An Analytical Framework With Application

Deficits: Definitions and explanations Fiscal sustainability. What do you want to

call fiscal balance? How should fiscal policy look like in

theory? How does it look in practice?

Different concepts of Deficit Full-employment (structural) deficit

Note that the deficit varies with the business cycle Revenues are greater in expansions Expenditures are greater in recessions

What would the deficit be if we leave aside these cyclical fluctuations?

In a recession, structural deficit is lower than overall deficit

Primary deficit Net of interest payments:

Some of the current deficit is simply interest on previously accumulated debt

Credit card again: regardless of what you do this month, you still have to pay interest on your balances

On-Budget and Social Security Balances

-8 .0 %

-6 .0 %

-4 .0 %

-2 .0 %

0 .0 %

2 .0 %

4 .0 %

6 .0 %

Ye a r

% o

f G

DP

On BudgetBalance

Soc ialSecurityBalance

S o urc e : E c o no m ic R e p o rt o f the P re s id e nt

Stabilization Fiscal Policy as a tool to manage AD in the short run Example: Tax cut But recall our discussion on the multiplier: What if

people look ahead and see that the extra deficit will have to be paid for at some point (with interest!)?

This is often called the “Ricardian” view “Tax Smoothing”

Even if deficits have no impact on AD, it may still be the case that you want to run them

Taxes have a distortive impact on incentives (i.e. they can affect AS) The distortion is greater at higher rates

If you have temporary need for high spending, you want to borrow instead of raising taxes

US Federal Budget (% GDP)

Source: Economic Report of the President

Country averages, 1999-2007 (2008 where available)

Deficits : Thinking about The Future Burden

Borrowing If the government needs to incur some expenditure

beyond current revenues, it can issue a bond and sell it to the private sector

In other words, it borrows money from the private sector, and pays interest on it

Ex: In the US, government can issue Treasury bill (to be paid back in one year or less), T-note (two to ten years), T-bond (twenty to thirty years) T-note and T-bond pay interest (“coupon”) every six

months; T-bill pays no explicit interest, but is sold at a discount

These bonds are also traded in secondary markets (that’s where the Fed conducts open market operations)

Monetizing In principle, the government can also sell

these new bonds to the Central Bank To buy them, the CB “prints money” This form of raising revenue for the

government is called “seignorage” This is a way in which FP can influence MP Independence of the Central Bank is meant

to prevent this type of process

Current Outlook Right now, most developed countries are running

very high budget deficits To a large extent, this is a product of the recessions However, there are structural issues that, if

unaddressed, may lead to structurally high deficits, and consequently to increasing (possibly unsustainably so?) debt levels

Demographic issues Aging Pensions / Health expenditures Fewer workers to tax to pay for that Less private savings (older people save less)

A lot of these are off-budget items

What Is “Unsustainable”? Ultimately, it’s about the country’s perceived ability to repay If investors think they won’t be repaid, they won’t buy bonds

Look at Greece right now If debt relative to GDP is too high (and rising), the ability to

repay may be a concern But how high is “too high”? That depends a lot on the situation of each country!

Debt is accumulated in order to fund a fiscal deficit

The fiscal deficit can be decomposed into three components

Deficit = G – T + i D Primary spending Current revenues Interest on the debt

We do not consider debt issuance or privatization as revenue or debt amortizations as spending

We call T – G the primary surplus, S Deficit = i D - S The deficit is just equal to the increase in net debt

SiDDeficitdt

dD

An unsustainable position is one where the debt rises faster than the capacity to pay for it

For debt to be sustainable in the long run, some ratios have to be stable Debt to GDP Debt to tax revenue

What needs to be the fiscal balance for this to occur?

