fiscal policy and public expenditure santiago herrera

Fiscal Policy and Public Expenditure

Santiago Herrera

PUBLIC EXPENDITURE ANALYSIS AND MANAGEMENT COURSE

March 2005

Outline

I. The Government’s budget identityII. Expenditure: composition, efficiency and growth

impactIII. Taxes and growth-optimal size of the

expenditure IV. Financing the budget-debt sustainability

analysis in practiceV. Policy coordination: fiscal, monetary, exchange

rate and public debt policies

I. The Government’s Budget Identity

1*

1 ttttt FiEBiG

Uses = Sources

Uses :

111 tttttttt MMFFEBBTSources:

Government’s Inter-temporal Budget Constraint

Today’s debt stock = NPV of (primary surplus + seigniorage revenue)

1

1/)(i

itititt RMSD

tttt FEBD

ititit GTS

where

II. Public spending:composition, efficiency, and growth impactObjectives of public expenditure:

Efficiency in resource utilization

Economic growth

Equity of income distribution and social stability

A. Cost-Benefit analysis

B. Measuring effciency

C. Growth impact

A. Costs Benefits Analysis• Rationale for public intervention

– Redistribute income– Correct market failure/positive externality– Greater supply of goods than private-sector provision

• Objectives and Targets• Valuing costs

– Additional fiscal burden• Source of funds to cover costs – borrowing vs. taxation• Marginal cost of public funds

– Sustainability – Macroeconomic Stability

• Valuing benefits – Comparing with a counterfactual

Net present value of geothermal project in the Philippines with different marginal cost of funds

-100

-80

-60

-40

-20

0

20

40

1.0 1.20 1.40 1.60

US m 29.7

-11.3

-52.3

-93.3

NPV

Source: Devarajan, et.al. (1997)

BOX 2: ROAMEF CYCLE

Source: The Green Book, HM Treasury

B. Measuring Efficiency of Public Spending

• Nonparametric Approaches: (Deterministic or Stochastic)– FDH (Free Disposable Hull)

– DEA (Data Envelopment Analysis)

• Parametric Approaches: (Deterministic or Stochastic)– Corrected OLS

– Stochastic Frontier

Parametric Approach: Stochastic Frontier - An Illustration

AGO

ARE

ARG

ARMAZE

BDI

BEN

BFA

BGD

BGR BHR

BHS

BLR

BLZ

BOL

BRA

BRBBWA

CAF

CHL

CHN

CIV

CMR

COG

COL

COM

CPV

CRICZE

DJI

DMA

DOM

DZA

ERI

EST

ET H

FJI

GAB

GEO

GHA

GIN

GMB

GNB

GNQ

GRDGT M

GUYHND

HRV

HUN

IDN

INDIRN

JAMJORKAZ

KEN

KGZ

KHM

KNA

KOR

KWT

LAO

LBN

LCALKA

LSO

LTULVA MAC

MAR

MDA

MDG

MEX

MKD

MLI

MNG

MOZMRT

MUS

MWI

MYS

NAM

NER

NIC

NPL

OMN

PAK

PAN

PER

PHL

PNG

POL

PRY

ROM

RUSRWA

SAU

SDN

SEN

SLB

SLE

SLVSVK

SWZSYR

TCD

TGO

THA

TJK

TON

TT O

TUN

TZA

UGA

UKR

URY

UZB

VCT

VNMVUT

WSM

YEM

ZAF

ZMB

ZWE

4060

8010

012

014

0G

ross

Pri

mar

y E

nrollm

ent

0 200 400 600 800 1000Public Expenditure on Education

Inefficiency Efficiency Frontier

Data Source: World Bank WDI

Primary Enrollment vs Education Expenditure

Methodology: Concept of Efficiency

X2/Y

X1/Y

Y’

