Catalog

	Table of Contents
p. 8 of 68 BACK | NEXT I. Developing Asia and the World Overview of Economic Trends and Prospects Overview of Fiscal Policy in Developing Asia II. Economic Trends and Prospects in Developing Asia III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : I. Developing Asia and the World

---

Overview of Fiscal Policy in Developing Asia

The developing member countries (DMCs) of the Asian Development Bank (ADB) have been confronted by global economic slowdown and weak external demand over the past few years. This has prompted many governments to adopt expansionary monetary and fiscal policies to stimulate economic growth and guard against further downturns. This section reviews recent fiscal policy implemented in DMCs. It shows that substantial variation in economic conditions and performance between subregions and countries has necessitated somewhat different policy frameworks. Where rising public debt burdens have become a cause for concern, efforts are now under way toward fiscal consolidation.

Fiscal Indicators and Postcrisis Policies

The 1997 Asian financial crisis and the subsequent global economic slowdown generally influenced East and Southeast Asian economies more than other subregions in Asia. The crisis directly hit a number of economies. Furthermore, the openness of these two subregions and the importance of the United States (US) as an export market made them especially vulnerable to the weakness of the US economy over the past 2 years. A slowdown in demand for information and communications technology (ICT) products also hurt both subregions' exports due to their heavy reliance on these ­products.

The crisis and policy responses to it formed a critical watershed for government fiscal positions in East and Southeast Asia, with fiscal balances in Southeast Asia deteriorating more dramatically. Government revenues contracted sharply in some cases. Simultaneously, greater expenditures were needed to support and rehabilitate the banking sector, meet increasing demands for social safety nets, and continue servicing foreign debt. The latter increased substantially in domestic currency terms following severe domestic currency depreciations. In addition, contingent fiscal liabilities became actual liabilities in some cases (Box 1.5).

In East Asia, some economies saw declining fiscal surpluses, while others began to register deficits. Perhaps the most dramatic turnaround occurred in Hong Kong, China. Its budget was mostly in surplus before 1997, but the financial crisis saw a surplus of 6.5% of GDP in 1997 converted into a deficit of 1.8% of GDP in 1998, and an estimated 5.5% of GDP during fiscal year (FY) 2002, as falling property prices continued to drain government coffers and weak economic conditions exacerbated the revenue shortfall. The fiscal deficit in Taipei,China, after lingering around 1.0% of GDP in the mid-1990s, climbed to 3.0% in 2002. The deficit in the PRC increased from 1.0% of GDP in 1995 to 3.0% in 2002. Korea's budget also dipped into the red from 1997 to 1999 but strong economic growth boosted government revenues and created budget surpluses from 2000 onward.

In Southeast Asia, Indonesia, Malaysia, and Thailand had long been running surpluses before the crisis. In 1994, the Philippines achieved its first fiscal surplus in more than two decades as it adopted more of the conservative fiscal policies pursued by its neighbors. However, all four countries' budgets went into deficit in 1998 and have remained there since. Singapore's moderate deficit in 2001 was the first since 1987 (Appendix Tables A22-A24).

In response to the postcrisis slowdown, governments in East and Southeast Asia also actively implemented expansionary fiscal policies. The PRC and Malaysia have made particular use of fiscal policies as their fixed or de facto fixed exchange rate regimes reduce the scope for monetary policies. Several major stimulus packages covering a wide range of initiatives were implemented to raise government spending and encourage private investment and consumption. Even Singapore, which had traditionally resisted using fiscal policies for short-term demand management, responded to the downturn in 2001 with large fiscal stimulus packages. While these packages injected momentum in these economies, it also accentuated fiscal deficits.

With the exceptions of Malaysia and Taipei,China, growth in current expenditures has generally outpaced capital expenditures. The rise of current expenditures devoted to welfare and social security spending has been particularly noticeable in several economies since 1997 (Figure 1.14). In the PRC, for example, social security and welfare spending soared from a mere 0.2% of total expenditures in 1996 to 6% in 2002 to stimulate domestic demand and support the economic transition. In part, this has been a response to a significant increase in unemployment as a large number of state-owned enterprises have been driven to the brink of bankruptcy by increased competition. Reforms have also gradually transferred welfare responsibilities from workplaces to the Government. Because of emerging urban poverty, expenditures on the minimum living allowance rose 23-fold during 1998-2002 to US$554.2 million.

