18 August 2016

Briefing note1

Fiscal consolidation, growth and employment: international evidence and implications Introduction When the global financial crisis and the world-wide recession that followed from it struck the international community in 2007-2009, the overwhelming response was one of coordinated fiscal expansion among the systemically important countries to stave off the adverse impact on jobs and livelihoods. Yet, by 2010, there was a shift in favour of fiscal consolidation ushering a global ‘age of austerity’.2 An ILO-supported study has found that, in 2014-2015, 91 out of 100 IMF Article IV consultations proposed fiscal consolidation for its member states.3 The move to fiscal consolidation since 2010 was most marked in the Eurozone economies as well as in the UK. Indeed, this move was endorsed in the June 2010 Toronto declaration of the G20 summit. The G20 leaders noted that ‘advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilize or reduce debt-to-GDP ratios by 2016’. To be fair, the Toronto G20 Summit also highlighted the ‘risk that synchronized fiscal adjustment across several major economies could adversely impact the recovery’ and that attention should be given to ‘strengthen social safety nets’. Nevertheless, the 2010 G20 declaration was based on the optimistic premise that a global recovery was underway and that an ambitious agenda of ‘structural reforms’ cutting across both labour and product markets would lift global output significantly, create ‘tens of millions more jobs’, sustain poverty reduction and reduce global imbalances significantly. Subsequent G20 declarations

1

Prepared by Iyanatul Islam, Adjunct Professor, Griffith Asia Institute, Griffith University, Australia and former Branch Chief, Employment and Labour Market Policies, ILO, Geneva for ILO, New Delhi, to support its policy dialogue with the FRBM Review Committee, Ministry of Finance, Government of India to be held on 23 August 2016. 2 The Economist (2010) ‘Fiscal Tightening and Growth’, 31 March 3 Ray, N and Schmitz, L (2016) ‘The IMF and Social Dimensions of Growth: A Content Analysis of Recent Article IV Surveillance Reports 2014-2015, Employment Working Paper No.202, ILO, Geneva. This evaluation was undertaken under the supervision of the author of the briefing note.

1|Page

have moved away from the endorsement of specific fiscal targets, but the emphasis on structural reforms has remained intact.4 It is against this global background that this briefing note revisits the issue of fiscal consolidation and its consequences from a growth and employment perspective. This note is intended to support ILO, New Delhi in its policy dialogue with the Fiscal Responsibility and Budget Management (FRBM) Review Committee of the Ministry of Finance of the Government of India. This Committee will re-examine India’s current fiscal framework and offer recommendations on improving its operation. The briefing note covers the following issues. It offers a brief definition and scope of fiscal consolidation. It then critically reviews the rationale for fiscal consolidation. The note discusses whether there are ‘tipping points’ beyond which there is a sharp deceleration in growth. It provides some international evidence on the consequences of fiscal consolidation and complements this discussion by a review of the evidence on the impact of fiscal rules from the perspective of low and middle income economies. The note moves beyond fiscal consolidation and critically examines whether regulatory and structural reforms are pivotal in enhancing growth and employment prospects in developing countries. The note concludes with some lessons learnt from the international evidence pertaining to fiscal consolidation and suggests how one can move towards a more holistic approach. Fiscal consolidation: definition, scope and rationale Fiscal consolidation entails the use of taxes and spending restraints to reduce public debt and budget deficit. This exercise is guided by targets pertaining to debts and deficits over a given period of time. The aim is to steer the fiscal position of the government towards those targets. The Eurozone’s Maastricht Treaty, promulgated in 1992, is a prime example of a targetdriven approach to fiscal policy. As is well known, the long-run fiscal targets for Eurozone economies are specified as 3 per cent fiscal deficit as a proportion of GDP and 60 per cent debt to GDP ratio.

4

As reviewed in Islam, I and Kucera, D (eds) (2014) Beyond Macroeconomic Stability: Structural Transformation and Inclusive Development, ILO and Palgrave Macmillan: Geneva and London