Y

O

T

P R

S

• Technical Efficiency: TE = OR/OP

• Allocative Efficiency: AE = OS/OP

Methodology: FDH XA

YA

O

E C

B

A

Output

Input

D

XB

YB

Input Efficiency for country B: XA/XB

Output Efficiency for country B: YB/YA

Non-parametric Approach: FDH – An Illustration

COG

CPVGABMWI

TJK

GNQ

MDG

TGO PERUGACHN

NPL FJILAO DOMRWA

GNB

PRYLSOGUY

BLZ

RUSBOL COL

KNA

IDN

ARG

LKA

ZAF

KHM

NAM

URYVNM

TUN

HND DZA

MOZ

LBN SWZ

SLETZA

SLV VUTBLR

LCAMEX

SYR

TON

ZMB

ROMNICKGZ

PAN

BGR

MUSCRI

WSMMKDIND

BRBBWA

JAM

CZEZWE

SLBAZE

HUNCHL SVK

KAZMNG

TT O

GT MBGD

VCTLTU BHR

MAR

MACEST

JORCMRGEO GRDIRN

POL

ARM

DMA LVA MYS

UZB

KOR

KEN

BHS

BEN

HRVTHA

MDA

TCDCAF

ARE KWT

MRTCOM UKR

GMBGHAPNG

OMN

YEMCIV

BDI

SENPAK

BFA

AGOSAU

MLI

GIN

ERI SDNET H

NER

DJI

BRA

PHL

4060

8010

012

014

0G

ross

Pri

mar

y E

nrol

lmen

t




Methodology: DEA

Country C: Efficient by FDH, but inefficient by DEA

Peers of country C: A and D

Country D: inefficient by CRS DEA, but efficient by VRS DEA

O

F

C

B

A

Output

Input

D CRS

VRS

N

V

X

Y VRS

DEA Efficient Frontier: Primary Enrollment

COG

CPVGABMWI

TJK

GNQ

MDG

TGO PERUGACHN

NPL FJILAO DOMRWA

GNB

PRYLSOGUY

BLZ

RUSBOL COL

KNA

IDN

ARG

LKA

ZAF

KHM

NAM

URYVNM

TUN

HND DZA

MOZ

LBN SWZ

SLETZA

SLV VUTBLR

LCAMEX

SYR

TON

ZMB

ROMNICKGZ

PAN

BGR

MUSCRI

WSMMKDIND

BRBBWA

JAM

CZEZWE

SLBAZE

HUNCHL SVK

KAZMNG

TT O

GT MBGD

VCTLTU BHR

MAR

MACEST

JORCMRGEO GRDIRN

POL

ARM

DMA LVA MYS

UZB

KOR

KEN

BHS

BEN

HRVTHA

MDA

TCDCAF

ARE KWT

MRTCOM UKR

GMBGHAPNG

OMN

YEMCIV

BDI

SENPAK

BFA

AGOSAU

MLI

GIN

ERI SDNET H

NER

DJI

BRA

PHL

4060

8010

012

014

0G

ross

Pri

mar

y E

nrol

lmen

t




An important factor of production (public spending) is used more intensively in the relatively richer countries

AGO

AREARG

ARM

AT G

AZE

BDIBEN

BFA

BGD

BGR

BHRBHS

BLRBLZ

BOL

BRA

BRB

BWA

CAF

CHL

CHNCIV

CMR

COG

COL

COM

CPV

CRI

CZE

DJI

DMA

DOM

DZA

ERI

EST

ET H

FJIGAB

GEO

GHA

GIN

GMB

GNB

GNQ

GRD

GT M

GUY

HND

HRVHUN

IDN

IND

IRNJAMJOR

KAZ

KENKGZ

KHM

KNA KOR

KWT

LAO

LBN

LCA

LKA

LSO

LTULVA

MAC

MAR

MDA

MDG

MEX

MKD

MLI

MNG

MOZ

MRT

MUS

MWI

MYSNAM

NER

NIC

NPL

OMN

PAK

PAN

PERPHL

PNG

POL

PRY ROMRUS

RWA

SAU

SDN

SENSLB

SLE

SLV

SVK

SWZ

SYR

TCD

TGO

THA

TJK

TON TT OTUN

TZA

UGA

UKRURY

UZB

VCT

VNM

VUTWSM

YEM

ZAF

ZMB

ZWE

02

46

8le

du/L

inea

r pr

edic

tion

6 7 8 9 10lgdp

ledu Linear prediction

Edcation Spending vs GDP per capita

Public Expenditure on Education and GDP per capita (both in logs)

ALB ARG

BFA

BGR

BLZ

BOL

BRA

BWA

CHLCOL

CUB

CZE

DOM

HUN

IDNIRN JOR

KEN

KOR

KWT

LSO

LTU

LVA

MAR

MDA

MDG

MEX MKD

MOZ

MUS

MYS

NAM

NER

PER

PHL

POL

PRY

ROM

SVK SVN

SWZ

SYC

TT OTUNTUR

TZA

VUT

ZAF

ZWE

200

300

400

500

600

Learn

ing S

core

s

0 20 40 60 80 100Net Secondary Enrollment

Data Source: World Bank WDI & Crouch and Fasih (2004)

