Fiscal space for development concept

Are we trading away fiscal space for development?

By Devika Dutt, Lecturer in Development Economics at King’s College, London and Kevin P. Gallagher, Director of the Boston University Global Development Policy Center, and Professor of Global Development Policy at Boston University

Developing nations need to mobilise an additional USD 1 trillion per year to meet their shared 2023 development and climate goals, but the need to invest comes precisely at a time when developing countries lack the fiscal space to do so.

What has been driving debt distress and how can governments and international institutions adapt to help?

Why the lack fiscal space

In recent years, multiple crises have contributed to the increase in external debt distress and reduced fiscal space in developing countries. This ‘polycrisis’ has forced developing countries to go to capital markets at higher prices, squeezing their already-meagre budgets in order to buffer populations against related shocks. These include the consequences of Russia’s illegal war in Ukraine, uneven interest rate rises in advanced economies, and climate shocks. 

Before these crises arrived, however, developing economies were already struggling, and mechanisms designed to expand exports for growth and foreign exchange (like trade and investment treaties) may have compounded the problem.

For example, an alarming and ground-breaking IMF study in 2005 found that developing countries were not able to compensate for the losses in tariff revenue due to trade liberalisation. King’s College and Boston University economists recently conducted a new study in which we extended the timeframe of this study and included analysis of more than 1 000 trade and investment treaties implemented since 2000 (when the IMF study ended).

The main conclusion of this study was that trade and investment treaties in developing countries have unintended consequences. They may boost trade but they hollow out fiscal space and make it difficult to raise new revenues, thus forcing countries to take on more debt.

To address this challenge, we propose two new measures of trade liberalisation:

  • the first measures a country’s total number of bilateral treaty links, followed by the countries’ “hub connectedness” (defined as the number of times a country functions as a bridge between all other country pairs in the network of trade agreements).
  • the second examines the links between trade and investment treaties and tax revenue and government expenditure, while also examining the impact on government debt.  

By using these measures, we were able to establish that an increase in trade and investment liberalisation does seem to be associated with a decrease in government revenues but, overall, there is not convincing evidence that this increased budget deficits. However, we have found that trade liberalisation is almost universally associated with an increase in government debt. 

What it all means

These findings have significant implications for both research and policy.

First, they debunk the assumption that lost revenues from trade and investment treaties are automatically recouped through other means.

As developing countries often have large informal economies that are hard to tax, and new taxes after a trade and investment treaty is signed can be subject to investor-state dispute settlement (ISDS) – and thus, nullified.

As such, conventional models of trade and investment liberalisation may be giving developing countries an inaccurate picture of trade and investment treaties.  

Secondly, in terms of policy, the research indicates that (to be effective and sustainable for all involved) international trade and investment negotiations should be coupled with transitional financing packages.

This has been echoed by the eminent trade economist Jagdish Bhagwati who wrote, “If poor countries that are dependent on tariff revenues for social spending risk losing those revenues by cutting tariffs, international agencies such as the World Bank should stand ready to make up the difference.” 

Next steps

Until the above support becomes a standard accompaniment to all trade agreements, governments and international institutions need to ensure that fiscal and financial implications of trade and investment treaties are taken into consideration for all in their negotiations.

Devika Dutt is a Lecturer in Development Economics at King’s College, London and a former Pre-doctoral Fellow at the Boston University Global Development Policy Center. 

Kevin P. Gallagher is the Director of the Boston University Global Development Policy Center, a Professor of Global Development Policy at Boston University and a Member of Task Force on Climate, Development and the International Monetary Fund and co-author of the 2022 book ‘The Case for a New Bretton Woods.’