2|Page

Some low and middle have adopted fiscal targets that are very similar to those specified in the Maastricht Treaty. Examples include India, Indonesia and the fiscal targets that are part of the convergence criteria adopted by the economic unions in Sub-Saharan Africa. The pursuit of fiscal consolidation by observing prudential norms have typically been endorsed by premier international institutions. Indeed, in 2015, the OECD has issued new guidelines on the need to observe fiscal targets by adopting balanced budget and expenditure rules.5 Thus, for high income countries, the OECD calls for 70 to 90 per cent debt thresholds; for Eurozone countries, the corresponding number are 50 to 70 per cent; for emerging economies, the debt threshold is set at 30 to 50 per cent. The OECD goes even further and calls for setting debt limits that are, on average, 15 percentage points below the afore-mentioned thresholds. This will enable policy-makers to avoid ‘overshooting’ of debt thresholds due to adverse shocks. Why are fiscal targets as a means of instituting prudent macroeconomic policy advocated? Its proponents claim that ‘…beyond a …threshold, government debt can undermine economic activity and the ability to stabilise the economy’ (OECD: 1, 2015). This happens because at ‘high’ debt levels (defined in relation to the threshold), governments lose market confidence and can see their borrowing costs increase sharply. This deters private investment and spending in general and paves the way for a recession. In such circumstances, fiscal consolidation can, according to its advocates, paradoxically turn out to be ‘expansionary’, that is, growth and employment can increase even in the presence of tax increases and spending cuts. Such a salutary outcome is possible because a credible and front-loaded fiscal consolidation strategy can restore market confidence and reduce borrowing costs to sustainable levels. Spending by the private sector is accordingly stimulated thus creating the enabling condition for growth to take place. Deficits and debts: are there tipping points? The notion that, in designing and implementing fiscal policy, governments should seek to have prudential thresholds or ‘anchors’ that can stabilize and stimulate private sector expectations in a growth-oriented direction requires a more critical assessment. Are there 5

OECD (2015) ‘Achieving prudent debt targets using fiscal rules’, Economics Department Policy Note No.28, July

3|Page

reliable tipping points beyond which growth sharply decelerates or even collapses? Furthermore, are private sector expectations driven entirely, or at least primarily, by fiscal concerns as the thesis of market confidence suggests? Consider the case of prudential thresholds for public debt. The most influential fiscal targets that are either currently in place or proposed are not grounded in any robust theory of ‘optimal’ public debt. The 1992 Maastricht Treaty target (60 per cent debt to GDP ratio) target was based on the historical experience of countries that eventually became the founding member states of the Eurozone. Hence, middle income economies (such as Indonesia) that adopted such a target appears to have done so without due diligence with respect to their applicability and relevance to country-specific circumstances. A widely noted study by Reinhart and Rogoff (2010) popularized the idea that when public debt reaches 90 per cent of GDP, growth declines sharply.6 This claim was highlighted by Ollie Rehn, the then EU Commissioner on Economic and Monetary Affairs, in a 2011 speech. As he observed: Carmen Reinhart and Kenneth Rogoff have coined the "90% rule", that is, countries with public debt exceeding 90% of annual economic output grow more slowly. High debt levels can crowd out economic activity and entrepreneurial dynamism, and thus hamper growth. This conclusion is particularly relevant at a time when debt levels in Europe are now approaching the 90% threshold, which the US has already passed.7

The ‘90 per cent rule’ has since then been shown to be afflicted by computational and methodological errors. More importantly, many subsequent studies have not been able to establish that a tipping point exists at the 90 per cent debt threshold ( Cobham, 2016; Islam and Chowdhury, 2014; Islam, 2014).8 Indeed, estimates based on debt sustainability analysis suggest a debt limit in excess of 100 per cent for developed countries (Ostry et al, 2010).9

6

Reinhart, C and Rogoff, K (2010) ‘Growth in a Time of Debt’, American Economic Review, 100(2), 573-77. The study is based on 44 developed and developing countries. 7 http://europa.eu/rapid/press-release_SPEECH-11-407_en.htm

8

Cobham, D (2016) ‘The Weakness of the Academic Case for Austerity’, in Bratsiositis, G and Cobham, D (eds) (2016) German Macro: How it is Different and Why it Matters, European Policy Centre; Islam, I and Chowdhury, A (2014) ‘Fiscal Consolidation: Issues and Evidence’ in Islam and Kucera (op.cit); Islam, I (2014)

4|Page

Consider now the case of targets on fiscal deficits which is part of the Maastricht Treaty and also a central plank of India’s Fiscal Responsibility and Budget Management Act of 2003. Table 1 lays out the various proposals that have been made - or inferences that can be drawn - with respect to prudential limits to fiscal deficits. As can be seen, the proposals range from 1 per cent budget deficit to GDP ratio to 5 per cent. In most cases, the numbers have not been derived from first principles. The exception is Adam and Bevan (2005) who draw on 45 non-OECD countries for the 1970-1999 period to suggest an optimal threshold at 1.5 per cent fiscal deficit. However, an inspection of the actual data does not reveal an intuitively obvious validation of the threshold – see figures 1 and 2.

