Is fiscal policy back?

An emerging markets perspective
OECD Development Centre

The economic crisis has hit the entire world economy, with governments stepping in to rescue financial systems and kick-start economic growth. This adds up to a triumph for government fiscal policy, though fiscal policy must be used audaciously.

One of the unexpected by-products of the current global financial crisis is that it has placed fiscal policy back at the centre of the public policy debate. The United States authorities toyed with fiscal responses in the early days of the crisis with tax rebates designed to stimulate consumer spending; these tentative steps would be followed by government spending on a truly massive scale, culminating in the Treasury’s US$700 billion bailout of the financial system and soon, an economic package of a similar magnitude.

Similar measures have been adopted in a host of other OECD capitals, with more sure to follow. China’s recently announced $500 million-plus package indicates that fiscal policy is gaining traction in emerging economies as well. Fiscal policy–public spending, taxes and debt management–is clearly a favoured lever among policymakers in OECD countries for jump-starting better economic performance. Was there any choice?

A look back in time suggests it hasn’t always been that way. While fiscal stimulus lay at the heart of the John Maynard Keynes’s prescription for confronting the Great Depression of the 1930s, and enjoyed a revival after the 1970s oil crisis, its appeal among economists has steadily waned since the 1980s. In particular, for the twin goals of macroeconomic policy making–economic growth on the one hand, and combating inflation and unemployment on the other–fiscal policy has lost prestige to other tools, particularly monetary policy.

Taxes, its opponents aver, may be a necessary evil to finance government operations and public services, but many economists believe they distort incentives, reduce investment and labour supply and dampen growth. As for short-term stabilisation, the critics say, discretionary fiscal spending is too susceptible to political interference–think pork-barrel projects for lawmakers’ home districts. Anyway, in a downturn fiscal spending rises to address unemployment and other social consequences of the downturn, and this buoys overall domestic spending. Better to rely on such automatic stabilisers that are beyond the reach of politicians’ capricious grasp and use interest rates and the money supply to influence prices or unemployment levels.

But then came the lie, which the crisis made louder. First in Japan, where deflation set in during the 1990s and interest rates became negative, the anaemic effectiveness of monetary policy measures had started to show. This was confirmed more recently in the United States, where despite deft interest cuts in the last few years, the economy started to sag well before the autumn 2008 crisis. Experts now worry if cuts will be ineffective in Europe too. Policymakers and economists have had to turn their attention back to the fiscal means at their disposal.

However, the fiscal comeback argument is, if anything, more relevant for emerging and developing economies. Consider the example of Latin America, where governments have taken enormous strides to put their fiscal houses in order. The OECD’s Latin American Economic Outlook 2009 shows that, since the end of the debt crisis of the 1980s, governments have tightened their belts assiduously. Fiscal deficits have fallen from 11% of public revenues in the 1970s and 1980s, to only 8% since 2000. The year-to-year volatility of taxes, spending and deficits–long a feature of fiscal policy making in the region with harmful effects for economic performance–has likewise fallen: an index of deficit volatility calculated for the 2009 Outlook shows a fall of a third from 1990-94 to 2000-06, with Latin America standing just 6% above the volatility levels in OECD countries in the latter period.

Fiscal policy in the current financial crisis is squarely focused on avoiding a deep recession. This focus, however, must not blind anyone to the other policy objectives for which fiscal tools are useful. Fiscal systems can provide the resources needed to carry out pro-growth investments and structural transformations, which in developing and emerging economies are so essential for long-term growth. Moreover, taxes and public spending can directly attack poverty and inequality, twin problems that continue to beset the region. In a word, fiscal policy has a powerful potential to promote development.

Seen in this light, the capacity of fiscal policy to do good is substantially unrealised in Latin America. Fiscal policy has done nothing to reduce vast income inequality in the region, for example, as the figure illustrates. While taxes and transfers reduce inequality by nineteen Gini points in Europe, the difference is less than two Gini points in Latin America (the Gini index is a commonly used measure of income inequality that ranges from zero–everyone has the same income–to one hundred–one person has all the income).

However, some of the very characteristics of fiscal policy derided by its critics actually increase its usefulness in the cause of development. In fact, precisely because fiscal policy is profoundly political, better fiscal policy can contribute to democratic consolidation (and vice versa). The performance of a country’s fiscal system provides a snapshot of the social contract that links its government and its citizens. Publicly provided goods and services of reasonable quantity and quality for the one part, and transparent and progressive tax systems for the other, are signs of a healthy social contract. These two parts go hand in hand: if public goods such as health, education and infrastructure are scarce, low-quality or inequitably provided, the social contract is weakened. Citizens’ perceptions that taxes and spending are fair and efficient–call it fiscal legitimacy–are closely linked to the legitimacy of democracy itself.

Click here for larger graph

Clearly, more money is needed to meet development deficits: in Latin America, despite impressive economic performances in recent years, nearly 200 million people live in poverty. More money has been mobilised in the domestic economy to address these challenges, but the gap with OECD countries is still a big one. Government expenditures averaged 25% of GDP in Latin America versus 44% in OECD countries over the period 1990-2006.

For a fiscal policy that serves development, however, quality matters as much if not more than quantity. On the spending side, education is illustrative: governments in the Baltics, Macau-China and other emerging regions spend about the same amount on primary and secondary schooling per pupil as do many Latin American countries, but their students clearly outperform their Latin American counterparts in international standardised tests. Not only do Latin Americans need high quality government spending, but they also need high quality government revenues, collected fairly and from a broad base. Non-tax revenues–often linked to volatile natural resource exports like oil or copper–are far more important in Latin America, averaging fully 8% of GDP over 1990- 2006. A reliance on non-tax revenues, as well as on taxes on spending rather than on income (40% of tax revenues in the OECD, versus 25% in Latin America) makes government receipts more volatile and less progressive in Latin America.

As fiscal policy takes some tentative steps into the spotlight, let’s hope for the sake of Latin America and elsewhere, that this potent policy toolkit is used audaciously in the service of democratic consolidation and real economic development.


OECD (2008), Latin American Economic Outlook 2009, Paris.

©OECD Observer No 270/271 December 2008-January 2009

Economic data

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