III. Fiscal Sector: Accounts, Analysis, and Forecasting

I. FISCAL SECTOR ACCOUNTS AND ANALYSIS………………………………. ….. 1 a. Some basic concepts………………………………………………………………. 1 b. Fiscal accounting………………………………………………………………….. 2 1. Defining the government sector………………………………………………. 2 2. Measuring government operations……………………………………………. 3 3. The GFS framework………………………………………………………….. 3 4. Classifying revenues and expenditures……………………………………….. 6 5. The conventional fiscal deficit………………………………………………... 6 c. Fiscal analysis…………………………………………………………………….. 8 1. The government saving-investment gap……………………………………… 8 2. Measures of fiscal imbalance…………………………………………………. 9 3. Financing the deficit………………………………………………………….. 11 4. The sustainability of fiscal policy……………………………………………. 13 5. Analysis of revenues…………………………………………………………. 16 6. Analysis of expenditure………………………………………………………. 20

II. FORECASTING THE FISCAL ACCOUNTS………………………………………… 27 a. Some basic concepts……………………………………………………………… 27 b. Forecasting revenue………………………………………………………………. 29 1. The model-based approach…………………………………………………… 29 2. The effective tax rate approach………………………………………………. 30 3. The approach based on tax elasticity…………………………………………. 31 4. The proportional adjustment method for estimating elasticity……………….. 32 5. The time-series approach……………………………………………………... 34 6. The effect of inflation on tax revenue………………………………………… 35 7. Forecasting nontax revenue…………………………………………………… 36 c. Forecasting expenditure……………………………………………………………37 1. Wages and salaries……………………………………………………………. 38 2. Subsidies and transfers………………………………………………………... 38 3. Expenditure on goods and services…………………………………………… 38 4. Interest expenditure…………………………………………………………… 38 5. Capital expenditure…………………………………………………………… 39 6. Financing of the budget balance……………………………………………… 39

Appendices I. The 2001 Manual on Government Finance Statistics (GFS Manual)……………...42 II. The Inflation Tax and Seigniorage: Some Implications………………………….. 48 III. The Accounting Approach to Fiscal Sustainability………………………………. 50 IV. Proportional Adjustment Method: The General Case……………………………. 54 V. Some Tax Revenue Sources and Their Proxy Bases…………………………….. 57

Tables Table 2.1. Government Revenue and Grants…………………………………………… 40 Table 2.2. Economic Classification of Government Expenditure and Net Lending…… 41

III. Fiscal Sector: Accounts, Analysis, and Forecasting

I. FISCAL SECTOR ACCOUNTS AND ANALYSIS

a. Some basic concepts

According to economic theory, one important economic role of government is to produce certain goods and services that would not be supplied efficiently if production were determined by the market mechanism. This topic is a major theme of economic writings in the area of public finance, and it is discussed briefly below. Stabilization policy is a second economic role. It focuses on the implications of government activity for the economy’s internal and external balance. From the point of view of stabilization policy, there are two paramount aspects of government activity. Government spending on goods and services increases aggregate demand in the economy, and tax revenues reduce aggregate demand (not necessarily to an equal extent). The relative magnitudes of government spending and taxing determine whether the fiscal budget contains a positive or negative influence on overall output and the price level. The second important aspect of government activity, from the viewpoint of stabilization policy, is the consequences of government borrowing. If a deficit is financed by borrowing from the central bank, there will be a link between monetary and fiscal policy; a fiscal deficit will occur at the same time as an increase in the money supply. Effects on the price level, and possibly on output, may be significantly increased. If, instead, the government deficit is financed by borrowing from commercial banks or the non-bank public, there will tend to be crowding out of private borrowing, and private-sector investment and growth may be reduced. If foreign financing is used, there will be consequences for the balance of payments in future years. While a quantity of foreign resources will be available to supplement domestic resources in the short run, offsetting inflationary pressure, the expenditure of foreign exchange will have to be reduced in the medium term, relative to receipts, to service and repay earlier borrowings. Whatever the source of finance, as government debt grows there are issues of sustainability, solvency, lender confidence, vulnerability to sudden speculative shifts, a restricted scope for use of fiscal policy for macroeconomic goals, and the threat of higher future taxes or reduced services.

3

b. Fiscal accounting 1. Defining the government sector The GFS Manual1 identifies several levels of government: (i) the central government; (ii) state or regional governments; (iii) local governments; and (iv) any supranational authority. The fiscal operations of the government sector include, at a minimum, the central government, which formulates national budgets. But in many countries fiscal operations are also performed by local and regional governments. The term general government includes all levels of government: central, provincial, and local. In order to emphasize the separation between the functions of the government and the financial sector, government finance statistics exclude any banking or monetary transactions that the government performs. In particular, all functions of the monetary authorities, irrespective of the institutions that carry them out (usually, but in some cases not exclusively, the central bank), are treated as activities of the monetary rather than the government sector. In order to distinguish fiscal policy from monetary policy, analysis must separate the activities of these two sectors.2 The broadest concept of government is the public sector, which includes the general government and nonfinancial public enterprises such as publicly owned railways and airlines or public utilities. Some of the central government’s revenues and expenditures typically reflect transfers from or to local governments and public enterprises. Such transfers have to be netted out so that double counting does not distort the sums when aggregates for the different levels of government operations are compiled. The accounting process of netting out and combining accounts at different levels of government is referred to as consolidation. At each level of government, there are potentially three groups of operations: budgetary, extrabudgetary, and social insurance programs. Budgetary operations are, by definition, covered in the budget. Extrabudgetary operations, which are outside the budget, also raise resources through compulsory levies and provide nonmarket goods and services. For example, an extrabudgetary fund may be established to receive revenue from taxes on fuel and to spend these resources to maintain roads. Social insurance programs are a special category of extrabudgetary operations; these programs typically include a pension fund, an unemployment insurance fund, and a social insurance fund that benefits persons with physical disabilities or who are destitute. In some countries, governments set up off-budget or extrabudgetary accounts to conduct what would otherwise be budgetary operations. The extensive use of extrabudgetary funds 1The government finance statistics accounting framework, which was developed to assist in the compilation of fiscal accounts, is set out in A Manual on Government Finance Statistics (Washington: International Monetary Fund, 1986). A new version of the Manual was published in 2001; a summary of this new version is presented in Appendix I. 2For an elaboration of these criteria for distinguishing government sector activities from nongovernment, see the GFS Manual, Chapter 1.

4

distorts the observable fiscal position, reduces flexibility in fiscal management by earmarking revenues for specific purposes, and, most importantly, leads to a loss of control over funds channeled through these accounts.3 To remedy this situation, countries create spending and revenue sub-categories within the budgetary framework to replace extrabudgetary accounts. In this way, a government may regain control, accountability, and scrutiny. 2. Measuring government operations Government finance statistics compiled in accordance with GFS standards record transactions on a cash basis rather than on an accrual basis as used in the national income and product accounts, the monetary accounts, and the balance of payments accounts. Receipts and payments recorded on a cash basis are documented as of the time of monetary settlement, while transactions recorded using the accrual method reflect the point in time at which a claim or liability arises or becomes due. An example of a difference between transactions recorded on a cash basis and on an accrual basis is payments arrears. Arrears reflect a government’s inability to meet its expenditure commitments on time and result in inconsistencies between the accrual and cash deficits. An accrual deficit includes the government’s full expenditure obligations, while a cash deficit reflects expenditures that were actually made. A government with a cash deficit that is smaller than the accrual deficit is typically behind on its payment obligations (see Box 3.2, below). 3. The GFS framework The GFS framework covers primarily government receipts, payments, and unpaid obligations. The main principles underlying this framework are discussed below. • Revenues, receipts, payments, and expenditures. In order to assess the government’s

overall fiscal position and the resultant macroeconomic impact, the first step is to note the distinction between receipts and revenues and between payments and expenditures. Revenues consist of all nonrepayable receipts other than grants. Receipts from loans to the government are not revenues, because the loans must be repaid. Similarly, not all payments are expenditures. By convention, a loan repayment is not an expenditure; it arises out of an obligation incurred when the loan was received. Interest payments, however, are an expenditure item. (Payments of grants or transfers to other governments, if any, are included in expenditure.)

• Gross and net. As a general principle, revenues and expenditures are shown on a

gross basis so that the statistics reflect the full magnitude and impact of the 3There are two legitimate uses of off-budget accounts: as trust funds (money held on behalf of nongovernment entities) and advance or suspense accounts (funds held against future payments).

5

government’s revenue-raising operations and the disposition of revenues. Thus, school fees collected by government are not counted as an offsetting item to the cost of providing education, nor are the costs of collecting taxes deducted from tax revenues as negative revenues. The main exception to this rule is special lending and borrowing for policy purposes; in this case, sizable flows both from and to government make net lending the only meaningful item.

• Requited and unrequited transactions. Requited transactions are those in which money is paid or received in exchange for goods or services. Unrequited transactions are those in which payment is made or received but nothing is received or given in return. Grants and certain transfers are examples of unrequited transactions.

• Tax and nontax revenue. Tax revenues are defined as compulsory and unrequited receipts collected by the government for public purposes. Tax revenues (shown net of refunds of earlier overpayment) include compulsory social insurance contributions and profits transferred to the government by its fiscal monopolies. Nontax revenues include receipts from property income, fees and charges, fines, and operating surpluses of public enterprises (typically including the central bank).

• Grants. Grants are unrequited, nonrepayable, noncompulsory receipts usually from other governments or international institutions. The GFS Manual groups grants together with revenues “above the line” (as transactions that reduce the deficit) rather than with deficit financing items.4 Nevertheless, for purposes of fiscal analysis and budgetary planning, it is necessary to recognize that grants differ from revenues in a fundamental way. Because grants are not predictable or sustainable, expenditures planned and incurred on the assumption that grants will continue at current rates can seriously distort fiscal planning and force a severe adjustment in the future if the assumption turns out to be optimistic. In analytical presentations of the fiscal accounts, it may be advisable to show the fiscal deficit with grants both above the line (making the deficit smaller) and below the line, as financing (making the deficit larger).

• Government net lending. Net lending (loans minus repayments) has a specific meaning in fiscal accounting. It refers to government lending undertaken to achieve public policy objectives.5 Examples of such lending include subsidized loans to farmers, students, or small businesses. Net lending is grouped with expenditures rather than with financing under GFS guidelines.6 This treatment reflects the

4The GFS Manual places grants in a line by themselves, separate from revenues. This treatment recognizes that the government has little control over the amount or sustainability of grants, unlike other receipts. 5Loans made by government to a foreign government for public policy purposes are also included in net lending and thus affect the size of the deficit. The borrowing country, however, treats the loan as foreign borrowing and includes it below the line. 6It is important to distinguish between incurring debt and merely guaranteeing it. Guaranteed

6

differences between the reasons for government lending and those that motivate its borrowing.

• Financing. Gross borrowing by government, and repayment of loans that are due, are

the main components of transactions “below the line.” Borrowing and amortization flows are typically shown disaggregated by the source of finance (foreign, domestic banks, and domestic non-banks). Changes in the government’s holdings of currency and deposits are also part of financing.

• The recapitalization of banks. In some countries, banks that are fully or partly owned

by the government have been facing large losses andare now undercapitalized.7 In such cases, governments may inject capital into the banks or take over their debts. As noted earlier, the GFS framework is cash-based and therefore does not treat the government’s noncash assumption of debt as an expenditure at the time the debt is assumed. Cash interest payments are included as expenditure, but cash amortization payments are treated as negative financing. In other words, according to GFS conventions, only the interest payments on the assumed debt affect the size of the fiscal balance.

• Privatization receipts. The GFS manual recommends treating the proceeds of the

sales of equity in public sector assets as negative net lending. This is to be distinguished from sales of government physical assets which are recorded in nontax capital revenue. The rationale behind this thinking is that privatization proceeds are sales of government equity in enterprises acquired earlier, either through transfers or capitalization. This accounting treatment results in a one-time reduction in the fiscal deficit.

While privatization receipts are formally treated as an above-the-line item, it is often useful to record them below the line in analytical presentations of the fiscal accounts, along with other transactions that affect the government’s net financial position. The one-time reduction in the fiscal deficit is offset by a smaller flow of nontax revenue, and thus larger deficits, in future years, reflecting the loss of government income from the enterprise’s remitted profits. These future deficits can be offset if the government uses the proceeds from the sale of enterprises to purchase other assets or to retire a portion of its own debt. In this sense, privatization proceeds resemble

debt is not included as a government transaction even though it constitutes a contingent liability of government. 7In finance, this means that a realistic value of a bank’s assets is so low, relative to the value of its liabilities, that the initial contribution of cash by the bank’s owners (“capital”) is not large enough to provide a prudent cushion against possible negative values of the difference, total assets minus total liabilities. The bank’s “net worth” is small or negative, and the bank is insolvent or nearly so.

