By Marcello Estevão, Senior Adviser for Equitable Growth, Finance, and Institutions, World Bank Group
Rarely since the end of the Second World War has the role of macro-fiscal policy been as salient as it is today. The management of revenue, expenditure, debt and fiscal risks within a medium-to-long-term, inclusive and sustainable growth strategy is regarded as an instrument to respond to crises and help address development challenges.
Good macro-fiscal policy has become imperative in a world facing multiple, simultaneous crises—the COVID-19 pandemic, earthquakes, flash floods, forest fires and other natural disasters alongside increased conflicts and wars. Getting macro-fiscal policy right during these crises will help stabilize economies, protect vulnerable households and support businesses. Getting the short-term response wrong will risk governments unintentionally promoting economic crises, rising poverty and growing vulnerability.
If short-term crises were not onerous enough, governments must conduct fiscal policy with an eye toward addressing medium-to-long-term challenges—including income inequality, aging societies, rising non-communicable diseases, globalization, digitalization and most serious of all, climate change with its requirements for mitigation and adaptation.
Failure to address short- and long-term challenges will feed into the poisonous political trends already underway—including the loss of faith in democracy and pluralism, replaced by populism, radicalism, instability and military conflict.
Indeed, the last few years have seen particularly tumultuous currents: The COVID-19 pandemic caused deep recessions in advanced and developing economies. The fiscal response to the crisis differed across countries. Revenue collection dropped sharply in both advanced economies (AEs) and emerging markets and developing economies (EMDEs). But AEs had sufficient fiscal space to boost spending to mitigate the impacts of the pandemic. EMDEs, on the other hand, were generally less able to increase public spending.
As a result, about 100 million people were pushed back into extreme poverty, with between 70 and 161 million likely to have experienced hunger. Progress in other areas, such as education and health (including stunting and non-communicable diseases), was halted or reversed, while inequality within and among countries increased.
COVID-19 vaccines were successfully rolled out in 2021, and the global economy started to fight back. In 2022, the Russian invasion of Ukraine, continued COVID-19 flare-ups, higher inflation rates, and gradual withdrawals of monetary and fiscal supports all weighed down on economic recovery. The year closed with grimmer prospects for the world economy, with several AEs flirting with recessions and weaker growth paths for EMDEs than expected before the war in Eastern Europe.
Higher fiscal deficits have pressured public debts across all country groups to rise to their highest levels in half a century. Debt vulnerabilities have risen particularly in developing countries, and more than half of low-income countries are now at high risk of debt distress or are already in debt distress; some countries have already defaulted on their debts; and debt restructurings have been completed or are underway in some countries.
Against this backdrop, governments must develop fiscal-policy strategies that address their fiscal and economic vulnerabilities.
Fiscal consolidation, which starts by identifying the sustainable fiscal space (i.e., investigating whether projections of revenues, expenditures and interest rates are consistent with debt-servicing needs), will be needed in many countries. This requires taking stock of contingent liabilities, such as government guarantees to state-owned enterprises and private companies. Realistic projections of gross domestic product (GDP), inflation, imports and exports, exchange rates, interest rates and oil prices are required, given their importance for projected revenue and expenditure.
This information can then be used to set fiscal targets. If debt is on an unsustainable path, fiscal authorities should define a sustainable debt level and determine how quickly fiscal consolidation should proceed to reach the target level. This entails: (i) setting targets for higher revenue collection as part of a medium-term revenue strategy; (ii) stabilizing or reducing expenditure as part of a medium-term expenditure framework; (iii) reforming or introducing enforceable fiscal rules (such as a public-deficit-limit rule or an expenditure-growth rule); and (iv) developing a medium-term debt strategy that manages risk exposures, reduces macro-financial risks and reinforces fiscal policy. Such a fiscal strategy needs to be set up in consultation with other government ministries and various stakeholders to obtain societal ownership of the likely sacrifices.
Getting this balance right matters a great deal. If fiscal consolidation is too slow, countries face a heightened risk of sovereign-debt crises, possible permanent contractions in output, increases in poverty, and rising political and social unrest. By the same token, rebuilding fiscal buffers will be critical to giving countries fiscal space to react to the next crisis. In a world of great uncertainty, fiscal buffers are critical lines of defense.
