long term, a high budget deficit hampers
economic growth.
Source World Economic Outlook, May 2000, IMF.
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II. Public finance and long-term economic growth
1. General government balance
There are also other important channels through
which public finance affects long-term economic
growth.
Long-term economic growth
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II. Public finance and long-term economic growth
2. Tax system
TAX SYSTEM
Level of taxes (tax burden) ( of GDP) -
official taxes - corruption taxes. The
problem of failed states.
Structure of taxes - taxes on labour -
taxes on capital - taxes on consumption.
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II. Public finance and long-term economic growth
2. Tax system
Empirical research confirms the negative impact
of high taxes on economic growth.
Authors Publication Research area Extent of impact
Willi Leibfritz, John Thornton, Alexandra Bibbee. Taxation and Economic Performance, OECD WP 176, 1997. OECD countries in the years 1965-1995. 10 pp increase of taxes-to-GDP ratio lowers GDP growth by 0.5-1.0.
Michael F. Bleaney, Norman Gemmell., Richard Kneller. Fiscal policy and growth evidence from OECD countries, Journal of Public Economics, 74, 1999. 17 OECD countries in the years 1970-1994. 1 pp increase in the distorting-tax revenues-to-GDP ratio lowers GDP per capita growth by 0.4 pp.
Stefan Folster, Magnus Henrekson. Growth Effects of Government Expenditure and Taxation in Rich Countries, European Economic Review, 45, 2001. Sample of most affluent countries of OECD and outside OECD in the years 1970-1995. 10 pp increase in the taxes-to-GDP ratio lowers GDP growth by about 1.
Eric M. Engen, Jonathan Skinner. Taxation and Economic Growth, NBER WO 5826, Cambridge 1996. United States and a sample from OECD countries. 2.5 pp increase in the taxes-to-GDP ratio reduces economic growth by 0.2-0.3
distorting tax revenue revenue from taxes on
income and profit, social security contribution,
tax on payroll, tax on property.
Source Skrok E., Taxation and Long-Term Economic
Growth Analysis of Polands Tax Policy Against
the Background of International Theory and
Experience, 2004.
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II. Public finance and long-term economic growth
2. Tax system

• The structure of taxes matters because taxes
  differ in their contribution to distorting
  incentives
• to work
• If direct taxes upon the wages of labour have
  not always occasioned a proportionable rise in
  those wages, it is because they have generally
  occasioned a considerable fall in the demand for
  labour. The declension of industry, the decrease
  of employment for the poor, the diminution of the
  annual produce of the land and labour of the
  country, have generally been the effects of such
  taxes.
• to invest
• The proprietor of stock is properly a citizen
  of the world, and is not necessarily attached to
  any particular country. He would be apt to
  abandon the country in which he was exposed to a
  vexatious inquisition, in order to be assessed to
  a burdensome tax, and would remove his stock to
  some other country where he could either carry on
  his business, or enjoy his fortune more at his
  ease. By removing his stock he would put an end
  to all the industry which it had maintained in
  the country which he left.

