Fiscal policy in developing countries: Escape from procyclicality

Jeffrey Frankel, Carlos A. Vegh , Guillermo Vuletin 23 June 2011

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Fiscal policy is taking centre stage. Among advanced countries, the news is bad; Europe’s periphery teeters, the UK slashes, the US deadlocks, Japan muddles. But in the rest of the world there is good news. In an historic reversal, many emerging market and developing countries have over the last decade achieved a countercyclical fiscal policy.

In the past, developing countries tended to follow procyclical fiscal policy. They increased spending (or cut taxes) during periods of expansion and cut spending (or raised taxes) during periods of recession. Many authors have documented that fiscal policy has tended to be procyclical in developing countries, in comparison with a pattern among industrialised countries that has been by and large countercyclical (Gavin and Perotti 1997, Tornell and Lane 1999, Kaminsky et al. 2004, Talvi and Végh 2005, Mendoza and Oviedo 2006, Alesina et al. 2008, and Ilzetski and Végh 2008).

Most studies look at the procyclicality of government spending, because tax receipts are particularly endogenous with respect to the business cycle. Indeed, an important reason for procyclical spending is precisely that government receipts from taxes or mineral royalties rise in booms, and the government cannot resist the temptation or political pressure to increase spending proportionately, or more. We can find a similar pattern on the tax side by focusing on tax rates rather than revenues, though cross-country evidence is harder to come by.1

Figure 1 (which is a version of evidence presented in Kaminsky et al. 2004) depicts the correlation between government spending and GDP for 94 countries over the period 1960-1999. More precisely, it shows the correlation between the cyclical components of spending and GDP with the longer-term trends taken out. The set includes 21 developed countries, which are represented by black bars, and 73 developing countries, represented by yellow bars. A positive correlation indicates government spending that is procyclical, i.e. destabilising. A negative correlation indicates countercyclical spending, that is, stabilising.

There is no missing the message. Yellow bars lie overwhelmingly on the right-hand side. More than 90% of developing countries show positive correlations (procyclical spending). Black bars dominate the left hand side. Around 80% of industrial countries show negative correlations (countercyclical spending).

Figure 1. Correlations between government spending and GDP, 1960-1999

Why would policymakers pursue procyclical fiscal policy? One does not have to believe in “fine tuning” to see the undesirability of a pattern under which government response exacerbates the amplitude of the business cycle. The most convincing explanations in the literature entail either imperfect access to credit or political distortions.

The historic shift in cyclicality

Over the last decade there has been a historic shift in the cyclical behaviour of fiscal policy in the developing world. Figure 2 updates the statistics, showing the period 2000-2009. The number of yellow bars on the left side of the graph (negative correlations) has greatly increased. Around 35% of developing countries 26 out of 73 now show a countercyclical fiscal policy, more than quadruple the share during the earlier period.

Figure 2. Correlations between government spending and GDP, 2000-2009

Figure 3 presents a scatter plot with the 1960-1999 correlation on the horizontal axis and the 2000-2009 correlation on the vertical axis. The lower right quadrant shows the graduates from procyclical to countercyclical fiscal policy. The star performers include Chile and Botswana; but 24 developing countries altogether (out of 73) have made this historic shift.

Figure 3. Correlations between government spending and GDP, 1960-1999 vs. 2000-2009

The evidence of countercyclicality among many emerging-market and developing countries matches up with other criteria for judging maturity in the conduct of fiscal policy, such as debt/GDP ratios, rankings by rating agencies, and sovereign spreads. Low income and emerging market countries in the aggregate have achieved debt/GDP levels around 40% of GDP over the last four years. The IMF estimates the 2011 ratio at 43% among emerging market countries and 35% among low-income countries. This is the same period during which debt in advanced countries rose from about 70% of GDP to 102%.

The financial markets have ratified the historic turnaround. Spreads are now lower for many emerging markets than for some “advanced countries.” Rating agencies rank Singapore as more creditworthy than Belgium, Korea ahead of Portugal, Mexico ahead of Iceland, and just about everybody ahead of Greece. Euromoney ranks Chile as less risky than Japan, Korea less risky than Italy, Malaysia less risky than Spain, and Brazil less risky than Portugal.

Largely as a result of their improved fiscal situations during the period 2000-2007, many emerging markets were able to bounce back from the 2008-2009 global financial crisis more quickly than advanced countries (Didier et al. 2011).  

How did they do it?

What explains the ability of some countries, particularly emerging-market and developing countries, to escape the trap of procyclical fiscal policy? We believe that the main story concerns institutions.2 In our new research (Frankel et al. 2011), we find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment.

