Fiscal Policies and Growth: Constraints and Opportunities

Carlo Cottarelli and Michael Keen

“Ascent after Decline”: Workshop World Bank, November 19, 2010

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THE MACROECONOMIC DIMENSION

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The state of the world’s public finances

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Advanced economies entered crisis with worst (non-war) fiscal outlook

General Government Gross Debt for G-7 Economies, 1950-2007(In percent of GDP)

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Gross Debt

Net Debt

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Emerging Advanced0

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200920302050

Old Age Dependency Ratio

With pressures from aging on top of that

• Pension reforms contain cost to 1 percent of GDP

• Health care costs increase by average 3.5 points by 2030

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Pre-crisis outlook for emerging economies better

1998 1999 2000 2001 2002 2003 2004 2005 2006 20070

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All Emerging Latin AmericaAsiaEurope

General Government Debt in Emerging Economies, 1998-2007(In percent of GDP)

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Fiscal legacy of crisis most marked in advanced economies---reflecting lasting impact on GDP

2007 2008 2009 2010 2011 2012 2013 2014 2015-10

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Advanced Emerging

2007 2008 2009 2010 2011 2012 2013 2014 20150

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Advanced Emerging

General Government Debt

General Government Balance

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Deficits, debt and growth

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0 50 100 150 200 250-10

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Debt ratio

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PB

Advanced Economies

In advanced economies, fiscal positions are unsustainable

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What debt target for stabilization?

Higher public debt associated with:

Higher real interest rates—perhaps 1.75 percentage points over 2008-15 for advanced economies

Lower growth (through reduced investment and labor productivity)—perhaps 0.5 points per year

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So need to do more than return to pre-crisis

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2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029 2030

Cyclically AdjustedPrimary Balance Primary

Balance

Overall Balance

Required adjustment is roughly:

• 8.5 percent GDP in advanced economies

• 3 percent in emerging

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Impact of fiscal adjustment on growth

Prospects for expansionary contractions limited:• Recent WEO work• Low interest rates

Evidence that adjustment on spending side is:• Associated with more durable consolidation• Less contractionary

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THE MICROECONOMIC DIMENSION

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Spending better

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Welfare reform

Pensions—Argue for raising retirement age by 2 years: stabilizes spending at 2010; best for growth

Health care—supply and demand side measures

‘Better targeting’?• Incentive effects of means-testing• Wage subsidies• Tagging by correlates with participation responsiveness;

increase UK workforce by 1 percent.

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Infrastructure and innovation Literature gives good reason to suppose strong

positive output effect from public capital....

...but little guidance on specifics

Institutions matter

Likely needs:• Climate change—adaptation not costly in most advanced,

but likely to be in some emerging• Fundamental R&D—energy research, geoengineering?

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Eliminating wasteful subsidies

Petroleum subsidies—cost around 0.3 percent global GDP in 2010

Exemptions and special treatment—importance of tax expenditure analysis

Subsidies to renewables—don’t let spending substitute for proper carbon pricing

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Taxing smarter

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In search of immobile tax bases

VAT: • Potential in Japan (and US?)• Large scope in most advanced economies to eliminate

exemptions and reduced rates—could raise £11 bn in UK even after compensation

Property tax

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Green taxes

Revenue potential is:• Significant but not transformational in advanced—about

$100 bn per year in U.S• More in some emerging—If internationally traded• But requires that permits not be given away

Not much money in other environmental taxes• Though potential in congestion pricing

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Investment and finance

Giving an allowance for notional cost of equity (an ‘ACE’) would

Eliminate corporate-level disincentives to invest Reduce debt bias

Financial sector• Pre-financing resolution/Corrective tax• ‘Financial Activities Tax’—a fix for the VAT

Gains from enhanced international cooperation