Correlation: Learning Scores and Net Secondary Enrollment

ARG

BGR

BOL

BRA

BWA

CHL

CMR

COL

CUB

CZE

DOM

HKG

HND

HUN

IDNIRN JOR

KEN

KOR

KWT

LSO

MEX

MLI

MOZ

MUS

MWI

MYS

NER

PER

PHL

POL

PRY

ROM

SEN

SGP

SVKSVN

SWZ

THA

TT OTUNTUR

TWN

TZA

UGA

ZAF

ZMB

ZWE

200

300

400

500

600

Lear

ning

Sco

res

0 2 4 6 8 10Average Years of School


Correlation: Learning Scores and Average Years of School

ARG

BFA

BGR

BLZ

BOL

BWA

CIV

CMR

CZE

HND

HUN

IDNIRN JOR

KEN

KWT

LSO

LTU

LVA

MAR

MDA

MDG

MKD

MLI

MOZ

MUS

MWI

MYS

NAM

NER

PER

POL

PRY

ROM

RUS

SEN

SVK

SWZ

THA

TT OTUN

TZA

UGA

VUT

ZAF

ZMB

ZWE

BRA

CHLCOL

MEX

PHL

TUR

200

300

400

500

600

Lear

ning

Sco

res

0 100 200 300 400Orthogonalized Public Expditure on Education


Learning Scores vs Education Expenditure

ARG

AUS AUT

BFA

BGR

BLZ

BOL

BWA

CANCHE

CIV

CMR

CYP

CZEDEU

DNK

DOM

ESP

FINFRAGBR

GRC

HND

HUN

IDNIRN

ISL

ISR

IT A

JOR

KEN

KWT

LSO

LTU

LVA

MAR

MDA

MDG

MKD

MLI

MOZ

MUS

MWI

MYS

NAM

NER

NLD

NORNZL

PER

POL

PRT

PRY

ROM

RUS

SEN

SVK SWE

SWZ

THA

TT OTUN

TZA

UGA

USA

VUT

ZAF

ZMB

ZWE

BRA

CHL COL

MEX

PHL

TUR

200

300

400

500

600

Lear

ning

Scor

es

600 800 1000 1200 1400 1600Orthogonalized Public Expditure on Education


Learning Scores vs Education Expenditure

C. Public Expenditure Composition and Growth

Question – What’s impact of public spending composition on growth?

• Re-allocation decisions among Infrastructure, Education, Health, and Transfers

• Financing decisions for expenditure change – debt or tax, or or different types of tax instruments

• Permanent vs. transitory expenditure changes

Modeling approach

• Question: Effect of public expenditure on growth• Building blocks of the model economy based on

some principles that allow replication of key features (growth, transfers, debt accumulation)

• Experiments a. Allocation decisions: Change compositions and

compare with SSb. Financing decisions: debt vs. taxes; or different

types of tax instrumentsc. Permanent vs. transitory expenditure changes

Building blocks

• Preferences (types of agents, consumption, unproductive government expenditure)

• Technology- Explicit relationship between inputs and output; productive government expenditure)

• Resource constraints (public and private sectors)

Building blocks (Glomm-Rioja)–Preferences

• Consumer’s utility maximization problem

1,, lnln)1ln( max ttttt ccn

tttLttt hwscts )1(.. ,,

11,1, ))1(1( ttttKtt Tsrc

2. periodin Retired 1. periodin Work

:periods 2 live sIndividual

Solution leads to optimal savings and labor supply decisions.

Building blocks -Technology

capitalhuman :

capital physical Private :

capital Public :

parameterty Productivi :

Output :

:Function Production1

H

K

G

A

Y

tttt HKAGY

Building blocks-productive government expenditure

• Human capital production function

11 tttt hEBnh

Laws of motion:

11 tttt HEBnH

ttGt YG ,1

Building blocks-Fiscal policy

where public expenditure (as % of GDP) - on infrastructure - on education- on transfers - on other non-utility enhancing public service

Tax rate - on labor income- on capital (interest) income

ttKtttPtTtEtGtttKtttLt DrYKrHwD ))1(1()( ,,,,,,,1

t,G

tE ,

tT ,

tP,

t,L

t,K

)(t

tYD

tt Rrr

Building blocks- The steady state• Competitive equilibrium conditions

– The household utility maximization problem is solved. – The representative firm’s profits maximization problem is solved. – The government budget constraint is satisfied.– The goods market clears – The competitive input markets clear

