Fiscal Policy and Long-Term Growth

Fiscal Policy and Long-Term Growth Sanjeev Gupta Deputy Director of Fiscal Affairs Department International Monetary Fund Tokyo Fiscal Forum June 10, 2015

Outline Motivation The Channels: How Can Fiscal Policy Affect Medium- to Long-Term Growth? Empirical Evidence: Results of a Multi-Pronged Analysis Other Key Lessons: Equity and Reform Design Conclusions 2

Output across advanced and emerging market economies remains below expectations 120 115 110 105 100 95 90 85 80 75 70 Advanced Asia 1/ Index of Real GDP, 2007 = 100 2000 2002 2004 2006 2008 2010 2012 2014 170 150 130 110 Fall 2007 Fall 2008 Fall 2014 Source: WEO. 1/ Hong Kong, Japan, Korea, Singapore, and Taiwan. 2/ China, India, Indonesia, Malaysia, Philippines, Sri Lanka, and Thailand. 90 70 50 Emerging Asia 2/ Index of Real GDP, 2007 = 100 2000 2002 2004 2006 2008 2010 2012 2014 3

How Can Fiscal Policy Affect Medium- to Long-Term Growth? 4

At the macro level, fiscal stabilization reduces volatility and promotes growth 8 Fiscal Stabilization Coefficient vs Output Volatility Significant coefficients Insignificant coefficients 8 Fiscal Stabilization Coefficient vs RGDP Growth 7 7 Output volatility (percent) 6 5 4 3 2 1 Correlation = 0.40 Real GDP growth rate (percent) 6 5 4 3 2 1 0-0.5 0.5 1.5 Fiscal stabilization coefficient 0-0.5 0.0 0.5 1.0 1.5 Fiscal stabilization coefficient 5

..and allowing automatic stabilizers to operate in good times can avoid public debt buildup 90 Asymmetric Stabilization: Unpleasant Public Debt Arithmetic (Percent of GDP) 80 Public debt 70 60 50 40 Revenue windfalls half spent Symmetric stabilization 30 t t+2 t+4 t+6 t+8 t+10 t+12 t+14 t+16 t+18 t+20 6

Fiscal stabilization is much more common in advanced economies Number of countries 12 10 8 6 4 Advanced Economies Median coefficient (0.7) Number of countries 35 30 25 20 15 10 Emerging Market and Developing Economies Median coefficient (0.3) 2 0-0.2 0.2 0.6 1.0 1.4 1.8 Stabilization coefficient Insignificant Significant 5 0 -.06-0.2 0.2 0.6 1.0 1.4 1.8 2.2 Stabilization coefficient Insignificant Significant 7

At the micro level, fiscal policy affects growth through four main channels Labor supply Human capital Physical capital Productivity/ Innovation 8

Fiscal Policies to Encourage Labor Supply Lowering the labor tax wedge increases after-tax earnings and the supply of labor (succeeded in Ireland, and the Netherlands) Use of in-work benefits can strengthen work incentives (used in Germany, the UK, Sweden) Targeted measures may be needed to increase LFP: Women: closing the gender gap in education (e.g., in India); or providing better child care and flexible work options (e.g., in Japan) Older workers: financial incentives (e.g., through tax rates); and increasing the retirement age; Low-skilled workers: in-work tax credits; hiring subsidies; targeted reductions social contributions. 9

Fiscal Policies to Enhance Investment In AEs, taxing excess returns or rents can reduce distortions from CITs Infrastructure investment can boost growth directly and indirectly by raising the productivity of private capital: but efficiency is key: The most efficient countries get twice the growth dividend from investment compared with the least efficient countries In developing economies, targeted and transparent incentives that reduce the cost of capital can promote investment Tax incentives can erode the revenue base without achieving any benefits from higher investment unless they are properly designed and limited 10

Open-ended and profit-based tax holidays should be avoided 100 80 60 40 20 Regional Prevalence of Tax Incentives (Percent) 0 Tax Holiday/Tax Exemption Reduced Tax Rate East Asia and Pacific Latin America and the Caribbean OECD Sub-Saharan Africa Source: James (2013). Investment Allowance/Tax Credit R&D Tax Incentive Super-Deduction Eastern Europe and Central Asia Middle East and North Africa South Asia 11

