China's Tax System
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Fiscal RulesEduardo Ley
In the past decade, several countriesoften reacting against the de-terioration of their public financeshave adopted rules constrain-ing the extent of discretionary fiscal policy to correct for the deficitbias. This article summarizes recent IMF research on the potentialbenefits of rules-based fiscal policy frameworks to enhance policycredibility and fiscal sustainability.
George Kopits and Steven Symansky (1998) define a fiscal policy rule as a per-manent constraint on fiscal policy, expressed as a summary indicator of fiscalperformance, such as the government budget deficit, borrowing, debt, or a majorcomponent thereof. They argue that the strongest case for fiscal rules is based onpolitical economy arguments that the rules correct the bias of short-sighted gov-ernments to accumulate public debt at the expense of future generations andthat avoiding time-inconsistency issues results in significant credibility gains.These benefits must be weighed against the loss of discretion. Kopits andSymansky also identify a list of characteristics for ideal fiscal rulesthe nowclassic Kopits-Symansky (K-S) criteriawhich dictates that an ideal fiscal ruleshould be well-defined, transparent, simple, flexible, adequate relative to the finalgoal, enforceable, consistent, and supported by sound policies, including struc-tural reforms if needed.
B U L L E T I N
VOLUME 5, NUMBER 3 SEPTEMBER 2004
In This Issue
Fiscal Rules 1
Financial Development in Low-Income Countries:Old Questions or New Problems? 1
Policy Discussion Papers 3
Visiting Scholars 4
IMF Staff Papers,Vol. 51, No. 3 5
Country Study: China 7
Working Papers 9
External Publications by IMF Staff, 2004 13
IMF Conference Honors Michael Mussa 16
Financial Development in Low-IncomeCountries: Old Questions orNew Problems?Thierry Tressel
Over the last few decades, many low-income countries (LICs) haveliberalized their highly repressed financial systems. Financialreforms have led to the elimination of interest rate controls and di-rected credits, and to the introduction of indirect instruments ofmonetary policy. However, limited access to financial services re-mains a pervasive phenomenon in low-income countries. This
paper selectively surveys recent IMF research on the development of financialsystems in low-income countries, including LICs experience with financial liberal-ization, the determinants of financial reform, the relationship between financialdeepening and growth, and the factors explaining the lack of access to formalfinance.
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This issue marks the departureof IMF Research Bulletins edi-tor Paolo Mauro, who wishesto thank all contributors to theBulletin over the past couple ofyears. Special thanks go to as-sistant editor, Archana Kumar;systems consultant, KellettHannah; and compositor,Choon Lee. Taking the batonfrom Paolo, I look forward tomaintaining continuity andbuilding on my predecessorsoutstanding work on theBulletin. At the same time, Iwelcome all suggestions fromthe readers.
Kell (2001) evaluates the two fiscal rules introduced in theUnited Kingdom in 1997a golden rule and a debt ruleagainst the K-S criteria. Although Kell concludes that U.K.fiscal rules broadly measure up strongly against the K-S idealcharacteristics, he also identifies room for improvementbysimply clarifying the benchmarks and objectivesin the pol-icy framework. Moreover, Kell argues that the discrepancybetween the two rules and medium-term fiscal plans couldundermine the credibility of the fiscal policy framework.
Drawing on international experience, Kopits (2001) re-examines the merits for and against fiscal rules. He identifiesthree broad lessons. First, governments with a strong reputa-tion for fiscal prudence do not need to be constrained byrules. Second, in countries that lack such a reputation, fiscalrules can indeed provide a useful policy framework that isconducive to stability and growth. Third, to enhance theirusefulness, fiscal rules need to meet the K-S criteria at theboth national and subnational levels.
Dabn and others (2003) study the design of rules-basedfiscal frameworks in the four largest economies in the euroareaFrance, Germany, Italy, and Spain. They argue that, toavoid procyclicality, the four countries would benefit fromincorporating spending rules on deficit and debt targets.Their paper advocates binding spending rules consistentwith medium-term debt targets while allowing cyclical rev-enue fluctuations to affect the budget balance. Dabn andothers review implementation issues and suggest that fiscalrules be embedded in medium-term macroeconomic frame-works, applied to the general government, and use compre-hensive expenditure targets. On real versus nominal rules,their paper points out that nominal rules may be preferablein countries where cyclical stabilization is a priority, whilereal rules may be more appropriate when there are automaticindexation clauses for significant expenditures (e.g., entitle-ments).