‘The Rise and Decline of the Fiscal Austerity Doctrine: Implications for the Euro Area Crisis’ in Papadakis, K and Youcef, G (eds) The Governance of Policy Reforms in Europe, Geneva: ILO, 2014 9

Ostry, J et al (2010) ‘Fiscal Space’, IMF Staff Position Paper, SPN/10/11, 1 September

5|Page

Table 1: Proposed targets with respect to fiscal deficit: some examples Author

Proposed targets (implied / explicit)

Comments

Williamson (1990)10

1 to 2 per cent (explicit)

Author suggests that exceeding this range is ‘ prima facie evidence of policy failure’. No evidence provided other than suggesting that this target might be breached in the case of productive expenditure. Receives pride of place in author’s suggestion of 10 good policy principles

11

Adam and Bevan (2005)

1.5 per cent (explicit)

Derived from estimates based on an ‘overlapping generations model’. 45 nonOECD countries, 1970-1999

12

Easterly (2004)

5 per cent (implicit)

Graph shown suggest that growth becomes negative after budget deficit crosses 5 per cent based on 1960-1994 period for developing countries

Source: Author’s interpretation based on the aforementioned studies

Consider, for example, figure 1. While growth declines modestly as one moves from a balanced budget to a deficit, it paradoxically improves as the budget deficit reaches 5 per cent. Figure 1 also suggests that progressive fiscal surpluses are associated with a lower growth rate. In Figure 2, the co-movement between five year averages of deficits and per capita growth over the 1970-1999 period is mixed (despite the linear relationship in which both the budget deficit and growth move in the same direction).

10

Willamson, J (1990) ‘What Washington Means by Policy Reform’, in Williamson, J (ed) Adam, C.S and Bevan, D.L (2005) ‘Fiscal deficits and growth in developing countries’, Journal of Public Economics, 89, 571-597 12 Easterly, W (2004) ‘The Widening Gyre: The Dynamics of Rising Public Debt and Falling Growth’, Paper presented at IMF/NIPFP Conference on Fiscal Policy in India, New Delhi, India, January 16-17 11

6|Page

Figure 1: Relationship between fiscal deficit and per capita GDP growth (Adam and Bevan, 2005)

7|Page

Figure 2: Co-movements between per capita GDP growth, five year averages, 1970-1999, 45

Annual average growth per capita GDP (%) : five year averages, 1970-1999

non-OECD countries 7 6 5 4

Growth(%) Deficit(%)

3

Linear (Growth(%)) 2

Linear (Deficit(%))

1 0 0

1

2

3

4

5

6

7

Overall budget deficit (%), five year averages, 1970-1999

Source: Derived by author from Adam and Bevan (2005)

There is the outstanding issue of ‘market confidence’ that governments often invoke in order to warn about tipping points. How valid is that view? The role of market confidence in supporting the case for fiscal consolidation has been misinterpreted. Markets care about the fiscal stance of governments, but they also care about growth. Market confidence will not be boosted if growth prospects are low and made lower still by fiscal consolidation.13 Hence, market confidence should not be used uncritically as a way of justifying prudential thresholds based on point estimates that are unlikely to be reliable. Fiscal consolidation, growth and employment: international evidence Estimating tipping points is one way of assessing the relationship between a government’s fiscal position and growth. There are, however, multiple studies that have assessed the 13

The evidence is reviewed in Islam, I and Hengge, M (2012) ‘Fiscal Austerity, Borrowing Costs and the Eurozone Economies’, July 12, Social Europe

8|Page

impact of fiscal consolidation on growth and employment without having to go through the exercise of identifying tipping points. Some early estimates for 20 industrialized countries for the 1970-1995 period suggest that fiscal consolidation was associated with growth recoveries in 19 per cent of the cases (or 14 out of 74 observed cases) (Islam and Chowdhury, 2014, drawing on Dermott and Wescott, 1996).14 The evaluation concluded that in the case of the success stories, a holistic policy approach played a key role. Thus, fiscal consolidation was combined with supportive monetary policy and competitive exchange rate regimes. The evaluation also emphasized that ‘strong global economic growth helps to achieve a successful consolidation, and weak global growth reduces the chances that consolidation will cut the debt-to-GDP ratio’. There have been – and continue to be - ardent advocates of ‘expansionary’ fiscal consolidation (such as Alesina and Ardagna, 2009, Alesina, 2010). In other words, fiscal contraction is expected to be associated with output and employment expansion because positive ‘market confidence’ effects can outweigh negative ‘Keynesian’ effects on aggregate demand. Even in the case of such studies, the thesis of ‘expansionary’ fiscal consolidation appears to hold in a minority of cases (25 per cent or 27 out of 107 observed cases). In any case, studies by such scholars of fiscal consolidation have been heavily criticized on methodological grounds. Estimated fiscal multipliers and their implications for ‘expansionary’ fiscal consolidation Another way of assessing ‘expansionary’ fiscal consolidation is to focus on the sign and size of the fiscal multiplier. If ‘expansionary’ fiscal consolidation prevails, the estimated value of the fiscal multiplier with respect to government expenditure should be negative, that is, fiscal contraction will be associated with output and employment expansion. Fiscal multipliers are frequently close to 1 or in excess of unity during downturns in developed countries. Fiscal multipliers tend to be significantly lower in developing countries – around 0.4 (Hory, 2016: Kraay, 2013).15 There is suggestive evidence that, as in the case of 14

