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Symposium 2015

Solution for The Design of Fiscal Consolidation Plans

The Challenge

In the aftermath of the global financial crisis and the Great Recession, many countries are facing substantial deficits and growing debt. As analyzed in the 16th Geneva Report on the World Economy, th ...

In the aftermath of the global financial crisis and the Great Recession, many countries are facing substantial deficits and growing debt. As analyzed in the 16th Geneva Report on the World Economy, the global debt-GDP ratio continues to grow, while growth and inflation remain low, raising concerns about the dangers posed by new crises. This situation spurs the need to consolidate public finances in order to bring down debt-GDP ratios. When setting up specific fiscal consolidation plans in order to achieve this, policymakers can generally choose from a wide range of possible fiscal instruments. The aim of this session is to discuss how consolidation plans should be designed to bring debt-GDP ratios down, while minimizing short-run social and economic costs.

Reconcile Fiscal Consolidation with Economic Growth and Social Inclusion

The proposed solution reconciles fiscal consolidation with economic growth and social inclusion by setting detailed priorities about where to reduce spending and increase taxes. The OECD has assessed economic and social effects of scaling back spending and raising taxes across all areas of expenditure and revenue. This assessment provides a way of ranking revenue and expenditure instruments according to their expected short- to medium-term impact on growth and equity. Figure 11 of the report by Cournède, Goujard, and Pina (2014) shows this ranking when giving equal weight to economic growth and income equality (see http://www.oecd.org/economy/reconciling-fiscal-consolidation-with-growth-and-equity.pdf, p. 26).

This solution gives priority to revenue increases from inheritance taxes (included in other property taxes) and reductions in subsidies and pension spending. Adjustments along these dimensions imply limited adverse effects on growth or income distribution. By contrast, spending cuts in education, health or child care, as well as hikes in social security contributions, generally harm growth or exacerbate income inequality.

The solution for growth- and equity-friendly fiscal consolidation is most effective when it adapts to country circumstances, evolves over time, and is built into a credible macro framework:

  • Adapt to country circumstances: The weighting of objectives can be easily modified in the light of country preferences. The OECD website includes a practical tool (see http://www.oecd.org/eco/public-finance/Simulation-ranking-web.xlsx) to do so. Furthermore, countries can rely to different degrees on different instruments, depending on their leeway. For instance, even if a given tax (e.g., inheritance tax) is attractive from the points of view of growth and equity, there is limited scope to increase it in countries where it is already very high. The OECD has published quantitative examples illustrating how governments can implement this approach.
  • Evolve over time: Reductions in public expenditure can hurt activity in the short term but become more attractive when taking a long-term perspective. Over time, economically efficient and socially inclusive fiscal consolidation strategies should shift away from tax increases, which are relatively easy to implement quickly, towards greater reliance on expenditure reduction, which requires more time.
  • Benefit from a credible fiscal framework. Prudent debt targets should be set and serve as reference points for fiscal rules. Fiscal rules should have two objectives: promote fiscal discipline and allow stabilization. The OECD solution recommends combining a budget balance rule and an expenditure rule. A budget balance target encourages hitting the debt target. And, well-designed expenditure rules appear decisive to ensure the effectiveness of a budget balance rule and can foster long-term growth. The design of these fiscal rules should be tailored to country characteristics such as their debt level, their exposure to shocks and their monetary regime. In addition, a fiscal council can bring transparency, foster fiscal discipline and make fiscal rules more credible, especially if it is independent and allowed to participate actively to the public debate.

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