In recent decades, numerous governments in Latin America and the Caribbean have adopted fiscal rules, which try to enforce fiscal discipline on governments and stop them from pro-cyclical spending, which involves spending too much when times are good and taking the ax to spending when times are bad. Pro-cyclical policies have been a historical trend in the region. They have not only generated wild swings, or volatility, in spending, but left countries without the financial resources to counteract economic downturns, including those caused by foreign shocks, such as a withdrawal of foreign investment or low commodity prices.
Cyclically-adjusted fiscal rules, or rules that take into account long-term economic trends, were designed precisely to prevent such pro-cyclical behavior by governments and curb the spending temptations that come with the need to please voters and win elections. But not all fiscal rules are the same. There are acyclical spending rules that require the government to pay back debt (or accumulate assets) when revenues are higher than usual and accumulate debt and spend assets when revenues are lower than the trend. And there are countercyclical fiscal rules that seek to further lean against the wind of economic cycles, increasing spending in bad times more aggressively than under a purely acyclical policy rule.
Determining the Level of Fiscal Activism
The key is finding the optimal degree of fiscal activism. Should governments seek to just insulate spending from volatile fiscal revenues through an acyclical rule, or is there a macroeconomic role in stabilizing the cycle via a countercyclical rule? Is the optimal response to the cycle of tax revenues the same as the optimal response to commodity-related revenues? And what is the role of social transfers and public investment?
To answer these questions, I set up a quantitative model of a small and open commodity-dependent economy in which a significant fraction of output and public revenues depends on exogenous, or external, volatile commodity prices. The economy features two household types: “savers” and “non-savers”. Savers own shares in the economy’s productive firms and have access to credit from the financial market which gives them money to spend even when the economy is in the doldrums. Non-savers, by contrast, live “hand-to-mouth” or are “financially constrained.” They work for a wage, consume their labor income period to period, and do not have access to credit markets.
Government revenues came from taxes and owning a share of the country’s commodity wealth. Government proceeds are spent on consuming goods and services, investing in (productive) public infrastructure, and targeted social transfers. The government follows a fiscal expenditure rule characterized by two policy parameters determining whether the government reacts procyclically, acyclically, or countercyclically to fluctuations in (1) tax revenues and (2) commodity-related revenues.
The results show that the welfare of non-savers, or those who are most vulnerable, is maximized under a strongly countercyclical stance with regard to tax revenues. A moderately procyclical approach to commodity revenues is also beneficial to them. In contrast, any deviation from the acyclical benchmark makes savers worse off.
Procyclical fiscal spending amplifies economic cycles and unambiguously harms all households. A countercyclical response to the tax revenue cycle, however, has a powerful macroeconomic stabilization effect. For instance, a procyclical balanced-budget rule regarding tax revenues increases the volatility of real GDP growth by 19% relative to an acyclical benchmark, implying a considerable welfare loss of 2.6% in lifetime spending for non-savers. In contrast, the countercyclical rule that maximizes non-savers welfare enables a 12% reduction in the volatility of GDP growth, leading to a welfare gain of 0.6%.
Handling Different Revenue Streams
Notably, there can be too much fiscal activism regarding commodity-related revenues. Since tax revenues are a direct function of domestic economic activity, household income and tax revenue are higher than usual when the economy is booming. So intuitively, a countercyclical response to tax revenues is desirable as it stabilizes aggregate output and household income. In contrast, commodity revenues are mainly a function of persistent fluctuations in international commodity prices, which do not (necessarily) correlate with the domestic business cycle. For instance, if commodity prices rise considerably during a domestic economic recession, a countercyclical response to the commodity windfall would cut spending. This would drag the economy further down, amplifying economic cycles and preventing the country from using the added revenues as a boost.
According to our quantitative results, the larger the share of financially constrained people and the lower the incidence of commodity revenues in total budgetary revenues, the more likely the optimal fiscal policy would be countercyclical. Each spending component plays a key role: government spending and especially public investment help stabilize real GDP, while social transfers are essential to allowing financially constrained households get through bad times.
If cyclically adjusted fiscal rules deliver macroeconomic stability and welfare gains, why are they not more widely used across Latin American countries? On the one hand, they are challenging to implement and sustain credibly over time, as they require substantial fiscal responsibility that outlive a particular government. Poor institutional quality often leads to discretionary spending by short-sighted governments, while limited access to international credit markets may prevent them from taking on additional debt, especially in bad times. On the other hand, countercyclical rules, while stabilizing for the economy as a whole, may involve more volatility, or swings, in government spending and debt.
Policymakers in the region could benefit from the Chilean experience. In 2006, Chile passed a law mandating an acyclical fiscal rule that was already being implemented. The results from our study suggest that additional welfare gains would be possible by moving from that neutral acyclical policy to an actively countercyclical approach.
The Need for Flexibility in the Design of Fiscal Rules
Of course, the specific design of fiscal rules will depend on context: no single approach is appropriate for every country. For instance, if a developing country has accumulated net foreign assets during a prolonged period of economic prosperity and needs financing for development projects, it may be in everybody’s interest to spend more than an otherwise rigid fiscal rule would allow. Such escape clauses require political and technical consensus about the economy’s absorptive capacity and independent oversight to function correctly. On the other hand, in the face of a large and persistent commodity price boom, the government may also wish to build a prudent buffer fund — such as Chile’s Economic Stabilization Fund — to protect against the possibility of future economic disasters. Such funds can also cover contingent (potential) liabilities, like those related to future pensions, or aim for intergenerational equity.
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