Although one thinks of institutions as slow-moving, they can change over time. Chile’s institutional quality has risen strongly since the early 1980s, during which time its fiscal policy has turned from procyclical to countercyclical. A country with good institutional quality in the general sense of rule of law can help lock in countercyclical fiscal policy through specific budget institutions. Frankel (2011a) explains how Chile did it, with the structural budget reforms of 2000 and 2006. Chile’s approach could be emulated by others.

Fiscal rules, such as the Eurozone’s Stability and Growth Pact, may accomplish little in themselves. Rules can actually worsen the tendency of governments to make overly optimistic forecasts for economic growth and budget balance (Frankel 2011b). Chile’s key innovation was to give responsibility for forecasting to independent expert commissions, insulated from politicians’ wishful thinking.

Even advanced countries have something to learn about countercyclical fiscal policy from Chile and others to the South. Saving during expansions such as 2001 to 2006 is critical for weathering the storm in recessions such as 2008-09. Otherwise there may be no way out but to adjust at the worst possible time.

References

Alesina, Alberto, Filipe Campante, and Guido Tabellini (2008), “Why is Fiscal Policy Often Procyclical?”, Journal of the European Economic Association, 6(5):1006-1036.

Alesina, Alberto and Roberto Perotti (1996), “Fiscal Discipline and the Budget Process ,” American Economic Review, 86(2):401-407.

Calderón, César, and Klaus Schmidt-Hebbel (2008), “Business Cycles and Fiscal Policies: The Role of Institutions and Financial Markets”, Working Paper 481, Central Bank of Chile.

Didier, Tatiana, Constantino Hevia, and Sergio Schmukler (2011), “How Resilient Were Emerging Economies to the Global Crisis?”, World Bank Policy Research WP 5637, April.

Frankel, Jeffrey (2011a),A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile”, NBER Working Paper 16945.

Frankel, Jeffrey (2011b),A Lesson From the South for Fiscal Policy in the US and Other Advanced Countries,” forthcoming, Comparative Economic Studies. HKS RWP11-014.

Frankel, Jeffrey, Carlos Végh, and Guillermo Vuletin (2011), “On Graduation from Procyclicality”, University of Maryland (in progress).

Gavin, Michael and Roberto Perotti (1997), “Fiscal Policy in Latin America”, NBER Macroeconomics Annual, 12:11-61.

Ilzetski, Ethan, and Carlos Vegh (2008), “Procyclical Fiscal Policy in Developing Countries: Truth or Fiction?”, NBER Working Paper 14191.

Kaminsky, Graciela, Carmen Reinhart, and Carlos Végh (2005), "When It Rains, It Pours: Procyclical Capital Flows and Macroeconomic Policies", NBER Macroeconomics Annual 2004, 19:11-82.

Mendoza, Enrique and P Marcelo Oviedo (2006), “Fiscal Policy and Macroeconomic Uncertainty in Developing Countries: The Tale of the Tormented Insurer”, NBER Working Paper 12586, October.

Persson, Torsten, and Guido Tabellini (2004), “Constitutional Rules and Fiscal Policy Outcomes”, American Economic Review, 94(1):25-45.

Poterba, James, and Jürgen von Hagen (1999) (eds.), Fiscal Institutions and Fiscal Performance, University of Chicago Press.

Talvi, Ernesto, and Carlos Végh (2005), “Tax Base Variability and Procyclicality of Fiscal Policy”, Journal of Development Economics, 78(1):156-190.

Tornell, Aaron, and Philip Lane (1999), “The Voracity Effect”, American Economic Review, 891:22-46.

Végh, Carlos, and Guillermo Vuletin (2011), “On the Cyclicality of Tax Rate Policy,” University of Maryland and Colby College (in progress).

von Hagen, Jürgen, and Ian Harden (1995), “Budget Processes and Commitment to Fiscal Discipline”, European Economic Review,39(3-4):771-779.


 1 Végh and Vuletin (2011) find evidence that tax-rate policy has been mostly procyclical in developing countries, and acyclical in industrialised countries.

2 In the case of fiscal policy, the importance of institutions has been emphasised by von Hagen and Harden (1995), Alesina and Perotti (1996),Poterba and Von Hagen (1999),Persson and Tabellini (2004), and Calderón and Schmidt-Hebbel (2008), among many others.

 

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Topics:  Global crisis Institutions and economics Macroeconomic policy

Tags:  risk, fiscal policy, spreads

Jeffrey Frankel

Professor of Economics, Harvard Kennedy School

Fred H. Sanderson Professor of International Economics at SAIS, Johns Hopkins University

Fellow in the Global Economy and Development Program and the Global-CERES Economic and Social Policy in Latin America Initiative, Brookings Institution