Islam and Chowdhury (op.cit); Dermott, C.J and Wescott, R (1996) ‘Fiscal Reforms that Work’, Economic Issues, No.4 15 Hory is based on a sample of 48 emerging and advanced economies for the 1990-2013 period. See Hory, M-P (2016) ‘Fiscal Multipliers in Emerging Economies: Can we Learn Something from Advanced Economies’, International Economics, 146, 59-84. Kraay is based on a sample of 102 developing countries using lending

9|Page

developed countries, fiscal multipliers are higher during recessions. Country characteristics also matter. Fiscal multipliers are higher for large, domestically oriented economies and for economies with flexible exchange rate regimes. Furthermore, capital expenditure multipliers can be close to one in developing countries.16 Some studies for emerging economies have found fiscal multipliers that are zero (as in the case of Brazil, IMF 2015).17 It has also been estimated that fiscal multipliers with respect to current expenditure might be negative in some circumstances, but these findings have been contested. 18 In the case of India, recent estimates of fiscal multipliers are shown in Table 2. As can be seen, there is no evidence of negative (expenditure) fiscal multipliers. Indeed, relative to other emerging economies, fiscal multipliers are rather high and apparently higher than what prevails in developed countries, such as USA and the European Union.19 This has important implications. Based on the estimates presented here, ‘expansionary’ fiscal consolidation along the lines suggested by Alesina (2010) in India is unlikely to succeed. Indeed, India-specific simulations suggest that ‘front-loaded fiscal consolidation’ in which expenditure cuts do not protect public investment and social protection expenditure run the risk of imposing high short-run output losses.20

data from creditor countries to covering observations that go back to the 1980s. See Kraay, A (2014) ‘Government spending multipliers in developing countries: Evidence from Lending by Official Creditors’, American Economic Journal: Macroeconomics, 6(4), 170-208 16 Estevao, M and Samake, I (2013) ‘The Economic Effects of Fiscal Consolidation with Debt Feedback’, IMF Working Paper No.136 17 Matheson, T and Pereira, J (2016) ‘Fiscal Multipliers in Brazil’, IMF Working Paper, No.79. Note that historical data preceding the global financial crisis of 2007-2009 suggest that fiscal multipliers in Brazil are approximately 0.5 18 IMF (2008) World Economic Outlook, October, Chapter 5. See Estevao, M and Samake, I ((op.cit). Contrarian views on negative fiscal multipliers are offered in Mason, J.W and Jayadev, A (2013) ‘How the New Consensus in Macroeconomics Let Austerity Lose all the Battles and Still Win the War’, Economic and Political Weekly, 48(2), 102-111 19 Tapsoba, S (2013) ‘Options and strategies for Fiscal Consolidation in India’, IMF Working Paper No.127 20 Tapsoba (2013: 12, 19)

10 | P a g e

Table 2: Fiscal multipliers, India Author(s)

Sign and size of (impact) fiscal multipliers

Comments

Bose and Bhanumurthy (2013)21

Capital expenditure:2.45

Based on a structural macroeconomic

Transfers: 0.98

model and applied to annual data for the

Other revenue multipliers: 0.99

1991-2012 period

Government spending: 0.6 to 0.9

Based on calibrations of IMF multi-region

Government revenue: 0.4

DSGE model and also using VAR model

Tapsoba (2013)22

Fiscal consolidation and growth: recent Eurozone and OECD experience (2010 onwards) The debate on the growth impact of fiscal consolidation began in earnest in 2010. By that time, the Eurozone countries embarked on synchronized fiscal consolidation in response to a putative sovereign debt crisis in Southern Europe with its epicentre in Greece. Between 2011 and 2013, there was large-scale fiscal consolidation in the Eurozone amounting to 4 per cent of GDP. By now, multiple evaluations have taken place on this most recent episode of fiscal consolidation. The latest study suggests that GDP declined by 3.5 per cent due to fiscal consolidation (Ranenberg, 2015).23 Greece was the worst hit and suffered a depression as a result of historically unprecedented fiscal austerity. Outside the Eurozone, the UK also undertook significant fiscal consolidation between 2010 and 2012. All evaluations suggest that this fiscal experiment led to reduced growth and employment (Wren-Lewis, 2015).24 Some studies have moved beyond the impact of fiscal consolidation on growth. They highlight the impact of fiscal consolidation along multiple dimensions. Based on data for 17 OECD countries for the 1978-2009 period, the authors of these studies show that fiscal

