Fiscal Strategy, Medium Term Fiscal Frameworks (MTFF) and Fiscal Risks

(L3 – Supplementary slides)

David Webber

METAC Budgeting Workshop

Dead Sea, Jordan, October 12-15, 2015

Supplementary Slides

These slides provide some more technical detail, and references on some of the topics covered by the main presentation.

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Historical Origins of MTEFs: forged in fiscal adversity…

General government balance(1990 to 2008)

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

% o

f G

DP

Canada Finland

France Netherlands

Sweden United Kingdom

Sweden introduces Expenditure Ceilings

UK introduces Spending Reviews

Canada introduces Expenditure Management System

Netherlands introduces Expenditure Ceilings

Finland introduces Expenditure Ceilings

France introduces Multi-year Budget

…but were introduced to maintain discipline AFTER the public finances had turned the corner.

Description of the Main Fiscal Indicators (1)

Overall fiscal balance:

• Total revenue – total expenditure• It is the most common fiscal indicator• It is linked to the government’s net financing requirements and the external

current account

Primary balance:

• Total revenue – total non-interest expenditure• It is an indicator of the ongoing fiscal effort, as interest payments are pre-

determined by previous levels of debt i.e., past policies.• It is a critical indicator for debt sustainability• The debt-stabilizing primary balance is the PB necessary to keep the ratio

of debt to GDP stable.

Main Fiscal Indicators (2)

Adjusted fiscal balance:

Excludes items such as grants, oil revenues, certain lumpy expenditure items that are outside the government’s control.

Grants: they do not add to debt, and (project grants) may finance expenditure that would otherwise not take place. But are volatile and uncertain—when they are significant, it is good to focus on the balance excluding them to try to decrease the dependence on them.

Non-oil balance: like grants, oil revenue is highly volatile and unpredictable. In addition, it is non-renewable, and consuming it, reduces government wealth.

Privatization receipts

Externally-financed project spending, also outside the government’s controlled and is automatically financed (but it does increase debt).

Main Fiscal Indicators (3)

Current balance:

• Current revenue – current expenditure

• Shows the extent of government savings

• Safeguards investment

• But: does not deal with debt sustainability concerns, especially if projects are not high quality and return to projects are not high

• Can be an incentive for creative accounting (putting current spending in capital).

Main Fiscal Indicators (4)

Cyclically-adjusted balance:

• Measures the fiscal position net of the output effects on the budget by removing the cyclical component.

• Complex techniques, and not often applied

Augmented balance:

• Overall balance plus exceptional one-off spending such as restructuring costs

• More relevant recently to capture government interventions in the financial sector

• Have a significant impact on debt accumulation.

Gross financing needs and sources:

• All resources and all uses: Revenue + loans + privatization receipts – (expenditure + amortization)

• Provides a picture of needed financing, taking into account, for example, )roll-over( of debt.

Main Fiscal Indicators (5)

Stock indicators:

Debt-to-GDP ratio: one of the most common medium-term fiscal anchors.

Based on debt sustainability analysis (DSA), debt dynamics.

In practice, when real interest rate exceeds the real growth rate, the debt is explosive: need to have a primary balance to stabilize debt/GDP.

Also have to consider the initial debt stock: is it comfortable?

There are no “safe levels” of debt. Depends on country circumstances. In the Middle East, in non-oil producing countries, the debt level is generally much higher than in other emerging countries, and yet, there have been no major debt crisis and defaults.

So debt composition is also important: (concessional/non concessional; official/private; maturity; currency denomination; inflation and exchange rate indexation) all these influence solvency.

Main Fiscal Indicators (5)

The government balance sheet at a certain point in time (also measures changes in the flow – “Net Worth”)

• Liabilities: typically = debt

• Net financial worth: liabilities – financial assets. Caution: only liquid assets can be used to meet liabilities.

• Overall Net worth: Includes financial and non-financial assets: very demanding to measure as it requires valuation (and periodic re-valuation) processes

Important note: The government balance sheet can miss critical variables such as contingent liabilities (loan guarantees, PPP obligations)

FRLs from around the world

Country Main Objectives Secondary Aims Success?