On the revenue side, to revive economic activity in the private sector, governments in East and Southeast Asia implemented tax reductions and tax incentives. Correspondingly, revenue growth was lower in most economies from 1997 to 2001 by a significant amount as economic activity remained subdued in several of these economies. (Revenue growth in the PRC has accelerated due to improved revenue collection since tax reforms in 1994, despite the recent lowering of corporate income tax.) In Hong Kong, China, total real revenues declined sharply by 11.3% annually on average from 1997 to 2002, compared with 15.3% average annual growth from 1990 to 1996. This post-1997 decline resulted from heavy reliance on property taxes and the slump in the property market, as well as countercyclical fiscal measures. In Thailand, tax breaks were provided for new businesses, home purchases, and stock exchange listings to stimulate domestic demand. Singapore's 2002 budget proposed reducing corporate and personal income tax rates, enhancing tax incentives for the financial sector, and increasing tax reductions for certain service company research and development expenses. Malaysia reduced personal income tax rates, lowered import duties on some intermediate goods, adjusted investment allowances, and introduced tax holidays. These measures, combined with weak economic growth, saw tax revenues as a share of GDP decrease significantly from 1997 to 2000. The share has increased slightly since 2000, but still remains below precrisis levels.

Most South Asian economies were less affected by the financial crisis. They have maintained moderate growth in the late 1990s, so budgetary pressure from slow growth was not a significant factor affecting their fiscal policies. Furthermore, persistent fiscal deficits have been the norm in South Asia because of weak revenue collection and governments' inability (or reluctance) to cut expenditures. This leaves little room for further fiscal expansion. As a result, most South Asian governments have not pursued fiscal expansion over the past few years, and their revenues and expenditures as shares of GDP have remained relatively stable. Deteriorating fiscal positions, however, have prompted several governments to undertake moderate fiscal consolidation recently (see the section Fiscal Consolidation below). The Sri Lankan Government reduced its deficit from 10.9% to 9.0% of GDP between 2001 and 2002, primarily by cutting expenditures. In Bangladesh, the Government improved revenue collection through a renewed emphasis on administrative initiatives and close monitoring and supervision.

Several Asian transition economies face fundamental structural problems affecting their fiscal situations. Mongolia, Cambodia, and the Lao People's Democratic Republic (Lao PDR) have recorded significant government deficits almost every year during the past decade. Economic transition, and particularly the closing of inefficient state-owned enterprises and the loss of very substantial foreign assistance, has presented Mongolia with many fiscal challenges, while political instability and lackluster economic performance underlie fiscal difficulties in Cambodia and the Lao PDR.

Economic transition has been the dominant factor shaping the fiscal conditions in the Central Asian republics (CARs). The initial stage of economic transition is often accompanied by deteriorating fiscal balances. This occurs because privatization and enterprise restructuring necessitate increased spending on unemployment benefits, pensions, and other forms of welfare. Social security and welfare expenditures make up over 30% of total current spending in some economies. (The profile is similar in Mongolia, where social security and welfare spending accounted for 24.6% of total government spending in 2000.) Meanwhile, revenue collection from state-owned enterprises declines and from the nascent private sector is slow to rise (Figure 1.15).

As a result of the declining revenues and increased spending associated with the transition, large fiscal deficits emerged and persisted in most CARs in the 1990s. However, improved economic conditions and robust growth since 1999 have allowed CARs to reduce their budget deficits and assist economic performance in turn, despite a global slowdown. After undergoing vast difficulties in the initial stages of economic transition, some of the CARs have achieved among the highest growth rates in the world in recent years. Rather than stimulating demand, government expenditures have mainly focused on long-term considerations, such as providing infrastructure. Some CAR economies have also made use of improved economic conditions to reform their fiscal systems and implement fiscal consolidation. Total expenditures as a percentage of GDP are lower now, however, than the very high level of the early 1990s, due to rapid GDP growth.

