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Fiscal Policy and Public Expenditure Santiago Herrera. PUBLIC EXPENDITURE ANALYSIS AND MANAGEMENT COURSE March 2005. Outline. I. The Government’s budget identity II. Expenditure: composition, efficiency and growth impact III. Taxes and growth-optimal size of the expenditure - PowerPoint PPT Presentation
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Fiscal Policy and Public Expenditure
Santiago Herrera
PUBLIC EXPENDITURE ANALYSIS AND MANAGEMENT COURSE
March 2005
Outline
I. The Government’s budget identityII. Expenditure: composition, efficiency and growth
impactIII. Taxes and growth-optimal size of the
expenditure IV. Financing the budget-debt sustainability
analysis in practiceV. Policy coordination: fiscal, monetary, exchange
rate and public debt policies
I. The Government’s Budget Identity
1*
1 ttttt FiEBiG
Uses = Sources
Uses :
111 tttttttt MMFFEBBTSources:
Government’s Inter-temporal Budget Constraint
Today’s debt stock = NPV of (primary surplus + seigniorage revenue)
1
1/)(i
itititt RMSD
tttt FEBD
ititit GTS
where
II. Public spending:composition, efficiency, and growth impactObjectives of public expenditure:
Efficiency in resource utilization
Economic growth
Equity of income distribution and social stability
A. Cost-Benefit analysis
B. Measuring effciency
C. Growth impact
A. Costs Benefits Analysis• Rationale for public intervention
– Redistribute income– Correct market failure/positive externality– Greater supply of goods than private-sector provision
• Objectives and Targets• Valuing costs
– Additional fiscal burden• Source of funds to cover costs – borrowing vs. taxation• Marginal cost of public funds
– Sustainability – Macroeconomic Stability
• Valuing benefits – Comparing with a counterfactual
Net present value of geothermal project in the Philippines with different marginal cost of funds
-100
-80
-60
-40
-20
0
20
40
1.0 1.20 1.40 1.60
US m 29.7
-11.3
-52.3
-93.3
NPV
Source: Devarajan, et.al. (1997)
BOX 2: ROAMEF CYCLE
Source: The Green Book, HM Treasury
B. Measuring Efficiency of Public Spending
• Nonparametric Approaches: (Deterministic or Stochastic)– FDH (Free Disposable Hull)
– DEA (Data Envelopment Analysis)
• Parametric Approaches: (Deterministic or Stochastic)– Corrected OLS
– Stochastic Frontier
Parametric Approach: Stochastic Frontier - An Illustration
AGO
ARE
ARG
ARMAZE
BDI
BEN
BFA
BGD
BGR BHR
BHS
BLR
BLZ
BOL
BRA
BRBBWA
CAF
CHL
CHN
CIV
CMR
COG
COL
COM
CPV
CRICZE
DJI
DMA
DOM
DZA
ERI
EST
ET H
FJI
GAB
GEO
GHA
GIN
GMB
GNB
GNQ
GRDGT M
GUYHND
HRV
HUN
IDN
INDIRN
JAMJORKAZ
KEN
KGZ
KHM
KNA
KOR
KWT
LAO
LBN
LCALKA
LSO
LTULVA MAC
MAR
MDA
MDG
MEX
MKD
MLI
MNG
MOZMRT
MUS
MWI
MYS
NAM
NER
NIC
NPL
OMN
PAK
PAN
PER
PHL
PNG
POL
PRY
ROM
RUSRWA
SAU
SDN
SEN
SLB
SLE
SLVSVK
SWZSYR
TCD
TGO
THA
TJK
TON
TT O
TUN
TZA
UGA
UKR
URY
UZB
VCT
VNMVUT
WSM
YEM
ZAF
ZMB
ZWE
4060
8010
012
014
0G
