Budgeting for Fiscal Space

1. Budgeting for Fiscal Space Allen Schick Annual Meeting ~ Senior Budget Officials Organization for Economic Co-operation and Development Vienna, 2-3 June 2008

2. The Contemporary Interest in Fiscal Space • The prospect of a constrained fiscal environment has spurred interest in fiscal space • Governments are not concerned about fiscal space when resources suffice to finance existing programs and policy initiatives • OECD governments have vastly more to spend than in the past, but their budget options have narrowed • The increments available for policy initiatives tend to be small • Demographic trends will intensify budget stress in many OECD countries • The impact of these trends will depend on the age structure of the population and the means of financing pensions and health care • The possibility that budgeting will become a decremental process that allocates losses rather than gains • Budgeting would be more contentious and politicians would have difficulty financing new policies

3. How the Fiscal Space Concept is Applied All Countries To measure the money available for policy innovation consistent with medium to long term fiscal sustainability Low Income Countries To assess the opportunity for additional spending to promote development, thereby stimulating economic growth and increases in government revenue Middle Income/Developmental Countries To promote rapid development without undue risk to the government’s future fiscal position Highly Developed Countries To assess the resources available for allocation through annual or medium-term budget decisions

4. Budgeting for Fiscal Space is Incremental • Fiscal Space recognizes that budgeting is inherently incremental • Past efforts to uproot incrementalism (such as PPBS and ZBB) failed • Incremental budgeting focuses on allocating additional resources and on marginal adjustments in ongoing programs • Over time, incremental decisions can aggregate to major changes in budget policy • Baseline projections are the starting point in budgeting for fiscal space • The baseline projects future budgets assuming no change in current policy • The Medium-Term Expenditure Framework (MTEF) institutionalizes incremental budgeting • This may be why MTEF, in contrast to previous reforms, has survived

5. The Four Determinants of Fiscal Space • The composition and trend of public expenditure • How large is public spending relative to GDP and how sticky is it? • The propensity to tax • What is the share of GDP extracted in taxes and can this share increase? • The propensity to borrow • Can government finance spending ambitions by borrowing more? • The performance of the economy • Will economic growth provide sufficient increments?

6. The Shrinkage of Fiscal Space: Public Expenditures • After decades of steep increases, public spending as a share of GDP has stabilized in most OECD countries • In view of its relative size, public expenditure is not likely to rise much in the decades ahead • Public expenditures are sticky • They do not readily adjust to changes in political/economic conditions or to changes in national priorities • Expenditures are sticky even for programs that are not effective • In fact, governments often spend more for programs that are not performing well • National governments have become holders of costly risks • Government must give priority to these risks (ageing, illness, unemployment, natural disasters) • Entitlements that establish a legal right to payment from government will claim a rising share of most national budgets • Demographic trends will compel national governments to allocate incremental resources to entitlements

7. The Shrinkage of Fiscal Space: Revenues • The era of large tax increases has ended in most OECD countries • It appears that many OECD countries are competing to reduce tax rates on individual and corporate income • Governments with large tax expenditures will try to curtail these preferences • In some countries, reducing tax expenditures will facilitate reductions in tax rates: in others, doing so will provide modest increments for expenditure • Fiscal decentralization has led some countries to assign a substantial share of their revenue to sub-national governments • The impetus for decentralization has slowed, but has not been reversed • Pressure will likely increase in decades ahead for taxes to finance international activities • These demands will influence the capacity of national governments to generate additional review for their own purposes

8. The Shrinkage of Fiscal Space: Deficit Financing • During the postwar growth spurt, many governments borrowed to finance current expenditure • Deficit financing occurred despite sharply rising revenue due to economic growth and tax increases • Deficit financing was accommodated by a shift from balanced budget norms to demand management • It was deemed more important to balance the economy than the budget • The advent of fixed fiscal targets and rules limits the capacity of most OECD governments to borrow • Fiscal rules such as the Stability and Growth Pact limit the deficits and debt of many OECD countries • Even when they are not fully effective, fiscal rules inhibit public borrowing • Net borrowing by OECD countries has declined during the past decade

9. The Shrinkage of Fiscal Space: Economic Performance • Economic growth is a necessary condition for incremental budgeting • Growth not only gave governments more money to spend, but it induced them to boost the portion of the economy allocated to public consumption, investment and transfers • In most OECD countries the potential for growth will be less robust in the future than in the past • Potential output is a function of the size of the work force, which will likely grow more slowly in the future, and of productivity, which is difficult to predict • Built in stabilizers protect fiscal space when the economy is weak • When the economy recovers, government may be pressured to stabilize its fiscal position

10. Protecting Fiscal Space • Governments often engage in budget practices that significantly reduce future space • Space-robbing behavior occurs in both affluent and poor countries • Policy changes that have modest short-term costs, but generate large downstream expenditures • This practice can be mitigated by having an effective MTEF, including baseline projections • Ad-hoc spending decisions made outside the regular budget framework curtail fiscal space • In some countries, decisions made between budgets have become as important as decisions made in the budget

11. Protecting Fiscal Space, continued • Spending units do not often propose significant reallocations • Governments can stimulate reallocation by increasing baseline expenditures by less than the rate of inflation or by reducing them for expected productivity gains, or by making across-the-board cuts and setting aside the savings in a bidding fund for policy initiatives • When fiscal space is tight, investment expenditure may be curtailed • One remedy is to finance investments through public-private partnerships, provided downstream costs and risks are prudently assessed • Fiscal space is narrowed when risks become due • Space can be protected by shifting risks to households or enterprises by imposing risk-sensitive premiums, increasing copayments and deductibles, and by shifting to defined contribution pensions

12. Adjusting the Budget Process • The primary role of the modernized central budget office should be to guard and allocate fiscal space • Performing this role requires that it manage baseline projections, assure that proposed and adopted program savings and initiatives are accurately costed, and shift from an annual to a multiyear horizon • To the extent politically feasible, the budget office should uphold the disciplined framework for compiling the budget • The capacity of the budget office to perform its responsibilities is greatly diminished by ad-hoc decisions

13. Adjusting the Budget Process, continued • Governments that incorporate future price changes in baseline projections should reconsider this practice • Protecting existing programs against future price changes greatly diminishes fiscal space and distorts perceptions of budget actions • The Medium-term (3-5 years ahead) may be an insufficient frame for protecting fiscal space • Budget offices that have well-running MTEFs should introduce longer-term perspectives into budgeting • An improperly operated MTEF can significantly reduce fiscal space by legitimizing larger claims on future budgets • The MTEF should be fully integrated into annual budgeting and should have a firm constraint

14. THE BUDGET OFFICE SHOULD REGARD FISCAL SPACE AS ITS SPACE. OFTEN IT IS THE ONLY PORTION OF THE BUDGET OVER WHICH IT HAS SIGNIFICANT INFLUENCE.