ttt

tt sb

g

rb

11

1Consider the following law of motion

Where b is the debt to gdp ratio, r is the nominal (real) interest rate, g is the nominal (real) rate of gdp growth and s is the primary surplus.Then b(t) = b(t-1) if:

bg

grs

1

A typical tax revenue ratio for an LDC is 15-20 percent

A typical real growth rate is 3-4 percent A typical debt ratio is 40% of GDP A typical real interest rate is 5% The equation implies that the primary

surplus needs to be s=(.05-.03).4=0.8% So if T/Y = 15%, then G/Y =14.2%

Rank2002 1995 2002 1995 2002 1995 2002

Turkey 1/ -19.2 -5.8 81.2 42.8 4.0 3.9 1Argentina 1/ -12.8 -3.2 174.0 38.3 0.3 -1.3 2India 2/ -10.2 -6.9 80.6 71.0 -4.0 -1.9 3Hungary -9.5 -6.2 49.9 84.3 -5.5 2.7 4Philippines 1/ -8.3 -4.2 99.4 80.5 2.3 80.5 5Brazil 1/ -4.7 -7.0 95.1 31.1 4.0 0.3 6Indonesia 3/ -1.8 0.8 80.6 29.0 3.8 2.6 7Chile 1/ -1.4 3.3 20.9 20.0 -1.1 4.2 8South Africa 3/ -1.2 -5.6 39.9 42.2 3.0 -1.0 9Ecuador 1/ 0.8 -1.2 57.8 39.7 4.4 2.9 10Russia 0.7 -6.5 34.7 37.9 2.8 -2.7 11

Source: WEO.

1/ Public sector.2/ For India gross debt.3/ Central government.

Table 1: India's General Government Finances in an International Context

General Government

(In percent of GDP)

Debt-to-GDP 1/Deficit-to-GDP Primary Deficit-to-GDP

*

*

eYY

eBBb

Consider the debt ratio

Where B* is debt in dollars (tradables) and Y* , Y is tradable and non-tradable output

1

1

)1(

*

1

eP

P

PP

P

P

EPq

PPP

N

T

NT

T

NT

**

**

eBBeYY

BYYBe

b

e

e

b

The elasticity of b relative to e is given by:

Table 22

Year b B/eB* Y/eY* Elasticity

El Salvador 1998 0.27 0.00 3.03 0.75

Argentina 1998 0.38 0.08 8.63 0.82

Brazil 1998 0.42 1.76 12.34 0.29

Ecuador 1998 0.67 0.02 2.94 0.73

Colombia 1998 0.22 0.59 6.36 0.49

Chile 1998 0.12 1.30 2.85 0.18

Source: Own calculationsNote: b: Total Public Debt/GDP

B*: Debt denominated in terms of tradablesB: Debt denominated in terms of non-tradablesY: Non-tradables GDPY*: Tradables GDP (proxied by exports)

Public Sector Debt Mismatch Measure

Fiscal policy as business-cycle management

Spend in bad times, save in booms Use fiscal policy when monetary policy is

ineffective Liquidity trap Japan

Problem: suffers from long and variable lags, but also slow to decide and difficult to change The problem with the shower temperature

People have expectations about the future The do not see debt as net wealth, since it

will be serviced with their own taxes Ricardian equivalence: an increase in

public spending is an increase in future taxes, leading the private sector to spend less in the present

Useless from the point of view of demand management

Two periods, no discount rate, r=0 i=0, rate of discount = 0 Government consumes always the same

amount but taxes only in period 2 G1=G2=G

Private income is given, Y1, Y2 2G= t * Y2 Y1+(1-t)Y2=C1+C2 U=u(C1)+u(C2) C1= C2= [Y1+(1-t)Y2]/2 = [Y1+Y2]/2-G dC1/dG = -1

Distortionary taxes Y=Y(t), Y’<0, Y’’<0 E.g. Y1 = Y – at2

Budget constraint of govt G1+G2=t1*Y1 + t2 * Y2 (1-t1)Y1+(1-t2)Y2=C1+C2 U=u(C1)+u(C2) C1= C2= [(1-t1)Y1+(1-t2)Y2]/2 At the optimum t1 = t2

Imperfect capital markets in dev. countries Off-set coefficient: how much does private

saving increase when public saving declines? Standard estimates at 0.5 (Edwards 1996) But only because of crisis times (Gavin 1997)

In normal times offset is very high It is very low in bad times

Overlapping generations I get the money, my children pay the taxes

Exploiting non-equivalence is a weak basis for policy Tell it to the Republicans

Y may be volatile because of supply and demand shocks

G may be volatile because programs may have uncertain costs

T depends on Y G may also depend on Y, ideally with a

negative correlation Unemployment compensation

Automatic stabilizers can do the trick

Optimal policy: stabilize tax rates in an inter-temporal program that is solvent

How does it look like? Run deficits in periods of low income Run surpluses in periods of high income Make sure that debt ratios remain stationary

Looks keynesian. What is the difference?