ross
Pri
mar
y E
nrollm
ent
0 200 400 600 800 1000Public Expenditure on Education
Inefficiency Efficiency Frontier
Data Source: World Bank WDI
Primary Enrollment vs Education Expenditure
Methodology: Concept of Efficiency
X2/Y
X1/Y
Y’
Y
O
T
P R
S
• Technical Efficiency: TE = OR/OP
• Allocative Efficiency: AE = OS/OP
Methodology: FDH XA
YA
O
E C
B
A
Output
Input
D
XB
YB
Input Efficiency for country B: XA/XB
Output Efficiency for country B: YB/YA
Non-parametric Approach: FDH – An Illustration
COG
CPVGABMWI
TJK
GNQ
MDG
TGO PERUGACHN
NPL FJILAO DOMRWA
GNB
PRYLSOGUY
BLZ
RUSBOL COL
KNA
IDN
ARG
LKA
ZAF
KHM
NAM
URYVNM
TUN
HND DZA
MOZ
LBN SWZ
SLETZA
SLV VUTBLR
LCAMEX
SYR
TON
ZMB
ROMNICKGZ
PAN
BGR
MUSCRI
WSMMKDIND
BRBBWA
JAM
CZEZWE
SLBAZE
HUNCHL SVK
KAZMNG
TT O
GT MBGD
VCTLTU BHR
MAR
MACEST
JORCMRGEO GRDIRN
POL
ARM
DMA LVA MYS
UZB
KOR
KEN
BHS
BEN
HRVTHA
MDA
TCDCAF
ARE KWT
MRTCOM UKR
GMBGHAPNG
OMN
YEMCIV
BDI
SENPAK
BFA
AGOSAU
MLI
GIN
ERI SDNET H
NER
DJI
BRA
PHL
4060
8010
012
014
0G
ross
Pri
mar
y E
nrol
lmen
t
0 200 400 600 800 1000Public Expenditure on Education
Data Source: World Bank WDI
Primary Enrollment vs Education Expenditure
Methodology: DEA
Country C: Efficient by FDH, but inefficient by DEA
Peers of country C: A and D
Country D: inefficient by CRS DEA, but efficient by VRS DEA
O
F
C
B
A
Output
Input
D CRS
VRS
N
V
X
Y VRS
DEA Efficient Frontier: Primary Enrollment
COG
CPVGABMWI
TJK
GNQ
MDG
TGO PERUGACHN
NPL FJILAO DOMRWA
GNB
PRYLSOGUY
BLZ
RUSBOL COL
KNA
IDN
ARG
LKA
ZAF
KHM
NAM
URYVNM
TUN
HND DZA
MOZ
LBN SWZ
SLETZA
SLV VUTBLR
LCAMEX
SYR
TON
ZMB
ROMNICKGZ
PAN
BGR
MUSCRI
WSMMKDIND
BRBBWA
JAM
CZEZWE
SLBAZE
HUNCHL SVK
KAZMNG
TT O
GT MBGD
VCTLTU BHR
MAR
MACEST
JORCMRGEO GRDIRN
POL
ARM
DMA LVA MYS
UZB
KOR
KEN
BHS
BEN
HRVTHA
MDA
TCDCAF
ARE KWT
MRTCOM UKR
GMBGHAPNG
OMN
YEMCIV
BDI
SENPAK
BFA
AGOSAU
MLI
GIN
ERI SDNET H
NER
DJI
BRA
PHL
4060
8010
012
014
0G
ross
Pri
mar
y E
nrol
lmen
t
0 200 400 600 800 1000Public Expenditure on Education
Data Source: World Bank WDI
Primary Enrollment vs Education Expenditure
An important factor of production (public spending) is used more intensively in the relatively richer countries
AGO
AREARG
ARM
AT G
AZE
BDIBEN
BFA
BGD
BGR
BHRBHS
BLRBLZ
BOL
BRA
BRB
BWA
CAF
CHL
CHNCIV
CMR
COG
COL
COM
CPV
CRI
CZE
DJI
DMA
DOM
DZA
ERI
EST
ET H
FJIGAB
GEO
GHA
GIN
GMB
GNB
GNQ
GRD
GT M
GUY
HND
HRVHUN
IDN
IND
IRNJAMJOR
KAZ
KENKGZ
KHM
KNA KOR
KWT
LAO
LBN
LCA
LKA
LSO
LTULVA
MAC
MAR
MDA
MDG
MEX
MKD
MLI
MNG
MOZ
MRT
MUS
MWI
MYSNAM
NER
NIC
NPL
OMN
PAK
PAN
PERPHL
PNG
POL
PRY ROMRUS
RWA
SAU
SDN
SENSLB
SLE
SLV
SVK
SWZ
SYR
TCD
TGO
THA
TJK
TON TT OTUN
TZA
UGA
UKRURY
UZB
VCT
VNM
VUTWSM
YEM
ZAF
ZMB
ZWE
02
46
8le
du/L
inea
r pr
edic
tion
6 7 8 9 10lgdp
ledu Linear prediction
Edcation Spending vs GDP per capita
Public Expenditure on Education and GDP per capita (both in logs)
ALB ARG
BFA
BGR
BLZ
BOL
BRA
BWA
CHLCOL
CUB
CZE
DOM
HUN
IDNIRN JOR
KEN