7

financing—the exchange of one asset for another, or use of an asset to redeem a liability. Under such a scenario, the government and the private sector have simply exchanged assets without affecting the demand for real resources. However, if the government uses the privatization proceeds to raise current expenditures, to cut taxes, or both, the deficit in the year of the sale will be unchanged while future deficits will be larger than otherwise, and the fiscal policy stance will be affected by privatization. The United Kingdom, which has had significant privatization receipts in recent years, has shown the fiscal deficit in the macroeconomic accounts both inclusive and exclusive of these receipts. This practice is useful because it clarifies the analysis by recognizing that privatization receipts represent an exchange of assets.8

• Central bank profits. The profits of the central bank that are actually transferred to

the government are treated as nontax revenue. However, these profits should not include unrealized profits stemming from the revaluation of holdings of foreign exchange or gold reserves. Moreover, profits remitted to government should cover the entire operations of the central bank, and not just selected operations (for instance, sales of appreciated foreign exchange or gold).

4. Classifying revenues and expenditures Government transactions are classified into broad categories under “revenues” and “expenditures.” The primary classifications are economic, including total, current, and capital revenues and expenditures. Within these categories, taxes are broken down according to the type of activity on which they are imposed, and expenditures according to their purpose—defense and education, for example. Expenditure may also be disaggregated by economic classification, which is more useful for fiscal analysis. 5. The conventional fiscal deficit9 In terms of the cash flow of government operations, total receipts are always equal to total payments, and therefore the government’s fiscal accounts are always, in one sense, in balance. However, for analytical and policy purposes, it is more useful to focus on the difference between government revenues and grants, and government expenditures including net lending. The conventional concept of the fiscal balance (also called the “overall balance”) does precisely this, defining balance as total revenue plus grants minus total expenditure: 8See Ke-Young Chu and Richard Hemming, eds., Public Expenditure Handbook (Washington: International Monetary Fund, 1991). 9For a discussion of the intertemporal shortcomings of the conventional deficit, see Mario I. Blejer and Adrienne Cheasty, “The Measurement of Fiscal Deficits: Analytical and Methodological Issues,” Journal of Economic Literature, Vol. 29 (December, 1991).

8

conventional total total balance = revenue and − expenditure grants and net lending. A government deficit thus represents the portion of expenditure and net lending that exceeds receipts from revenue and grants. The government covers the deficit by borrowing and/or by running down its liquid asset holdings. This conventional concept of the fiscal deficit is of central importance to fiscal analysis because it offers a comprehensive picture of the government’s overall financial position. Nevertheless, it suffers from a number of shortcomings when used as a measure of the impact of the budget on aggregate demand, of the allocation of resources in the economy, and of the distribution of income. First, the same deficit level may have substantially different macroeconomic effects depending on the associated structure of taxation and expenditure. It has long been established that changes in taxes affect macroeconomic aggregates differently than equal changes in expenditures. Second, different ways of financing a given fiscal deficit clearly have different macroeconomic effects. As explained below, central bank financing of the fiscal deficit has substantially different macroeconomic effects than, say, nonbank financing or foreign financing. The conventional fiscal balance must be equal to the figure for financing but with the opposite sign (a fiscal deficit will be matched by positive financing). It may be presumed that, if the balance is a def icit, financing is made up mostly of borrowing. However, in any period a typical indebted government will make some repayment of past debt. Therefore, it is gross new borrowing net of amortization that is related to the fiscal deficit. Several other details are worth noting. In the identity, conventional gross increase balance = − borrowing − amortization − in cash and deposits other + revenue from + financing money creation items “cash and deposits” refers to the government’s own short-term liquid assets (usually held at the central bank). In practical terms, revenue from money creation is invisible and may well be included as part of gross borrowing, although the two can be separated analytically. The “other” item could contain arrears if expenditures are recorded on an accrual basis (typically they would not be); “other” could also contain proceeds of the sale of gold or minerals from state-owned deposits (though usually profits from government enterprises are part of nontax revenues); finally, this item could contain privatization receipts (not according to GFS conventions, but reflecting analytical judgments in an individual reporting country).

c. Fiscal analysis

9

1. The government saving-investment gap As with other sectors, two key relationships define the fiscal sector’s resource balance. One of these is in terms of income and absorption, and the other is in terms of savings and investment. Whichever way the resource gap is viewed, it can be shown to be the same in principle as the fiscal balance (the conventional surplus or deficit, defined above). The two identities are derived in this section. Let Tr represent government transfer payments (interest, subsidies, and social insurance benefits), and let net lending be grouped with capital expenditure. The government budget may then be written as: T − (Cg + Ig + Tr) = CB (3.1) where CB is the conventional balance and T is tax and non-tax revenue and grants. By definition, T − Tr is disposable income of government, Ydg ; Cg + Ig is absorption; and income minus consumption is saving. Substituting these definitions into the above expression yields, YDg − (Cg + Ig) = CB; YDg − Ag = CB; (3.2) Sg − Ig = CB. (3.3) Total income in the economy (Y = GDP) can be separated into government and nongovernment parts by recognizing that private disposable income includes transfers and excludes taxes: Y = (Y − T + Tr) + (T − Tr) = YDp + YDg. (3.4) Since consumption and investment disaggregate in a straightforward way into government and nongovernment parts, then from Y = C + I + X − M, where X and M refer to goods and services, one may write, substituting from above, YDp + YDg = (Cp + Cg) + (Ip + Ig) + X − M; [YDp − (Cp + Ip)] + [YDg − (Cg + Ig)] = X − M;

10

(YDp − Ap) + (YDg − Ag) = X − M; (3.5) (Sp − Ip) + (Sg − Ig) = X − M. (3.6) If Y is defined as GNDI instead of GDP, then (3.5) and (3.6) will have the current account balance on the right-hand side instead of X − M (as shown in Section V). 2. Measures of fiscal imbalance10 Although the conventional GFS concept of deficit is widely used, there is no single or best measure of the fiscal deficit. Alternative concepts can also be useful depending on the analytical purpose at hand. The conventional, or overall, deficit measured as a proportion of GDP is often used as a summary measure of fiscal performance and is perhaps the most widely accepted indicator of a country’s fiscal situation. But even this conventional ratio should be supplemented by some or all of the other measures discussed in this section. • The public sector borrowing requirement (PSBR) is the conventional fiscal deficit

defined for the entire public sector. This comprehensive deficit concept can be applied at each level of government. The central government borrowing requirement and the general government borrowing requirement are contained within the public sector borrowing requirement. In practice, the PSBR can be derived by combining the general government and the public enterprise sector borrowing requirements with appropriate netting out of transfers between the two.

• The current fiscal deficit (current account deficit) is defined as current revenue

minus current expenditure. It is often used as a measure of government saving and therefore as a measure of the government’s contribution to the economy’s total saving. This measure can be written as

current fiscal

balance

=

Government

Saving

=

total

current revenue

−

total

current expenditure.

There are, however, limits to the usefulness of the concept of the current deficit in

practical fiscal analysis. It depends on the distinction between capital and current expenditures and revenues. Capital expenditures include purchases of assets that are expected to be used in production for a period of more than one year, plus capital transfers; all other expenditures are classified as current. Thus, spending on education (teachers’ salaries) is counted as consumption by society, however essential it is for long-term growth, and only tangible physical assets like buildings and roads are included as investment. The conventions for classifying expenditures as current or

10See Blejer and Cheasty, “Measurement of Fiscal Deficits.”

11

capital are inherently somewhat arbitrary.11 More importantly, the underlying assumption that all government investment spending contributes to growth, and is therefore desirable, is questionable in view of the many instances of highly wasteful public investment projects. Moreover, spending on investment to the detriment of expenditure on maintenance of the existing capital stock may result in a net decrease in the latter, and ultimately reduce (rather than raise) the rate of economic growth.

Thus, while attractive at first glance, the current fiscal deficit is not necessarily a very useful indicator. It also is not helpful in analyzing the impact of fiscal developments on either the external or the domestic macroeconomic balance.

• The primary or noninterest deficit accurately measures the effects of current

discretionary budgetary policy by excluding interest payments from the conventional measure of the deficit.12 This type of deficit indicates how recent fiscal actions of the government affect the allocation of resources in the economy and government debt, in abstraction from past borrowing decisions. This measure can be written as

primary fiscal deficit

=

conventional fiscal deficit

−

interest payments.

• The operational deficit is the conventional deficit less the inflation-induced portion

of interest payments or, equivalently, the primary deficit plus the real component of interest payments. Inflation lowers the real value of the stock of public debt. Creditors are compensated for this loss through high nominal interest rates, which restore the buying power of the original loan principal. But a part of government interest payments is therefore actually amortization; in real terms the value of the principal of the debt is decreasing, as though it were being repaid. If the implicit amortization is not separated from interest payments above the line, the deficit will be overstated. The concept of the operational deficit overcomes this problem. This concept is particularly important in countries with high inflation and large public debt. The relationship can be expressed as, operational

conventional

inflation component

11Such conventions also differ sharply among countries, making intercountry comparisons of public investment quite difficult, even for the major industrial countries. 12Generally, total interest payments are subtracted from total expenditures to calculate the primary balance. However, conceptually, only the net interest payments by the government (net of interest receipts) should be subtracted.

12

deficit = deficit − of interest payment,

or

operational deficit

=

Primary deficit

+

real component of interest payments.

3. Financing the deficit The macroeconomic impact of a government deficit depends on the way the deficit is financed. There are essentially three ways of financing a deficit: (i) borrowing from the central bank, or “monetizing” the deficit; (ii) borrowing from the rest of the banking system or from the domestic nonbank sector; and (iii) borrowing abroad. In a broad sense, each form of financing is associated with a major macroeconomic imbalance: excessive money creation with inflation; excessive foreign borrowing with an external debt problem; and excessive domestic borrowing with high real interest rates. In addition, explosive growth in public debt may occur because of the dynamic interactions between higher interest payments, larger deficits, and greater debt. Complicating the analysis, government and banking-sector data on government debt may not be consistent.13 • Borrowing from the central bank (monetizing the deficit). Government borrowing

from the central bank is equivalent to the creation of high-powered money.14 Creating money at a rate that exceeds demand at the current price level creates excess cash balances and eventually drives up the overall price level. In economies in which government deficits are monetized, this process is likely to be the principal source of inflation. Not all money creation is inflationary, but whether inflationary or not, it provides government with a claim on the resources of the economy in addition to revenue. Figuratively speaking, the government can spend the new money first, or part of it, and thus finance part of its expenditure other than by taxation. The claim on resources

13In practice, reconciling fiscal and monetary data on financing gives rise to a number of problems, including (i) timing; (ii) the definition of government; (iii) the treatment of noncash transactions (such as debt assumption by the government) that is not reflected in fiscal accounts but is covered in monetary statistics; (iv) discrepancies in coverage between bank and nonbank financing; and (v) errors in data. 14“High-powered money” refers to liquid liabilities of the central bank, and includes commercial bank deposits. In a fractional reserve banking system, a change in high-powered money tends to result in a much larger change in the total money supply. See Section II.

13

that the government realizes as a consequence of increasing the money supply is called “revenue from money creation.” It is discussed in Appendix II.

• Borrowing from the rest of the banking system. Unlike borrowing from the central bank, borrowing from deposit money banks (commercial banks) does not automatically lead to the creation of high-powered money. If the central bank accommodates extra demand for credit from the deposit money banks by supplying them with additional reserves, then this type of borrowing is similar to borrowing from the central bank. But if the central bank does not accommodate the extra demand for credit, the deposit money banks will be forced to reduce credit to the private sector in order to meet the higher demand for government credit. This phenomenon, which is referred to as crowding out of private spending, takes place principally through interest rate increases.

• Nonbank borrowing. The government may sell securities to residents other than

banks. Nonbank borrowing allows the government to finance a deficit in the short run without increasing the monetary base or raising the level of foreign debt. Nonbank domestic borrowing is, thus, considered an effective way to avoid both the risk of inflation and of external crisis that normally accompany a large, continuing fiscal deficit. However, like bank borrowing, borrowing from the public directly crowds out borrowers from the private sector to some extent by putting upward pressure on domestic interest rates (Box 3.1). Not only do high real interest rates hurt economic growth by inhibiting investment, but issuing public debt at high rates adds to the cost of future debt service and thus to future fiscal deficits. If the average real interest rate exceeds the rate of real economic growth, debt service will grow as a share of GDP, so that public debt will threaten to outrun the economy’s ability to service it. The debt burden can be described as “unsustainable” in this case.

In countries experiencing high inflation, the value of government bonds erodes

rapidly if nominal yields are less than the rate of inflation; voluntary demand for such bonds is limited. Governments are often tempted to coerce banks (directly or indirectly), and even the public, to hold these bonds, but such actions can severely damage the government’s credibility.

• External borrowing. Governments can finance deficits abroad by issuing bonds to

nonresidents or through direct borrowing from foreign banks, governments, or international organizations. For many developing (and some transition) economies, overborrowing in the past and a lack of creditworthiness severely limit this source of financing for the present. Even when available, foreign credit from commercial sources carries interest rates that tend to be high.