The OECD calculates the full-employment deficit They calculate what would have been the

deficit if the economy was at the equilibrium Y Is this appropriate for developing

countries?

The terms of trade may be at non-equilibrium levels The current account may be at non-equilibrium

levels Since there is taxation on spending and imports, this may

generate a difference of income vis a vis equilibrium The real exchange rate has important fiscal

implications Calculate FD at equilibrium RER

Are interest rates at equilibrium levels? Domestic rates and the “peso problem” Foreign rates are volatile Old debt may be at different rates than current rates

“Structural fiscal deficit” is where the FD&BB curve cross the NN curve

-30%

-20%

-10%

0%

10%

20%

1 2 3 4 5 6 7 8 9 10 11 12 13 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

recessions

Cummulative GDP fall (%) Change in fiscal surplus (% del PIB)

Fiscal balance during recessions

OCDE América Latina

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

Fiscal Balance Public Consumption Inflation tax

América Latina OCDE

Correlation coefficient with GDP; 1970-95

0%

5%

10%

15%

20%

25%

30%

35%

Fiscal shock Revenues Current spending Capital expenditures

OCDE América Latina

Volatility of fiscal variables; 1970-94(Standard deviations of the rates of growth)

200

400

600

800

1000

1200

Jan

-97

May

-97

Se

p-9

7

Jan

-98

May

-98

Se

p-9

8

Jan

-99

May

-99

Se

p-9

9

Jan

-00

May

-00

Se

p-0

0

Jan

-01

May

-01

Se

p-0

1

776 pb

The cost of borrowing is volatile(LEI, Spread over US Treasuries)

Pre-Asian Crisis

Pre-Russian Crisis

Pre-Argentine Crisis

Current level

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

Pro

-cyc

lical

ity

of

go

vern

men

t co

nsu

mp

tio

n

1% 2% 3% 4% 5% 6% 7%

Volatility of GDP growth

ARG BRBBOL

BRACHL

COL

CRI

DOMECU

GTM

HND

JAM

MEX

PANPRY

PER

SLV TTOURY

VEN

CAN

FRA

DEU

ITAJAP

GBRUSA

Volatility of GDP growth andPro-cyclicality of government consumption

1970-95

-1.5

-1

-0.5

0

0.5

1

1.5

Per

cent

of G

DP

Fiscal Outcome

Pre-election Election year Post-election

Fiscal Policy and ElectionsLatin America, 1980-96

Why do developing countries face precarious access to borrowing? Do they borrow too much? Do they tax too little?

Why do they exhibit pro-cyclical instead of anti-cyclical fiscal policy?

Why is there an electoral budget cycle?

Coordination problems The common pool problem Delayed stabilization

Aggregation problems Arrow’s impossibility theorem Electoral rules

Agency problems Credibility/time-inconsistency problems

Chicken and lobster While their benefits tend to be concentrated,

they tend to be financed from a common pool of resources (Weingast, Shepsle and Johnsen 1981)

The budget is the result of a collective decision-making process, involving a variety of agents: Legislators Spending ministers The finance minister

Generates a tendency to overspend and to overborrow

Dynamic version Tendency towards pro-cyclical spending

Delegated choice, incompatible objectives and asymmetric information

Governments may want to spend more money than the public, because they can appropriate part of it

Lack of confidence Incentives to lie about real situation

Incentives to distort reality through policy E.g. The electoral budget cycle (Nordhaus

1975, Tufte 1978, Rogoff 1990)

What is optimal today is not optimal tomorrow Let bygones be bygones

Promise to repay in good times is not credible Imperfect credibility leads to undereborrowing

in bad times Signalling (Saint Paul)

Whose choice is it? Down to West Palm Beach

Proportional representation vs. first past the post District magnitude Margaret Thatcher’s landslide?

What are the costs and benefits Better representation vs. more difficult

aggregation Effective number of parties One or two chambers?