KOR
KWT
LSO
LTU
LVA
MAR
MDA
MDG
MEX MKD
MOZ
MUS
MYS
NAM
NER
PER
PHL
POL
PRY
ROM
SVK SVN
SWZ
SYC
TT OTUNTUR
TZA
VUT
ZAF
ZWE
200
300
400
500
600
Learn
ing S
core
s
0 20 40 60 80 100Net Secondary Enrollment
Data Source: World Bank WDI & Crouch and Fasih (2004)
Correlation: Learning Scores and Net Secondary Enrollment
ARG
BGR
BOL
BRA
BWA
CHL
CMR
COL
CUB
CZE
DOM
HKG
HND
HUN
IDNIRN JOR
KEN
KOR
KWT
LSO
MEX
MLI
MOZ
MUS
MWI
MYS
NER
PER
PHL
POL
PRY
ROM
SEN
SGP
SVKSVN
SWZ
THA
TT OTUNTUR
TWN
TZA
UGA
ZAF
ZMB
ZWE
200
300
400
500
600
Lear
ning
Sco
res
0 2 4 6 8 10Average Years of School
Data Source: World Bank WDI & Crouch and Fasih (2004)
Correlation: Learning Scores and Average Years of School
ARG
BFA
BGR
BLZ
BOL
BWA
CIV
CMR
CZE
HND
HUN
IDNIRN JOR
KEN
KWT
LSO
LTU
LVA
MAR
MDA
MDG
MKD
MLI
MOZ
MUS
MWI
MYS
NAM
NER
PER
POL
PRY
ROM
RUS
SEN
SVK
SWZ
THA
TT OTUN
TZA
UGA
VUT
ZAF
ZMB
ZWE
BRA
CHLCOL
MEX
PHL
TUR
200
300
400
500
600
Lear
ning
Sco
res
0 100 200 300 400Orthogonalized Public Expditure on Education
Data Source: World Bank WDI & Crouch and Fasih (2004)
Learning Scores vs Education Expenditure
ARG
AUS AUT
BFA
BGR
BLZ
BOL
BWA
CANCHE
CIV
CMR
CYP
CZEDEU
DNK
DOM
ESP
FINFRAGBR
GRC
HND
HUN
IDNIRN
ISL
ISR
IT A
JOR
KEN
KWT
LSO
LTU
LVA
MAR
MDA
MDG
MKD
MLI
MOZ
MUS
MWI
MYS
NAM
NER
NLD
NORNZL
PER
POL
PRT
PRY
ROM
RUS
SEN
SVK SWE
SWZ
THA
TT OTUN
TZA
UGA
USA
VUT
ZAF
ZMB
ZWE
BRA
CHL COL
MEX
PHL
TUR
200
300
400
500
600
Lear
ning
Scor
es
600 800 1000 1200 1400 1600Orthogonalized Public Expditure on Education
Data Source: World Bank WDI & Crouch and Fasih (2004)
Learning Scores vs Education Expenditure
C. Public Expenditure Composition and Growth
Question – What’s impact of public spending composition on growth?
• Re-allocation decisions among Infrastructure, Education, Health, and Transfers
• Financing decisions for expenditure change – debt or tax, or or different types of tax instruments
• Permanent vs. transitory expenditure changes
Modeling approach
• Question: Effect of public expenditure on growth• Building blocks of the model economy based on
some principles that allow replication of key features (growth, transfers, debt accumulation)
• Experiments a. Allocation decisions: Change compositions and
compare with SSb. Financing decisions: debt vs. taxes; or different
types of tax instrumentsc. Permanent vs. transitory expenditure changes
Building blocks
• Preferences (types of agents, consumption, unproductive government expenditure)
• Technology- Explicit relationship between inputs and output; productive government expenditure)
• Resource constraints (public and private sectors)
Building blocks (Glomm-Rioja)–Preferences
• Consumer’s utility maximization problem
1,, lnln)1ln( max ttttt ccn
tttLttt hwscts )1(.. ,,
11,1, ))1(1( ttttKtt Tsrc
2. periodin Retired 1. periodin Work
:periods 2 live sIndividual
Solution leads to optimal savings and labor supply decisions.
