fiscal standards and economic development leszek balcerowicz national bank of poland world bank...

FISCAL STANDARDS

AND ECONOMIC DEVELOPMENT

Leszek Balcerowicz

National Bank of Poland

World Bank Workshop

3 April 2006

Agenda:

I. Public finance and short-term economic growth

II. Public finance and long-term economic growth

1. General government balance

2. Tax system

3. Public expenditure

3

General government deficit (ESA’95, % of GDP, left scale) and GDP growth rate (%, right scale) in 1999-2004.

Source: Eurostat.

6.4

12.3

6.67.8

3.83.1

2.0

3.8

4.6 4.5

5.5

1.5

0

4

8

12

16

1999 2000 2001 2002 2003 2004

0

2

4

6Slovakia5.6

2.0

1.41.2

1.4

2.5-1.7

3.9

7.2 6.8

10.5

7.0

1

3

5

1999 2000 2001 2002 2003 2004

-4

0

4

8

12Lithuania

1.40.7

3.73.3

4.8

3.9

4.5 4.2

1.1 1.4

5.3

3.8

0

2

4

6

1999 2000 2001 2002 2003 2004

0

2

4

6Poland

General Government budget deficit (ESA’95, in % of GDP) GDP growth rate (in %)

I. Public finance and short-term economic growthThe 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.

4

Non-Keynesian effect

Output increase

Keynesian approach

rigid prices

Budget deficit reduction

Drop in interest rates

Change of private demand bigger and stronger than change of government demand

Increase of interest rates sensitive

private expenditure

Net export increase

Depreciation of domestic

currency

Dispelling of concerns for government

solvency

Increase of cumulated

disposable income expected in a

horizon of utility maximization

Output increase in long term

Non-Keynesian approach

Increase of enterprise capability

and propensity to invest

Improvement in external

competitiveness

Positive supply shock (cost fall)

flexible prices

Source: Rzońca A., Ciżkowicz P., Non-Keynesian Effects of Fiscal Contraction in New Member States, ECB Working Paper, No. 519, September, 2005.


5

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.



6

‘‘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.”

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.



7

The impact of fiscal policy on long-term economic growth may be underestimated...


Fiscal Position ofGovernment

Legal System and PropertyRights

Sound MoneyFreedom to Trade

Internationally

Regulation of Credit, Laborand Business

Developed countries Transition countries

Asian Tigers The poorest countries

Source: Fraser Institute.

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.

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.

Fraser Institute Economic Freedom of the World Index

8

...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.

9

II. Public finance and long-term economic growth1. General government balance

GENERAL GOVERNMENT DEFICIT

Crisis Crowding out of investment

PUBLIC DEBT

Fall in the growth rate

or in the level of

output

‘‘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.

‘‘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.

10

In the long term, a high budget deficit hampers economic growth.

Source: World Economic Outlook, May 2000, IMF.


General government deficit in the years 1970-98 (% of GDP)

2.3

4.8

1

3

5

Countries at medium income level with

fast convergence divergence or slow growth

0.7

5.2

0

2

4

6

Countries at low income level with

fast convergence divergence or slow growth

11


There are also other important channels through which public finance affects long-term economic growth.

Long-term economic growth

Level of taxes Structure of taxes

TAX SYSTEM

Level of public expenditure

Structure of public expenditure

PUBLIC EXPENDITURE

12


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.

2. Tax system

13

II. Public finance and long-term economic growth2. Tax system

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%

Source: Skrok E., Taxation and Long-Term Economic Growth: Analysis of Poland’s Tax Policy Against the Background of International Theory and Experience, 2004.

* distorting tax revenue – revenue from taxes on income and profit, social security contribution, tax on payroll, tax on property.

Empirical research confirms the negative impact of high taxes on economic growth.

14


Source: Smith A., An Inquiry Into The Nature and Causes of The Wealth of Nations, Vol. 2, Methuen & CO. LTD., London.

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.”

15


Laszlo Goerke

Taxes and Unemployment, Kluwer Academics, Boston, 2002.

Taxes have a negative impact on employment. The magnitude of the tax policy’s influence on employment depends on the labour market’s 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.”

Empirical research confirms the negative impact of high taxes on employment...

16

...and investment.

Michael Funke

Determining the taxation and investment impacts of Estonia’s 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.


17

Public expenditure and long-run economic

growth

II. Public finance and long-term economic growth3. Public expenditure

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

18

Public sector expenditure in West European countries in 1950 and in Poland in 2004 (% of GDP).

Source: Middleton R., Britain’s economic problem: too small a public sector?, Centre for Contemporary British History, 1995.Eurostat.

16.218.0 19.0 19.8

22.2 22.626.5 27.6 28.6

32.0 32.136.0

43.0

10

20

30

40

Sweden

Austri

a

Denmar

k

Switzer

land

Italy

Belgium

Nether

lands

Norway

Finlan

d

Germ

any

United K

ingdom

Franc

e

Poland

2004


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 today’s highly developed countries in the middle of the 20th century.


19

Source: Heitger B., The Scope of Government and Its Impact on Economic Growth in OECD Countries, Kiel Working Paper No. 1034, April 2001.


30.0

37.5

44.546.34.0

2.0

1.71.5

20

25

30

35

40

45

50

1960s 1970s 1980s 1990s

Pub

lic e

xpen

ditu

re (

in %

of

GD

P)

1

2

3

4

GD

P p

er c

apita

gro

wth

rat

e (in

%)

Public expenditure GDP per capita growth rate

Public expenditure and GDP per capita growth in OECD countries.

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.

20

Source: Heitger B., The Scope of Government and Its Impact on Economic Growth in OECD Countries, Kiel Working Paper No. 1034, April 2001.


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/communication.

21

Source: Tanzi V., Schuknecht L., Reconsidering the Fiscal Role of Government: The International Perspective, The American Economic Review, Vol. 87, No. 2, 1997.


‘‘(...) 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.”

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.


22


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%.

Bangladesh74% of teachers employed in public education system do not attend classes.

BrazilThe economic growth of Brazil is hampered by the high costs of doing business (including tax wedge) caused by the excessive welfare state.

IndiaThe 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.

23

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.

A high level of social spending discourages people from active participation in the labour market (social traps).

24


Source: Hagglund P., Effects of Changes in the Unemployment Insurance Eligibility Requirement on Job Duration – Swedish Evidence, 2000.

• 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.

25


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.


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.

Public sector efficiency in 2000 *

1.26

1.03

0.90

0.8

1.0

1.2

1.4

"Small" governments "Medium" governments "Big" governments

* 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.

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.

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