21

Bose, S and Bhanumurthy, N.R (2013) ‘Fiscal Multipliers for India’, National Institute of Public Finance and Policy 22 Tapsoda , S (2013) ‘Options and strategies for Fiscal Consolidation in India’, IMF Working Paper No.127 23 Ranenberg, A (2015) ‘The Consequences of Europe’s Fiscal Consolidation’, World Economic Forum, November 16, 24 Wren-Lewis, S (2015) ‘The Austerity Con’, London Review of Books, 19 February

11 | P a g e

consolidation episodes lead to the following long-run consequences (Ball et al, 2013; Lougani, et al 2016).25 

Inequality (as measured by the Gini ratio) goes up by 3.4 percentage points



Wage share declines by 0.8 percentage points



Long-run unemployment goes up by 0.5 per cent.

Fiscal rules, growth and employment: evidence from low and middle income countries Fiscal targets are often embedded in fiscal rules26. In recent years, there has been a substantial increase in the number of low and middle income countries that have adopted fiscal rules. Very few developing countries operated de jure fiscal rules at the beginning of the 1990s. By 2014, well over 50 low and middle income countries, including India, have adopted at least one fiscal rule. Admittedly, many of these countries, especially in SubSaharan Africa, have adopted fiscal rules in order to facilitate currency union convergence aims, but there are numerous examples of countries, such as India, that have embraced fiscal rules unilaterally and without any currency convergence considerations. Countries with explicit fiscal targets embedded in fiscal rules are worth studying because they are more likely to embrace fiscal consolidation in case of significant and persistent breach of fiscal targets. This is another way of assessing the impact of fiscal consolidation on growth and employment when country characteristics vary - in this case whether or not a country adopts and operates fiscal rules. Do countries with fiscal rules necessarily have better growth and employment outcomes than others? An ILO-supported study examined these issues (Ray, Velasquez and Islam, 2015).27 The study found that, in general, there were statistically insignificant differences in ILO-labour market based indicators between low and middle income economies that adopt fiscal rules and those that do not (see Table 2). Furthermore, there were no statistically significant 25

Ball, L et al (2013) ‘ The Distributional Effects of Fiscal Austerity’, UN-DESA Working Paper No.129, New York, United Nations 26 ‘A fiscal rule represents numerical limits on budgetary aggregates during the budget cycle. The definition of the budget cycle may vary and the rules may target revenues, total debt stock, the annual budget deficit or specific categories of expenditure’ (Ray et al, 2015:1). See citation below in note 22. 27 Ray, N, Velasquez, A and Islam, I (2015) ‘Fiscal Rules, Growth and Employment: a Developing Country Perspective’ Employment Working Paper No.184, ILO, Geneva

12 | P a g e

differences in growth rates. Low and middle income economies with fiscal rules grew at 2.4 per cent over the 1997-2013 period, while low and middle income countries without fiscal rules grew at 2.5 per cent. Regression estimates also do not support a strong case for fiscal rules as an enabling condition of growth and employment (see Table 3). Table 3: Fiscal rules and labour market indicators in low and middle income economies Variable

With fiscal rules

Without fiscal

Statistically significant difference

rules (Yes/No)

Working poor (% earning less than 2 USD)

42.3

42.4

No

Vulnerable employment (% of work-force)

58.4

57.1

No

Labour productivity (USD, 2005 as base

6785.5

5054.7

Yes

Unemployment rate (%)

8.3

8.8

No

Employment rate (%)

60.3

60.0

No

year)

Source: Adapted from Ray et al (2015: 15)

13 | P a g e

Table 4: Fiscal rules as a growth determinant vis-à-vis other variables in a mainstream growth equation Explanatory variables

Statistically significant at 5% level (yes/no)

Statistically significant at 5% level (yes/no)

Regression with time effects

Regression without time effects

Initial per capita GDP

Yes

Yes

Investment

Yes

Yes

Years of schooling

Yes

Yes

Population growth

Yes

Yes

Balanced budget rule (BBR)

Yes, but with wrong sign, suggesting BBR associated with negative growth

No

Debt limits

No

No

Source: Adapted from Ray et al (2015: 35-38)