The most extreme fiscal situations may be found in the Pacific economies, which continue to face narrow economic bases, heavy reliance on aid, vulnerability to external shocks, and difficulties in fiscal and financial management. Some of these economies have also recently suffered from political instability, ethnic tension, and civil disorder. Economic growth remains low in most of them. As a result, many of these economies have persistent fiscal deficits.

Many Pacific economies are characterized by relatively large public sectors, with central government spending accounting for a large share of GDP. This makes the economies highly sensitive to changes in such spending. Domestic revenue generation in many of them remains weak and government expenditures are heavily dependent on external assistance. Heavy dependence on grants reduces the use of fiscal policies for macroeconomic management as government spending hinges on the availability of aid. Volatile fiscal balances have resulted as aid is often not as stable or sustainable as tax revenues.

Economies can suffer severe strain if grants are not forthcoming, as happened in the Marshall Islands where the Government and the economy as a whole were very reliant on provisions for US funding under the Compact of Free Association. The Government borrowed heavily, but public investments failed to deliver expected returns and the public sector became excessively large and inefficient. This, together with the scaling back of grants from the US, led to a major financial crisis in 1996 and 1997, and economic weakness since then. Similarly, with the exception of 2000, growth in the Federated States of Micronesia has been very weak since the mid-1990s following reductions in US funding under the provisions of that country's Compact. The resumption of economic growth since 1999 has been driven by expansionary fiscal policy made possible by revenue "bump-ups" from Compact funds (see the relevant country chapters in Part 2).

Fiscal Challenges Facing Developing Asia

Fiscal deficits financed by increased public borrowing can add to the public debt burden, potentially jeopardizing fiscal sustainability and hindering economic performance. The debt-to-GDP ratio has risen in most DMCs over the past few years. Rapid growth in debt can crowd out private investment and inhibit private consumption, divert resources away from development goals, constrain investment in human development and infrastructure, and create difficulties for the implementation of monetary policies. A high debt-to-GDP ratio also tends to make fiscal policy less effective in stimulating economic growth. Reducing deficits and paying off debt are essential for economic development in economies suffering persistent fiscal deficits and heavy indebtedness.

In most East Asian economies, overall debt-to-GDP ratios are still moderate but have increased significantly in recent years in line with widening or emerging fiscal deficits. In some cases, governments also face increased contingent liabilities. In the PRC, the Government moved to shift the burden of supporting state-owned enterprises to the state-owned banking sector. The potential for accumulating nonperforming loans can threaten fiscal sustainability and hinder macroeconomic stability. A combination of sharp currency depreciation, high real domestic interest rates, lower government revenues, and a drop in exports as a result of the financial crisis caused a steep increase in both the size and burden of external debt repayment in Indonesia, Malaysia, Philippines, and Thailand. Fiscal expansion has further led to increased fiscal deficit and debt accumulation.

Several South Asian economies suffer heavy indebtedness due to persistent fiscal deficits. In India, for example, combined central and local government indebtedness increased to an estimated 72.6% of GDP in 2001. In some economies, access to external finance eased the pressure on domestic credit and reduced the likelihood of deficit financing, thereby reducing the crowding out of private investment. However, excessive reliance on external finance runs the risk of increasing exposure to external shocks.

Strong economic growth has provided public finance relief for the CARs. External public debt declined in line with government intentions to limit borrowing and pay down outstanding external debt. Nevertheless, the CARs still face substantial debt burdens. For example, Tajikistan's public external debt was over 87% of GDP in 2002.

In the Pacific, reining in persistent fiscal deficits and cutting debt remain major challenges. High deficits and debt have threatened fiscal sustainability and triggered macroeconomic instability in several of them. Government debt in the Cook Islands and the Marshall Islands reached unsustainable levels in the mid-1990s, leading to fiscal and economic crises. Nauru has few funding options for its continuing budget deficits; the Government's ability to secure new funds is seriously impaired by the absence of adequate collateral, local liquidity, or future revenue sources. Some Pacific economies now face difficulties paying public sector wage and utility bills.