0 4 8 12 16 20

BahamasTrinidad

HaitiBarbados

JamaicaBelize

PanamaChile

EcuadorDom RepParaguay

PeruColombiaSurinameUruguay

GuatemalaHondurasNicaragua

Costa RicaEl SalvadorVenezuelaArgentina

BoliviaMexico

Brazil

Representatives per electoral districtLower chamber

Guyana ha sido excluída del gráfico por razones de presentación. Su número de representantes es 43.4.

1

10

Nú

me

ro d

e P

art

ido

s E

fec

tiv

os

1 10 100 1000

ARG

BHS

BLZ

BOL

BRA

BRB

CHL

COLCRIDOM

ECU

GTM

GUYHND

HTI

JAM

MEX

NIC

PAN

PER

PRY

SLV

TTO

URY

VEN

GBR

AUT

BELDNK

FRA

DEU

ITA

NED

SWE

FIN

GRE

IREPOR

SPA

El número de representantes por distritos en los sistemas bicamerales es el máximo entre las dos cámaras

Instituciones Electorales y Resultados Políticos

Representatives per district (log scale)

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Rep

rese

nta

tio

n o

f th

e ex

ecu

tive

’s p

art

y i

n c

on

gre

ss

1 10 Effective number of parties

ARG

BHS

BRB

BLZ

BOLBRA

CHLCOL

CRI

ECU

SLV

GTMGUY

HTI

HND

JAM

MEX

NIC PAN

PRY

PER

DOM SUR

TTO

URY

VEN

Fragmentation and minority governmentsLower chamber

-0.12

-0.10

-0.08

-0.06

-0.04

-0.02

0.00

0.02

0.04

1 10 100 1000

ARGBHS

BLZ

BOL

BRA

BRB CHL

COLCRIDOM

ECU

GTM

HNDHTI

JAM

MEX

NIC

PAN

PER

PRY

SLV

TTO

URY

VEN

GBR

AUT

BEL

DNK

FRA

DEU

ITA

NED

SWE

FIN

IRE

PORSPA

Superávit Fiscal(% del PIB)

Representatives per district (log scale)

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1 10 100 1000

ARG

BHS

BLZ

BOL

BRA

CHLCOL

CRI

DOM

ECU

GTM

HND

JAM

MEX

PAN

PER

PRY

SLV

TTO

URY

VEN

GBR

AUT

BEL

DNK

FRA DEU

ITA

NED

SWE

FIN

GRE

IRE

POR

SPA

Public debtPercentage of revenues)

Representatives per district (log scale)

-0.60

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1 10 100

ARGBOL

BRA

BRB

CHL

COL

CRI

DOMECU

GTM

HND

JAM

MEX

PANPERPRY

SLV

TTO

URY

VEN

GBRFRA

Pro-cyclicality of government consumptionvs. district magnitude

Representatives per district (log scale)

Budget institutions matter because they affect the rules of the game under which the different actors involved in the budget process interact, either by placing constraints to the whole process, or by distributing the power, information and responsibilities among the different agents, and thus affecting fiscal outcomes.

Following Alesina and Perotti (1995), we identify three different types of budgetary rules: numerical rules procedural rules rules that affect the transparency of the

budget

Balanced budget rules, such as those of the U.S. states

Maastricht criteria (which impose limits on deficit and debt)

Gramm-Rudmann-Hollings (in the US), which imposes a gradual reduction of deficits, until their elimination

Regarding the indicator of performance they refer to

regarding the legal rank of the norm that establishes them

regarding their coverage regarding the stage of the budget process in

which they apply regarding their “flexibility”

They may be non-contingent or contingent, with clearly specified escape clauses

may be defined on the basis of an indicator of structural deficits

as a general rule, the greater the flexibility, the greater the complexity, the easier it becomes to elude them

Pros: If they are enforced, they may solve the majority

of the problems identified above they limit the strategic used of debt they limit the transfer from future to present

generations they limit the electoral cycle they limit the common pool problem, etc.

Cons: They may generate incentives for “creative

accounting” They limit the possibility of engaging in tax-

smoothing (a la Barro) (at least in the case of balanced budget rules)

They tend to be too inflexible (in particular in the case of highly volatile regions such as Latin America)

Volatility itself may be induced by the absence of fiscal discipline. Thus, if the rule is effective, the need to respond to the cycle may decline

Even in the absence of numerical rules, Latin America has been characterized by having a procyclical fiscal policy.