14

If fiscal accounts are presented on an accrual basis, another form of financing enters the picture: payments arrears. In some economies, governments have incurred large arrears, resulting in cash deficits that are significantly lower than deficits measured on an accrual basis. If the fiscal accounts are on cash basis, arrears usually do not appear explicitly but can still constitute a form of finance. If arrears become sizable and protracted, they directly undermine faith in a government’s unwillingness or ability to keep its commitments (Box 3.2). 4. The sustainability of fiscal policy In recent years the issue of the sustainability of fiscal policy has attracted considerable attention. It was formerly argued that debts of government were riskless as long as the creditor would accept payment in domestic currency, since the government could always print enough currency to meet its obligations. The experience of countries with protracted, large fiscal deficits in an environment of international capital mobility has demonstrated that the earlier view is no longer sufficient. If a government uses note issue or other money creation to finance a large, recurring deficit, inflation may result. Because money loses value rapidly during high inflation, money holders

Box 3.1. Debt Neutrality1

According to the debt neutrality or “Ricardian equivalence” hypothesis, borrowing is no more than deferred taxation. Specifically, for given government expenditure, a reduction in current taxes will clearly raise the budget deficit and hence borrowing. Insofar as the private sector recognizes that increased government borrowing today means higher taxes in the future, it increases private saving in order to provide for increases in taxes in the future. The Ricardian equivalence hypothesis in its pure form stipulates that a shift from tax financing to debt financing does not change total national saving, because the initial reduction in government saving will be fully offset by an increase in private sector saving. Thus, a tax cut financed by government borrowing does not reduce the tax burden; it only postpones it. Nor does it stimulate spending on a net basis. The debt neutrality hypothesis gets limited support from available empirical evidence. In industrial countries, there seems to be a tendency for a partial offset, but not a full offset, of a decrease in government savings. In developing countries the hypotheses finds no support. ______________________ 1This is also sometimes referred to as the Barro-Ricardo debt neutrality theorem. See Robert J. Barro, “The Ricardian Approach to Budget Deficits,” Journal of Economic Perspectives, Vol. 3 (Spring, 1989).

15

will prefer to hold as little as possible, and the resulting increase in velocity will add to the inflation rate. In an environment of accelerating inflation, the change in inflationary expectations will have an effect on the government’s ability to borrow from the nonbank public. Potential bond holders will insist on a positive expected rate of return, and experience suggests they will require a large safety margin in the nominal yield in case the erratic inflation rate should jump higher. Bond holders appear to insist on such a cushion even when the maturity of government debt is quite short, for example, three months. At any rate, this interpretation is consistent with yields that have reached the range of 15–40 percent in real terms in Latin America in the 1980s.

Thus, the nominal rates of interest required to make government securities attractive on financial markets may be very high, especially in times of marked changes in the observed inflation rate, and especially in an environment of capital mobility. Domestic securities have to compete with foreign bonds, on which the real rate of return is more certain and capital gains, if they occur, are more likely to be positive than negative. (The currency of the high inflation country is more likely to be devalued, in real terms, than revalued.)

The high nominal rates of interest required to make domestic government debt attractive will tend to add significantly to government interest payments and to the size of the deficit to be financed. This adds to the quantity of bonds that must be sold as an alternative to more inflationary central bank finance. The ratio of government debt to GDP will rise, perhaps rapidly. At some point financial markets form the view that the government may become unable to borrow sufficient funds to pay the interest that is due without unleashing enough extra inflation to wipe out the risk cushion incorporated in current nominal interest rates. Securities will no longer be marketable. As soon as this situation is foreseen (perhaps long before it occurs), a full-blown financial crisis will take place.

Economic theory does not provide a straightforward answer to the question, what size of fiscal imbalance is sustainable? Instead of a concrete number, there is broad agreement that fiscal policy is not sustainable if the present and prospective fiscal stance results in a persistent and rapid increase in the ratio of government debt to GDP. A constant debt ratio is therefore one concept of fiscal sustainability. (Obviously, whether the ratio is large or small must also matter, although it is not clear how to incorporate this information analytically).15

To see how this notion has been useful in the development of an operational indicator of sustainability, consider the government’s budget constraint. It can be shown16 that the budget constraint (in terms of GDP) can be written as

∆dt = pdt + (rt − gt ) * dt-1 − rmct , (3.7)

15A country with a low but rapidly rising debt ratio might appear more likely to run into trouble than a country with a larger but slowly diminishing ratio. 16See Appendix III.

16

where _dt : debt-to-GDP ratio in period t, pd : primary fiscal deficit as a fraction of GDP, r : real interest rate on government debt expressed as a fraction, g : rate of growth of real GDP expressed as a fraction, and rmc: revenue from money creation as a fraction of GDP. The expression for the change in the debt-GDP ratio (Equation (3.7)) implies the following points: • The change in the debt-GDP ratio is determined by the primary deficit, revenue from

money creation, and the built-in positive or negative momentum of the debt-GDP ratio. When interest rates exceed the growth rate, the debt ratio will tend to rise b-y feeding on itself since interest payments add more to public debt than growth adds to GDP, unless the primary deficit is kept below what can be financed by printing money. Put differently, when interest rates exceed the growth rate, it becomes unsustainable for the government to run a permanent primary deficit in excess of revenues that can be raised through printing money. The more the policy adjustment is delayed, moreover, the higher the debt-GDP ratio will be and the lower the room to maneuver for the government.

• If, on the other hand, the real interest rate is lower than the growth rate, then the

country can grow out of its debt. Alternatively, the country can afford to run a primary deficit permanently in excess of the desirable level of money creation without making the fiscal imbalance unsustainable. It does not mean that there is no constraint on the debt-GDP ratio. If the country increased its borrowing substantially, it would risk raising interest rates to a point where they exceed growth rates. This would convert sustainable policies into unsustainable ones.

• Whether fiscal policy is sustainable depends not only on factors that the fiscal

authorities control, such as revenue and spending, but also on other factors such as the interest rate on government obligations, the long-run growth rate of the economy, and demographic trends.

• The proper measure of debt for the government budget identity is net rather than

gross debt. Net debt comes close to measuring the net worth of the government (assets minus liabilities), although it records financial assets at book value and may not adjust for unfunded liabilities and nonfinancial assets.

• The government budget identity can be used to calculate budget targets that would

achieve specific debt objectives, such as stabilizing or reducing the debt-GDP ratio. It can be shown that stabilizing the debt-GDP ratio requires that the ratio of the deficit

17

to GDP, inclusive of interest payments on the debt, not exceed the initial debt-GDP ratio multiplied by the growth rate of nominal GDP (see Appendix III).

5. Analysis of revenues Tax elasticity and buoyancy The elasticity of a tax is defined as the relative change in revenues from that tax compared with the relative change in the tax base, holding the structure of the tax (tax rates, brackets, coverage, exemptions, and deductions) unchanged. It can be written as

The phrase “in arrears” means to be overdue in the discharge of a financial obligation to suppliers or creditors. Since fiscal accounts typically are kept on a cash basis, government expenditure arrears cause an underestimate of spending and of the size of the fiscal problem facing a country. Since arrears are a form of forced lending, the government’s borrowing requirement is also understated, leading to a distorted picture of the sources of credit expansion in the economy. While deficit financing can allow the government to absorb more of the economy’s resources than would otherwise be possible, this initial effect may be offset as the rest of the economy responds by raising suppliers’ prices or holding back payments for taxes and fees. Ultimately, expenditure arrears raise the cost of providing government services. The accumulation of government arrears may also have an adverse impact on the private sector’s confidence in the soundness of government finances. Private consumers and investors may anticipate an increase in the tax rate, higher inflation, or a general worsening of the financial situation in the medium term. Arrears may spread throughout the economy as a result of government arrears, with severe consequences for the stability of the financial and production systems and prospects for economic growth. Arrears are often caused by an overly optimistic revenue forecast or a lack of proper mechanisms for monitoring or controlling government spending. A well-functioning treasury can therefore play an important role in preventing the emergence of payment arrears. ___________________ 1Adapted from Chu and Hemming, Public Expenditure Handbook.

Box 3.2. Expenditure Arrears1

18

elasticity percent change in tax revenues

of tax = (under an unchanged tax system) revenue percentage change in the tax base

If GDP is taken as a proxy for the actual tax base, then elasticity with respect to GDP is

GDP/GDPAT/AT = elasticity

∆∆ (3.8)

where AT : is the tax receipts from an unchanged tax system,17 and ∆ : the change during a period. Elasticity provides a tax system with built-in flexibility. A tax system is elastic when it has an elasticity value greater than one, suggesting that tax revenues are increasing at a higher rate than GDP without new taxes or increases in tax rates—that is, with no discretionary change in tax policy. Elasticity greater than one may be desirable in a tax system and should be encouraged in countries in which government expenditures tend to increase more rapidly than GDP. The tax system is likely to be elastic with respect to GDP when taxes are levied on growing economic sectors and when tax rates are progressive. The tax system will be ineslastic if taxes are specific rather than ad valorem,18 and/or when taxes are not collected promptly. This last point is especially important in the case of high inflation, when an unduly long lag between the assessment and collection of taxes will erode the real value of tax revenues. An elastic tax system is useful from the point of view of economic growth, which generally calls for a sustained rise in spending on social and economic infrastructure and maintenance. If these increases in expenditures are not accompanied by rising revenues, they can lead to undue reliance on deficit financing, either external or domestic. With an elastic tax system,

17AT is usually a data series that is not observed. It is derived from the actual tax revenue series T by adjusting for the effects of changes in the tax system that occurred during periods under consideration. The resulting data series shows the revenues that would have been collected if all tax rates, exemptions, brackets, and other elements of the tax system had remained constant over the period. Any changes in revenues from year to year would have been caused by increases or decreases in the tax base (see Appendix IV). 18Specific taxes are those expressed as a fixed currency value per unit; ad valorem taxes are expressed in terms of percent of the nontax price. If a country has zero inflation, revenues will be maintained under either form of tax, but with inflation the real value of revenue of specific taxes will decline.

19

there is usually no need for the frequent and unanticipated tax changes that can adversely affect anticipated real wage and property income. The buoyancy of a tax is defined simply as the increase in the revenue collected compared with the relative increase in GDP. The change in revenue includes any effects of changes in the tax system, including discretionary changes in the tax structure. The algebraic expression of the formula for tax buoyancy is

In the case of buoyancy, the numerator, ∆T, measures the change in actual tax revenues over the period; in the elasticity formula, ∆AT measures the change in tax revenues adjusted for the estimated impact of changes in the tax system over the period (that is, excluding the impact of all discretionary changes). The elasticity of a particular tax or tax system will usually tend to be approximately constant over time, but there is no presumption that buoyancy will remain constant. If the changes in the tax system are revenue enhancing, then buoyancy will exceed elasticity, because the actual tax revenue will exceed the amount that would have been generated in the absence of changes in the tax system. Assessing a tax system Analysts engaged in reviewing a country’s tax system will want to consider the appropriateness of that system and explore possible directions for improving it. While the primary objective of taxation is to pay for government services and transfers, it has also been used to correct market failures, to achieve external and internal balance, and to help redistribute incomes. A number of criteria have been developed to assess how well a tax system works in generating revenue. The Tanzi Diagnostic Test (summarized in Box 3.3), although largely subjective, can be a useful guide to evaluating a country’s tax system.19 Besides revenue productivity, the analyst may assess a tax system from the point of view of the value of revenues collected relative to GDP. Called “tax effort analysis,” this approach relies on intercountry comparisons. However, using the actual tax ratio to judge these efforts can be misleading in cases in which GDP is not an accurate indicator of relative taxable capacity. Taxable capacity is defined as the level of income that would produce revenue comparable to an inter-country average using average tax rates. The amount of tax revenue actually collected as a proportion of the taxable capacity therefore indicates tax effort. Three major factors that can determine capacity have been identified: (i) the degree of openness of

19For a more detailed analysis of tax policy, see Tax Policy Handbook, Parthasarathi Shome, ed. (Washington: International Monetary Fund, 1995).

(3.9) GDP/GDP

T/T =buoyancy ∆

∆

20

an economy; (ii) the level of development and income; and (iii) the composition and distribution of income. Tax effort analysis, while useful in assessing tax performance, has obvious limitations. It is not a normative measure; a country with “below-average ”tax effort may nevertheless find its tax ratio appropriate in light of national preferences. Tax effort analysis is also purely static in nature because it does not take into account changes in tax ratios and tax efforts over time. In the dynamic sense, the elasticity of tax revenue with respect to GDP is often regarded as a more useful indicator.