Mounting debt can spin into a vicious circle (Table 1.3). Rising debt has placed upward pressure on many countries' expenditures because of correspondingly higher debt interest payments, potentially leading to higher debt levels, greater pressure on interest rates, bigger budget deficits, and further increases in debt. Nearly 20% of total revenues were diverted to serve interest payments in Indonesia and the Philippines in 1999. In 2000, over 30% of current revenues in India and Sri Lanka went to interest payments. Several economies had to reschedule bilateral debt with Paris Club members in December 2001, including Indonesia, Pakistan, and Tajikistan. To reduce debt levels, governments must achieve substantial primary budget surpluses and perhaps sell off some assets.

Increased public spending and rising public debt can restrict the credit available to the private sector, lead to higher interest rates, and crowd out private investment. Simulations using macroeconomic models for some countries indicate that the crowding-out effect has been low in East and Southeast Asia because private investors' demand for credit suffered a severe blow in the aftermath of the financial crisis, and economies in these subregions still have substantial excess capacity. If continued, however, debt accumulation will eventually impede private investment. In South Asia, simulation results suggest that high public spending has led to crowding out. In the Pacific, the public sector is large and absorbs substantial resources, stifling private sector development. Large amounts of grants may also have driven up exchange rates, handicapped export growth, and impaired the ability of domestic products to compete with imports. Rising debt can also constrain monetary policy options as perceptions about the sustainability of public debt affect financial market sentiment and interest rates. Prudent fiscal policy is necessary to ensure monetary policy credibility and avoid overburdening monetary policy with the sole responsibility for maintaining macroeconomic stability.

Fiscal Consolidation

Persistent deficits and debt accumulation may signal structural problems that require government action to carry out fiscal consolidation. Indeed, in response to fiscal imbalances, many DMCs have implemented or are contemplating such moves, and most recent DMC government budget statements vow to bring down deficits.

As economic recovery and growth continue in East and Southeast Asia, attention seems to be shifting from stimulating short-term demand toward fiscal consolidation. The PRC Government introduced measures to keep its budget deficit under control, including reducing tax evasion by strengthening collection efforts, and tightening auditing procedures for enterprises and high-income groups. Measures have also been taken to improve supervision of extrabudgetary funds and unauthorized spending. The FY2003 budget in Hong Kong, China aims to restore budgetary balance by FY2006. Measures proposed in the new budget include sales of public assets; pay cuts for civil servants; a freeze on new recruits for government positions; and increasing departure, payroll, profit, and property taxes. In Thailand, expenditures on special programs will be reduced. The Government is also considering raising the value-added tax (VAT) rate from 7% to 10%. In order to offset revenue loss from reduced income taxes, Singapore proposes to increase its goods and services tax rate from 3% to 4%. The Malaysian Government intends to balance the government budget by 2005 through containing growth in operating expenditures and scaling back noncore development projects. Indonesia has been progressively lowering fuel subsidies.

Several South Asian governments are also addressing fiscal concerns. India's Task Force on Direct and Indirect Taxes has recommended wide-ranging reforms of tax policy and tax administration, including eliminating a range of tax exemptions, raising the minimum taxable income, and simplifying the tax structure. With combined state deficits roughly equal to the central government deficit, a Medium-Term Fiscal Reform Program for States was also negotiated between the central Government and several state governments. In Pakistan, the Government has drafted a Fiscal Responsibility and Debt Limitation Ordinance, which requires it to eliminate the deficit by end-June 2007 and to lower the outstanding public debt from around the current 90% of GDP to 60% by end-June 2012. Sri Lanka's 2002 budget focused on fiscal consolidation to achieve macroeconomic stabilization. Wide-ranging changes were made to simplify tax administration and widen the tax base. The Government of Nepal approved an Immediate Action Plan in June 2002 to prioritize development expenditures and drop low-priority projects.