– Permanent increase in expenditure financed by debt

Increase in expenditure (Permanent 1% of GDP, financed by debt)

1.75

2.00

2.25

2.50

2.75

3.00

3.25

3.50

0 1 2 3

Period

GD

P g

row

th r

ate

(%)

Benchmark Transfer Education Infrastructure

–Temporary increase in expenditure financed by debt

Increase in expenditure (Temporary 1% of GDP, financed by debt)

1.75

2.00

2.25

2.50

2.75

3.00

3.25

3.50

0 1 2 3

Period

GD

P g

row

th r

ate

(%)


– Permanent increase in expenditure financed by tax

Increase in expenditure (Permanent 1% of GDP, Financed by tax)

1.75

2.00

2.25

2.50

2.75

3.00

3.25

3.50

0 1 2 3

Period

GD

P g

row

th r

ate

(%)


Income per capita - Permanent Expenditure Reallocation (1% of GDP)

Income in base year: $4500 for Brazil, constant 1995

Reallocation in expenditure (Permanent 1% of GDP)

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

0 1 2 3

PeriodBenchmark From Transfers to Education

From Transfers to Infrastructure From Education to Infrastructure

III. How much government expenditure? a simple model and international comparison

• The model (Barro and Sala-I-Martin, 1995)• Production function of the economy :

Yt= AtF(K, N, G) or Y=AL1-KG1-

• Government Budget constraint : G=Y• Representative individual maximizes a utility

function subject to a budget restriction

Public expenditure has two opposite effects on growth rate of consumption of

• One positive effect derived from larger government services

• One negative effect due to the after-tax marginal product of capital

The simple estimate of the optimal size of government expenditure

g

From this simple model we obtain:

• The maximum growth rate is achieved for = G/Y=1-• Indicators of productiveness or unproductiveness of

government services ( dy/dg>0 ?)

• The degree of over-provisioning or under- provisioning of public capital

Atf1< r+d+n

Implications of Maintenance in Public Capital

• Aggregate Production Y=AL1-KG1-

• Private capital

• Public capital

• Maintenance expenditure

• New public investment

• Government Budget constraint Optimal tax rate that maximizes growth

YM YI g )1(

*

*

1

1

1)1( tktt KIK

1)](1[ tGGtt GY

MIG

YIM g

Does government expenditure (as a ratio to revenue) conform to international experience?

R atio of G overnm ent Spending to R evenueR ati o o f Go v e r n m e n t Sp e n d in g to R e v e n u e

1 .1 8

0 .9 8

1 .05

0 .9 60 .99

1 .41

1 .0 71 .09

1 .041 .0 9

1 .14

1 .30

1 .4 7

1 .121 .0 8

1 .2 2

0 .99

1 .1 1

1 .1 8

1 .10

1 .1 7

1 .06

0 .76

1 .1 1

1 .03

1 .26

1 .4 6

1 .12

0 .95

1 .0 8

1 .141 .0 9

0 .00

0 .20

0 .40

0 .60

0 .80

1 .00

1 .20

1 .40

1 .60

Ra

tio

of

Go

vt.

Sp

en

din

g t

o R

ve

nu

e

A RG

B HR

B RA

CA N

CHL

COL

CRI

CZE

ES T

HRV

HUN

IND

K A Z

LTU

LV A

MDA

NZL

PER

PHL

POL

ROM

RUS

S GP

S V K

S V N

THA

TUR

URY

USA

V EN

V NM

Z A F

The same holds when private investment is used as a metric

R atio of Public to P rivate Investm entR atio o f Pu b lic to P riv a te In v e stme n t

0 .10

0 .20

0 .2 9

1 .04

0 .2 10 .17

0 .2 1

0 .45

0 .14

0 .220 .2 4

0 .2 1

0 .09

0 .5 9

0 .20

0 .6 7

0 .360 .3 9

0 .8 1

0 .40

0 .00

0 .20

0 .40

0 .60

0 .80

1 .00

1 .20

A RG B RA CHL COL CRI EST HRV IND LV A MDA PER PHL POL RUS SV N THA TUR URY V EN Z A F

Ra

tio

of

Pu

blic

to

Pri

va

te I

nv

es

tme

nt

A RG

B RA

CHL

COL

CRI

EST

HRV

IND

LV A

MDA

PER

PHL

POL

RUS

S V N

THA

TUR

URY

V EN

Z A F

The ratio between capital and current expenditures. Expenditure composition is a matter of concern