Vito Tanzi has proposed eight qualitative diagnostic tests to help assess the Αrevenue productivity of a given tax system. These tests are as follows: 1. Concentration index: Does a large share of total tax revenue come from relatively few taxes and tax rates? 2. Dispersion index: Are there very few, if any, low Βrevenue Βyielding, nuisance taxes? 3. Erosion index: Are actual tax bases as close to potential ones as possible? 4. Collection lags index: Are tax payments made by taxpayers without much time lag and close to the time when they should be made? 5. Specificity index: Does the tax system depend upon as few taxes with specific rates as possible? 6. Objectivity index: Are most taxes levied on objectively measured bases? 7. Enforcement index: Is the tax system enforced fully and effectively? 8. Cost of collection index: Is the fiscal cost of collecting taxes as low as possible? A positive answer to all these questions simultaneously, according to Tanzi, should entitle a country’s tax system to high marks for revenue productivity. Source: Vito Tanzi, “ΑTax System and Policy Objectives in Developing Countries: General Principles and Diagnostic Tests,” unpublished IMF paper, November 28, 1983.

Box 3.3. The Tanzi Diagnostic Test for Revenue Productivity

21

6. Analysis of expenditure20 Government-produced goods and services Government expenditure involves the provision of goods and services and income transfers. The goods and services provided by government are sometimes categorized according to whether they are consumer goods (national parks) or producer goods (support for research and development). However, most government-produced output combines both characteristics—consider education, health, defense, and infrastructure (highways). Some public expenditures—pensions, unemployment compensation, and production subsidies, for example are not related to the supply of goods and services but represent direct transfers to households or business enterprises. Four aspects of government spending commonly are considered in an assessment of expenditure: • an aggregate spending level and fiscal balance that are consistent with

macroeconomic objectives; • judicious use of the private sector in the delivery of certain goods and services; • analysis of capital and current spending within a program or a sector to ensure a

balanced allocation for each; and • an analysis of budgetary institutions to ensure that incentives and rules help to control

aggregate spending and facilitate efficiency and equity in the composition of spending.21

A macroeconomic adjustment program may require a degree of fiscal retrenchment. The adverse effects of higher rates for existing taxes and a lack of alternative revenue sources may dictate that a substantial share of this retrenchment be achieved through expenditure cuts. Thus, adjustment programs typically have to focus on spending priorities. Governments seeking to reform spending must identify areas in which markets can effectively substitute for public sector involvement, and consider how scarce government-sector resources can best be utilized in those areas where public sector involvement is considered appropriate.

20This section draws on Ke-Young Chu, “Public Expenditure Policy: “An Overview of Macroeconomic and Structural Issues,” in Fiscal Adjustment in Eastern and Southern Africa, (Washington: International Monetary Fund, 1994). 21For a detailed exposition of these principles of public expenditure analysis, see Sanjay Pradhan, “Evaluating Broad Allocations of Public Spending: A Methodological and Data Framework for Public Expenditure Reviews” (Washington: World Bank, 1995).

22

Types of public expenditure The main economic categories (as distinct from functional categories) of public expenditure are wages and salaries, goods and services, subsidies, interest payments, other transfers, and capital. It may be noted that both interest payments and subsidies are types of transfer payment if the latter is broadly defined. The purchase of goods and services that appears in the fiscal accounts covers inputs to be used in the production of government services: uniforms for policemen, typewriter ribbons and printer cartridges for clerks, weapons for soldiers. See Box 3.4, “Quasi-Fiscal Operations,” for a class of expenditure that tends to be omitted from the accounts. • Wages and salaries. Government policies regarding civil service employment and

pay have a major impact on the efficiency of government expenditures. Low pay and inadequate salary differentials for skilled and technical staff may contribute to poor recruitment and low productivity in the government sector. At the same time, the widespread practice of using the public sector as employer of last resort may substantially increase wage costs. Recent reforms in several countries have sought to reduce the government wage bill through a variety of measures, including a civil service census and the elimination of “phantom” workers; the elimination of vacancies and temporary positions; hiring freezes; the suspension of employment guarantees; voluntary retirement programs; wage cuts, caps, and freezes; and the most difficult measure, layoffs. Attempts have also been made in some countries to increase salary differentials in favor of senior staff.

• Goods and services. Although substantial economies are often possible under this

heading, it is important to ensure that cuts in goods and services do not compromise the efficient delivery of government services. An important part of current spending on goods and services goes for the operation and maintenance of capital stock. Inadequate spending on supplies can lead to low levels of effectiveness in areas such as education and health. Similarly, inadequate spending on maintenance (for example, of highways) can lead to the rapid deterioration of physical capital. Pursuing a policy that focuses on creating new capacity while allowing existing infrastructure to deteriorate can be costly and counterproductive. Similarly, across-the-board cuts in materials, supplies, and services in the context of macroeconomic adjustment programs should be avoided in order not to undermine the effectiveness of government functions.

• Capital expenditures. Growth-oriented adjustment requires productive government

investment combined with policies to correct distortions in relative factor and commodity prices. It is important to ensure that the investment program is well designed and that projects are economically sound because the cost of poorly designed or inefficiently implemented projects can be high. In general, emphasis should be given to government investment that complements and supports rather than

23

competes with market-determined activities. Education, health, urban services, and rural infrastructure are priority areas for government involvement.

Box 3.4. Quasi-Fiscal Operations1

In some economies, central banks and other public financial institutions are involved in activities—including significant loss-making activities—that give rise to financial transactions with government that have an effect on the true fiscal deficit. Some of the main types of quasi-fiscal operation are: • exchange rate subsidies administered through the foreign exchange system; • subsidized lending to government, public enterprises, or private entities; • unfunded or contingent liabilities such as loan or exchange rate guarantees; • support for the exchange rate through central bank interventions in the presence of strong market expectations of a devaluation; and • borrowing by the central bank at high interest rates from the public in an effort to sterilize excessive foreign exchange receipts and prevent rapid money growth. Where these quasi-fiscal operations are significant, their costs should be included in any comprehensive measure of the public sector deficit, for several reasons. In many countries, central and public sector bank losses are so large that they contribute to financial instability. Their existence also means that the conventional measures of government’s fiscal balance are misleading indicators of the role of fiscal operations in the economy. The taxes and subsidies associated with quasi-fiscal operations may have distortionary effects on resource allocation. Although they are not always easy to quantify precisely, quasi-fiscal operations need to be extracted from the accounts of the central bank and public financial institutions. To the extent possible, quasi-fiscal activities should be transformed into normal budgetary operations—that is, quasi-fiscal taxes and subsidies should be replaced with explicit taxes and subsidies. The long-term objective should be to address the root causes of quasi-fiscal operations, such as lending activities, that are essentially substitutes for explicit subsidies that otherwise would be in the budget, and the lack of a unified exchange system. The legal authority of the central bank may need to be revised to limit the extent to which it can carry out quasi-fiscal operations. Such structural reforms are essential to minimize and eventually eliminate the need for quasi-fiscal operations. _________________________ 1See International Monetary Fund, 1995, “Quasi-Fiscal Operations of Public Financial Institutions,” SM/95/65 (Washington: IMF, Fiscal Affairs Department, 1995). Also, see IMF, “Guidelines for Fiscal Adjustment,” IMF Pamphlet Series, No. 49 (Washington: IMF, Fiscal Affairs Department).

24

• Subsidies.22 Subsidies are defined as government assistance to producers or consumers for which the government receives no compensation in return. Subsidies can take many different forms, including (i) direct payments to producers or consumers (cash grants); (ii) loans at interest rates below the government borrowing rate and with government guarantees (credit subsidies); (iii) reductions in specific tax liabilities (tax subsidies); (iv) the provision of goods and services at below market values (in-kind subsidies); (v) government purchases of goods and services at above-market prices (procurement subsidies, price supports); (vi) implicit payments through government regulatory actions that alter market prices or access (regulatory subsidies); and (vii) maintenance of overvalued or undervalued currencies (exchange rate subsidies to consumer or exporters).

Whether explicit (direct) or implicit (indirect), subsidies are a major drain on government budgets in some economies. Subsidies are explicit if they are fully reflected in the budget as expenditures, and implicit if they are not. Implicit subsidies may arise as a result of administered prices that are set at levels below or above free market values—for example, for energy—or may support unrealistic interest rates and overvalued exchange rates. Since a significant portion of government subsidies are implicit, budgets do not fully reflect their range and value. Subsidies also affect resource allocation by reducing the flexibility of the economy, and are often an obstacle to structural adjustment. One example of the distortions subsidies can cause is the pricing of energy products below market levels, leading to wasteful energy consumption.

Any assessment of subsidies should take account of the following: • Effectiveness. Not all subsidies are bad, but only those that meet given policy goals

by transferring a minimum of resources with a minimum of distortions to the incentive system can be called effective. Effective subsidies are also well targeted—that is, they do not spill over onto groups and activities for which they are not intended. If bread is subsidized in general, then government funds are being used to support the rich as well as the poor.

• Duration. How long subsidy programs last is a serious concern because people

change their behavior in order to be included in these programs and may resist being 22This section is adapted from Gerd Schwartz and Benedict Clements “Note on Subsidies: Evaluation and Impact,” IMF Seminar on Fiscal Adjustment in Eastern and Southern Africa, September–October, 1994. For a discussion of the issues relating to subsidies, see Benedict Clements, Rejane Hugounenq and Gerd Schwartz, “Government Subsidies: Concepts, International Trends, and Reform Options,” IMF Working Paper WP/95/91 (Washington: International Monetary Fund, September, 1995). See also “Social Safety Nets for Economic Transition: Options and Recent Experiences,” IMF Paper on Policy Analysis and Assessment, PPAA/95/3 (Washington: International Monetary Fund, February, 1995).

25

excluded when their circumstances change. It is this behavior that makes many subsidies ineffective over time. While some subsidies should be limited from the outset, effectively implementing a subsidy program requires periodic reassessments of the rationale behind the subsidy, and, if needed, revision, retargeting, or termination of the program.

• Transparency. The size of a subsidy program and the implied financing requirement

should be made explicit in public budgets. Transparency is desirable from both public and private perspectives in order to identify clearly the benefits and costs. As a general rule, governments should aim to identify subsidy expenditures explicitly in public budgets and should to the extent possible provide them as cash grants rather than as procurement, tax, interest, or regulatory supports. Only cash grants provide both government and beneficiary with a clear and explicit picture of the amounts involved. In turn, this transparency provides a basis for judging the affordability and desirability of subsidies.

• Financing. To foster transparency and accountability, subsidies should be financed

through the budget. Attempting to solve financing problems with extrabudgetary instruments such as government marketing boards or parastatal agencies or through the central bank is dangerous. Such methods hide the costs of subsidy from voters and protect recipients from public scrutiny of the special benefits granted by the legislature. This lack of transparency, in turn, encourages unofficial private payments from beneficiaries to administrators or legislators.

• Selecting a pragmatic approach. Subsidy programs must be consistent with a

government’s institutional and administrative capabilities. Implicit (indirect) subsidies may be more difficult to control effectively than explicit (direct) subsidies. To simplify administrative burdens, subsidy programs should be made as explicit as possible.

Public expenditure and the role of the state Governments often engage in production activities because markets have failed to fill a need. Markets will not provide public goods, such as national defense, law enforcement, or national parks, because these goods are consumed collectively and do not enable producers to charge individual users (or to exclude from service those who do not pay). The theory of public finance provides other examples of market failure leading to a role for government: natural monopolies (supply of water, gas, electricity), externalities (pollution, job training), and investment in projects with extraordinary business risk (the search for a cure for cancer). The government’s economic role may also include macroeconomic stabilization, redistribution of income, initiative-taking in the case of certain very risky investments, and

26

influencing consumption patterns in useful or fashionable ways (campaigns to urge citizens to stop smoking).23 The growth implications of public investment and its financing24 Public expenditure affects both aggregate supply (production) and aggregate demand (spending). Productive public investment in physical and human capital directly increases the capacity of the economy to produce output. In addition, in many cases public investment is complementary to private investment, so that strategic government investment can result in an increase in the return to private investment. For both reasons, government investment tends to increase the rate of real GDP growth. The effects on supply may be fairly immediate, such as when a few key infrastructural bottlenecks are removed. More often, however, the returns to public investment are fully realized only in the longer term, especially in such areas as education. In the short run, the public sector competes with the private sector for resources, and public expenditure (whether financed through taxation or borrowing) tends to crowd out private expenditure, including private investment. Many economies are limited in their ability to finance expenditures through either method. In the short run, they have neither the administrative and political capacity to raise taxes nor the well-developed domestic capital markets necessary to support public borrowing, and borrowing from the central bank is disadvantageous because it is inflationary. In this situation, a government’s attempts to spend more may actually worsen its financing difficulties by triggering higher inflation, inducing taxpayers to delay tax payments and thus reducing the real value of tax revenue. Moreover, an increase in public sector borrowing can raise domestic interest rates, increase the cost of private investment along with government's borrowing costs, reduce the country’s long-term growth potential, and create a debt burden. Unless the government uses borrowed resources productively, generating the output and income required to raise tax revenues sufficient to finance future debt repayments and interest, the public sector will have to finance the debt burden by cutting services in the future. With international capital mobility, an increase in domestic interest rates can induce large capital inflows, an exchange rate appreciation, and a deterioration in the country’s external competitive position.

