Tuesday, July 11
Carlos Mulas-Granados, Senior Economist, Fiscal Affairs Department, International Monetary Fund
The IMF Takes on Political Economics
Fiscal Politics edited by Vitor Gaspar, Sanjeev Gupta, and Carlos Mulas-Granados, published by the IMF in March, discusses how politics, through elections, political fragmentation, or ideological biases, can distort optimal fiscal policy, and how fiscal rules and institutions can mitigate the resulting negative effects. The book is the first from the IMF to deal with political economy; it draws on four decades of data from 90 countries to illustrate its empirical findings.
Mr. Mulas-Granados of the IMF Fiscal Affairs Department started his presentation on Fiscal Politics by pointing out that economics and politics are co-determined, especially where fiscal policy is concerned. State-building and tax capacity are fundamentally political. Tax capacity is essential for financing the three core functions of government: allocation, stabilization, and redistribution. Because these functions are intrinsically political, it is necessary to study the impact of politics on fiscal outcomes. Mr. Mulas-Granados concentrated primarily on how elections, political divisions, and ideology affect fiscal outcomes, though he also touched briefly on the role of fiscal rules, institutions, and supranational fiscal politics.
The core of the book is a discussion of how fiscal outcomes are related to elections, political divisions, and ideology. First, based on a variety of indicators, elections appear to have a significant impact on fiscal outcomes. For instance, in election years deficits tend to be higher by up to 1% of GDP. Fiscal non-compliance with targets also increases in election years, whether the elections are national or regional. In terms of expenditure composition, the growth rate of public consumption tends to go up in the 12 months preceding elections, while investment growth slows down, as large infrastructure projects tend to reach completion by the time elections take place. On the consumption side, raising pensions and salaries of public employees just before elections tends to boost spending. Pre-election growth in public wages seems to be more pronounced in emerging market economies (EMEs) and low income developing countries (LIDCs). These results suggest that institutions and governance may dampen the impact of electoral cycles.
Second, it appears that political divisions and fragmentation also have a large impact on fiscal outcomes. The gap between the size of the promised fiscal consolidation and the actual outcome decreases as political strength increases. Noncompliance with set fiscal targets is seven times worse under politically weak than under politically strong governments. Thus, having a weak majority government is correlated with higher non-compliance, higher deficits and debt. The findings of the book also suggest that cabinets with many ministers tend to accumulate much more public debt relative to GDP than small cabinets. Responding to a question about this finding, Mr. Mulas-Granados noted that this certainly does not imply that the optimal solution is to have one minister or a benevolent ruler; instead, it suggests that from a fiscal point of view what is important is that the fiscal system generates enough capacity to finance the spending levels that each society chooses democratically.
Third, the authors of Fiscal Politics found no evidence that political ideology has much impact on aggregate fiscal outcomes. While there is no evidence that left-wing parties are more or less fiscally responsible than right-wing ones, ideology does matter for the composition of taxes and spending. Right-wing governments are more likely to increase VAT rates during banking crises; left-wing governments prefer to raise the top personal income taxes, according to evidence from OECD countries. Also, left-wing governments are associated with larger public investment booms.
Moving on through the book, Mr. Mulas-Granados emphasized an important message: fiscal rules can help to soften political biases. Spending rules appear to tame both the size of government spending and its volatility. However, what triggers introduction of these expenditure rules is also important: they seem to be more beneficial when governments commit themselves to more prudent policies. Fiscal councils can also help to improve a country’s fiscal performance.
Finally, the last chapter of Fiscal Politics concludes that supranational institutions have a positive impact if country authorities own their policies. In euro area countries, on average noncompliance with set objectives has been high at about 80%—lack of ownership explains why. IMF programs, on the other hand, have shown a higher degree of compliance. The data suggest that countries with program conditionality in the revenue area were more successful in increasing public revenues.
Mr. Mulas-Granados summed up by restating the decisive influence that politics has on the formulation and conduct of fiscal policy. Empirical evidence suggests that elections and political divisions have a particularly significant impact on fiscal outcomes; political ideology seems to have less effect on final outcomes but matters for the composition of revenues and spending. Budget institutions can be helpful in softening the effect of politics on fiscal policy. External constraints posed by supranational organizations can be useful, but only if country authorities own the policies. Further information on this book is available here.
Maria Arakelyan, Senior Research Officer, JVI