Ratio of Government Capital to Current ExpenditureRatio of Capital to Currrent Expenditure (%)

7.2

25 .5

2.5 1.7

18 .9

29.7

11.0 9.98.1

10.2

13.0

9 .9 9.911.6

7 .2 7.7

2.7

17 .5

1 0.1

4.7

10 .7

7 .3

44.5

13 .2

7 .8

67.1

8.7

5 .0 4.7

22.3

46 .1

5.1

0 .0

10 .0

20 .0

30 .0

40 .0

50 .0

60 .0

70 .0

80 .0

AR

G

BH

R

BR

A

CA

N

CH

L

CO

L

CR

I

CZ

E

ES

T

HR

V

HU

N

IND

KA

Z

LT

U

LV

A

MD

A

NZ

L

PE

R

PH

L

PO

L

RO

M

RU

S

SG

P

SV

K

SV

N

TH

A

TU

R

UR

Y

US

A

VE

N

VN

M

ZA

F

ca

pc

ur

(%)

ARG

BHR

BRA

CAN

CHL

COL

CRI

CZE

EST

HRV

HUN

IND

KAZ

LTU

LVA

MDA

NZL

PER

PHL

POL

ROM

RUS

SGP

SVK

SVN

THA

TUR

URY

USA

VEN

VNM

ZAF

IV. Debt sustainability and productivity of capital expenditures

• The traditional debt dynamics equation

sb ttt

T

tf

g

ieeb

g

gr

1

*

1 11

1

11

1. Debt targeting- S instrument of fiscal policy

2. “Fiscal space”-productivity of public capital

Revised debt dynamics equation, with current and capital expenditures disaggregated

ksb t

c

ttt

T

t g

drf

g

ieeb

g

gr11

*

1 1

)(

11

1

11

r+d= rental price of public capital

p = marginal productivity of public capital

Policy coordination: fiscal, monetary, exchange rate and public debt management-

“fiscal space” considerationsunder liquidity constraints-Brazil 2002

• Features of Brazilian public debt1. Mostly domestic2. Short maturity and duration3. Indexed to the exchange rate or to short

term interest rates (Selic)4. Concentrated holders (mutual funds, few

banks)

Public debt jumps in 2001 as currency depreciates (Argentina crisis unfolding)

1.6

2.0

2.4

2.8

3.2

3.6

4.0

44

48

52

56

60

64

68

1999 2000 2001 2002 2003

Exchange Rate

Public Debt (right scale)

% o

f GD

PR

eais

/dolla

r

The primary surplus falls. The presidential campaign is no fertile ground for fiscal adjustments.

Primary Fiscal Balance of the Public Sector 2000-2003(as a percentage of GDP)

3.2

3.6

4.0

4.4

4.8

2000 2001 2002 2003

-.3

-.2

-.1

.0

.1

.2

.3

96 97 98 99 00 01 02 03

Brazilian Spreads and Exchange RateJan 2000 – April 2003

Capital Flows to Brazil (ratio to international reserves)

Public debt sustainability concerns causes a run on mutual fund “deposits”

Net Resource Flow to Mutual Funds(as a fraction of net worth)

-.08

-.06

-.04

-.02

.00

.02

.04

.06

1998 1999 2000 2001 2002 2003

The central bank was forced to print money to redeem public debt

2.0

2.5

3.0

3.5

4.0

4.5

5.0

95 96 97 98 99 00 01 02 03

-.3

-.2

-.1

.0

.1

.2

.3

.4

1999 2000 2001 2002 2003

Money Base as a Share of GDP

(seasonally adjusted data

Monetary Impact of Treasury’s

Operations 1999- 2003(ratio to the monetary base

-1

0

1

2

3

4

5

6

2001 2002 2003

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

2000 2001 2002 2003

Monthly Inflation Rate in Brazil 2000-2003

Seignorage from Money Creation 2000-2003

(% of GDP)

Exchange rate and interest rates adjust after the fiscal commitment is certain.

1.6

2.0

2.4

2.8

3.2

3.6

4.0

4.4

14

16

18

20

22

24

26

28

2000 2001 2002 2003

Selic(right scale)

Exchange rate

%

Reais

/dolla

r

fiscal policy and public expenditure santiago herrera

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