- Commandment VI: You shall be fair. To be sustainable over time, the fiscal adjustment should be equitable.
Equity has various dimensions, including maintaining an adequate social safety net and the provision of public services that allow a level playing field, regardless of conditions at birth. Fighting tax evasion is also a critical component to equity. For VAT, a tax that is relatively resilient to fraud, tax evasion averages about 15% of revenues in G20 advanced countries. Evasion for other taxes is likely to be higher.
- Commandment VII: You shall implement wide reforms to boost potential growth.
Strong growth has a staggering effect on public debt: a one percentage point increase in potential growth – assuming a tax ratio of 40% – lowers the debt ratio by 10 percentage points within 5 years and by 30 percentage points within 10 years, if the resulting higher revenues are saved. An acceleration of labour, product and financial market reforms will thus be critical.
In the current context of weak aggregate demand, reforms that increase investment are more desirable than reforms that increase saving. While both have positive long-run effects, investment friendly reforms increase demand and output in the short run, while saving friendly reforms do the opposite. A word of caution, though: the timing and magnitude of the effects of structural reforms on growth are uncertain: fiscal adjustment plans relying on faster growth would not be credible.
- Commandment VIII: You shall strengthen your fiscal institutions.
Sustaining fiscal adjustment over time requires appropriate fiscal institutions. The current institutions allowed a record public debt accumulation before the crisis. They are insufficient. This requires better fiscal rules, including in Europe; better budgetary processes, including in the US, where, at least for Congress, the budget is essentially a one-year-at-a-time exercise; and better fiscal monitoring, including through independent fiscal agencies of the type recently created in the UK.
- Commandment IX: You shall properly coordinate monetary and fiscal policy.
If fiscal policy is tightened, interest rates should not be raised as rapidly as in other phases of economic recovery. Calls for an early monetary policy tightening in advanced economies are misplaced.
- Commandment X: You shall coordinate your policies with other countries.
In a number of advanced countries, the reduction in budget deficits must come with a reduction in current account deficits. Put another way, if the recovery is to be maintained, the initial adverse effects of fiscal consolidation on internal demand have to be offset by stronger external demand. But this implies that the opposite happens in the rest of the world.
In a number of emerging market economies, current account surpluses must be reduced, and these countries must shift from external to internal demand. The recent decisions taken by China are, in this respect, an important and welcome step. Policy coordination will also be important in some structural areas: for example, over the medium term, it will be critical to protect fiscal revenues from rising tax competition.
Obey these commandments, and chances are high that you will achieve fiscal consolidation and sustained growth.
Note: This was first posted on iMFdirect; reposted here with permission.
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