Beyond fiscal consolidation: regulatory/structural reforms vs a holistic approach Perhaps the biggest deficiency in the advocacy of fiscal consolidation is that it does not respond to labour market challenges represented by the fundamental goal of providing durable and productive employment opportunities for all. While one can readily agree that private sector-led economic dynamism holds the key to realizing such a goal, it is by no means obvious that simply relying on fiscal retrenchment measures will automatically enable the private sector to become an engine of growth. Not surprisingly, the advocates of fiscal consolidation emphasize that fiscal consolidation should be complemented by regulatory/structural reforms that encompass labour, capital and goods markets. The aim is to boost market confidence by improving the business climate that in turn is expected to spur private investment across a range of sectors and create broad-based employment opportunities. The emphasis in this approach is monitoring the extent to which a developing

14 | P a g e

country improves its ranking in ‘doing business’ surveys of the World Bank and ‘global competitiveness’ surveys of the World Economic Forum. This approach, while useful, often does not investigate the binding constraints that hold back private sector-led job creation capacities. The role of the government is to alleviate such binding constraints to enable private sector-led growth and employment. This is where another survey undertaken by the World Bank – world enterprise surveys – provides important insights. Table 5a shows the major binding constraints (or ‘business environment obstacles’) as perceived by the private sector in more than 100 countries covering more than 135,000 firms with respect to particular variables: corruption, taxes and business regulations, labour regulations, infrastructure (as represented by availability of reliable electricity supply, transport networks), access to finance, availability of a skilled work-force. It appears that governance issues (as reflected in corruption, crime, theft and disorder), lack of electricity and transport networks, inadequately trained and educated work-force are more important concerns for the private sector than regulatory issues pertaining to taxes, business licensing and permits and labour market regulations. Indeed, the latter attracts the least concern among private sector firms. The case of India (Table 5b) is even more striking with less than 5 per cent of the more than 9,000 firms that were surveyed regarding tax administration and labour regulations as being the most important obstacle to business operations.

15 | P a g e

Table 5a: World enterprise surveys, global overview Major constraints to business operations as perceived by more than 135,000 firms in more than 100 countries (2009-2014)

% of firms that agree with survey question

Corruption

36.8

Crime, theft and disorder

26.5

Access to finance

30.8

Electricity

36.3

Transportation

22.3

Tax administration

21.9

Business licensing and permits

14.8

Customs and trade regulations

18.4

Labour regulations

12.3

Inadequately educated work-force

27.4

16 | P a g e

Table 5b: World enterprise survey, 2014, India Major constraints to business operations as perceived by more than 9000 firms in India (2014)

% of firms that agree with survey question

Corruption

19.9

Crime, theft and disorder

-

Access to finance

11.7

Electricity

15.3

Transportation

-

Tax administration

3.7

Business licensing and permits

-

Customs and trade regulations

-

Labour regulations

4.9

Inadequately educated work-force

3.4

Even if one concedes that structural reforms can engender ex-ante long term gains in terms of higher output and more jobs, their short-run consequences cannot be ignored. The latest (model-based) conclusions based on an IMF evaluation (2016) are that, while there are likely to be ex-ante long-term gains in terms of higher output and more jobs, a lot depends on the state of the business cycle.28 If structural reforms are pursued during a recession and periods of slow growth – as is the case now in some BRICS – it will worsen prevailing 28

IMF (2016) World Economic Outlook, April

17 | P a g e

economic conditions by reducing output and employment that might persist for more than a year. In the case of India, expected long-term gains from labour market reforms need to consider high short transition costs as noted above. As one study observes: ‘There is a fall in GDP, a rise in unemployment, and a fall in the share of formal firms in the first four to five quarters post labour market reform’ (Anand and Khera, 2016: 36, italics added).29 The qualitative aspects of growth and employment are often ignored in an agenda of structural reforms. This means that one should consider pragmatic and innovative policy options that focus on the quality and inclusiveness of growth and jobs rather than simply emphasizing their quantitative dimensions. Despite the above caveats, there is an influential view that cutting labour and corporate taxes, lowering the tax wedge and cutting social benefits can strengthen work incentives, increase labour supply and encourage private investment. While this might be true in principle, the impact might be modest in practice. Cross-country evaluations, drawing on OECD economies and multiple country studies cutting across high, middle and low income countries, do not suggest that tax cuts necessarily boost growth and employment on a significant scale. For example, cutting both labour income and corporate taxes can yield, at best, a 0.05 per cent reduction in the ‘employment gap’, that is the gap between actual employment and potential employment when the economy is at full capacity. Furthermore, 63 per cent of episodes of tax reform across a range of countries are not accompanied by sustainable growth accelerations. Table 6 provides pertinent details. The preoccupation with tax reforms as a way of boosting growth and employment overlooks the critical role that public expenditure plays in such a process. For example, a 1 per cent increase in current government expenditure as a proportion of GDP can boost employment by 0.4 percentage points, which is significantly more than the impact that follows tax reforms. In addition, as Table 6 shows, tax and related reforms – such as a freeze on public

29

Anand, R and Khera, P (2016) ‘Macroeconomic Impact of Product and Labor Market Reforms on Informality and Unemployment in India’, IMF Working Paper No.16, The authors note that this can be mitigated by focusing on product market reforms.

