Aspects of prudent fiscal management in small states

The IMF has come up with a  staff report that outlines macroeconomic policies for small developing economies, particularly in light of the lower oil prices and exchange rate volatility.

Here are some of the takeaways on fiscal management.

Expenditure

• Diseconomies of scale in providing public goods and services means recurrent spending are typically large (plus indivisibility of public goods)
  • Recurrent spending is rigid
• Growth-promoting capital spending is important
  • Sequencing the implementation of capital projects is also important
  • Impact of capital spending on growth is stronger
• Helpful to use fiscal anchors to smooth volatility of revenue and capital expenditure over the business cycle
  • Strengthen medium-term orientation of fiscal policy as opposed to year-by-year basis only
  • Fiscal anchors should be country-specific and kept simple
• Increasing public debt after a certain threshold do not support growth
  • 30% of GDP for small states in the Asia and Pacific (?)
  • Preserving fiscal space for growth-enhancing investment, including infrastructure spending, is important
• Government expansion led by capital spending results in higher real GDP per capita and lower public-debt-to-GDP ratios (about 2%) than do expansions by recurrent spending (about 10%)
  • However, quality investment in terms of project selection and implementation, returns on investment, and sources of financing determine the impact of public spending on growth
• Impact of public investment on real GDP growth in small states is lower than in larger states
  • Lower fiscal multipliers because capital inputs are mainly imported
  • Weaker PFM frameworks prevent efficient public investment
• Higher population dispersion is associated with lower efficiency in education and health expenditures

Revenue

• Government revenue is volatile due to the exposure to exogenous shocks and narrow production bases
  • Hard to finance temporary fiscal shocks because domestic banking systems are shallow and they have limited access to international capital markets
  • Revenue volatility expected to continue due to the recent large drop in oil prices
  • Sources of volatility depend on cyclical as well as non-cyclical factors
• Natural disasters in small states also cause revenue volatility
  • A natural disaster that affects 1% of the population is associated with a drop in real revenue of 0.2 percentage point.
• Strengthening revenue administration is key
  • A proper mix of income and consumption taxations is desirable

Fiscal resilience

• Pro-cyclical fiscal bias is not desirable (revenue rises, then expenditure rises)
  • Building fiscal buffers for countercyclical support and creating policy space for spending on infrastructure may enhance resilience
• Fiscal anchors to insulate the budget from revenue volatility is key as it minimizes revenue volatility and ensures debt sustainability
  • Country-specific fiscal anchors is desirable to better reflect both short-term cyclical and medium-term sustainability goals
  • Saving windfall revenue to avoid fiscal pro-cyclicality
  • Need to go hand in hand with medium-term orientation of fiscal policy and design of quality public investment projects
• Improving the spending mix toward investment in human and physical capital is helpful.
  • Requires spending reform and medium-term expenditure frameworks
  • Reallocate resources toward priority spending, especially infrastructure investment, education and health sectors
  • Effectively identify, prioritize, and implement public investment projects