You are here: Home Knowledge Base The Design of Fiscal Consolidation Plans Solutions On the Design of Fiscal Consolidation Plans
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.

On the Design of Fiscal Consolidation Plans

Fiscal consolidation, understood as a set of measures that are designed to either boost government revenue or to reduce public expenditure, or both, usually entail difficult policy decisions both from a technical as well as from a political perspective. In almost all countries, the design of efficient public spending and investment programs and the choice and reform of the tax system require significant expertise in various fields, and entail complex negotiations between the executive branch of government and congress. In federal democracies, these decisions often also involve negotiations between the federal and subnational (provincial) governments.

Therefore, given such complexity, it is very difficult to come up with solutions that apply uniformly to all countries. Moreover, while fiscal consolidation in a number of countries are almost a permanent challenge, policy recommendations may vary depending on the nature of the circumstances that originate to the need for fiscal consolidation.

The challenge of this session refers to the design of fiscal consolidation plans in response to the high and growing debt-to-GDP ratios that several countries have reached in the aftermath of the global financial crisis. Hence, in this case, fiscal consolidation needs to be thought in conjunction with debt sustainability. In turn, debt sustainability is highly dependent on international capital market conditions affecting a particular economy.

The conventional “tax smoothing” framework implicitly assumes that fiscal policy is designed to meet an intertemporal budget constraint and, hence, it assumes that the government has an unlimited access to financing at all times within that solvency constraint (full credibility). The conventional framework provides little guidance as to debt sustainability as long as, for instance, any path that stabilizes the debt-to-GDP ratio is, by definition, sustainable in the sense that is compatible with intertemporal solvency.

When imperfect credibility in introduced into the picture in response to the capital market being unwilling to finance possibly unsustainably high debt levels, conclusions change quite dramatically. In a world of imperfect credibility liquidity constraints tend to appear and governments face limits on the size of their borrowing requirements that can be financed. As the emerging market economies learned in the 1990s, and some advanced European economies learned in this decade, capital-market access cannot be taken for granted. In such a context, a truly sustainable fiscal policy needs to be designed taking into account not just intertemporal solvency but also liquidity considerations such as the size of the yearly borrowing requirement and the maturity structure of the public debt. Limits on the size of the borrowing requirement can be shown to translate into limits on the debt-to-GDP ratio that is sustainable (Guidotti, 2007). These limits can be quite low, often within a 25–40% range (Reinhart, Rogoff, and Savastano, 2003; Mendoza and Oviedo, 2004).

Moreover, when a government or country loses the full confidence of the capital market, it may face a dramatic reduction in the debt ratio that is regarded as sustainable. In such case, no fiscal consolidation is enough and debt restructuring or external official financing (or both combined) become necessary.

Some governments that maintain their credibility may finance high debt ratios even though these may not be ultimately sustainable (e.g., Japan). These cases may fall into an “unsustainability trap” where the high debt-to-GDP ratios become a Damocles sword hanging over the economy, resulting in a protracted stagnation.

Proposed Solutions

Based on the above discussion, I put forward the following (partial) solutions to fiscal consolidation and public debt sustainability:

  1. The G20 and/or the IMF should develop a debt sustainability framework that explicitly introduces debt limits into the picture. Debt limits should be related to capital market conditions, credit ratings, and liquidity considerations such as the maturity structure of the public debt. Debt limits should differ across groups of countries depending on the perceived credibility they command in the international capital market. For instance, among advanced economies, debt limits should be tighter for countries such as Italy, Portugal and Spain, than for Germany, the US or France, under current conditions.
  2. Given the framework developed above, the official community should develop institutions to deal with the transition of a country/government from the full credibility to the imperfect credibility equilibrium (Portugal, Spain, Italy) in which the reduction in the sustainable debt ratio may be potentially sudden and large. The ESM is an example of such institutional response.
  3. When dealing with economies that exceed their sustainable debt limits, the design of fiscal consolidation plans should include the use of temporary extraordinary taxes on wealth. Temporary taxes of this sort (of no more than 5 years duration), may avoid or reduce the probability of a debt-restructuring scenario, and are progressive. It goes without saying that, whenever possible, complementary measures to reduce inefficiencies in government expenditure programs should be adopted. The adoption of temporary taxes that frontload fiscal adjustment is remindful of a result found in Calvo and Guidotti (1998). They show that, in the presence of time inconsistency or lack of credibility that results in a risk or expected inflation premium, the optimal plan displays “debt aversion” and, contrary to the conventional tax smoothing model, tax revenue is anticipated and optimality requires to reduce the debt-to-GDP ratio to zero in the long run.

 

References

Calvo G., and P.E. Guidotti (1982). Optimal Maturity of Nominal Government Debt: An Infinite-Horizon Model. International Economic Review (Nov. 1992): 895–919.

Guidotti, P. (2007). Global Finance, Macroeconomic Performance, and Policy Response in Latin America: Lessons from the 1990s. Journal of Applied Economics X (2, Nov.): 279–308.

Mendoza, E., and P.M. Oviedo (2004). Public Debt, Fiscal Solvency, and Macroeconomic Uncertainty in Latin America: The Cases of Brazil, Colombia, Costa Rica, and Mexico. NBER Working Paper 9908.

Reinhart, C., K. Rogoff K., and M. Savastano (2003). Debt Intolerance. Brookings Papers on Economic Activity 34(1): 1–74.

    Related Solutions

    Solution
    Symposium 2015

    Reconcile Fiscal Consolidation with Economic Growth and Social Inclusion

    Reconcile Fiscal Consolidation with Economic Growth and Social Inclusion

    Reconcile Fiscal Consolidation with Economic Growth and Social Inclusion

    Solution
    Symposium 2015

    The Answer to High Debt Is Growth

    The Answer to High Debt Is Growth

    The Answer to High Debt Is Growth