Budgeting for Fiscal Space
Allen Schick
Annual Meeting ~ Senior Budget Officials
Organization for Economic Co-operation and Development
Vienna, 2-3 June 2008
The Contemporary Interest in Fiscal Space
• The prospect of a constrained fiscal environment has spurred
interest in fiscal space
– Governments are not concerned about fiscal space when resources
suffice to finance existing programs and policy initiatives
• OECD governments have vastly more to spend than in the past, but
their budget options have narrowed
– The increments available for policy initiatives tend to be small
• Demographic trends will intensify budget stress in many OECD
countries
– The impact of these trends will depend on the age structure of the
population and the means of financing pensions and health care
• The possibility that budgeting will become a decremental process
that allocates losses rather than gains
– Budgeting would be more contentious and politicians would have
difficulty financing new policies
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How the Fiscal Space Concept is Applied
All Countries
To measure the money available for policy innovation consistent with
medium to long term fiscal sustainability
Low Income Countries
To assess the opportunity for additional spending to promote
development, thereby stimulating economic growth and increases in
government revenue
Middle Income/Developmental Countries
To promote rapid development without undue risk to the
government’s future fiscal position
Highly Developed Countries
To assess the resources available for allocation through annual or
medium-term budget decisions
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Budgeting for Fiscal Space is Incremental
• Fiscal Space recognizes that budgeting is inherently incremental
– Past efforts to uproot incrementalism (such as PPBS and ZBB) failed
• Incremental budgeting focuses on allocating additional resources
and on marginal adjustments in ongoing programs
– Over time, incremental decisions can aggregate to major changes in
budget policy
• Baseline projections are the starting point in budgeting for fiscal
space
– The baseline projects future budgets assuming no change in current
policy
• The Medium-Term Expenditure Framework (MTEF) institutionalizes
incremental budgeting
– This may be why MTEF, in contrast to previous reforms, has survived
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The Four Determinants of Fiscal Space
• The composition and trend of public expenditure
 How large is public spending relative to GDP and how sticky is it?
• The propensity to tax
 What is the share of GDP extracted in taxes and can this share
increase?
• The propensity to borrow
 Can government finance spending ambitions by borrowing more?
• The performance of the economy
 Will economic growth provide sufficient increments?
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The Shrinkage of Fiscal Space: Public Expenditures
• After decades of steep increases, public spending as a share of
GDP has stabilized in most OECD countries
 In view of its relative size, public expenditure is not likely to rise much in
the decades ahead
• Public expenditures are sticky
 They do not readily adjust to changes in political/economic conditions or
to changes in national priorities
• Expenditures are sticky even for programs that are not effective
 In fact, governments often spend more for programs that are not
performing well
• National governments have become holders of costly risks
 Government must give priority to these risks (ageing, illness,
unemployment, natural disasters)
• Entitlements that establish a legal right to payment from
government will claim a rising share of most national budgets
 Demographic trends will compel national governments to allocate
incremental resources to entitlements
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The Shrinkage of Fiscal Space: Revenues
• The era of large tax increases has ended in most OECD countries
 It appears that many OECD countries are competing to reduce tax rates on
individual and corporate income
• Governments with large tax expenditures will try to curtail these
preferences
 In some countries, reducing tax expenditures will facilitate reductions in tax
rates: in others, doing so will provide modest increments for expenditure
• Fiscal decentralization has led some countries to assign a
substantial share of their revenue to sub-national governments
 The impetus for decentralization has slowed, but has not been reversed
• Pressure will likely increase in decades ahead for taxes to finance
international activities
 These demands will influence the capacity of national governments to
generate additional review for their own purposes
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The Shrinkage of Fiscal Space: Deficit Financing
• During the postwar growth spurt, many governments borrowed to
finance current expenditure
– Deficit financing occurred despite sharply rising revenue due to
economic growth and tax increases
• Deficit financing was accommodated by a shift from balanced
budget norms to demand management
– It was deemed more important to balance the economy than the
budget
• The advent of fixed fiscal targets and rules limits the capacity of
most OECD governments to borrow
– Fiscal rules such as the Stability and Growth Pact limit the deficits and
debt of many OECD countries
• Even when they are not fully effective, fiscal rules inhibit public
borrowing
– Net borrowing by OECD countries has declined during the past decade
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The Shrinkage of Fiscal Space: Economic Performance
• Economic growth is a necessary condition for incremental
budgeting
– Growth not only gave governments more money to spend, but it
induced them to boost the portion of the economy allocated to public
consumption, investment and transfers
• In most OECD countries the potential for growth will be less robust
in the future than in the past
– Potential output is a function of the size of the work force, which will
likely grow more slowly in the future, and of productivity, which is
difficult to predict
• Built in stabilizers protect fiscal space when the economy is weak
– When the economy recovers, government may be pressured to
stabilize its fiscal position
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Protecting Fiscal Space
• Governments often engage in budget practices that significantly
reduce future space
 Space-robbing behavior occurs in both affluent and poor countries
• Policy changes that have modest short-term costs, but generate
large downstream expenditures
 This practice can be mitigated by having an effective MTEF,
including baseline projections
• Ad-hoc spending decisions made outside the regular budget
framework curtail fiscal space
 In some countries, decisions made between budgets have become
as important as decisions made in the budget
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Protecting Fiscal Space,
continued
• Spending units do not often propose significant reallocations
 Governments can stimulate reallocation by increasing baseline
expenditures by less than the rate of inflation or by reducing them for
expected productivity gains, or by making across-the-board cuts and
setting aside the savings in a bidding fund for policy initiatives
• When fiscal space is tight, investment expenditure may be curtailed
 One remedy is to finance investments through public-private
partnerships, provided downstream costs and risks are prudently
assessed
• Fiscal space is narrowed when risks become due
 Space can be protected by shifting risks to households or enterprises
by imposing risk-sensitive premiums, increasing copayments and
deductibles, and by shifting to defined contribution pensions
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Adjusting the Budget Process
• The primary role of the modernized central budget
office should be to guard and allocate fiscal space
– Performing this role requires that it manage baseline
projections, assure that proposed and adopted program
savings and initiatives are accurately costed, and shift from
an annual to a multiyear horizon
• To the extent politically feasible, the budget office
should uphold the disciplined framework for compiling
the budget
– The capacity of the budget office to perform its
responsibilities is greatly diminished by ad-hoc decisions
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Adjusting the Budget Process,
continued
• Governments that incorporate future price changes in baseline
projections should reconsider this practice
 Protecting existing programs against future price changes greatly
diminishes fiscal space and distorts perceptions of budget actions
• The Medium-term (3-5 years ahead) may be an insufficient
frame for protecting fiscal space
 Budget offices that have well-running MTEFs should introduce
longer-term perspectives into budgeting
• An improperly operated MTEF can significantly reduce fiscal
space by legitimizing larger claims on future budgets
 The MTEF should be fully integrated into annual budgeting and
should have a firm constraint
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THE BUDGET OFFICE SHOULD
REGARD FISCAL SPACE
AS ITS SPACE.
OFTEN IT IS THE ONLY PORTION OF
THE BUDGET OVER WHICH IT HAS
SIGNIFICANT INFLUENCE.
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