Fiscal space in developing countries: It’s about revenues

By Alexander Pick, Fiscal economist, OECD Development Centre

planting-moneyFiscal space is big right now. It was an important part of the OECD’s policy prescriptions in last year’s Economic Outlook and was high on the World Bank President’s agenda at this year’s Spring Meetings in Washington. It also featured in discussions at the 2017 Forum on Financing for Development in May. Yet the term has a different meaning depending on whether it is applied to a developed or a developing country, and it doesn’t appear to resonate with policy makers at a national level.

So what does fiscal space mean for developed economies? The OECD and IMF view the concept in terms of long-term debt sustainability. By this approach, fiscal space is interpreted as the distance between actual debt levels and a theoretical higher level of debt that is nonetheless safe. Fiscal space suggests how much wiggle-room national governments have to increase growth-enhancing spending, such as infrastructure investment, without raising taxes. This is important in the current context of a sluggish global economy where monetary policy has done all it can to support growth and the pressure is thus on fiscal policy and structural reform to propel the recovery.

Yet fiscal space methodologies centred on long-term debt levels are inappropriate for most low- and lower-middle-income countries.Why? These countries typically don’t have the same access to markets as OECD countries, are more vulnerable to macroeconomic shocks and rely on a greater range of financing sources, including official development assistance.

The timeframe of fiscal space also differs between developed and developing countries. “For developing and emerging market countries, the issue of fiscal space arises in the immediate term. There is a pressing need for expenditure today, and the challenge is how to find the resources for their financing.”This, in turn, means that the sums involved are different: the shorter time horizon imposes a constraint on how much money can be generated through fiscal space analysis. This limits its usefulness when countries are trying to raise significant additional resources to achieve the Sustainable Development Goals (SDGs), for example.

A specific (and crude) example of fiscal space in developing countries occurs when developing countries are advised to finance a ‘good’ policy by eliminating a ‘bad’ one. The textbook prescription in this regard is to cut defence spending or eliminate a poorly targeted subsidy to finance an increase in social spending. This is a zero-sum reprioritisation rather than an exercise in generating fiscal space. It is also not something that should be imposed from outside, since such decisions rest with the institutions responsible for a country’s budget process.

Another application of fiscal space distinguishes between non-discretionary spending (items such as public sector wages, social transfers and interest payments) and discretionary spending (everything else). Discretionary spending then becomes synonymous with fiscal space insofar as it is possible to reprioritise between these items. Again, this is not a helpful approach. Aside from the fact that ‘discretionary’ tells you nothing about a government’s priorities, this method overlooks the fact that the government wage bill is also discretionary to the extent that salary levels are negotiable and headcount can be managed.

So how do developing countries themselves perceive fiscal space? As part of the European Union Social Protection Systems Project, I discuss the financing of social protection with finance ministries in a number of developing countries. When the issue of fiscal space comes up, the shutters quickly go down: officials are tired of being told how they can find money for a particular policy, ignoring the dozens of other funding pressures they confront.

This chimes with my seven years at the South African Treasury, where I never heard the term fiscal space. However, a term that did arise in the final throes of the budget negotiations was that of the ‘back pocket’ – as in, ‘what do we have in our back pocket to fund X or Y?’ I suspect South Africa is not alone in this regardand perhaps this is the closest many developing countries get to fiscal space. The problem is that few back pockets are deep enough to meet the financial demands of the SDGs.

Ultimately, fiscal space is better considered on a forward-looking basis, which is where a medium-term expenditure framework (MTEF) comes in. MTEFs formalise spending plans over (ideally) a three-year period into the future through provisional allocations to departments or functional groups. Fiscal space emerges when, for example, tax revenues exceed expectations or when a particular programme proves unable to spend its allocation. Of course, the opposite can also occur, so it’s useful to have a contingency reserve that gets larger towards the outer years of the MTEF. This contingency reserve becomes an additional source of fiscal space should downside risks not materialise. The MTEF process is also important because it changes the discussion from being about ‘affordability’ – what programme can we finance this year? – to one of sustainability – what can we finance indefinitely?

Even with a MTEF, however, the potential for identifying significant additional resources on the expenditure side is limited. In developing countries, the best means of creating fiscal space lies on the revenue side, where average tax revenues are around 15% of GDP, less than half the level in OECD countries, where tax revenues averaged 34.2% of GDP in 2014.

Domestic resource mobilisation is the only sustainable way of financing the step-change in expenditure required by most developing countries to achieve the SDGs. However, this is not a short-term project. Rather, long-term financing strategies based on a concerted effort to increase domestic revenues and leverage other sources of funding are the only viable means of attaining the goals.

1.↩See a  recent paper by the IMF, Baum et al.

2.↩ As Heller (2005) recognises.

3.↩ South Africa’s budget process was ranked third out of 115 countries for its transparency by the Open Budget Survey in 2015.