23For a general discussion of the appropriate economic role of government, see Joseph E. Stiglitz, Economics of the Public Sector (New York: W. W. Norton, 1986), especially Chapters 4 and 5. 24This topic is explored in more detail in G.A. MacKenzie and others, “The Composition of Fiscal Adjustment and Growth,” IMF Occasional Paper 149 (Washington: International Monetary Fund, 1997).

27

Box 3.5. Social Safety Nets1

Social safety nets are designed to mitigate the short-term adverse effects of economic reforms on the poor, such as the increases that result from the reductions in subsidies on basic necessities, and unemployment caused by the reform of state enterprises and the civil service. Social safety nets need to be tailored to the circumstance of each country, including its administrative framework and formal and informal social support systems. Major components of social safety nets include: • Targeted commodity subsidies and cash compensation aimed at protecting

people’s ability to buy basic foodstuffs during inflationary periods; • Social security arrangements, including pension and disability insurance and

child care allowances, with effective targeting and incentive structures; and • Unemployment benefits and public works schemes that mitigate the impact of

rising joblessness on low-income groups. The main issues in the design of social safety nets are targeting and incentives. Social benefits should be limited to those most in need. In the absence of sophisticated means testing, many countries rely on categorical targeting, such as limiting benefits to children or pensioners. In terms of incentives, the fiscal cost of social safety nets is reduced if benefits are phased out as household incomes increase, but at the cost of increasing both the implicit marginal tax rate on beneficiaries and the potential adverse impact on incentives. 1 Adapted from “Guidelines for Fiscal Adjustment,” IMF Pamphlet Series, No. 49, 1995.

28

II. FORECASTING THE FISCAL ACCOUNTS

a. Some basic concepts The government’s fiscal operations have a major impact on aggregate expenditure and output as well as on the allocation of resources in an economy. In view of the central macroeconomic impact of the budget, the forecasting of government transactions is an intrinsic part of the design of stabilization and adjustment programs. Forecasting fiscal aggregates is also a key part of the process of fiscal policy formulation because only on the basis of a set of budget projections can a government assess whether fiscal adjustment is needed and design appropriate measures to promote such adjustment.

• Fiscal forecasting must be based on a consistent set of overall macroeconomic assumptions, for example, for output, inflation and the balance of payments. The overall assumptions have to include, as well, those relating to the external environment facing the economy, for example prices of oil and other key primary commodities, international interest rates, and economic developments in major trading partner countries. Therefore, fiscal forecasting demands prior coordination and information-sharing among the various economic agencies of the government and a central decision concerning an appropriate and realistic forecast of the broad macroeconomic aggregates over the budget planning period. Tax revenue and expenditure forecasts should be based on the same set of macroeconomic assumptions even though they may be prepared by different departments or ministries. It is also important to ensure that the budget forecast and the macroeconomic assumptions (for example, GDP and inflation) refer to the same period. This may require adjusting the assumptions if the budget period is different from a calendar year, for which most macroeconomic forecasts are prepared.

• Fiscal revenues and expenditures affect, and are affected by, the overall macroeconomic situation, in particular by changes in economic activity, household behavior, the rate of inflation, and developments in the external environment, including the exchange rate. For example, budget expenditure on unemployment assistance depends on economic activity, which itself is determined in part by the size of government expenditure. In order to ensure consistency between the forecasts for the fiscal aggregates and those for the broader macroeconomic aggregates, an iterative process of estimation may be followed. This means that the provisional macroeconomic and fiscal forecasts are adjusted to bring them into line with each other.

• Ideally, the forecasting process should allow for feedback at the level of individual tax and revenue categories. For example, a large tax on cigarettes might reduce the volume of their consumption, reducing the tax base from what it would have been in the absence of the tax. It is also useful to keep in mind the timing of tax changes, in particular the lag structure of the impact of a tax change, although this can be hard to quantify.

29

• Every tax system defines in law the associated tax base, the rate of tax, and

exemptions, if any. The legal tax base is usually too complex to be useful for economic analysis and forecasting. Therefore an alternative, or proxy, tax base is selected by considering economic criteria. For example, the base of the personal income tax is usually household income, and the law specifies ranges of incomes to which various tax rates apply. Data for aggregate personal income by taxable income range are, however, not usually available. A proxy variable may be sought within the national accounts. Aggregate disposable income would be a candidate proxy variable for forecasting. If disposable income data are not available, even broader aggregates, such as GDP, could be used. In a typical case, import duties are payable at different rates on a number of categories of foreign goods. The revenue from import tariffs could be related to an aggregate variable from the external sector for purposes of analysis or forecasting—in this case, to the value of all imports. In both of these cases, it is reasonable to assume that changes in the proxy base will tend to move in line with changes in the items on which tax is actually due. An advantage of proxy bases for forecasting tax revenue is that values of the proxies—say GDP or imports—may already have been forecast for the future period for which revenue forecasts are desired. Box 3.6 below provides some possible proxy bases that can be used to forecast revenue from different tax categories. A more detailed table is provided in Appendix V.

• In preparing fiscal data for revenue forecasting, it is necessary to decide on the

appropriate level of disaggregation of the tax system. Since a tax system generally consists of a large number of taxes, selectivity is needed in order to avoid excessive detail. As a rule of thumb, it is useful to disaggregate tax categories that contribute at least 5 percent of tax revenue on average over a sample period. Also, a group of taxes should be disaggregated if their bases are quite dissimilar. A balance needs to be

Box 3.6. Suggested Proxy Bases for Tax Revenues

Tax Revenue Source Suggested Proxy Base

1. Taxes on income, profits, GDP at current prices and capital gains 2. Sales tax Private consumption at current prices 3. Excise duties Private consumption at current prices 4. Import duties Value or volume of imports

30

struck between the greater information provided by a finer disaggregation and the cost of making the exercise unwieldy. A higher degree of disaggregation does not necessarily enhance the accuracy of a forecast.

• A significant part of fiscal expenditure depends heavily on the discretion of

policymakers. This mixture of discretionary and automatic elements renders the task of forecasting expenditures difficult in the absence of knowledge about the policy measures planned by the government. In practice therefore, and in this chapter, there is relatively more emphasis on forecasting revenue than on forecasting expenditure.

b. Forecasting revenue

The discussion below sets out the main approaches to forecasting tax revenue: a model-based approach, the effective tax rate approach, the elasticity-based approach, and a time-series approach. Use of the assumption of unitary buoyancy in the context of high inflation is presented as a further alternative. A final section mentions forecasting nontax revenue. 1. The model-based approach Some countries use general-equilibrium forecasting models to project tax revenue. Such models have the advantage of being able to take into account the interdependence of the revenue system and the macroeconomy: higher tax rates on personal income tend to raise revenues, but at the same time reduce incentives to work, to earn income, and to report income to the tax authorities; general equilibrium models can, in principle, allow separately for the positive and negative effects on revenue. A second type of model for forecasting tax revenue uses detailed data from a large sample of actual taxpayer reports (tax “returns”). Estimated revenue is derived from projections of the tax bases for categories of taxpayers and the detailed provisions of the tax laws for each category and then aggregated across categories. A well-known example of this approach is the income tax model for the United States developed at the Brookings Institution, which served as a prototype for models in OECD countries. Similar models for the corporate profits tax are in use in the United States, the United Kingdom, and other industrial countries. A third example of this approach is to construct a model consisting of a number of estimatable equations for major categories of revenue and expenditure. Models of this type are useful in analysis as well as forecasting—for example, in analyzing the impact of a given change in the tax structure or expenditure composition. Such model-based techniques require a heavy investment of resources and a large amount of statistical information. 2. The effective tax rate approach

31

This approach relies on calculated values for the implicit average (or “effective”) tax rate of a tax category, defined as recorded tax revenue divided by the tax base. The effective tax rate may differ from the statutory tax rate or the legal tax rate schedule if there are exemptions or deductions, illegal or privileged tax-free transactions, recording errors, or changes within a period. Moreover, typically the effective-rate method is applied to aggregates (such as all luxuries, all imports, or all sales) to avoid taking account of different rates of taxation on individual items or sub-categories. The revenue forecast is calculated by multiplying the forecast of the tax base by the observed effective tax rate in the preceding period. The attractiveness of the approach is its simplicity and that it does not require a knowledge of the detailed tax system and provisions of the tax laws, such as exemptions. For example, even if a general sales tax has a complex structure of rates and exemptions, one can simply use the recorded values of sales-tax revenue and private consumption expenditures for a recent period, and calculate the ratio of the former to the latter as the effective rate of the sales tax. This calculation can be done without knowledge of allowable exemptions or of the statutory tax-rate structure. Then, on the basis of a forecast of private consumption for a particular future period, one can project revenue from the sales tax for the same period using the calculated effective rate from a past period. Moreover, if one does not have a forecast of private consumption, but only one for GDP, it is possible to calculate the effective tax rate with respect to GDP simply on the basis of the observed proportion of private consumption in GDP during a recent period. The simplicity of the effective tax rate approach explains its widespread use in forecasting in many countries. In the context of the transition economies, however, the approach has to be applied with caution because the approach rests on three important assumptions that are unlikely to hold in these economies. The assumptions do not hold perfectly well for non-transition economies, either. The assumptions are: • Unchanged structure of the tax base. If the composition of the tax base changes from

one period to the next, the effective tax rate approach may give misleading revenue forecasts. In the above example, if there is a significant change in the composition of private consumption between taxed and tax-exempt items, then the approach would not give reliable forecasts.

• Unchanged tax system. If there are changes in the rate structure and rate level, relying

on the effective tax rate would be insufficient by itself and would need to be complemented by other information and adjustments.

• Unchanged compliance ratio. If there is a change in the rate at which taxpayers

comply with the tax laws, the effective tax rate would lead to under- or over-estimation of revenues. In periods of high inflation, general economic instability, or growth of an “underground” (gray-market) economy, tax compliance ratios frequently fall quite dramatically.

32

3. The approach based on tax elasticity A widely used method of revenue forecasting exploits the stable relationship between the growth of receipts from a given tax and the growth in the tax base. Thus, a change in revenue from a tax is decomposed into two parts, one corresponding to a change in the tax base and its impact on revenues, and one corresponding to a change in the tax system (including changes in the tax rate, the tax structure, the coverage of the tax, and so forth). It is important to note that the term “tax system” is used here in a broad sense, encompassing the system of tax administration, which influences the compliance ratio. Recall that the elasticity of tax revenue is defined as the ratio of the percentage change in revenue to the percentage change in the base under the condition of no change in the tax system during the period. Given an estimate of the elasticity of the tax in question and a forecast of the growth rate of the tax base, a forecast of the change in revenue can be obtained by simply multiplying the growth rate in the tax base by the elasticity (see Figure 3.1). The main advantage of the elasticity-based approach is that, although it is difficult to obtain precise estimates of elasticities, it is often possible to estimate a range of likely values, especially for taxes on income and profits, based on the past experience of the same country or the experiences of countries that are comparable in levels of income and economic structure. Observed elasticities for major tax categories for many economies typically fall in a relatively narrow range. Judgmental estimates of elasticities are useful in cases in which historical data for statistical estimation are generally not available. Logically, the elasticity of revenue with respect to the base will be unity in the case of proportional taxes (VAT, sales tax) and greater than unity in the case of a personal income tax system with increasing rates on higher income levels. Exemptions and deductions may result in observed elasticities that are lower than these theoretical values. Elasticities can decline further in the presence of high inflation for the following reasons: • A lag between the time tax liability is generated and the time when it is paid (unless

tax liabilities are indexed to the price level). • A specific (fixed in money terms), as opposed to an ad valorem (proportion of value),

basis for the levy of indirect taxes. • Caps on the taxable base (for example, social security contributions that apply to

wages only up to a certain level). • Problems with tax administration and compliance. Taxes on property and on land generally have an elasticity with respect to nominal GDP of significantly less than unity because of lags in the reassessment of property values.

33

Figure 3.1. Tax System, Tax Base, and Tax Revenue

Changes in the Tax Base

Changes in the Legal Tax Rate

Changes in Exemptions

Changes in Tax Adminis- tration and Compliance

Elasticity of Tax Revenues

Changes due to the Growth in the Tax Base

Changes Due to Changes in the Tax System

Changes in Tax Revenues

4. The proportional adjustment method for estimating elasticity The main drawback of the elasticity approach is difficulty in estimating the correct current value of the elasticity. Simple estimation based on observed values of revenue and tax base over a sequence of years will not take into account legislative changes in the tax system, those that are planned for the future or those that occurred in the past.