Countries moving too fast may risk “self-defeating” fiscal consolidation. This is a situation in which the impact of a fiscal contraction is big enough to bring economic output down not only in the short term but also in the medium term and (possibly) long term, hampering fiscal consolidation by raising debt-to-GDP ratios and reducing tax revenues.
Four principles can help guide policymakers as they formulate strategies:
- Align short-term measures with sustainable and inclusive growth objectives,
- Maximize the efficiency and effectiveness of fiscal spending and revenue,
- Minimize distortions affecting economic growth,
- Promote a fair distribution of the adjustment burden.
An eye on the medium term
One of the lessons from previous consolidation efforts is that strategies were excessively focused on short-term economic adjustment. It is important to include medium-term goals of raising productivity growth, tackling poverty and inequality, building resilience to natural disasters and transitioning to a low-carbon economy to mitigate climate change. Indeed, increased risk from vulnerability to climate change is projected to raise EMDEs’ interest payments significantly. Thus, climate-adaptation investments will not only help vulnerable countries increase their resilience to climate shocks but also help them bring down their borrowing costs.
Unfortunately, policymaking often ignores the connection between the short and long terms. We have shown, for instance, that most of the COVID-19 fiscal stimulus was either “legacy” or new brown spending.1 Such brown spending increases the likelihood that the resulting assets will lose their value due to changes in the marketplace (becoming “stranded assets”). The much-needed low-carbon transition may well precipitate the realization of this risk. Economies and livelihoods connected to fossil fuels directly or indirectly are likely to be hit. Middle-income coal exporters such as Colombia, Indonesia and Mongolia could face the greatest risks of stranded assets impacting their economies.
Countries introducing a carbon price (through carbon taxation, an emissions-trading system or a mix of both) while issuing green bonds would support a more accelerated shift to renewable-energy sources. To meet the Paris Agreement climate goals, carbon pricing alone would result in rapid and significant energy-price increases that would be recessionary. Similarly, the level of public green investment needed to reach the Paris Agreement goals without recourse to carbon pricing would be so great that it would endanger debt sustainability. Instead, it is by combining both these supply-side and demand-side policies that countries can achieve a low-carbon transition within a fiscal sustainability framework.
Maximizing efficiency and effectiveness
Besides reducing expenditure and increasing revenue to meet fiscal targets, fiscal consolidation is also an opportunity to improve the “quality” of expenditure and revenue. Such “quality” can be measured by the extent to which the budget: (1) is allocated to sectors and programs supporting developmental objectives, including boosting productivity and human capital; (2) is spent efficiently; and (3) is effective in meeting governmental goals.
It is critical that countries enhance the effectiveness and targeting of policy measures for crisis mitigation and recovery, especially of existing subsidies. For example, due to mobility restrictions, energy consumption and prices fell during the pandemic in 2020, bringing fossil-fuel subsidies down to a record low of about US$180 billion, or 40 percent lower than 2019 levels. Yet, as energy prices and consumption rebounded in 2021, subsidies jumped to US$440 billion, or approximately 0.5 percent of global GDP. This is a problem because fossil-fuel subsidies benefit the rich, who consume more of these fuels, and are harmful to most people, the economy and the climate. For example, air pollution caused by burning fossil fuels cost the world an estimated US$2.9 trillion in 20182 and resulted in an estimated 10.2 million global excess deaths in 2012.3
Countries could instead re-channel a share of the resources spent on fossil-fuel subsidies into cash transfers targeted at poor and vulnerable households and another share into investments in public transportation and green technology, which could reduce fossil-fuel dependence. Improving spending efficiency, effectiveness and fairness has other critical benefits: It also improves citizens’ trust in government, leading to higher voluntary compliance with paying taxes.4
Revenue collection should be improved through tax-system reforms. Investments in IT (information technology), data and skills that strengthen the revenue authority’s capacity to undertake enhanced compliance-risk management and auditing are key. Simplifying the tax code improves clarity, thus reducing taxpayer errors, tax-filing and payment burdens, and tax evasion and avoidance.
Minimizing distortions on economic growth
But what if countries need to undertake a more rapid fiscal consolidation? In most cases, fiscal consolidation, particularly one that is pursued rapidly, may unduly weigh on demand and growth.
