Fiscal Policy and Economic Growth: Lessons for Eastern Europe and Central Asia

Key questions  How do broad public finance patterns and trends affect economic growth? Fiscal balance Size of government Patterns of spending and taxation  How can the efficiency of spending and taxation be increased? Infrastructure Education Health Pensions Flat income taxes Labor taxes

Key messages o The impact of fiscal policies on growth depends on the quality of governance. o Government size and expenditure composition matter most when governance is weak; Tax composition also matters when governance is strong o High fiscal deficits reduce growth in both cases o In most ECA countries fiscal space needs to be created through efficiency gains rather than increased spending.  There are opportunities for efficiency gains in infrastructure, education, health, and pensions. o Recent reforms in income taxation are welcome but do not adequately address the high labor tax wedge.

Public Finance and Economic Growth: Trends and Interrelationships

Growth in ECA has been rapid in recent years after initial collapse.

Fiscal balances have improved in recent years in most ECA countries. …but further fiscal adjustment is still needed in some settings.

Successful fiscal adjustments have been stronger than unsuccessful ones and have been driven mainly by broad-based expenditure cuts

Growth has been higher when fiscal adjustment has been successful…

… and adjustments financed by “non directly productive” expenditure cuts have had higher growth impact

Most ECA governments are larger than in comparator high-growth countries Primary Public Expenditures and Per capita Incomes (PPP) (average )

Large size tends to reflect large spending for social transfers

Large government size is associated with slower growth in poorly-governed countries … but not in well-governed countries

Why might “big governments”, beyond a certain size, adversely affect growth?  Misallocation of expenditures: Big governments may spend more on less productive functions  Low efficiency: Weak administrative capacity may be more of a binding constraint when public responsibilities are large  High taxes: Financing of high levels of public spending requires high taxes that can distort incentives for saving, investment, and work effort …and the negative effect of these factors tends to be stronger when governance is poor

The impacts on growth of public spending and revenues also depend on the quality of governance. Size of government and spending mix matter most when governance is poor; Spending and revenue mix matters more when governance is good. SPENDING Good governance Poor governance “ Unproductive ” expenditures No measurable impact Negative impact “ Productive ” expenditures Positive impactNo measurable impact TAXATION “ Distorting ” taxesNegative impactNo measurable impact “ Non distorting ” taxes Positive impactNo measurable impact

The Challenge of Improving Public Spending Efficiency

Few ECA countries have fiscal space for additional spending

Infrastructure: Policy reforms are high priority -- and maintenance, private sector participation, some new investment

Education and health: ECA has good outcomes given its level of income…

…but these results come at a high cost. Example: Input efficiency score for life expectancy at birth

Reforms can increase efficiency in education and health Education  Allocate financing on a per student basis  Move to more efficient (generally larger) class sizes  Reduce emphasis on expensive vocational education  Enhance private financing, particularly at tertiary level Health  Consolidate hospitals to improve efficiency  Strengthen incentives for cost saving by providers and consumers (e.g. co-payments, basic benefits package)  Address high out-of-pocket payments (often informal)  Improve transparency and accountability at all levels

Pensions are a particular challenge in ECA  Situation different than in comparators Legacy of generous pension coverage Falling employment levels (exacerbated by high labor taxes) Aging populations  Share of elderly receiving pensions exceeds percentage of working-age population making contributions

A two-pronged approach for pension reform?  MICs: public/private contributory systems + means-tested social assistance  LICs: universal low-rate pension (financed from general revenues)  All contributory systems should be entirely self-financing  In many cases financial sustainability will require benefits to be tightened

How can Distortions in the Tax System be Reduced?

ECA leads the world in flat-rate income tax reforms… Revenue, incentive, equity, and growth effects have generally been positive.

…but complementary policies are needed to enhance the impact of flat-income taxes  Closing tax loopholes and ad hoc exemptions  Maintaining appropriate tax allowances to enhance equity  Strengthening tax administration  Reforming payroll taxes and social insurance

Labor taxes are still too high…

…and are associated with low labor force participation in ECA ECA countries need to streamline social benefits and move to general revenue financing of health and some social transfers to help spur employment

Summing up  The impact of fiscal policies on growth depends on the quality of governance.  Government size and expenditure composition matter most when governance is weak; Tax composition also matters when governance is strong  High fiscal deficits reduce growth in both cases  In most ECA countries fiscal space needs to be created through efficiency gains rather than increased spending.  There are opportunities for efficiency gains in infrastructure, education, health, and pensions.  Recent reforms in income taxation are welcome but do not adequately address the high labor tax wedge.

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