1 Australia, 1998 Fiscal

Transparency

Fiscal Stability: lower deficits

or run surpluses;

reduce debt

Yes2 New Zealand, 1994 Yes3 United Kingdom, 1998 Yes

4 Hungary, 2008 Fiscal stability and fiscal transparency

??5 Brazil, 2000 Yes6 Argentina, 1999, 2001,

2004Fiscal stability

(targets for spending,

deficits and/or debt)

Transparency

No

7 Colombia, 1997, 2001, 2003

No

8 Ecuador , 2002, 2005 No9 Panama, 2002 Focus on

targets.No

10 India, Pakistan, Sri Lanka, 2003, 05

Transparency Mixed

Revenue Forecasting Methods: Effective Tax Rate (ETR) Method (1)

Effective tax rate method. This is a relatively simple but robust method for countries where data limitations may rule out more sophisticated methods. The effective tax rate (ETR) is defined as the revenue from a tax (R) divided by the economic base of the tax (B):

Rt = ETRt-1 * Bt

• Where: ETRt-1 = Rt-1/Bt-1

• If the ETR is held constant (that is, if unit elasticity is assumed), it can be used to forecast revenues.

Revenue Forecasting Methods: Effective Tax Rate (ETR) Method (2)

Choice of tax base (B).

i) Income taxes. Wages are the natural choice for the personal income tax, and corporate profits for the corporate income tax. Interest and other forms of income should also be used for the relevant tax categories.

ii) Consumption taxes. For ad valorem taxes, consumer spending is used. Imports can also be used since the initial collection of a large proportion of these taxes in most developing and some emerging economies takes place at customs. For unit based excises, unit of consumption is used.

• Import and export duties. Import and export values are the natural choice.

Revenue Forecasting Methods: Effective Tax Rate (ETR) Method (3)

GDP as a proxy base. While some methods use GDP as a proxy base for many taxes—as data on the relevant tax bases may not be available, the relationship between the real tax bases and GDP is rarely constant. During a business cycle, tax bases may not follow the same path as GDP.

Assumption of constant ETR. A constant ETR assumes no change in the (i) structure of the tax base; (ii) tax system; and (iii) compliance ratio. When preparing forecasts, one should be mindful of any changes in these variables, especially during sharp downturns and crises. The ETR cannot be assumed to remain constant as (i) the structure of the economy may be changing dramatically; (ii) loss-making firms can carry losses forward (or backward), and some firms (both profitable and loss-making) may be unable to offset previous period VAT credits against slumping current VAT sales (leading to an increase in refund claims); and (iii) noncompliance may increase substantially.

Revenue Forecasting Methods:Revenue Elasticity

• Revenue elasticity measures the responsiveness of revenue to the change in its base in the absence of measures.

• Revenue buoyancy includes revenue from new measures.

• Distinction between revenue elasticity and revenue buoyancy is closely related to the distinction between revenue forecasting and revenue estimation.

Revenue Forecasting Methods: Revenue Elasticity (1)

• At an aggregate level, the revenue elasticity is:

R = Rt-1 * (1+ε*ΔB)

• Calculate elasticity/buoyancy from historical data

• Trend extrapolation

Revenue Forecasting Methods: Revenue Elasticity (2)

• Elasticity =1: the tax’s rate structure is proportional rather than progressive, there are no significant lags in collection, and when it is levied on an ad valorem rather than a specific basis. E.g., VATs with non-progressive rate structures, and ad valorem excise taxes levied on goods other than luxury items.

• Elasticity > 1: can arise because of a progressive rate structure, especially with the personal income tax, and to lesser extent with the VAT and the enterprise profits tax. If they are steeply progressive and non-indexed, individual income taxes can exhibit revenue elasticities with respect to nominal personal income (or nominal GDP) of 1.5 or higher.

• Elasticity < 1: in the presence of high inflation, because of lags between the time the tax liability is generated and the time at which it is paid, or if they are set on a specific basis instead of an ad valorem basis.

Individual Taxes and Revenue Items

• The major taxes bases:– the personal income tax wages– the corporate income tax profits– consumption tax (VAT, excise duties) consumption– import duties imports

• The corresponding tax bases can be taken from macroeconomic accounts and models.

• If data is not available, use the GDP as a proxy (see above) - non-oil GDP for oil producing countries

Individual Taxes and Revenue Items (continued)

Resource revenue (oil, gas, etc.)

– Production, world prices

– Agreements with oil companies (royalties, profit transfers, etc.)

– Higher degree of uncertainty than other revenues contingencies.

Individual Taxes and Revenue Items (continued)

Small taxes:– Some taxes do not have a base which is related to

variables included in a macroeconomic model.

– This is especially true of wealth-based taxes (capital gains, property, and asset transfer taxes).

– The elasticity method can be used, based on GDP.

– Specific models may be appropriate, where revenue is related to relevant variables such as interest rates, inflation, a stock market index, property prices.