Tanner (forthcoming) uses numerical simulations to com-pare three fiscal regimes: a pure tax-smoothing regime, abalanced-budget rule regime, and a regime in which the gov-ernment runs primary deficits and accumulates debt in thepresent. On introducing two sources of uncertaintyoutputuncertainty and random sudden stops to foreign capitalflowsTanner finds that the tax-smoothing regime is prefer-able to the balanced-budget rule because tax rates have aboutthe same average but are less variable. Also, although over aninfinite horizon the economy clearly gains by moving from adeficit regime to a balanced-budget rule, over shorter hori-zons the issue is not as clear-cut. Under the deficit regime,policymakers can give current constituents their tax-break,but only at the expense of higher tax rate variability: in the
event of a credit cutoff, the country must undertake a sharpfiscal adjustment. The simulations conducted by Tanner sug-gest that the cross-regime trade-offs between higher averagetax rates and less dramatic fiscal adjustments may be sub-stantial. He finds that, even in the short run, taxpayers mightaccept higher taxes in return for a steadier fiscal policy. Basci,Fatih, and Yulek (2004) also use numerical simulations tocompare the performance of a variable-surplus rule with asimple fixed-surplus rule. They find that the variable-surplusruledefined as an increasing function of the debt ratioperforms better than the simple fixed-surplus rule, by reduc-ing debt sustainability concerns and the necessary medium-term primary surplus (Ley, 2004).
When is compliance with a fiscal rule just an illusion? Toaddress the issue of whether fiscal rules lead to genuine fiscaladjustments or simply encourage the use of creative ac-counting, Milesi-Ferretti (2003) develops a model in whichfiscal rules are imposed on measured fiscal variables, whichcan differ from true variables. In addition to the standardtrade-off between deficit bias and margin for cyclical stabi-lization, he emphasizes a second trade-off between costlywindow dressing and real fiscal adjustment, relating it to thedegree of transparency of the budget. In other words, rulesthat are imposed when the budget is not transparent yieldmore creative accounting and less fiscal adjustment. Milesi-Ferretti and Moriyama (2004) examine the degree to whichreduction in government debt in EU countries has beenmore cosmeticthat is, accompanied by a decumulation ofgovernment assetsthan structural. They find a strong cor-relation between changes in government liabilities and gov-ernment assets in the run-up to the Maastricht Treaty.
However, fiscal rules may impose severe constraints ongovernments willing to undertake structural reforms with as-sociated up-front costs. Beetsma and Debrun (2004) analyzethe trade-off between short-term stabilization and long-termgrowth, andin the context of the euro areas Stability andGrowth Pactthey find that sometimes fiscal rules mayneed to be relaxed for countries that are actively pursuingmuch-needed structural reforms.
The essays in Kopits (2004) explore various aspects ofrules-based fiscal policy in emerging markets. In the fore-word to the edited collection, IMF Deputy ManagingDirector Agustn Carstens warns that a major unifyingtheme is the sober and balanced assessment which helpscounter the unrealistic view (popular in some quarters) thatpolicy rules automatically insure fiscal sustainability andmacroeconomic stability. The first part of the book reviewsthe macroeconomic setting and rationale for rules-basedpolicies in emerging markets, taking into account relevantpolitical economy aspects. Drazen (2004) examines how
IMF Research Bulletin
Fiscal Rules (continued from page 1)
properly designed fiscal rules can be a useful means for building reputation andcan serve as a disciplining device, as long as they are accompanied by variousprocedural rulesincluding those that prevent creative accounting practices.Hausmann (2004) observes that emerging market economies would benefitfrom fiscal rules that aim not only at eliminating deficits and reducing debtratios but also, more importantly, at containing the risk in the composition ofthe debt. Perry (2004) argues that Latin American economiessubject to highmacroeconomic volatility, which is often aggravated by the procyclical stanceadopted under various fiscal adjustment programsought to follow a rule thatincorporates a countercyclical stance through a structural balance target or astabilization fund. The openness of emerging market countries to high capitalmobility, according to Kopits (2004), underscores the case for predictable time-consistent macroeconomic policies and