34

When changes in the tax system are frequent and major, the elasticity of a tax can in principle be estimated by adjusting past revenue data to remove the impact of discretionary changes in the tax system.25 This adjustment can be done based on an exogenous estimate of the impact of each change in the system on tax revenues. If a change in the tax system in a given year changes revenue by a certain proportion, then tax revenues in previous years can be adjusted by the same proportion to put them on a comparable basis with the later figures. This approach assumes that the changes in the tax system have a stable proportional impact on the tax yield. For example, assume that T1, T2, ..., T5 are tax revenues over a five-year period and year five is chosen as the reference year. Assume also that discretionary changes in the tax system occurred at the beginning of years two and four, with estimated yearly impacts of D2 and D4

respectively on revenue in those years. Then, the expression )D-T

T(44

4 represents the ratio of

actual revenue to what it would have been without the discretionary change in year four. Revenue levels for years prior to year four can be adjusted by this factor to show the revenue that would have been collected if the change in the tax system in year four had been in effect in earlier years as well with the same proportional revenue impact. Similarly, revenue in

years prior to year two would have to be adjusted by a factor of )D-T

T(22

2 . The adjusted

revenue series, where ATi stands for adjusted revenue, will therefore be as shown in Box 3.7. Apart from data for actual revenue collections, the information required to apply the proportional adjustment method includes estimates of the revenue impact of discretionary changes in the tax system. Sometimes these estimates are prepared by the fiscal authorities and are available along with the budget estimates. When a discretionary change takes place part way through the year, it is necessary to adjust the tax base taking into account the timing and the impact of the change in the tax system on a full-year basis over two successive years. The proportional adjustment method results in a time series of adjusted tax revenue. The series for adjusted revenue and the tax base, or proxy, can be combined to yield a regression estimate of the underlying elasticity in an equation of the form,

ln(AT) = a + b ln(B), (3.10)

25If such changes in the tax system are relatively few, they can be taken into account in the framework of a regression-based estimating procedure by the insertion of dummy variables into the specification of the equation.

35

where B is the tax base, b is the elasticity, and ln refers to the natural logarithm. This regression relationship can be used to obtain a forecast of tax revenue by substituting a forecast value of B in the equation and solving for the corresponding value of AT for the period t + 1. A forecast obtained in this manner should be adjusted for any changes in the tax system that may be envisaged for the forecast year.

Box 3.7 Illustrative Proportional Adjustment Method1

)D - T

T( T = AT

,)D - T

T( T = AT

,)D - T

T( )D - T

T( T = AT

44

433

44

422

22

2

44

411

AT4 = T4 AT5 = T5 No adjustment is needed for year five because the change in the tax system in year four is already incorporated into the system prevailing in year five. 1For a general formula for adjusted revenues in year t, see Appendix IV.

5. The time-series approach The elasticity approach is feasible if there have been no changes in the tax system (in rates, exemptions, and compliance) during a sufficiently long period to permit estimation of its value. Alternatively, tax elasticity can be estimated if the impacts of past and prospective tax changes can be estimated independently, year by year, and used to construct an adjusted data series that shows what revenues would have been in the absence of changes. It is quite likely, however, that neither of these conditions is satisfied: the tax authorities of the country in question change tax rates and deductions frequently, and the data required to estimate the revenue impacts of the individual changes are not readily available.

36

If we apply the methods of Sections c and d without allowing for tax changes, regression results will measure tax buoyancy; they will include both the combined effects of changes in tax bases (for example the growth of household income) and also the effects of changes in tax laws (adjusting tax brackets for inflation, increasing tax rates to raise revenue, or strengthening tax administration and collections). The slope coefficient may appropriately be interpreted as an average for the historical period. However, the tendency of parliament to change tax laws is a political process, and not a stable parameter of economic behavior. Since the estimate of the slope coefficient represents buoyancy and not elasticity, it is unclear whether it adds significantly to the accuracy of the forecast relative to simpler, nonregression methods. An alternative is to discard the concepts of tax elasticity and buoyancy and the economic basis of the revenue equations in general, and use regression analysis to exploit trends and correlations in the series of data for revenue and the proxy base, including autocorrelation in the revenue series. This approach is in the spirit of the “time series analysis” branch of econometrics.26 It does not involve the assumption of an absence of tax changes, and it requires modest types and quantities of data. The time-series approach does not rest on economic theory, but on the assumption that the future will be like the past, without specifying why that might be true. The time series approach will provide accurate forecasts if, in fact, there are stable trends and correlations at work behind the scenes that will continue into the forecast period. Suppose that nominal income and other tax bases tend to increase steadily, and that tax revenues also increase steadily—whether because parliament gradually changes tax laws to adjust for inflation, or because the country has a unitary-elastic system, or some combination of these two cases. Under these circumstances, the time series method suggests estimating an equation of the form, ln (Tt) = f [ln(Bt), ln(Bt-1), . . ., ln(Bt-i), ln(Tt-1), . . ., ln(Tt-j)] (3.11) where, as above, T is actual revenue and B is the tax base. In practice the specification would probably be confined to one or two current and lagged terms on the right-hand side because these variables tend to be highly collinear, and the addition of further lags would fail to achieve any significant decrease in the standard error of the regression. 6. The effect of inflation on tax revenue 26See, for example, Francis X. Diebold, Elements of Forecasting (Cincinnati, Ohio: South-Western College Publishing, 1998), and D.F. Hendry, Dynamic Econometrics (Oxford, England: Oxford University Press, 1995).

37

In the presence of continuing high inflation, the authorities may be forced to modify tax rates more or less continuously, or modify the tax system, in order to keep buoyancy close to unity so that revenue does not grow or shrink excessively. To illustrate this point, imagine a hypothetical economy with zero inflation and a revenue system based solely on specific taxes. If there is no inflation the elasticity of the tax system will be unity for real increases in output (or income). The ratio of revenue to GDP will remain constant. In the opposite case, in a country with high inflation but no output growth, the revenue received from specific taxes will be constant in nominal terms, and will fall in relation to GDP as the price level rises. In this second case, if no changes are made in tax rates, the buying power of total revenue will shrink and become negligible as time passes; elasticity is zero. If a country’s tax system contains specific taxes, and inflation occurs, tax rates must be raised continuously to keep revenue growing in line with nominal GDP; if all taxes are proportional (and there are no exemptions), then revenue will keep pace with the value of output without legislative changes in the tax structure. A progressive tax—for example, higher rates of tax on personal income falling in higher tax brackets—results in the opposite problem; revenue will increase relative to income when there is high inflation, even with little increase in real income, until virtually all income is taxed at the highest marginal rate, and the ratio of income tax to income for the average household is at a value originally intended only for the rich. Whether elasticity is low or high, if the economy experiences a changing tax share with high inflation, the legislature will be pressured to act to offset the effects of inflation on the buying power of government revenue and household income. It can raise or lower specific rates repeatedly, increase or decrease personal tax brackets frequently (“indexing”), or move the system toward one of proportional tax rates so that inflation adjustment is automatic. (For example, law-makers could choose a constant VAT rate on all expenditures, and/or a single-rate system of personal income taxation with no deductions or exemptions.) If such changes in the nature of the tax system occur, not only will buoyancy tend to equal unity, but elasticity will approach unity as well. Unitary buoyancy may not be precisely achieved in every period. Parliamentary adjustments may under- or overcompensate for actual inflation in any particular year or group of years. Correcting a tax system for inflation may be a complex exercise, and changes may go too far or not far enough in the short run. Alternatively, parliament may intend to raise or lower the ratio of revenue to the base, which will also influence the average relation between revenue and the base over time. In such cases, the assumption of unitary elasticity, that the ratio of revenue to base will remain unchanged, will not be correct. However, the higher the inflation in the economy, and the more entrenched, the likelier it is that the ratio of revenue to GDP will remain unchanged in the short run as a first approximation. Forecasts based on this deduction may be as accurate as those based on either of the regression approaches unless there is a change in tax policy. 7. Forecasting nontax revenue

38

Nontax revenue includes receipts from property income, fees and charges (wedding and fishing licenses, bridge tolls, receipt of funds for the right to extract mineral ores on public land, the right to operate a radio transmitting station), fines, and net profits of financial and nonfinancial public enterprises including the central bank. The operating surpluses of most departmental enterprises (the cafeteria in the finance ministry) are also counted as nontax revenue. If the government has a monopoly on the import and sale of a particular commodity (tobacco, sugar, salt, petroleum), and charges a high price relative to the world market, either to earn revenue or to discourage consumption, the resulting revenues are considered to resemble those from excise taxes and are included as tax revenue. In the case of other public enterprises (railroads and the national airline, the postal service, telecommunications), the operating surplus, if any, is considered nontax revenue if transferred to the central government. (Social security contributions would normally be counted as tax revenue.) The flow of aggregate nontax revenue is difficult to relate to macroeconomic developments according to theoretical behavioral patterns. Profits of the central bank may be low temporarily because it has intervened in the foreign exchange market to support the exchange rate, or because it attempted to sterilize a capital inflow by selling bonds to the domestic public at prices lower than those at which it acquired the securities originally. Whether the railroads and the telephone system make a larger or smaller profit depends partly on whether they are permitted to adjust their fees and charges upwards as their costs rise or are obliged to wait until after an upcoming election to do so. Because of the absence of compelling economic explanations of these kinds of behavior, it is reasonable to resort to trend and autocorrelation exclusively for nontax revenues. Specific knowledge about likely developments in the forecast year, including the timing of increases of the prices of public services, may significantly enhance the accuracy of forecasts.

c. Forecasting expenditure

Compared with revenue, there is significantly less scope for forecasting the level of government expenditure through reliance on economic relationships. This is largely because of the political nature of the process by which many decisions on public expenditure are made, thereby making a significant portion a part of discretionary policy. Broadly speaking, expenditure can be divided into two categories: those that are compressible in the short-run and therefore discretionary, and those that are not. The latter category would clearly include interest payments, which are determined by the size of the public debt and the prevailing interest rate structure, leaving little discretion for the government. Other economic categories of expenditure that are partly endogenous and partly discretionary are social insurance payments, including unemployment and pension benefits, and expenditure on wages and salaries. For example, the wage and salary bill would reflect in part the size of the civil service, existing pay-scales, and labor market conditions in general. It would also be significantly affected by government policies regarding changes in civil service employment and its wage and incomes policies. Ultimately, total noninterest government spending is

39

compressible; from a macroeconomic point of view, it is a policy instrument and not an endogenous variable. 1. Wages and salaries Expenditure on wages and salaries, a major category of current expenditure, is likely to be influenced by institutional reforms aimed at restructuring the government sector. These would be reflected in government policies regarding civil service employment and public sector wages. The latter would also reflect the ongoing rate of inflation and developments of wages in the private sector. In economies with a large civil service, policies reducing the number of government employees may be put in place. A forecast of the wage bill should take account of the government’s intentions about the size of the civil service and the estimated change in average wages. 2. Subsidies and transfers A forecast of expenditure on subsidies and transfers, in the absence of new initiatives and a strong political will for change, will normally reflect previous trends. However, in an economy undergoing significant reform, reductions in subsidies and/or transfers may be both desirable and possible. Change in the desired role of the state, government down-sizing for whatever reason, the liberalization of prices, the restructuring and privatizing of state enterprises, reducing or limiting unemployment benefits, and national pension reform are changes that may have significant quantitative implications for expenditure on subsidies and transfers. 3. Expenditure on goods and services Aside from the wage bill, these expenditures are the main operating expenses of the government. They typically share the brunt of expenditure cuts. However, for government to continue operating in an efficient way there must, as a first approximation, be rough proportionality between the size of the civil service and expenditure on goods and services. 4. Interest expenditure In principle, information on the (i) size, (ii) domestic or foreign composition, (iii) maturity profile, and (iv) interest rates applicable to different maturities of public debt would be obtained in order to forecast interest payments. The breakdown of the debt into portions carrying fixed interest rates or contracted at floating rates is also relevant. As a first approximation, one can estimate the change in interest payments on government debt from an estimate of the interest rate and the change in the average level of indebtedness. The estimate of the change in indebtedness usually requires an estimate of the fiscal balance, which in turn, requires an estimate of the interest payments themselves. A simplified method is illustrated below, in Section d(4).

40

Interest rates applicable to domestic debt are affected by government policy regarding the financing of the deficit and the stance of monetary policy. These policies should be taken into account in projecting the average interest rate applicable to government borrowing. 5. Capital expenditure In comparison with current expenditure, capital expenditure is generally considered to be more subject to adjustment and frequently bears the brunt of fiscal tightening. In practice, however, capital projects are not so easy to turn on and off, especially when they depend on external concessional sources of funding. Indeed, capital spending in most countries in any year is set in the context of a multi-year investment program subject to annual changes in the light of resource constraints and changing fiscal priorities. In projecting capital expenditures, one needs to talk careful account of spending already in the pipeline that is difficult to reverse. Moreover some, though not all, forms of government investment are crucial complements to private output and a higher growth rate of GDP and rising living standards. 6. Financing of the budget balance Financing is derived from forecasts of fiscal revenues and expenditures. The forecaster would, however, need to assess the breakdown of financing between domestic and external sources, and bank and nonbank categories, in the light of information about the amount of external financing that is available and the scope for the private nonbank sector to absorb additional government debt. Forecasting would also need to take into account of the impact of exchange rate changes on the domestic currency value of external financing, the range of domestic financial instruments available for financing, and the potential consequences for domestic interest rates of the size of nonbank financing.