Fiscal Policies for Human Capital Development Improving access to education and health for disadvantaged groups is a priority, including by: Increasing investment at lower levels of education and increasing cost-recovery in tertiary education (while protecting the poor) Providing a basic health package; expanding services to remote areas; and reducing user charges for poor households Conditioning cash transfers on school attendance and preventive health visits In AEs, allowing for the deductibility of education expenses can mitigate the adverse impact of progressive taxation 12

Fiscal Policies to Promote Productivity and Innovation Average Real GDP Per Capita Growth R&D Expenditures and Growth, 2001-2012 (Percent) 12 10 8 6 4 2 0-2 -5 0 5 10 15 20 Average Real R&D Expenditure Per Capita Growth Source: WDI. Note: Excludes countries with fewer than five observations during the 13

Empirical Evidence: Results of our Multi- Pronged Analysis 14

The growth dividend from fiscal reforms can be substantial 6 5 Estimated Growth Gain (Percent, GDP per capita, 10-year average 1/ 2/) Advanced Economies Emerging Markets Low-Income Countries 4 3 Average EME and LIC 2 1 Average, AE (excluding Ireland) 0 Source: IMF staff calculations; Supplement 1. 1/ 5-year averages for Germany and Poland. 2/ Chile (1) refers to the first reform episode (1974); Chile (2) to the second reform episode (1983); Australia (1) to the first reform episode (1985); and Australia (2) to the second reform episode (1998). 15

Country Focus: Malaysia Malaysia s reform period from 1986-90 chosen based on quantitative selection criteria; A large expenditure-based fiscal adjustment, reduction in the size of the public sector, and economic deregulation were key elements of the reforms; Growth picked up markedly in the period following fiscal reforms, increasing by 2 percentage points vis-à-vis the counterfactual; Fiscal policy appears to have contributed to boosting Malaysia s growth by promoting private investment, job creation and gains in TFP. 16

Malaysia: Growth post-reform exceeded expectations 9 8 7 6 5 4 3 2 1 0 Annual GDP Growth, 1986-1990 (Percent, 10-year average) Reform period 1976-1985 1986-1990 1991-2000 2001-2010 Malaysia Synthetic Control Group 1/ 1/ Indonesia, Korea, and Philippines. 17

Fiscal reforms increase the probability of growth accelerations 50 40 30 20 10 0 Type of Reforms and Conditional Probability of Growth Accelerations (Percent) Personal income taxes Health spending Social security contributions Corporate income taxes Consumption taxes Education spending Transport and communication spending Property taxes Capital spending Source: IMF staff calculations. Note: Reported are the ratios of fiscal reforms followed by a growth accelerations within a 5-year period to the total number of fiscal reforms (in percent). 18

Other Key Lessons 19

Social dialogue helps deepen and sustain reform efforts 0.5 Cumulative Change in the Public Wage Bill (Percent of GDP) 0-0.5-1 -1.5-2 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+10 Social Dialogue Little Social Dialogue Source: IMF staff calculations. 20

Equity-efficiency trade-offs can be avoided 16 12 Net Inequality 1/ (10-year avg. post-reform minus 10-year avg. pre-reform) Decrease in spending/ increase in inequality Increase in spending/ increase in inequality Change in Gini coefficient 8 4 0 Chile (1) Australia (1) Chile (2) Germany Ireland Australia (2) Netherlands Poland -4 Decrease in spending/ decrease in inequality Malaysia Increase in spending/ decrease in inequality -8-30 -25-20 -15-10 -5 0 5 10 Maximum Reduction/Increase in Primary Spending (Percent of GDP) Advanced Economies Emerging Markets Source: IMF staff calculations, SWIID 5.0. 1/ Refers to Gini coefficient after taxes and transfers. 21

Conclusions 22

Conclusions Fiscal policy can be an effective tool for supporting medium- to long-run growth. The mix of fiscal policy options should be tailored to countryspecific conditions, administrative capacities and preferences. The growth dividends of fiscal reforms depend to a large degree on complementary structural reforms and supportive macroeconomic policies. Strategies such as effective communication with stakeholders and compensatory measures for those made worse off can help foster public support for fiscal reforms. Both growth and equity objectives can be achieved when fiscal reform packages are appropriately designed. 23

Thank you

Annex Slides 25

Three studies find a positive link Methodology Growth impact Synthetic control method ¾ pp for AEs and even higher for DCs Endogenous growth simulations Statistical analysis ½ pp from budget neutral tax reforms + ¼ pp for enhancing composition of spending Increased likelihood of growth following fiscal reform

Synthetic Control Method Overview Formal data-drive procedure to quantify the effect of fiscal policy on long-run growth. Removes discretion in selection of countries. The effect of fiscal policy is difference between growth in the country and its synthetic counterpart. Results should be treated with caution due to potential biases.