Building blocks -Technology
capitalhuman :
capital physical Private :
capital Public :
parameterty Productivi :
Output :
:Function Production1
H
K
G
A
Y
tttt HKAGY
Building blocks-productive government expenditure
• Human capital production function
11 tttt hEBnh
Laws of motion:
11 tttt HEBnH
ttGt YG ,1
Building blocks-Fiscal policy
where public expenditure (as % of GDP) - on infrastructure - on education- on transfers - on other non-utility enhancing public service
Tax rate - on labor income- on capital (interest) income
ttKtttPtTtEtGtttKtttLt DrYKrHwD ))1(1()( ,,,,,,,1
t,G
tE ,
tT ,
tP,
t,L
t,K
)(t
tYD
tt Rrr
Building blocks- The steady state• Competitive equilibrium conditions
– The household utility maximization problem is solved. – The representative firm’s profits maximization problem is solved. – The government budget constraint is satisfied.– The goods market clears – The competitive input markets clear
– Permanent increase in expenditure financed by debt
Increase in expenditure (Permanent 1% of GDP, financed by debt)
1.75
2.00
2.25
2.50
2.75
3.00
3.25
3.50
0 1 2 3
Period
GD
P g
row
th r
ate
(%)
Benchmark Transfer Education Infrastructure
–Temporary increase in expenditure financed by debt
Increase in expenditure (Temporary 1% of GDP, financed by debt)
1.75
2.00
2.25
2.50
2.75
3.00
3.25
3.50
0 1 2 3
Period
GD
P g
row
th r
ate
(%)
Benchmark Transfer Education Infrastructure
– Permanent increase in expenditure financed by tax
Increase in expenditure (Permanent 1% of GDP, Financed by tax)
1.75
2.00
2.25
2.50
2.75
3.00
3.25
3.50
0 1 2 3
Period
GD
P g
row
th r
ate
(%)
Benchmark Transfer Education Infrastructure
Income per capita - Permanent Expenditure Reallocation (1% of GDP)
Income in base year: $4500 for Brazil, constant 1995
Reallocation in expenditure (Permanent 1% of GDP)
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
0 1 2 3
PeriodBenchmark From Transfers to Education
From Transfers to Infrastructure From Education to Infrastructure
III. How much government expenditure? a simple model and international comparison
• The model (Barro and Sala-I-Martin, 1995)• Production function of the economy :
Yt= AtF(K, N, G) or Y=AL1-KG1-
• Government Budget constraint : G=Y• Representative individual maximizes a utility
function subject to a budget restriction
Public expenditure has two opposite effects on growth rate of consumption of
• One positive effect derived from larger government services
• One negative effect due to the after-tax marginal product of capital
The simple estimate of the optimal size of government expenditure
g
From this simple model we obtain:
• The maximum growth rate is achieved for = G/Y=1-• Indicators of productiveness or unproductiveness of
government services ( dy/dg>0 ?)
• The degree of over-provisioning or under- provisioning of public capital
Atf1< r+d+n
Implications of Maintenance in Public Capital
• Aggregate Production Y=AL1-KG1-
• Private capital
• Public capital
• Maintenance expenditure
• New public investment
• Government Budget constraint Optimal tax rate that maximizes growth
YM YI g )1(
*
*
1
1
1)1( tktt KIK
1)](1[ tGGtt GY
MIG
YIM g
Does government expenditure (as a ratio to revenue) conform to international experience?
R atio of G overnm ent Spending to R evenueR ati o o f Go v e r n m e n t Sp e n d in g to R e v e n u e
1 .1 8
0 .9 8
1 .05
0 .9 60 .99
1 .41
1 .0 71 .09
1 .041 .0 9
1 .14
1 .30
1 .4 7
1 .121 .0 8
1 .2 2
0 .99
1 .1 1
1 .1 8
1 .10
1 .1 7
1 .06
0 .76
1 .1 1
1 .03
1 .26
1 .4 6
1 .12
0 .95
1 .0 8
1 .141 .0 9
0 .00
0 .20
0 .40
0 .60
0 .80
1 .00
1 .20
1 .40
1 .60
Ra
tio
of
Go
vt.