18 | P a g e

sector employment, adjustments to pension benefits – can worsen inequality and thus impair the goal of inclusive growth. Table 6: Fiscal policy, growth and employment Fiscal instrument Reduce taxes on labour income and reduce corporate taxes

Ex-ante transmission mechanism Induces work incentives and increases labour supply; induces private investment

Grant tax credits or deductions to R&D

Promotes technical progress

Rationalize social benefits by reducing social transfers, such as unemployment benefits and pensions, reduce or freeze public employment

Induces work incentives and increases labour supply; induces private sector employment

Enhance access to education and health care by spending more at lower levels, increasing cost recovery for tertiary education but providing financial support to low income HHs, addressing supply side barriers in less developed countries Invest in infrastructure and make such investment efficient by improving governance of investment process

Empirical evidence: impact on growth and employment Impact on employment modest. ‘Employment gap’ likely to reduce at most by 0.05% 63% of episodes of tax reforms do not lead to sustainable growth accelerations Less effective for developing economies with insufficiently developed R&D regime Impact on employment modest

Supports increase in human development

Current expenditure on such items can boost employment significantly, e.g. 1 per cent increase in GDP of current government expenditure can boost employment by 0.4%

Supports investment in physical capital and improves productivity of private sector

Capital expenditure does not boost employment in short run but has long term growth gains. When spending initiatives are combined with appropriate tax reform, 60% of cases from multiple country studies show sustainable growth accelerations

Implications for inequality Reduces progressivity of tax system and thus inequitable

Neutral with respect to impact om equity Inequitable with considerable evidence that such measures hurt vulnerable groups by reducing their purchasing power Higher inequality can retard growth and thus growth gains from such fiscal reforms Promotes equity

Promotes equity if investment in infrastructure geared towards improving basic services, such as transport and communications, including digital networks, water supply and sanitation

Source: Adapted from Bova, E et al (2014) ‘A Fiscal Job’? An Analysis of Fiscal Policy and the Labor Market, IMF Working Paper No.216 and IMF (2015) ‘Fiscal Policy and Long-Term Growth’, April 20

Fiscal instruments to promote growth and employment should also take account of efficient public investment, especially in infrastructure, which can raise the economy’s productive capacity and create employment opportunities. Furthermore, it is well known that equitable access to education and health care contributes to human capital accumulation and hence growth and employability.

19 | P a g e

Lessons learnt Some broad lessons might be gleaned from this succinct review of the pertinent issues and evidence on the impact of fiscal consolidation, growth and employment. Such lessons might be summarized as follows. 

Tipping points pertaining to debts and deficits rely on ratios in which GDP is the denominator. Hence, growth slowdowns will be associated with worsening debts and deficits even in the absence of profligate fiscal policies.30



Point estimates pertaining to specific debt/deficit thresholds are not reliable. This does not mean that fiscal targets are irrelevant. Governments need targets to guide policies. One should aim for a range of thresholds (along the lines suggested by the latest OECD guidelines), but this should be anchored in evidence and country-specific experiences.



One should not uncritically invoke the notion of market confidence in justifying fiscal targets that are based on unreliable point estimates.



Short-run output losses are often associated with fiscal consolidation. There are also long run costs of fiscal consolidation in terms of higher unemployment and greater inequality.



Debt to GDP ratios at the end of a fiscal consolidation exercise could be paradoxically higher than at the beginning of such an exercise. In the Eurozone, for example, debt to GDP ratio in the third quarter of 2015 was 91.6 per cent while in 2011 it was 86 per cent.



This is once again because fiscal consolidation took place in a context of slow growth and recession. The growth slowdown was exacerbated causing the debt to GDP ratio to rise.