41

Table 2.1. Government Revenue and Grants

I. Total revenue and grants (II + VII)

II. Total revenue (III + VI)

III. Current revenue (IV + V)

IV. Tax revenue

Tax on income, profits, and capital gains Individual Corporate Social security contributions Taxes on payroll and work force Domestic taxes on goods and services General sales tax or VAT Excises Profit of fiscal monopolies Taxes on specific services Taxes on use of goods Other taxes on goods and services1

Taxes on international trade Import duty

Export duty Other taxes on international trade Other taxes V. Nontax revenue2 VI. Capital revenue3 VII. Grants Source: International Monetary Fund, A Manual on Government Finance Statistics (Washington, D.C.: IMF 1986). 1Including business and professional licenses and motor vehicle taxes. 2Including property income, administrative fees and charges, fines, and operating surpluses of public enterprises and the central bank. 3Including the sales of fixed assets, sales of stocks, land and other intangible assets and capital transfers.

42

Table 2.2. Economic Classification of Government Expenditure and Net Lending I. Total expenditure and net lending (II + V) II. Total expenditure (III + IV)

III. Current expenditure

Expenditure on goods and services Wages and salaries Employer contributions to social security and pension Purchases of goods and services

Interest payments Domestic Abroad

Subsidies and other current transfers Subsidies1

To nonfinancial public enterprises To financial institutions

Transfers To nonprofit institutions, household, and abroad

IV. Capital expenditure

Acquisition of fixed capital assets Purchase of stocks and land Capital transfers

V. Lending minus repayments

Source: International Monetary Fund, 1986, A Manual on Government Finance Statistics (Washington.: International Monetary Fund). 1Subsidies include all unrequited, nonrepayable transfers on current account to private industries and public enterprises and the cost of covering the cash operating deficits of departmental enterprise sales to the public.

43

THE 2001 MANUAL ON GOVERNMENT FINANCE STATISTICS (GFS MANUAL)27

INTRODUCTION

The new GFS Manual is based on an accounting system that, to the extent possible, is harmonized with the System of National Accounts 1993 (1993 SNA). This harmonization explains a substantial portion of the differences between the new and the 1986 version of the GFS Manual. The main changes could be summarized as follows: • The general government sector is defined on the basis of units (“resident government

units”) rather than functions. Statistics are compiled from the sets of accounts maintained by each government unit. Sets of units constitute subsectors.

• Flows are measured and recorded on the accrual basis, instead of the cash basis. • The system’s analytical framework has been expanded to include stocks as well as

flows. The framework includes i) the government operations table; ii) the statement of other economic flows; iii) the government balance sheet, and iv) a statement of sources and uses of cash. The system fully integrates data on flows (transactions, revaluations and other changes in assets and liabilities) with data on stocks. Consequently, the value of the stocks in the balance sheet at the beginning of the period plus the flow data will equal the value of stocks in the balance sheet at the end of the period.

• There is a clear identification, classification, and separation of transactions

according to their nature: “revenue and expense,” or “changes in assets and liabilities.” In addition, the latter are differentiated between financial and nonfinancial.

• A new set of indicators of the financial position of the government may be derived

from the system’s financial statements, including “change in net worth,” allowing for a more comprehensive analysis.

A more detailed explanation of the main changes, as well as other specific issues included in the new GFS Manual are presented below. Coverage of the GFS Manual The GFS system is based on the sectoring principles of the 1993 SNA, and defines the general government sector as the “set of resident government units.” Government units are those that have as their main purpose the provision of public goods and services, and/or the 27 This appendix is based entirely on the new GFS Manual and the 1986 version of the same.

APPENDIX I

44

redistribution of income and wealth by means of transfers. To accomplish that objective, those units have the power to impose directly or indirectly compulsory levies, including taxes. The general government sector includes the central government, state and local governments, and social security funds (which could be included as part of each level of government or as a separate subsector). For analytical purposes, the coverage could be expanded to have measures for the public sector by including other units owned or controlled, directly or indirectly, by units of the general government. The three standard analytical measures would be: • The nonfinancial public sector: general government and all public nonfinancial

corporations. • The nonmonetary public sector: nonfinancial public sector and all public financial

corporations except the public banking system (central bank and other depository institutions).

• The public sector: general government and all financial and nonfinancial public

corporations. The following diagram represents the composition of the public sector.

Diagram 1. Structure of the Public Sector

Public Sector

Monetary

Public Sector

Central Bank

Other Public

Depository

Institutions

Nonmonetary

Public Sector

Public Nondepository

Financial Corporations

Nonfinancial

Public Sector

GeneralGovernment

Sector

PublicNonfinancialCorporations

StateGovernments

LocalGovernments

CentralGovernment

Scope of the

New GFS

Manual

45

Flows, stocks, and accounting rules As indicated above, the GFS system allows for the full integration of stocks and flows. This means that for any period,

Vj1 = Vj0 + Fj1

Where Vj1 and Vj0 represent the values of item j in the balance sheet at times 1 and 0 respectively, and Fj1 the cumulative value of all flows that affect Vj between times 0 and 1. To allow for the integration, two types of flows are calculated, transactions (presented in the government operations table), and other economic flows (presented in the statement of other economic flows). Transactions represent the interaction of two units, and can be classified as exchanges if one unit provides goods, services or assets to another unit and there is a counterpart of the same value, or as transfers if there is no counterpart. Other economic flows are changes in the volume or value of an asset or liability that are not transactions. (for example, writing off of a debt, destruction of an asset, and valuation changes—called holding gains and losses. Based on the accrual principle, flows are recorded at the time the economic value is created, transformed, exchanged, transferred, or extinguished. If the cash payment does not take place at the same moment, a receivable or a payable (included as financing items) is recorded. Accordingly, taxes should be recorded when the activities or transactions that create the tax liability occur. Similarly, transactions in goods and nonfinancial assets are recorded when the legal ownership changes; transactions in services are recorded when the services are provided. All flows and stocks should be valued at market prices. Flows in foreign currency should be converted to their value in domestic currency at the rate prevailing at the time of recording. Stocks should be converted at the rate prevailing on the balance sheet date. (in both cases, the mid-point between the buying and selling rates should be used). Any difference in the recording values between two periods associated with the same transaction, or balance sheet item, should be registered as a holding gain or loss. Analytical framework A summary of the analytical framework is presented in Diagram 2. As mentioned above, there are four types of financial statements, the balance sheet, the government operations table, the statement of other economic flows, and the statement of sources and uses of cash. The government operation table presents the transactions of the general government sector during a given accounting period. The transactions are classified as: revenue (expense) if they increase (reduce) net worth; capital asset if they change the stock of a nonfinancial asset, and financing if they change the stock of a financial asset or liability. In this framework, the acquisition or construction of a capital asset is not classified as an

46

expense because it does not change net worth (it only changes its composition). Four types of capital assets are considered: fixed assets, inventories, valuables and nonproduced assets (for example, land, subsoil assets). Transactions classified as financing include the acquisition or disposal of financial claims for fiscal policy purposes (equivalent to the term net lending in the 1986 version), or for liquidity management (transactions on a market basis, equivalent to financing in the 1986 version). Three key balances are calculated in the government operations table. • net operating balance: revenue less expense (including consumption of fixed capital),

equal to change in net worth. • Net lending/borrowing: net operating balance less the net acquisition of capital assets;

also equal to total financing requirements (net increase in financial assets less net increase in financial liabilities).

• Policy balance: net lending/borrowing less net acquisition of financial assets for policy

purposes (on a nonmarket basis). This is the accrual equivalent of the overall deficit/surplus in the 1986 version.

Other useful concepts of government balance are: • Net saving equal to the net operating balance less net capital transfers (receivable less

payable). This measure is useful in analysis of fiscal sustainability. • Primary balance or net lending/borrowing plus net interest payable. The basic structure of the government financial statements is presented in Tables 1–2.

47

Diagram 2. Analytical Framework

STOCKS

OpeningBalance Sheet

Capital Assets

Financial Assets

Liabilities

Net worth

Table 2

FLOWS

Government Operations

Table

Statement of Other Economic

Flows

Revenue—

Expense=

Change in net worth due to transactions

Transactions in capital assets

Transactions in financial assets

Transactions in liabilities

Change in net worth due to transactions

Change in net worth due to

other economic flows

Revaluations and other changes of

capital assets

Revaluations and other changes of financial assets

Revaluations and other changes of

liabilities

Change in net worth due to other

economic flows

STOCKS

ClosingBalance Sheet

Capital Assets

Financial Assets

Liabilities

Net worth

Table 2

=+ +

+

+

=

-

+

=

—-

==

-

+

48

Table 1. Government Operations Table I. Transactions affecting net worth

1. Revenue (increase net worth) 1.1 Taxes 1.2 Social contributions 1.3 Grants 1.4 Other revenue

2. Expense (reduce net worth) 2.1 Compensation of employees (wages and salaries) 2.2 Use of goods and services 2.3 Property expense (interest and rent) 2.4 Subsidies 2.5 Grants 2.6 Social benefits 2.7 Other expense 3. Gross operating balance = 1 – 2 2.8 Consumption of fixed capital expense

4. Net operating balance = 3 – 2.8 II. Transactions in capital assets

5. Net acquisition of capital assets 5.1 Fixed assets 5.2 Change in inventories 5.3 Valuables 5.4 Nonproduced assets

6. Net lending/borrowing = government’s financing requirement = 4 – 5 III. Transactions in financial assets and liabilities = financing

7. Net acquisition of financial assets on a nonmarket basis 8. Policy balance = 6 – 7 9. Net acquisition of financial assets for liquidity management 10. Net incurrence of liabilities 10.1 Domestic 10.2 Foreign

49

Table 2. The Balance Sheet Opening Balance Closing Balance Capital assets Fixed assets Inventories Valuables Nonproduced assets

Financial assets Acquired by nonmarket means Equities Central bank Other financial corporations Nonfinancial corporations Financial assets other than equities Acquired for liquidity management Central bank Other financial corporations All other units

Liabilities Domestic Central bank Other financial corporations All other units7 Foreign General government All other units Net financial worth = financial assets less liabilities Net worth = total assets less liabilities

50

THE INFLATION TAX AND SEIGNIORAGE: SOME IMPLICATIONS A government can finance spending by raising tax revenue from the public, by borrowing, or simply by printing money. Revenue from money creation arises because of the government's monopoly power to supply fiat or paper money to the economy. Since the cost to the government of printing a currency note is negligible, but it acquires purchasing power over resources equivalent to the face value of the banknote, the government gains revenue simply by providing money to the economy. In a modern economy, banks also create money and hence also get revenue from this source. Thus, revenue from money creation (RMC) can broadly be defined as the total amount of real resources appropriated by those that issue the money stock in an economy. Formally, RMC in this case is shown by:

MRM C = or RM C = mP

µ (1)

where MM = µ or the percentage growth in nominal money stock. Revenue from money

creation is thus defined as the change in nominal money balances held by the public( M ) expressed in terms of the price level (P) or equivalently, the percentage growth rate of

nominal money stock (µ) times the real money stock, )PM( = m 1. The RMC received by the

government (RMCg) will, of course, be much smaller and will only reflect the government issuance of reserve money or high-powered money (H):

g gH H = or = RMC RMCP P

β (2)

where HH = β , or the percentage growth in reserve money.

Revenue from money creation can be decomposed into seigniorage and inflation tax, thus:2

M PRMC = m + m, where m = ( ), ( )P P

π π = 3 (3)

RMC = Change in real cash balances + Inflation rate * Stock of real cash balances.

RMC = Seigniorage + Inflation tax. (4)

• The seigniorage component is the change in real cash balances ( m ) . It comes about because of real growth in the economy or a favorable shift in the demand for money.

• The inflation tax component is equal to the inflation rate, which in this case acts as

the “tax rate” (π) times the stock of real cash balances held by the public m (which constitute the tax base). In the absence of inflation, the inflation tax will obviously be zero, but seigniorage will still be collected unless there is no growth in real cash balances.

APPENDIX II

51

• Seigniorage accrues not just to the government; banks also “collect” part of the revenue from money creation. However, in many countries, banks “redistribute” their share of this revenue by making loans at below-market interest rates. In this case, borrowers will also get a portion of that revenue.

• The inflation tax “paid” by the public is significantly higher than that “collected” by the government. Put differently, the cost inflicted on the public by the government's policy aimed at covering part of the deficit through an inflation tax is considerably more than the real resources appropriated by the government. In this sense, the inflation tax is highly inefficient.

