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Fiscal Consolidation Instruments

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Best Practices Project


 

Practice Advice on Public Financial Management

Fiscal Consolidation Instruments (OECD)

Summary Advice: The
OECD advises that countries can reap sizeable budgetary benefits by adopting “best practices” in many spending and revenue areas, notably health and education and via pension reforms. 

Main Points: Country-specific estimates of budgetary gains from a wide range of spending and revenue measures, which have little adverse or even a positive effect on growth, at least over the medium term, have been assembled. On average across all countries, consolidation of 7% of GDP could be achieved by such measures.

Broad approach

  • Against a backdrop of often poorly targeted and sometimes quite generous benefits, some governments may benefit from reforming transfer programmes to rein in spending and to sharpen incentives to work and save.
  • Revenue measures should initially concentrate on limiting tax-induced distortions that are detrimental to growth by broadening tax bases.
  • Governments should also favour less harmful taxes, such as those on immobile property and corrective taxes such as pollution charges.
  • Should the less fortunate members of society face additional hardship due to consolidation, flanking measures could cushion the blow.

Fiscal consolidation will require discretionary measures

  • Fiscal consolidation will require both spending cuts and revenue measures. But these have to be chosen carefully, balancing trade-offs between occasionally conflicting policy objectives.
  • Fiscal consolidation should minimise negative near-term weakening of domestic demand, and should include remedial actions in anticipation of unacceptable adverse distributional consequences. In the short term the choice of instrument could favour initially policies with comparatively low multipliers or reforms that underpin credibility, but have little negative effect on demand in the short run.

Balancing spending cuts and revenue increases

  • Successful fiscal consolidations in the past have been largely driven by spending cuts due to political economy considerations and their positive impacts on efficiency and, when concentrated on transfers and other current spending, their perceived durability.
  • Where further cutbacks in spending are either undesirable or politically unfeasible, however, fiscal consolidation will require revenue increases. Raising additional revenue by minimising their adverse effects on efficiency and welfare would help reduce the long-term costs of consolidation.

Cutting spending without harming outcomes

  • Achieving savings through efficiency gains
    • Strengthening the role of market mechanisms, changing reimbursement schemes, improving public management and control and imposing budget caps should form part of a cost containment strategy.
    • Improving the efficiency of public services more generally can yield significant savings. A host of management, governance, and pay reforms can help achieve the same public service outcomes at lower resource cost.
  • Rationalising transfers can reduce outlays and boost long-run growth
    • Reforms that restore the original focus of the transfers and reconsider the level of generosity could yield considerable savings which together with improving job search and work incentives can boost growth, with positive knock-on impacts on revenues over time.
    • Public pension programmes continue to threaten fiscal sustainability. Several reforms hold particular promise of improving the sustainability of public pension schemes and contributing to fiscal consolidation, including lengthening the contribution period required for a full pension, increasing incentives to postpone retirement and remain employed, and linking the pensionable age to life expectancy.

Raising revenue should reduce harmful distortions

  • In searching for additional revenue, governments should examine the scope for broadening tax bases in order to keep rates low, and focus on mobilising revenue from the least harmful taxes.
  • Scaling back tax expenditures is long overdue in most countries
    • While some tax expenditures, such as earned income tax credits, raise employment and thereby economic activity, many are distorting, poorly targeted and reduce transparency. And by narrowing the tax base, distortionary tax expenditures cause statutory rates to be higher than otherwise, further damaging overall efficiency.
  • Less distortive and corrective taxes should be given priority
    • Additional revenue can be raised from sources that are either less distortive or can improve welfare by taxing harmful behaviour, such as through property taxes and pollution taxes.

Example: OECD Advice for Canada

  • For jurisdictions (i.e., central government or provincial governments) with large deficits, maintain ambitious but achievable deficit targets on the way to a balanced budget. For jurisdictions not in deficit but with a significant debt burden, announce medium-term debt-to-GDP-ratio targets accompanied by fiscal-balance or surplus targets consistent with meeting these debt targets. Allocate realised surpluses automatically to debt reduction.
  • Begin fiscal consolidation in 2011 by allowing temporary stimulus measures to expire as planned. Make restraining the growth of expenditure the cornerstone of fiscal-consolidation strategies, and consider supporting this approach by legislating spending growth caps for which governments can be directly held to account.
  • To enhance credibility, flesh out existing fiscal-consolidation plans including, where necessary, plans for structural reforms. Implement these plans starting in 2011. Adopt or implement existing public-sector wage-restraint policies.
  • If raising new revenue is necessary, use instruments that reduce or minimise distortions to economic efficiency. Start with broadening tax bases by eliminating tax expenditures that do not have a compelling economic rationale. Then use measures that correct negative externalities (e.g. carbon tax or emission permit auctions) or relatively efficient taxes (e.g. value-added taxes and property taxes at the local level.
  • Consider establishing provincial budget agencies similar to the federal Parliamentary Budget Office that provide independent analysis of fiscal forecast and cost estimates for policy proposals; and/or an agency reporting to the Council of the Federation and tasked with providing independent analysis on provincial fiscal matters.

 

Source: OECD (2012) “What are the Best Policy Instruments for Fiscal Consolidation?” at http://www.oecd.org/tax/publicfinanceandfiscalpolicy/50100775.pdf (accessed 28 December, 2012). OECD (2012) “Fiscal-Consolidation Strategies for Canadian Governments?” at http://www.oecd-ilibrary.org/economics/fiscal-consolidation-strategies-for-canadian-governments_5km36j7nc2g4-en (accessed 4 January, 2012).

Page Created By: Matthew Seddon on 28 December 2012. Updated by Ian Clark on 17 January 2013. The content presented on this page is drawn directly from the source(s) cited above, and consists of direct quotations or close paraphrases. This material does not necessarily reflect the official view of the publishing organization.


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