With strong economic growth easing the fiscal pressures in the CARs, some of these economies have taken advantage of the situation to implement active measures to strengthen their fiscal position. In 2002, for example, Kazakhstan enacted a new tax code, designed measures to monitor large taxpayers, and introduced an electronic registration system for taxpayers and tax reporting. Improved tax collection and administration helped revenues reach the budget target. The Government of Azerbaijan has taken measures to curtail implicit energy subsidies and enhance the transparency and accountability of its budget management. The Kyrgyz Republic removed many VAT exemptions in 2002, consolidated personal income tax rates, increased retail sales tax rates, raised the nonagricultural land tax and energy tariffs, initiated steps to reform and strengthen the customs administration, and created a special unit to monitor and collect taxes from large taxpayers.

Fiscal consolidation has been a difficult but serious issue in the Pacific. To reduce fiscal deficits and debt, the 2003 budget of the Fiji Islands proposed increasing excise and tariff rates, raising the VAT rate from 10% to 12.5%, and reducing capital expenditures. Following the fiscal crisis of 1996, the Marshall Islands implemented a Public Sector Reform Program, reducing the civil service by about 35% between 1995 and 2000. The Papua New Guinea 2003 budget also signaled measures to help correct the fiscal position, with notably an increase in the company tax rate and an emphasis on improved tax compliance. Some cuts to expenditures were also made.

Samoa announced a raft of taxation changes for FY2003, including increasing VAT, reducing the import tariff on goods, and increasing excise rates and motor vehicle fees. Further efforts were made to corporatize and privatize state-owned enterprises, which have been a drain on public finances. The 2003 budget of the Solomon Islands proposed significant reductions in the government wage bill through civil service retrenchments with redundancy payments financed by donors and making all capital purchases subject to the discipline of the Central Tender Board. Similarly, Tonga's 2003 budget also proposes reducing public sector wages and salaries.

Notwithstanding these efforts, the Pacific economies still require substantial fiscal reforms, made even more pressing by the fact that they tend to rely heavily on trade-related revenues that will likely decline with anticipated tariff reductions. Their public financing also relies heavily on grants, which, together with the low level of private sector development, continues to pose fiscal challenges. The prospects for fiscal sustainability remain fragile while high debt burdens persist.

Fiscal consolidation assists long-term growth since countries with low deficit and debt levels can exercise more options over expenditure priorities, and allocate more resources to productive sectors. However, fiscal tightening may cause output to contract in the short term. European experience during the 1990s, however, suggests fiscal consolidation when there is a large fiscal imbalance and a high level of government debt can lead to higher output growth even in the short run. This is because deficit and debt reduction can lead to lower interest rates and increased private sector confidence, thereby boosting private investment and consumption. Thus, countries suffering from persistent fiscal deficits and high debt may benefit from fiscal consolidation both in the short and long term.

There is no easy way to carry out fiscal consolidation to eliminate fiscal deficits and debt. Several ways are at hand to finance the fiscal deficit, including higher taxation, cutting spending, domestic borrowing, external borrowing, external assistance, selling public assets, or printing money. Each one faces constraints and carries risks. Heavy domestic borrowing can raise real interest rates, reduce the credit available to the private sector, and crowd out private investment. If real interest rates exceed the real growth of public revenues, domestic debt growth can become explosive. Furthermore, domestic financial markets in developing countries are often not developed enough to provide the necessary financing. While external borrowing eases the short-term constraints on capital, increasing foreign indebtedness may result in balance-of-payments or currency problems. Although fiscal deficits can be financed by external grants and aid, these sources are not always forthcoming or reliable. Selling public assets is also an unsustainable source of financing. Monetizing fiscal deficits (i.e., printing money) causes inflation and curbs private consumption. When inflation becomes very high, revenues from an inflation tax can fall because of reduced economic activity. Inflationary financing can also create uncertainties, distort prices, and lead to economic inefficiency.

The difficulties associated with financing fiscal deficits provide a strong case for countries to implement prudent fiscal policies. They also indicate that sustainable fiscal consolidation is best achieved through increasing revenues, improving revenue collection, and reducing spending. However, financing through increased taxes and spending cuts has its own problems, and needs to contend with administrative difficulties, economic cost, and political resistance. Despite these difficulties, DMCs with persistent deficits and high debt-to-GDP ratios may need to seriously consider measures to increase revenues and cut spending to bring about sustained improvements in their fiscal positions.