Sp
en
din
g t
o R
ve
nu
e
A RG
B HR
B RA
CA N
CHL
COL
CRI
CZE
ES T
HRV
HUN
IND
K A Z
LTU
LV A
MDA
NZL
PER
PHL
POL
ROM
RUS
S GP
S V K
S V N
THA
TUR
URY
USA
V EN
V NM
Z A F
The same holds when private investment is used as a metric
R atio of Public to P rivate Investm entR atio o f Pu b lic to P riv a te In v e stme n t
0 .10
0 .20
0 .2 9
1 .04
0 .2 10 .17
0 .2 1
0 .45
0 .14
0 .220 .2 4
0 .2 1
0 .09
0 .5 9
0 .20
0 .6 7
0 .360 .3 9
0 .8 1
0 .40
0 .00
0 .20
0 .40
0 .60
0 .80
1 .00
1 .20
A RG B RA CHL COL CRI EST HRV IND LV A MDA PER PHL POL RUS SV N THA TUR URY V EN Z A F
Ra
tio
of
Pu
blic
to
Pri
va
te I
nv
es
tme
nt
A RG
B RA
CHL
COL
CRI
EST
HRV
IND
LV A
MDA
PER
PHL
POL
RUS
S V N
THA
TUR
URY
V EN
Z A F
The ratio between capital and current expenditures. Expenditure composition is a matter of concern
Ratio of Government Capital to Current ExpenditureRatio of Capital to Currrent Expenditure (%)
7.2
25 .5
2.5 1.7
18 .9
29.7
11.0 9.98.1
10.2
13.0
9 .9 9.911.6
7 .2 7.7
2.7
17 .5
1 0.1
4.7
10 .7
7 .3
44.5
13 .2
7 .8
67.1
8.7
5 .0 4.7
22.3
46 .1
5.1
0 .0
10 .0
20 .0
30 .0
40 .0
50 .0
60 .0
70 .0
80 .0
AR
G
BH
R
BR
A
CA
N
CH
L
CO
L
CR
I
CZ
E
ES
T
HR
V
HU
N
IND
KA
Z
LT
U
LV
A
MD
A
NZ
L
PE
R
PH
L
PO
L
RO
M
RU
S
SG
P
SV
K
SV
N
TH
A
TU
R
UR
Y
US
A
VE
N
VN
M
ZA
F
ca
pc
ur
(%)
ARG
BHR
BRA
CAN
CHL
COL
CRI
CZE
EST
HRV
HUN
IND
KAZ
LTU
LVA
MDA
NZL
PER
PHL
POL
ROM
RUS
SGP
SVK
SVN
THA
TUR
URY
USA
VEN
VNM
ZAF
IV. Debt sustainability and productivity of capital expenditures
• The traditional debt dynamics equation
sb ttt
T
tf
g
ieeb
g
gr
1
*
1 11
1
11
1. Debt targeting- S instrument of fiscal policy
2. “Fiscal space”-productivity of public capital
Revised debt dynamics equation, with current and capital expenditures disaggregated
ksb t
c
ttt
T
t g
drf
g
ieeb
g
gr11
*
1 1
)(
11
1
11
r+d= rental price of public capital
p = marginal productivity of public capital
Policy coordination: fiscal, monetary, exchange rate and public debt management-
“fiscal space” considerationsunder liquidity constraints-Brazil 2002
• Features of Brazilian public debt1. Mostly domestic2. Short maturity and duration3. Indexed to the exchange rate or to short
term interest rates (Selic)4. Concentrated holders (mutual funds, few
banks)
Public debt jumps in 2001 as currency depreciates (Argentina crisis unfolding)
1.6
2.0
2.4
2.8
3.2
3.6
4.0
44
48
52
56
60
64
68
1999 2000 2001 2002 2003
Exchange Rate
Public Debt (right scale)
% o
f GD
PR
eais
/dolla
r
The primary surplus falls. The presidential campaign is no fertile ground for fiscal adjustments.
Primary Fiscal Balance of the Public Sector 2000-2003(as a percentage of GDP)
3.2
3.6
4.0
4.4
4.8
2000 2001 2002 2003
-.3
-.2
-.1
.0
.1
.2
.3
96 97 98 99 00 01 02 03
Brazilian Spreads and Exchange RateJan 2000 – April 2003
Capital Flows to Brazil (ratio to international reserves)
Public debt sustainability concerns causes a run on mutual fund “deposits”
Net Resource Flow to Mutual Funds(as a fraction of net worth)
-.08
-.06
-.04
-.02
.00
.02
.04
.06
1998 1999 2000 2001 2002 2003
The central bank was forced to print money to redeem public debt
2.0
2.5
3.0
3.5
4.0
4.5
5.0
95 96 97 98 99 00 01 02 03
-.3
-.2
-.1
.0
.1
.2
.3
.4
1999 2000 2001 2002 2003
Money Base as a Share of GDP
(seasonally adjusted data
Monetary Impact of Treasury’s
Operations 1999- 2003(ratio to the monetary base
-1
0
1
2
3
4
5
6
2001 2002 2003
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
2000 2001 2002 2003
Monthly Inflation Rate in Brazil 2000-2003
Seignorage from Money Creation 2000-2003
(% of GDP)
Exchange rate and interest rates adjust after the fiscal commitment is certain.
1.6
2.0
2.4
2.8
3.2
3.6
4.0
4.4
14
16
18
20
22
24
26
28
2000 2001 2002 2003
Selic(right scale)
Exchange rate
%
Reais
/dolla
r