Individual Taxes and Revenue Items (continued)

• Nontax revenue Nontax revenue is heterogeneous, and does not lend itself to a

uniform approach to forecasting. The usual way is to extrapolate trends.

Sometimes there can be firmer basis on which specific items can be forecast (e.g., royalties, user charges, profits, dividends)

• Grants depend upon the commitment of other governments and multilateral agencies to provide assistance.

• Central bank profit transfers often depend not upon central bank profitability but on agreement between the central bank and the government.

Remarks on for revenue forecasting (1)

• Use the correct “proxy” tax base where data are available (wages, private consumption, imports, etc), mindful of the large structural changes in the economy. Ensure that these variables are not artificially inflated to support high revenue projections.

• Use disaggregated revenue data (by sector, by source), particularly if revenue from some sectors/sources (financial and others) are large and subject to different developments compared to other revenue.

• Monitor carefully the outstanding stock and net increase in tax refunds for both the VAT and corporate income taxes, as well as tax credits claimed as a share of gross tax collections.

Checklist for revenue forecasting (2)

• Be aware of exceptional factors and correct for them by excluding them from the base year: For example:

Tax arrears accumulation

Clearance of arrears in a particular year

One off sale of cell phone licenses

• Be aware that non-tax revenue, such as dividends from public enterprises and central bank profit transfers, are subject to larger than usual volatility during downturns.

Expenditure Forecasts (Components)

Wage Bill: Assumption on wage increases; Numbers of civil servants outflows and inflows; What does the civil service regulations assume? Historical trends

Goods and Services: flat or growing in real terms

Pensions and other transfers to households Consistent with demographics Pension law (indexation, etc.)

Transfers to enterprises

Expenditure Forecasts (continued)

Interest payments – given by past debt stock and future deficits– Assumptions on interest rate, maturity, etc.

Capital Expenditures: Fixed investment Consistency with national priorities/desire to increase infrastructure The multiyear forecasts will help link capital expenditure and their

forthcoming current costs (e.g., operating and maintenance costs)

Net lending

Contingencies

Deficits and Financing

• Deficit: Revenue – Expenditure

• Deficit = Financing:

• What is the available financing– Net external financing—consistency with balance of payments– Net domestic financing—consistency with monetary policy objectives– Financial markets conditions– Privatization receipts

• What is the desired financing– Debt sustainability issues – Macroeconomic stabilization (e.g., limit on borrowing from central

bank)

Deficits and Financing (continued)

• Determine “fiscal gap” or “fiscal space”= difference between deficit and financing: – On the basis of available resources: revenue + gross financing– On the basis of the level of expenditure – On the basis of the desired deficit (in line with fiscal strategy)

• If financing > desired deficit there is fiscal space to conduct additional priority spending

• If financing < desired deficit Policy measures to close the gap

Exploring Forecasting Scenarios

Compare against baseline scenario: changes in the (1) macroeconomic environment or (2) in policies

Changes in macroeconomic variables:

Optimistic scenario: Higher growth rates Lower inflation Lower interest rates Higher external grants

Pessimistic Scenario Lower growth rates Higher inflation, interest rates, exchange rate Calls on government guarantees

Exploring Forecasting Scenarios (contd.)

Changes in policies:Reforms:

Tax policy (increase tax base; tax rates; simplify tax system; improve tax administration)

Expenditure policy (pension reform; civil service reform; public enterprise reforms; pricing policies)

Expansionary fiscal policy: Assumes less revenue (tax breaks, reduction in rates, etc.) General wage and pension increases Less control over subsidies to enterprises and households

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Location and Size of Contingency Margins in 6 Countries

Implicit Margins Explicit MarginsTotal

Contingency

GDP forecastother economic

assumptionswithin expenditure

estimatewithin budget

balance% of total spending

Canada MoF uses ave of ind. forecast

MoF adds 0.5 to 1% to interest rates and runs

through model

Contingency reserve of 1.5 to 2% of total

spending

MoF targets a surplus of 0.1% of GDP despite

balance rule3.5 to 4%

United Kingdom

MoF uses GDP forecast 0.25%

below trend

7 other economic assumptions explicitly

‘cautious’

Reserves and margins equal to 0.75 to 1% of

total spending

MoF targets ave. surplus of 0.2% of GDP despite

Golden Rule2.5 to 3%

SwedenMoF claims to use central assumptions for

GDP and its determinants but recent forecasts have proven cautious

Budget margin within expenditure ceiling

rising from 1.5 to 2.5% of total spending

MoF’s MT objective was ave. surplus of 2% of

GDP over cycle (1% post 2007)