It is possible to set the numerical rules so that they respond to the cycle (such as stabilization funds)

It must be simple, and easy to monitor has to be defined on the basis of fiscal indicators

which cannot be easily manipulated there must be a credible scorekeeper must be defined on the basis of fiscal indicators

which are to a reasonable extent under the control of the fiscal authorities

must be defined in such a way that the cost of complying with the rules should not be excessive under a reasonable set of likely circumstances

Gramm-Rudman-Hollings Maastricht The experience of the US states

Gradual reduction of the deficit to achieve balance

Limited results Strategic use of estimates Increase in creative accounting Part of the reduction was covered by

asset sales But GRH did have some effect on deficits

Criteria for access to common currency deficit/GDP<3% debt/GDP<60% Credibility of the rule is in this case

imposed by a group of countries (with some flexibility), not by the individual countries alone.

Have been effective in helping achieve convergence, but part of the adjustment was achieved through creative accounting, as well as a reduction in the quality of expenditures (Easterly 1998)

49 out of 50 states have balanced budget rules. The only exception is Vermont.

But they differ in several dimensions: legal rank of the rule (statutory or

constitutional) Coverage of the rule Stage of the budgetary process in which

they apply: drafting, approval or implementation.

States with more restrictive rules (see Poterba, 1995)... Tend to have lower deficits (Eichengreen 1992, Bohn and

Inman 1995) and lower debt (von Hagen 1991) tend to face lower interest rates, even after controlling

for the size of deficits (Goldstein and Woglom 1992, Eichengreen 1992, Lowry and Alt 1995, Poterba and Reuben, 1998)

adjust more in response to past deficits (Alt and Lowry 1994)

react by adjusting more during the fiscal year in response to adverse shocks (Poterba 1994)

have a less counter-cyclical fiscal policy (Bayoumi and Eichengreen 1996), but...

This is not translated into increased output volatility (Alesina and Bayoumi 1997)

They affect the rules of the game in the interaction among the different agents that participate in the budget process

May be more “hierarchical” or more “collegial”

Hierarchical rules concentrate the power on the finance minister vis a vis the spending ministers, and on the executive vis a vis the legislature

Collegial rules tend to allocate power more equally among all the actors involved

During the drafting of the budget: Hierarchical: At the beginning of the drafting of the

budget, spending ministers receive spending caps which they must observe.

Collegial: each spending minister drafts its own budget, and these are then negotiated within the cabinet.

During the approval of the budget: Hierarchical : Congress can modify the composition

of expenditures, but cannot increase total expenditure or deficits

Collegial: Congress may propose any changes, without restrictions

During the implementation of the budget: Hierarchical : The government may cut

expenditures unilaterally if revenues are lower than projected

Collegial: Congress has the initiative to propose increases in the budget, even after it has been approved

Pros: They may generate fiscal discipline by concentrating

power on those who are responsible for macro stability. May solve the common pool problem They are more flexible than numerical rules, and allow

a response to the cycle Cons:

They do not solve the electoral cycle problem They do not solve the problems associated to the short

time horizon of politicians. They do not solve the problem of the strategic use of

debt By allowing a greater degree of discretion, they may

have a slower effect on the credibility of fiscal policy

Budget Enforcement Act (US) The experience of the European Union The experience of Latin America

Studied by von Hagen (1992) and von Hagen and Harden (1995)

build index of BI based on relative power of finance minister within the cabinet structure of negotiations within the cabinet relative power of executive vis a vis legislative Degree of expenditure control by the finance

minister degree of transparency of the budget

They find that more hierarchical (centralized) institutions tend to reduce deficits and debt, without affecting the capacity of govt. to stabilize output.