Source Smith A., An Inquiry Into The Nature and
Causes of The Wealth of Nations, Vol. 2, Methuen
CO. LTD., London.
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II. Public finance and long-term economic growth
2. Tax system
Empirical research confirms the negative impact
of high taxes on employment...
Laszlo Goerke Taxes and Unemployment, Kluwer Academics, Boston, 2002. Taxes have a negative impact on employment. The magnitude of the tax policys influence on employment depends on the labour markets institutional conditions.
Vincent Hogan Do Taxes Cause Unemployment?, University College Dublin, 2001. The burden of higher taxes is spread among employees and employers, and in turn leads to higher unemployment. Even a temporary (up to 1 year) tax increase leads to higher unemployment which persists for several years.
Edward C. Prescott Tax Not Culture Explains Why Europeans Work Less, The Wall Street Journal, 21 Oct 2004. I determine the importance of tax rates in accounting for (...) differences in labor supply for the major advanced industrial countries and find that tax rates alone account for most of these differences in labor supply.
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II. Public finance and long-term economic growth
2. Tax system
...and investment.
Michael Funke Determining the taxation and investment impacts of Estonias 2000 income tax reform, Bank of Finland Working Paper no. 15, 2000. Differences in tax systems explain a large proportion of differences in economic growth. The tax reduction in Estonia in 2000 will lead in the long run to a 6 increase in the capital stock.
Robert Douglas, Holtz-Eakin,Mark Rider,Harvey S. Rosen Entrepreneurs, Income Taxes, and Investment, NBER Working Paper No. 6374, 1998. The level of corporate income tax has a significant influence on companies investment decisions. A 5 percentage point increase in the marginal rate of taxation in the USA would lead to a 10 per cent decrease in investment.
Eric M. Engen,Jonathan Skinner Taxation and Economic Growth, NBER Working Paper No. 5826, 1996. In the USA an average tax-rate change of 2.5 percentage points leads, by means of a positive impact on employment, investment and productivity dynamics, to a 0.2-0.3 percentage point economic growth acceleration per year.
Reint Gropp, Kristina Kostial The Disappearing Tax Base Is Foreign Direct Investment (FDI) Eroding Corporate Income Taxes?, IMF Working Paper No. 173, 2000. The tax level has a significant impact on the value of foreign direct investment. Lower taxes are linked with a larger inflow of FDI.
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II. Public finance and long-term economic growth
3. Public expenditure
Public expenditure and long-run economic growth
Level of expenditures
Structure of expenditures
expenditures on public goods The theoretical
concept of public goods is misused in its
application to the real world (Coase versus
Stiglitz)
other expenditures - government consumption -
transfers - public investment
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II. Public finance and long-term economic growth
3. Public expenditure
It is a mistake to associate the fast development
of many Western economies with their currently
high public expenditure levels because they
achieved their highest economic growth in years
when their expenditures were low. The present
level of public expenditure in Poland is much
higher than it was in todays highly developed
countries in the middle of the 20th century.
Public sector expenditure in West European
countries in 1950 and in Poland in 2004 ( of
GDP).
Source Middleton R., Britains economic
problem too small a public sector?, Centre for
Contemporary British History, 1995. Eurostat.
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II. Public finance and long-term economic growth
3. Public expenditure
The increase of public expenditure at a pace
exceeding the GDP growth rate has been an
important source of GDP growth slowdown in OECD
countries since the middle of the 20th century.
Source Heitger B., The Scope of Government and
Its Impact on Economic Growth in OECD Countries,
Kiel Working Paper No. 1034, April 2001.
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II. Public finance and long-term economic growth
3. Public expenditure
Empirical research suggests that expanding
general government expenditures in OECD countries
have worsen the structure of expenditures. As
Heitger states, in OECD countries the expenditure
share in core categories is about or below 14
of GDP. This is true even in countries where the
scope of government is relatively large.
The empirical analysis of national accounts of
the main OECD countries revealed that the supply
of public goods in the 90s only accounted for
about 14 percentage points of gross domestic
product. Given the observation that the scope of
government in European OECD countries, as
measured by government shares, on average
accounted for about 50 per cent of gross domestic
product one may suggest that these countries have
significantly surpassed the optimum of
government activities and thus, accordingly to
the hypothesis, should have reduced the growth
potential of their economies considerably.
Core government expenditures consist of
expenditures on public order and safety, national
defence, education and transportation/communicatio
n.
Source Heitger B., The Scope of Government and
Its Impact on Economic Growth in OECD Countries,
Kiel Working Paper No. 1034, April 2001.
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II. Public finance and long-term economic growth
3. Public expenditure
It is a mistake to claim that a higher level of
public expenditure is the cure for the societal
problems and leads to higher well-being.
(...) the large increase in public spending
(...) that occurred especially after 1960 does
not seem to have contributed much to social
welfare. This leads us to conclude that by the
time countries reach the level of public spending
shown by the small governments, namely, between
30 and 40 percent of GDP, much of the potential
social gain from public spending has been
obtained. Spending beyond that level does not
contribute much.
Source Tanzi V., Schuknecht L., Reconsidering
the Fiscal Role of Government The International
Perspective, The American Economic Review, Vol.
87, No. 2, 1997.
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II. Public finance and long-term economic growth
3. Public expenditure