1.5 to 2.4%

NetherlandsDeficit target & expenditure ceiling in CA &

Budget based on cautious economic scenario in which GDP 0.5 to 1% below outturn

Central contingency reserve of 0.1% of total

spending

Most recent CA targets structural surplus of 1%

of GDP1 to 2%

Australia Budget is based on central economic assumptions

Contingency reserve rising from 1.6 to 5.2%

of total spending

MoF targets a surplus of 1% of GDP despite

objective of balance1.5 to 5%

New Zealand

Budget is base on central economic assumptions

Central contingency reserve of 0.25% of

expenditure

No stable fiscal objective but targeted surplus

since mid 90s0.25%

Potential impact of fiscal risks

• Pressure to reduce deficits can result in governments assuming off-budget risks, including through guarantees.

• Can result in very big, immediate, unexpected increases in debt/GDP: banking crises; exchange rate crises (especially when large share of debt is denominated in foreign currency); assumptions of debts.

• Identification, disclosure and management of fiscal risks are mutually supporting activities.

Potential impact of fiscal risks (2)

• The recent global financial crisis increased risks and highlighted the need to monitor and disclose them:

Financial sector interventions (e.g. guarantees, asset swaps)

More than usual uncertainty about recovery, further financial sector support, asset recovery

Pressure to reduce deficits can result in more off-budget activity

How to incorporate fiscal risk in the MTFF and the budget process (1)

1. Organized by type of risk:

– Past realization (e.g. systematic optimism in revenues, frequent SOE bailouts)

– Policies to reduce risks– Forward risk estimates

2. By type of analysis

• Sensitivity analysis, alternative scenarios (e.g., minimum wage in Brazil)

• Alternative macroeconomic scenarios (e.g., New Zealand)• Stress tests • Debt Sustainability Analysis• Descriptive analysis

How to incorporate fiscal risk in the MTFF and the budget process (2)

• When preparing the budget, authorities should take into account risks stemming from public interventions, and possibly provide allowances for the possibility that some risks and contingent liabilities will materialize.

• MTFFs and Debt sustainability analyses should include scenarios with different assumptions with regard to:

- the materialization of contingent liabilities;- recovery rates of purchased assets;- resources generated from equity stakes.

• Stress tests of the balance sheet of the government to different shocks should be conducted.

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What countries disclose

Loan GuaranteesGuarantee and Insurance Programs

Infrastructure Guarantees

Pension Guarantees

Lawsuits

Environmental Liabilities

Callable Capital (International Org.)

Quasi-fiscal deficit Central Bank

Implicit Liabilities

Unquantifiable Liabilities

Australia, Canada, Chile, Colombia, New Zealand, South Africa, US

Chile, Colombia

Chile, South Africa, US

Australia, Brazil, Canada, Chile, Colombia, New Zealand, US

Canada, New Zealand, US

Australia, Chile

Australia, Canada, New Zealand

Australia, Canada, New Zealand

Chile, Pakistan, US

Maximum authorized, face value, expected loss (annual & NPV), unexpected loss (annual & NPV; 95% & 99% probability), details of guarantee and guaranteed loan (maturity, currency, interest)

Face value

SELECTED COUNTRIES QUANTIFIABLE INFO DISCLOSED

Maximum loss, expected loss (annual & NPV), unexpected loss (annual & NPV; 5, 50, 95, 99% probability), evolution of NPV expected costs

Face value, expected payments (annual & NPV), calls on past guarantees

Face value (amounts claimed), expected losses (annual, NPV), range of expected losses, unexpected losses (99%), past success rates

Expected costs

Quasi-fiscal deficit and capital position of CB; guaranteed CB liabilities

Description of liability

Fiscal cost of past banking crisis, past costs of stabilizing fuel prices

Contingent Liabilities

References on Contingency Liabilities

• Cebotari, A., “Contingent liabilities – Issues and Practice”, IMF WP/08/245

• Cebotari, A. and others, Fiscal Risks: Sources, Disclosure and Management, IMF, 2009

• Daban, T. and J.-L. Helis, “A Public Financial Management Framework for Resource-Producing Countries”, IMF WP/10/72

• Daniel, J. and others, Fiscal Adjustment for Stability and Growth, IMF, Pamphlet Series No. 55, 2006

• Fiscal Monitor

• IMF Staff Position Note 09/18 “Disclosing Fiscal Risks in the Post-Crisis World”