On the revenue side, most DMCs need to improve tax collection, tax administration and compliance, and to reduce tax evasion. DMC tax revenues as a share of GDP tend to be significantly lower than in industrial countries, often making up less than 20% of GDP, compared with more than 30% of GDP in most Organisation for Economic Co-operation and Development countries. The proportion of GDP coming from tax revenues is particularly low in South Asia, averaging about 8% in 2001 (Figure 1.16).

One reason for the low reliance on direct taxation in developing countries is that it is difficult to administer and collect taxes. This is particularly so for income tax. A greater share of national income is derived from agriculture in developing countries than in more developed ones. Without effective taxation of income from land, much of the income derived from the agriculture sector goes untaxed. Similarly, the income of the self-employed and most of the informal urban sector remains untaxed. Furthermore, low literacy rates and poor tax administration also contribute to the ineffectiveness of direct taxation.

The relatively low ratio of tax revenues to GDP in DMCs carries important macroeconomic consequences. A low tax share limits the ability of tax revenues to serve as an automatic stabilizer. Low tax-to-GDP ratios also limit governments' capacity to use countercyclical fiscal policies to stabilize economies. Many DMCs introduced VAT and reduced reliance on trade taxes in the 1980s and 1990s to broaden their tax bases. However, they still tend to have fairly low revenue shares from direct taxes, such as income taxes and corporate taxes, despite often having high top marginal tax rates. In many economies, there is still scope for further widening the tax base by broadening collection.

On the expenditure side, transfers to finance inefficient public enterprise investment or cover their operating losses often drain public finances. Phasing out subsidies or privatization can reduce this. Public consumption, which largely comprises the public sector wage bill, accounts for a large share of total government spending in most DMCs. Streamlining government consumption may offer another option. The budget process in some DMCs is often haphazard, with low computer capacity, and weak public accountability. There are also substantial capacity constraints in the administration of taxes, providing potential for tax evasion and avoidance. Improving budgetary planning, process, and systems offers another avenue to improve fiscal positions.

Concluding Remarks

Fiscal positions vary significantly across countries and subregions. Significant fiscal deficits and accumulation of public debt are relatively new phenomena for most East and Southeast Asian economies. However, expenditure growth outpaced revenue growth throughout the 1990s in many South Asian, CAR, and Pacific economies, leading to persistent budget deficits and high indebtedness. The situation has started to improve in the CARs over the past 2 years as expenditure growth has come more in line with revenue growth, and efforts toward improvement are under way in South Asia and the Pacific.

Fiscal consolidation is essential for reducing public debt, improving operation of monetary and exchange rate policies, and facilitating private sector-led growth. Weak fiscal positions have left little room for further fiscal expansion in most DMCs when faced by economic slowdown. Sustained fiscal deficits and debt accumulation can also hinder growth by generating higher inflation, interest rate hikes, and reductions in private investment and consumption. As economic recovery takes hold in East and Southeast Asia, attention has consequently shifted from stimulating domestic demand to fiscal consolidation. These active efforts, together with economic growth, can potentially resolve fiscal imbalances in these two subregions. Strengthened economic performance has helped the CARs improve their fiscal positions. Tackling persistent and substantial deficits in South Asian and Pacific DMCs depends on sustained commitment to overcome political and economic hurdles.

Compared with monetary policy, which is essentially a tool for short-term demand management, fiscal policy covers a greater number of issues and affects both short- and long-term economic performance. Fiscal policies contribute to long-term economic performance through creating a stable macroeconomic environment, correcting market failures, and providing public goods. Fiscal policies can also promote economic growth by helping mobilize resources, fostering capital formation, developing technology, building infrastructure, and developing human capital. Sound fiscal policies and robust economic performance go hand in hand. Prudent fiscal policies can help achieve sound economic performance and allow governments more leeway to exercise demand management and weather unfavorable international conditions. In turn, sound economic performance and buoyant long-term economic growth relieve many fiscal problems. These relationships mean that fiscal policy needs to be considered within a broad economic framework.

Back Developing Asia: Risks and Uncertainties	Next II. Economic Trends and Prospects in Developing Asia