• Especially destructive are the welfare states
  in less developed economies.
• (...) while governments devote about a third
  of their budgets to heath and education, they
  spend very little of it on poor people. (...)
  Public spending on health and education is
  typically enjoyed by the non-poor. (World Bank,
  2004).
• Examples
• Mexico
• In 1989 execution of the National Solidarity
  Program was started. The possible reduction of
  poverty was forecasted at 64, but the real
  reduction had amounted only to 3 until 1995. The
  cost of the program came to 1.2 of GDP. The
  simple distribution of such an amount of money to
  all people (including wealthy people) would
  reduce poverty by 13.
• Bangladesh
• 74 of teachers employed in public education
  system do not attend classes.
• Brazil
• The economic growth of Brazil is hampered by the
  high costs of doing business (including tax
  wedge) caused by the excessive welfare state.
• India
• The transfers originally directed to the poor
  peasants are taken over by wealthy farmers.
• The prohibition to fire the worker, even in
  private enterprise, leads to high unemployment in
  India.

Source World Development Report Making
Services Work for Poor People, World Bank 2004.
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II. Public finance and long-term economic growth
3. Public expenditure
A high level of social spending discourages
people from active participation in the labour
market (social traps).

• Fall in the labour supply caused by social traps
  depends on
• the level of social benefits
• The cut of the replacement rate in unemployment
  insurance from 80 percent to 75 percent in Sweden
  in 1995 caused an increase in the transition rate
  of employment of roughly 10 percent. (Carling,
  Holmlund, Vejsiu 1999)
• the entitlement period
• The results of econometric analysis have shown
  that the prolongation of entitlement periods and
  its extension to successively younger age groups
  in West Germany in the 1980s has increased
  unemployment durations for males. (Steiner, 1997)

Sources Carling K., Holmlund B., Vejsiu A., Do
benefit Cuts Boost Job Findings? Swedish Evidence
from the 1990s, 1999. Steiner V., Extended
Benefit Entitlement Periods and the Duration of
Unemployment in West Germany, 1997.
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II. Public finance and long-term economic growth
3. Public expenditure

• availability and conditions to exercise social
  benefits
• The extension of the number of weeks a person
  must work to become eligible for unemployment
  insurance benefits on the Swedish labour market
  from 80 days to 6 months between 1996 and 1998
  caused an approximate 2.9-week extension in
  average employment duration. (Hagglund, 2000)
• Changes in the conditions to exercise social
  benefits in the United States in 1996
  (obligatory to work or participate in training
  courses, eliminating part of the social
  programs, etc.) led to a 56 decrease in social
  benefits recipients in the years 1996-2001.

Source Hagglund P., Effects of Changes in the
Unemployment Insurance Eligibility Requirement
on Job Duration Swedish Evidence, 2000.
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II. Public finance and long-term economic growth
3. Public expenditure
To conclude, an expansion of public expenditure
from a relatively low level leads to a decline in
the economic growth rate. As Schuknecht and Tanzi
state, in the years 1980-2000 the expansion of
public expenditure in relation to GDP led to
lower values of the quality-of-life indicators,
including the economic growth rate.
Public sector efficiency in 2000

• Efficiency indicators for the public sectors of
  23 industrialised OECD countries.
• small governments public spending less than
  40 of GDP
• medium governments public spending between 40
  and 50 of GDP
• big governments public spending greater than
  50 of GDP.

The average level of public sector performance
was set to 1. The public sector performance
indicator is based on measures of administrative
performance of government, education, health
performance, public infrastructure, income
distribution, economic stability and economic
performance.
Sources Afonso A., Schuknecht L., Tanzi V.,
Public sector efficiency an international
comparison, ECB Working Paper No. 242, 2003. A.,
Schuknecht L., Tanzi V., Public Spending in the
20th Century A Global Perspective, Cambridge
University Press, 2000.