• As inflation accelerates, the demand for real cash balances is likely to be reduced as the public adjusts to the higher inflation, including by substituting foreign currency (for instance, U.S. dollars) for the heavily “taxed” national currency.

• A reduction in the real cash balances in response to higher inflation amounts to a shrinkage in the base of the inflation tax. Such an erosion in the base implies that, in order for the government to “collect” the same revenue from the inflation tax, a higher inflation rate (“tax rate) must prevail.

• Revenue from money creation follows an inverted U-shaped curve. As inflation increases, so will the revenue from seigniorage but only up to a maximum beyond which any increase in inflation will lead to a reduction in revenues.

• In most industrial countries, the maximum RMC has been estimated in the range of 1 to 2 percent of GDP. But in some developing and transition economies, the maximum has fluctuated between 5 and 10 percent of GDP.

1For any variable x, ( x ) denotes dx/dt, or the change over a given period of time. 2It can be seen that the rate of change in real cash balances is equal to

, henceM M P M( )P P P P

= + where M PRMC = m + m, m = ( ), ( )P P

π π =

3Please note that for discrete data the equivalent formula for Equation 3 is:

Also, note that in terms of GDP (RMCt) is defined as RMCt = ∆mt/GDPt , where GDPt equals nominal GDP (see Stanley Fischer, 1982, “Seigniorage and the Case for a National Money,” Journal of Political Economy, Vol. 10 (February–December).

THE ACCOUNTING APPROACH TO FISCAL SUSTAINABILITY

( ) tt t t 1 t 1

t

RMC m m m1

seignorage inflation tax

ππ− −

⎛ ⎞= − + ⎜ ⎟+⎝ ⎠

APPENDIX III

52

In a technical survey for the World Bank, John Cuddington quotes Max Corden’s quip: “The growth of a child is not sustainable, but is desirable nevertheless.”28 The issue of fiscal sustainability—whether a deficit means trouble in the longer run, even if not in the short run—is one that economic theory can address only partially and obliquely. Probably the governments of most countries do not intend that large deficits will recur indefinitely, whereas the formal analysis of sustainability focuses on this case. One approach to sustainability studies whether the ratio of government debt to GDP is increasing. This approach is based on the assumption that a continuing increase in this ratio will eventually undermine the confidence of lenders in the government’s ability to service its obligations, while stability of this ratio seems more manageable, at least through the medium term. This is sometimes called the “accounting approach” to sustainability, and the two key constraints that follow from it are derived in this appendix. The other approach, called the “present-value constraint,” is not presented here. It is based on the comparison between the size of the present debt and the governments’ ability to repay in the long run if expenditure and revenue remain at current proportions of GDP. This last assumption may be somewhat artificial—as illustrated by the studies in the early to mid-1990s that claimed to demonstrate that the U.S. deficit was unsustainable (see Cuddington). The accounting identity for financing a fiscal imbalance is

Conventional gross increase

balance = − borrowing − amortization − in cash and deposits other

+ RMC + financing (1) items

The change in government net indebtedness can be defined as gross new borrowing net of amortization payments and net of the change in government bank deposits and cash balances. The change in debt defined in this way will equal the conventional fiscal balance (with sign reversed) after allowing for RMC gains and miscellaneous financing sources such as gold sales or privatization receipts, if any. To simplify the algebra that follows, let RMC be combined with miscellaneous financing items. Also, let the algebraic signs of both sides of this equation be changed (on the left-hand side, a deficit is a positive number, to match positive borrowing on the right). Using the notation,

Dt : net government debt at the end of period t,

28John Cuddington, 1997, “Analyzing the Sustainability of Fiscal Deficits in Developing Countries,” Policy Research Working Paper 1784 (June) (Washington: The World Bank). For a more recent discussion on sustainability, see Enzo Croce and Hugo Juan-Ramón, 2003, “Assessing Fiscal Sustainability: A Cross-Country Comparison,” IMF Working Paper 03/145.

53

RMCt : revenue from money creation accruing to government during period t (plus miscellaneous financing items, if any), and

CDt : the conventional fiscal deficit for period t as defined implicitly in Section b(5),

and where ∆Dt = Dt − Dt -1 , the financing identity above may be written

CDt = ∆Dt + RMCt (2)

Adding Dt-1 to both sides, and rearranging, yields

Dt = Dt-1 + CDt − RMCt ,

which becomes, after dividing by GDP,

t t -1 t t

t t t t

CD RMCD D = + - GDP GDP GDP GDP

Let lowercase letters denote the ratio of a variable to GDP in the same period (for example, rmct = RMCt/GDPt). If one also defines, gt : the growth rate of real GDP, and πt : the rate of inflation measured by the GDP deflator (both expressed as fractions, not in percent, to simplify the algebra), then GDPt / GDPt-1 = (1 + gt)(1 + πt), and the above expression may be rewritten as

(3)t -1 t-1t t-1 t t t tt

t tt

GDP d = + - d = + - d d cd rmc cd rmc(1 + )(1 + )gGDP π=>

t tt tt t -1 t t

tt

+ + g g = - + ( - ) d d cd rmc(1 + )(1 + )g

π π∆π

⎡ ⎤⎢ ⎥⎣ ⎦

If the rate of nominal GDP growth is low, the value of the bracketed factor in (3) does not change much if the denominator is taken to equal unity approximately. This is the basis for the statement in Section c(4) that stabilizing d requires “the ratio of the deficit to GDP, inclusive of interest payments on the debt, not exceed the initial debt-GDP ratio multiplied by the growth rate of nominal GDP”. This statement assumes that the deficit is equal to CD-RMC (or that RMC equals 0). This result is an approximation and involves a significant error if the

It follows that the change in d is given by t -1

t t-1 t-1 t ttt

d - = - + - d d d cd rmc(1 + )(1 + )g π

54

growth rate of nominal GDP is larger than a few percent per year, whereas Equation (3), above, involves no approximation.29 It is possible to disaggregate the conventional deficit in (2) into the primary deficit (PD) and interest expenditure. Utilizing the assumption of a lag of around six months between loan disbursal and interest payment, one may rewrite cd in (3) as

where i is the nominal interest rate paid on average in period t on government debt. If rt is defined to be the average real rate of interest on government debt, so that

it = (1 + rt)(1 + πt) − 1,

The assumption that g is small makes the bracketed term in (5) roughly equal to (r − g). Then (5) reduces to the version presented as Equation (3.7) in this part.

29The statement in the body of the chapter is based on calculus and applies to an indefinitely small change in d, in which case the error of approximation is negligible.

,GDP

D i + GDPPD = cd

t

1-tt

t

tt (4)

then (4) can be written as

,d ) + )(1g + (11-) + )(1r + (1 + pd = cd 1-t

tt

tttt ⎥

⎦

⎤⎢⎣

⎡

ππ

and (3) as

t t ttt t t -1t

tt

(1 + )(1 + ) - 1 + 1 - (1 + )(1 + )gr = - + pdd rmc d(1 + )(1 + )gπ π∆

π

⎡ ⎤⎢ ⎥⎣ ⎦

by collecting terms on dt-1. After simplifying, the bracketed factor becomes (r - g)/(1 + g), so that the precise result is,

d g + 1g - r + s - pd = d 1-tttt ⎥⎦

⎤⎢⎣

⎡∆ (5)

55

PROPORTIONAL ADJUSTMENT METHOD, THE GENERAL CASE30 ASSUME THE FOLLOWING SERIES OF ACTUAL REVENUE COLLECTION IN YEARS 1 THROUGH N:

T1, T2, ..., Tn-1, Tn where n is the last or the current year. Let the estimated revenue effect of discretionary changes in the years in which they occurred be as follows:31 D2, ..., Dn-1, Dn Let us now construct an adjusted series of revenue equal to those revenues that would pertain if the current year’s tax structure had been in operation throughout the period under analysis: AT1, AT2, ..., ATn-1, ATn Since the current year (n) is the reference year, the actual and adjusted revenue for that year would be the same. ATn = Tn However, actual revenue collection in years n-1, n-2, ..., 2, 1, must be corrected for discretionary changes in subsequent years. Under the proportional adjustment hypothesis, the series of adjusted revenue, with n as the reference year, becomes as follows:

which can be expressed by the general formula:

30Adapted from Financial Policy Workshop: The Case of Kenya, IMF Institute, 1981. 31Note that the first discretionary change occurs in year 2 since year 1 is the first year in the time series.

⎟⎟⎠

⎞⎜⎜⎝

⎛

D-TT T = AT

nn

n1-n1-n

⎟⎟⎠

⎞⎜⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛

DTT

D-TT T = AT

1-n-1-n

1-n

nn

n2-n2-n

⎟⎟⎠

⎞⎜⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛

D-TT ...

DTT

D-TT T = AT

33

3

1-n-1-n

1-n

nn

n22

1-n 2,-n ..., 2, 1, =j ,D-T

AT T = AT1+j-n1+j-n

1+j-nj-nj-n ⎟⎟

⎠

⎞⎜⎜⎝

⎛

APPENDIX IV

56

It may be helpful to provide a numerical illustration of the method. Let the actual revenue collections in years 1 through 5 be as follows: T1 = 100, T2 = 140, T3 = 170, T4 = 250, T5 = 320 Assume that discretionary changes occurred only in years 2 and 4, with D2 = 20, D3 = 0, D4 = 30, D5 = 0 Let us now construct and adjusted revenue series with year 5 as reference year. The effect of the discretionary action in year 4 was to raise revenue collections in that year by 13.64 percent:

If this discretionary action had been taken at the beginning of the data period, the proportional adjustment hypothesis would imply a corresponding proportionate increase in revenue collections in all years preceding year 4. Similarly, the effect of the discretionary action in year 2 was to raise revenue in that year by 16.67 percent:

Only revenue in year 1 needs to be corrected for the change in year 2. Thus, if both discretionary actions had been taken at the beginning of the data period, the revenue series would have become as follows under the proportional adjustment hypothesis: AT5 = T5 = 320

AT4 = T4 = 250

1.1364 = 30-250

250 = D-T

T44

4 ⎟⎠⎞

⎜⎝⎛

⎟⎟⎠

⎞⎜⎜⎝

⎛

1.1667 = 20-140

140 = D-T

T22

2 ⎟⎠⎞

⎜⎝⎛⎟

⎠

⎞⎜⎝

⎛

193.2 = 1.1364* 170 = D-T

T T = AT44

433 ⎟⎟

⎠

⎞⎜⎜⎝

⎛

159.1 = 1.1364* 140 = D-T

T T = AT44

422 ⎟⎟

⎠

⎞⎜⎜⎝

⎛

132.6 = 1.1667* 1.1364* 100 = D-T

T D-T

T T = AT22

2

44

411 ⎟

⎠

⎞⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛

⎟⎠

⎞⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛⎟⎟⎠

⎞⎜⎜⎝

⎛

D-TT

D-TT ...

DTT

D-TT T = AT

22

2

33

3

1-n-1-n

1-n

nn

n11

57

Some Tax Revenue Sources and Their Proxy Bases 1

Tax Revenue Sources

Possible Proxy Bases

A. Taxes on net income and profits

1. Corporate

1a. Profits of corporations derived from

the national accounts 1b. Share of major bases in gross

domestic product (e.g., value added in manufacturing)

2. Individuals

2. Wages and salaries and other private

income from the national accounts B. Social insurance taxes or

contributions

3. Employer

3. Wages and salaries

4. Employee

4. Wages and salaries and nonwage

personal income for self B employed contributors

C. Taxes on property Total wealth or

5. Real estate 5. Rents

6. Personal wealth

6. National income

7. Death and gift taxes

7. Demographic indices of deaths and

number of persons in the highest income brackets

8. Property transfers

8. Value of urban properties and

number of transactions D. Taxes on production, consumption,

and sales

9. Sales, turnover, or value

Badded tax

9. Private consumption expenditure or

commodity groupings suitably classified

10. Selective excises

10. Production or consumption figures

on major excisable commodities

11. Profits of fiscal monopolies 11. Value or volume of consumption of

fiscal monopoly commodities

APPENDIX V

58

Tax Revenue Sources

Possible Proxy Bases

E. Taxes on international trade and transactions

12. Import duties

12. Value and volume of total imports or,

preferably, the value and volume of major categories of imports

13. Export duties

13. Value and volume of major exports

14. Export marketing boards

14. Estimated profits on the exports

concerned

15. Exchange profits 15. Value of exchange transactions

16. Exchange rates

16. Value of exchange transactions

F. Other taxes

17. Business and professional

licenses

17. Number of licenses issued

18. Poll taxes or personal taxes

18. Demographic data on relevant age

and sex category

19. Stamp taxes 19. Value of important categories of

transactions involved and estimated frequency of transactions

20. All other taxes on income,

property, production, and trade

20. National income

1The table is adapted from Sheetal Chand, 1975, “Some Procedures for Forecasting Tax Revenue in Developing Countries,” DM/75/91 (October) (Washington: International Monetary Fund).