Studied by Alesina, Hausmann, Hommes and Stein (1996) and by Stein Talvi and Grisanti (1998)

AHHS build an index of budgetary institutions, based on a questionnaire that was responded by budget directors in 20 Latin American countries, for the period 1990-1993

Includes the stages of drafting, approval, and implementation of the budget

1 Are there any constitutional or legal constraints on fiscal deficits?

2 Is there a requirement that the budget be consistent with fiscal targets previously specified in a macro program?

3 What kind of borrowing constraints are there on the government?

4 Is the authority of the Finance Minister greater than that of spending ministers on budgetary issues?

5 What kind of restrictions does Congress have to amend the budget proposed by the government?

6 What happens if Congress rejects the budget, or does not approve it within the constitutionally set time frame?

7 Can the budget be modified after approval? On whose initiative?

8 Can the government legally empowered to cut spending after the budget has been approved? Under what circumstances?

9 Does the government typically assume debt originally contracted by other public agencies? Under what circumstances?

10 Can subnational governments and public enterprises borrow autonomously?

We find that more hierarchical and restrictive budget institutions lead to smaller primary deficits

A difference of 20 points in the index (which ranges from 0 to 100) is associated with a difference of three percentage points of GDP in the primary deficit

This result is very robust to changes in the way the index is built, in changes in the methodology of estimation, as well as to the inclusion of other variables that control for the effects of: external shocks the economic cycle age structure of the population initial level of debt wars and natural disasters

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

DOMBOLSLVBRAHNDPERVENPRYECUCRI

ARGGTMBHSTTOURYPANMEXCHLJAMCOL

0.45

0.47

0.50

0.50

0.52

0.54

0.55

0.55

0.56

0.56

0.57

0.57

0.57

0.58

0.62

0.66

0.72

0.73

0.75

0.76

Index of budget institutions

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.4 0.45 0.5 0.55 0.6 0.65 0.7 0.75 0.8

ARGBHS

BOL

BRA

CHL

COLCRIDOM

ECU

GTM

HND

JAM

MEX

PAN

PER

PRY

SLV

TTO

URY

VEN

Index of budget institutions

Fiscal deficits:1990-95(% of GDP)

0.0

1.0

2.0

3.0

4.0

5.0

6.0

0.4 0.45 0.5 0.55 0.6 0.65 0.7 0.75 0.8

ARG

BHS

BOL

BRA

CHLCOL

CRIDOM ECU

GTM

HND

JAM

MEX

PAN

PER

PRY

SLV

TTOURY

VEN

Index of budget institutions

Public debt: 1990-95(as a share of revenues)

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

0.4 0.45 0.5 0.55 0.6 0.65 0.7 0.75 0.8

ARGBOL

BRACHL

COL

CRI

DOM

ECU

GTM

HND

JAM

MEX

PAN

PER

PRY

SLV TTO

URY

VEN

La Prociclicalidad:1990-95(Correlación entre el Gasto Público y el PIB)

Index of budget institutions

…or limit electoral cycles

-0.04

-0.03

-0.02

-0.01

0

0.01

0.4 0.45 0.5 0.55 0.6 0.65 0.7 0.75 0.8

Los Ciclos Electorales:1990-95(Superávit Fiscal Promedio en años electorales menos Superávit Fiscal

Promedio en años pos-electorales)

Index of budget institutions

Off-budget items strategic use of macroeconomic forecasts

used for the drafting of the budget Treatment of contingent liabilities Creative accounting NEED FOR AN INDEPENDENT AND

CREDIBLE SCOREKEEPER WHY IS IT SUB-OPTIMAL TO LIE?

Numerical rules and procedural rules: alternative ways of introducing fiscal discipline But they solve different problems

Numerical rules and transparency: They are complements: without transparency,

numerical rules will not be effective However, the more restrictive the rule, the

larger the incentives for creative accounting Thus, if numerical rules are introduced, it is

important to improve transparency at the same time

Does not include numerical rules. It is based on procedural rules, and places a lot of emphasis on disclosure and transparency

Requires the government to follow a set of principles of responsible fiscal management

The government may depart from the principles, but must explain publicly why it does so, and indicate how and when it will conform with the principles again

Reduce debt to prudent levels, so as to provide a buffer against future adverse events, by achieving operating surpluses every year until prudent levels of debt have been achieved This suggests that debt reduction cannot be

achieved by selling assets Maintaining debt at prudent levels by

ensuring that, on average, over a reasonable period of time, total operating expenses do not exceed total operating revenues This allows for departures from budget balance

during recessions

Achieving levels of net worth that provide a buffer against future adverse events Recognizes that financial strength depends on

overall balance sheet, not just debt Managing fiscal risk prudently

Recognizes the need to treat contingent liabilities in a prudent way

Pursuing policies that are consistent with a reasonable degree of predictability about the level and stability of tax rates

Who defines what is a “prudent” level of debt, or a “reasonable” period of time over which the budget should be balanced?