Measures that minimize distortions in growth should thus be prioritized. OECD (Organisation for Economic Co-operation and Development) research has suggested that corporate and personal income taxes are the most harmful to growth, while recurrent taxes on immovable property appear to have the least impact. We have shown that raising taxes on carbon emissions is less harmful to growth than higher taxes on labor incomes (personal income tax, or PIT).5 Raising PITs is associated with permanent negative effects on consumption and significant impacts on employment, whereas these effects are minor with carbon taxes. In addition, carbon taxes can improve firm-level productivity, as they nudge firms to invest in energy-saving technologies, thus reducing costs and improving profits and productivity.
Promoting a fair distribution of the burden
Equity and fairness considerations contribute to fiscal policy’s role in eradicating extreme poverty and lessening income inequality.
Consider corporate income taxation (CIT). CIT-rate hikes might harm growth when current rates are already set at reasonable levels. Yet, reforming inefficient CIT exemptions and addressing tax evasion and avoidance by firms and individuals should be prioritized to raise the effective CIT burden on undertaxed taxpayers. Ensuring “horizontal equity” (taxing businesses of similar turnover and profits and individuals of similar income in an even manner) helps to improve the fairness and equity of fiscal policy, raises substantial revenue and reduces the need to hike growth-damaging taxes. Such CIT reform requires international coordination given the global nature of capital and the business landscape, which raises the importance of ongoing multilateral efforts such as the G20-OECD-led “Two Pillar Solution”.6
Finally, a holistic poverty and equity assessment of fiscal policy is needed. Some tax instruments may be suited to raising a significant amount of revenue but may, on their own, be less progressive. However, if their revenues are spent on targeted health and social-protection measures to help the most vulnerable, their net impact on reducing poverty and inequality could be higher than before these interventions. This type of analysis7 is critical to ensuring fiscal policy is designed to support inclusive growth.
Renegotiating the social contract
It will not be easy for any country to adhere to the principles outlined here, especially in times of crisis. Aligning short-term measures with medium-to-long-term objectives requires an enlightened approach to policymaking when politicians may face intense public pressure to deliver in the here and now. For all the jargon on maximizing efficiency and effectiveness or minimizing distortions in economic growth, the activities needed to achieve success on these criteria are not merely technical exercises. Political craft is required to sequence reforms, calibrate objectives to balance winners and losers, and forge a unifying narrative that inspires a broad coalition of actors in support of sustained reform. And that includes future generations, who do not have a vote today, and marginalized groups.
No fiscal-reform journey will be perfectly devoid of mistakes or follow a linear path of progress. But implementing a good fiscal strategy is achievable even in times of crisis and will have markedly lower costs than the alternatives of inaction or uncoordinated, haphazard actions.
As it once did in the aftermath of the great wars, our world must unite again to imagine and negotiate a new social contract. By leveraging sound fiscal policy, governments will have a better chance of meeting the aspirations of citizens for a newfound vision.
1 Green Fiscal Policy Network, “Can Fiscal Instruments Turn a Crisis into Opportunity,” Marcello Estevão and Miria Pigato. November 4, 2021.
2 Centre for Research on Energy and Clean Air (CREA): “Quantifying the Economic Costs of Air Pollution from Fossil Fuels,” Lauri Myllyvirta, February 2020.
3 Science Direct: “Global mortality from outdoor fine particle pollution generated by fossil fuel combustion: Results from GEOS-Chem,” Karn Vohra, Alina Vodonos, Joel Schwartz, Eloise A. Marais, Melissa P. Sulprizio and Loretta J. Mickley, February 18, 2021.
4 The World Bank, Voices, “To Raise More Tax Revenues, First Build Up Taxpayers’ Trust,” Marcello Estevão, Kalpana Kochhar and Ed Olowo-Okere, February 17, 2022.
5 The World Bank, Voices, “The Green Tax Switch: Climate Action Need Not Come at the Expense of Growth,” Marcello Estevão and Christian Schoder, November 14, 2022.
6 Organisation for Economic Co-operation and Development (OECD): “OECD/G20 Base Erosion and Profit Shifting Project Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalisation of the Economy,” October 2021.
7 The World Bank: “Fiscal Policy: Incidence”.