The contractionary impact of fiscal consolidation can be counteracted by expansionary monetary policy and competitive devaluations. However, the former can be nullified or its effectiveness blunted if economies become vulnerable to a ‘liquidity trap’, that is, when nominal interest rates approach zero even when slack

30

Easterly, W (2013) provides evidence on the impact of growth slowdowns on a government’s fiscal position in both developed and developing countries. See Easterly, W (2013) ‘The Role of Growth Slowdowns and Forecast Errors in Public Debt Crises’, in Alesina, A and Giavazzi, F (eds) (2013) Fiscal Policy after the Financial Crisis, University of Chicago Press

20 | P a g e

economic conditions persist. This makes it difficult for monetary authorities to push down such interest rates lower than the ‘zero bound’. One could argue that advanced economies have been subject to a liquidity trap in the wake of the global recession of 2008-2009. This has worsened the adverse consequences of fiscal condition as monetary policy offset was not effective, despite attempts by the monetary authorities to engage in policy innovations, most notably quantitative easing and forward guidance.31 

The ability to pursue competitive devaluations depends critically on the ability to have policy autonomy with respect to the exchange rate. Once again, the experience of the Euro Area countries that experienced a debt crisis in 2010 is highly instructive. Given that they gave up policy autonomy with respect to the exchange rate by adopting the Euro, the opportunity to engage in competitive devaluations was not available to member states. The alternative was a costly process of ‘internal devaluation’ in which real wages declined over a protracted period to engender cost competitiveness.



One should pay attention to how debt is financed and used. Prudent borrowing, especially, when there is ample fiscal space and low borrowing costs, is desirable if directed towards productive investment. This also implies that one should ensure that ‘productive expenditure’, such as public investment, is protected during fiscal adjustment exercises. This is frequently overlooked.32



Of course paying heed to such lessons on the promises, pitfalls and perils of fiscal consolidation does not mean that one can simply ignore the fiscal situation of a country if it becomes unsustainable. Then fiscal consolidation is unavoidable and can bring in long-term benefits, despite short-term pain, in terms of higher growth and better employment prospects. On the other hand, one should not succumb to fiscal

31

Some central banks (the European Central Bank, Denmark, Switzerland, Sweden, and Japan) have adopted so-called negative interest rates. The consequences of these actions are uncertain and fraught with risks. See New York Times, ‘What Two Years of Negative Interest Rates in Europe Tell Us’, August 15, 2016. 32 See Serven, L (2007) ‘Fiscal Rules, Public Investment and Growth, World Bank Policy Research Working Paper No.4382; Easterly, W, Irwin, T.C and Serven, L (2007) ‘Walking Up the Down Escalator: Public Investment and Fiscal Stability’, World Bank Policy Research Working Paper No.4158. As authors observe: ‘Fiscal adjustment becomes like walking up the down escalator when growth-promoting spending is cut so much as to lower growth and thus the present value of future tax revenues to a degree that more than offsets the improvement in the cash deficit’.

21 | P a g e

fetishism and advocate spending restraint and tax increases without undertaking due diligence with respect to the particular circumstances of a country. 

It is necessary to move beyond a preoccupation with fiscal consolidation and enunciate a broader growth and employment strategy with due consideration given to appropriately designed fiscal policy in supporting such a strategy.



It is essential to develop a sustainable resource mobilization strategy to invest in health, education, infrastructure and social protection.



It is highly desirable to invest in financial inclusion initiatives as this has been shown to be important in reducing poverty and promoting employment, both directly and indirectly.



It is important to invest in active labour market policies (ALMPs).33



It is essential to use due diligence to assess policy interventions.



As an example, consider the case of ALMPs. For example, one study that covers 152 impact evaluations across developed, developing and transition economies arrives at the following conclusion for the latter.34



Employment services and skills training had the most positive impacts, both on employment probability and earnings.



Results from public employment programs as well as and employment subsidies are mixed, being effective in some cases, but not in others.



There is insufficient evidence to arrive at credible conclusions pertaining to selfemployment/small business assistance programs. As an ILO-supported study concludes, ‘on the basis of the evidence and data reviewed, it is not clear that the self-employment and entrepreneurship schemes that have been tried actually created new jobs, nor is it clear whether these jobs are of sufficient merit to be worth creating’.35



Such meta-evaluations are not infallible, but they provide a way of developing an evidence-based approach to policy design.

33

ALMPs range across intermediation services, such as job search and counselling, wage subsidies and worksharing programmes, public/employment guarantee schemes, training and re-training, self-employment and entrepreneurship initiatives. 34 Betcherman, G (2008) ‘Active Labor Market Programs: Overview and International Evidence on What Works’, World Bank, April 35 Burchell, B et al (2015) ‘Self-employment programmes for young people: A review of the context, policies and evidence’, Employment Working Paper No.198, ILO, Geneva

22 | P a g e



Hence, in the case of ALMPs, one can be reasonably confident that some interventions work better than others. This means that one should take care in designing the appropriate mix of ALMPs as part of a holistic policy framework.

23 | P a g e