The government of the time However, the government must justify

its interpretation of what is prudent and reasonable in parliament, as well as to the general public

A lot of emphasis on “disclosure” The government must present a Budget

Policy Statement well before the beginning of the budget year, which should include: their strategic priorities for the next budget their short-term fiscal intentions their long-term fiscal objectives

Three year horizon Regularly present updates of impact of

fiscal decisions.

0%

5%

10%

15%

20%

25%

Median Average

8.3%

15.6%

9.6%

17.2%

13.6%

19.3%

1985 1990 1995

Decentralization trends in Latin America

Su

bn

atio

nal

Exp

end

itu

re/T

ota

l exp

end

itu

re

services are better matched to preferences

greater accountability greater political participation innovations in services

Free riding Capture

Power to elect Power to spend Power to tax Power to borrow System of inter-governmental transfers

Success or failure depend on how these dimensions are organized and combined

Local Democracies

0

2

4

6

8

10

12

14

16

18

Co

un

trie

s

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97

Year

Number of countries where mayors are elected by the population

0% 10% 20% 30% 40% 50%

Subnational Expenditure/Total expenditure

ARG

BRA

COL

BOL

MEX

VEN

URY

CHL

HND

PER

GTM

ECU

TTO

PRY

SLV

NIC

PAN

DOM

CRI

BRB

BHS

Avg. OECD

Avg. LA

34.9%14.6%

Federal Unity

Decentralization in Latin America, 1995

Good local taxes are hard to findMobility of the tax base

Economies of scale

0% 20% 40% 60% 80% 100%

PERURYPRYBRACOLBOLHNDARGECUCHLMEXGTMVENSLVTTO

Average LAAverage OECD

5%

17%

23%

33%

38%

43%

49%

56%

58%

61%

61%

67%

83%

90%

92%

52%

42%

Vertical Fiscal Imbalance

Inter governmental transfers/ Total Subnational Collection

Discretional:Not stable or predictable

May generate soft budget constraints

Discretional:Not stable or predictable

May generate soft budget constraints

ARG

BOL

CHI

COL

ECU

SLV

MEX

PAN

PER

DOM

SUR TTO

VEN

Discrecionality in the transfer system

Mostly DiscretionalDistribution

HON, GUA, CRI

Mostly AutomaticDistribution

Mostly DiscretionalAmount

Mostly AutomaticAmount

DiscretionalNot stable or predictable

May generate soft budget constraints

Tied to revenue sources (most widely utilized)Prociclicality

Unwanted effects during adjustment

DiscretionalNot stable or predictable

May generate soft budget constraints

Tied to revenue sources (most widely utilized)

ProciclicalityUnwanted effects during adjustment

Earmarked (little utilized)Predictable and stable

They follow output not inputs

Varied experiences on the degree of borrowing autonomy

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

CHL

PAN

TTO

CRI

BOL

HND

VEN

DOM

GTM

URY

PRYSLV

PER

MEX

ECU

COL

BRA

ARG

0.5

0.5

0.5

0.5

1.0

1.0

1.0

1.0

1.0

1.0

1.5

1.5

1.8

2.0

2.0

2.9

3.0

Borrowing autonomy

Concurrent expenditure responsibilities High degree of vertical imbalance Discretionality in the transfer system Lax subnational borrowing rules that

may lead to possible bailouts

-0.12

-0.08

-0.04

0

0.04

0.08

0.12

Res

idua

ls*

0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45

Decentralization*Fiscal Imbalance*Borrowing Autonomy

BOL

BRA

CHL

COL

CRI

DOM

ECU

GTM

HND

MEX

PAN

PER

PRY

SLV

TTO

URY

VEN

Latin America

Note: Residuals for a total expenditure regression on the following control variablesInitial debt, population over 65 years, and degree of openness.

Strengthen local democracies Harden budget constraints

Limit vertical imbalance while maintaining efficiencyAdopt non-discretionary transfer rules

Clarify rules by avoiding concurrent responsibilitiesSet tight limits on borrowing autonomy of subnational

governments