Economy

Tackling the budget problem

 

More about public finances

    

Pier Carlo Padoan, OECD Chief Economist and Deputy Secretary-General

 

Public debt in the OECD area is fast approaching 100% of GDP, as the financial and economic crisis badly deteriorated government budgets. A concerted move towards more balanced budgets is needed, while preparing the ground for economic growth.

The recession has weakened the public finances of most OECD countries. Stimulus packages, lower tax takes, high unemployment: these are just some of the factors that have led to historically high general government deficits and debt.

 

Major government spending and tax measures were clearly necessary to help keep economies afloat during the crisis and the recession that followed. But a combination of support measures and the effects of the downturn on the budget will now push the OECD-wide budget deficit to the post-World War II high of about 7. 5 % of GDP in 2010. OECD public finances will improve in 2011 as economic activity picks up , and the announced consolidation measures begin to bear fruit . However, u nderlying deficits - which exclude the effect of fluctuations in economic activity on the budget - will remain historically high in several countries, including Japan, the United Kingdom and the United States.

 

Large budget deficits will push government debt to close to 100% of GDP in 2011 in the OECD area as a whole. Debt levels are even higher in a few countries. Japanese government debt, for example, is projected to exceed 200% of GDP in 2011.

 

Without urgent and coherent action, debt levels will continue to rise in most countries. How to restore the public finances while sustaining the recovery, not to mention upholding key public services, is a balance OECD countries need to get right. Bringing government debt-to-GDP ratios back to pre-crisis levels will require enormous efforts, especially in countries where debt was already high before the crisis struck.

 

Most OECD countries are in a position to start consolidating their public finances from 2011. Consolidation programmes will need to be implemented in conjunction with policy action in other domains, including monetary and structural policies. The start, sequencing and pace of these actions will depend on conditions specific to each country, including the state of public finances more generally, the strength of the recovery and the ease with which budget deficits can be financed. The scope for monetary policy to offset the short-term effects that fiscal adjustment will have on economic activity will also vary by country.

 

There are good reasons for being ambitious on the fiscal side. It is difficult to be certain about how much government indebtedness a country can sustain. Many countries have to reduce their government debt anyway, before the fiscal strains of population ageing become even more burdensome. Moreover, persistently high debt would constrain governments' ability to deal with any future downturns.

 

High indebtedness has other consequences. An excess supply of government bonds can force up interest rates and compromise long-term growth. So far, most countries have been able to finance large deficits comfortably. But investors' appetite for government securities may change suddenly, as evidenced by the recent sovereign debt turmoil in the euro area. At the same time, the government's interest bill rises with indebtedness and would likely divert scarce budgetary resources away from programmes that promote economic growth and towards debt service obligations. This would make consolidation all the more difficult.

 

The key policy question is then how to deliver consolidation without undermining longer-term growth. There are a number of options and tradeoffs that need to be considered. Governments must also take equity issues into account as the costs and benefits of different instruments will not affect all social groups to the same extent.

 

Where expenditure cuts are needed, they should aim to preserve pro-growth programmes. Education, R&D and infrastructure are good examples, as these promote growth in the longer term, via productivity gains, and uncover new sources of growth. Initiatives to improve public infrastructure favour growth to the extent that they unleash opportunities for private investment, as well as supporting broader economic activity.

 

Tax hikes may also be necessary and should be limited to the least growth-distorting instruments, such as taxes on property and consumption. Personal and corporate income taxes are not growth-friendly, because they affect investment decisions by firms and the number of hours people are prepared to work. Moreover, countries would do well to rely on “green” revenue in their fiscal consolidation programmes, including receipts from green taxes and carbon trading, which would raise revenues and enhance welfare at the same time.

 

And there is much that structural policy can do. Reforms that lift the economy's growth potential by boosting productivity and/or the labour supply can also help to balance the budget at the same time. Policies that remove obstacles to job creation mean more people working and paying taxes. Cutting down on early retirement schemes can also increase labour utilisation and potential growth. In turn, faster growth would make fiscal consolidation easier, while such reforms would bolster the long-term health of the economy.

 

Improving efficiency in the public sector and getting more for less also holds out promise. Many OECD countries could reduce health expenditure without sacrificing the quality of services, for instance, by encouraging more primary and outpatient care. In education too, current levels of attainment and student performance could be achieved from lower, more cost-effective, spending. Savings from such reforms could help finance programmes that enhance economic growth.

 

Additional structural reforms may also contribute to better government finances. This includes, for example, eliminating subsidies that encourage the consumption of fossil fuels and tightening up on support for agricultural producers. Action in these areas could yield a triple dividend of productivity gains, saving public money and contributing to environmental protection.

 

In the end, good reform is important for the credibility of fiscal consolidation, especially in these uncertain times. International efforts to co-ordinate policies, via the G20, for instance, and the OECD, can only reinforce confidence and further help this process.

 

It is a matter of combining different policies and exploiting synergies. If policymakers are to put the recession well and truly behind them and to lay the groundwork for stronger, more balanced and sustainable growth in the years to come, they should make full use of the policy toolkit available to them. With the right choices, they can advance their pro-growth structural reform agenda while putting the public finances back on a sustainable track.

 

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