Synthetic Control Method Intuition Goal: Evaluate the impact of fiscal reforms on long-run growth in a country of interest Issue: Difficult to find counterfactual showing what the long-run growth would be if the country did not implement the reform How does synthetic control method address this issue? o Use a panel data of countries (synthetic control) that did not implement fiscal reforms around the same time as the country of interest, but have similar observable characteristics (region, level of development, etc.) o o Assess the impact of fiscal reforms by taking the difference between the post-reform growth rate in the country of interest and weighted-average growth rate of synthetic control group Countries with more similar observable characteristics with the country of interest in the pre-reform period carry higher weights 28

Synthetic Control Method Formal implementation Units: j = 0, 1, 2, J countries, where j=0 is the treated or reforming country, and j = 1, 2, J are control countries Time: t = 1, 2,... T 1 periods, where pre-reform period is t = 1, 2, T 0 ; post-reform period is t = T 0 +1, T 1 Variables of interest: o Y I 0t : GDP growth in treated country 0 at time t assuming reforms were implemented at T 0 o Y N 0t : GDP growth in treated country 0 at time t assuming reforms were not implemented at T 0 Effect of fiscal reform: Y I 0t - Y N 0t = α 0t (for t>t 0 ), where Y N 0t is not observable and needs to be estimated 29

Synthetic Control Method Formal implementation (continued) Regression model: Y = δ + θz + λµ + ε jt t t jt t j jt where: Z: observed covariates of growth (GDP per capita, trade openness, inflation rate, terms of trade index, human capital per person) δ: unobserved time effects µ: unobserved country effects λ, θ: time-varying coefficients (λ is constant in dif-in-dif regressions) Y * N wy 0t j jt Counterfactual growth rate is, where vector of nonnegative weights w* is chosen to minimize the difference between j= 1 observable characteristics of treated and control groups N J = 30

Synthetic Control Method Advantages and Disadvantages Main advantages Main limitations Allows selection of control group based on a transparent and flexible statistical procedure, rather than ad-hoc reasoning Can lead to over-fitting if initial sample of control group is not selected based on similarity to the reforming country Allows for a study of the dynamic impact of reforms. SCM suffers from reverse causation bias if reforms depend on expected future growth. Robust to endogeneity bias due to time-varying omitted variables. Tests of statistical significance are difficult with SCM 31

Synthetic Control Method Literature Abadie, A. and Gardeazabal, J. (2003) The Economic Costs of Conflict: A Case Study of the Basque Country, American Economic Review, 93(1): pp. 113-132 impact of terrorism on output in the Basque Country Abadie, A., Diamond, A., and Hainmueller, J. (2010) Synthetic Control Methods for Comparative Case Studies: Estimating the Effect of California's Tobacco Control Program Journal of the American Statistical Association, 105 (490): pp. 493-505 - effect of California s 1988 tobacco control program on tobacco consumption Cavallo, E., Galiani, S., Noy, I., and Pantano, J. (2013) Catastrophic Natural Disasters and Economic Growth Review of Economics and Statistics, 95(5): pp. 1549-1561 - effect of large natural disasters on economic growth Billmeier, A. and Nannicini, T. (2013) Assessing Economic Liberalization Episodes: A Synthetic Control Approach, Review of Economics and Statistics, 95 (3): pp. 983-1001 impact of economic liberalization on real GDP per capita growth Abadie, A., Diamond, A., and Hainmueller, J. (2014) Comparative Politics and the Synthetic Control Method, American Journal of Political Science (forthcoming) impact of Germany s 1990 unification on real GDP per capita 32

Endogenous Growth Model Methodology Key Features: o Two sectors: final output and human capital o Government investment in productive public capital o Endogenous labor supply o Constant returns to scale in public and private capital o Accumulation of public and human capital offsets diminishing returns to physical capital accumulation 33

Endogenous Growth Model Results Budget-neutral experiments Fiscal Reform Δ Capital tax -5% Δ Labor tax -5% Δ public investment +1% of GDP Increase in LT Growth Relative to Benchmark Offsetting Measures 0.4-0.5 pp consumption tax 0.15-0.2 pp unproductive spending by 1 pp of GDP 34