Deficit Reduction: Experiences of Other Nations (Chapter Report,
12/13/94, GAO/AIMD-95-30).
This report reviews the deficit reduction experiences of six
nations--Australia, Canada, Germany, Japan, Mexico, and the United
Kingdom. GAO identifies the situations prompting these governments to
adopt fiscal austerity policies, what budget actions they took, and how
they achieved political agreement on these actions. All six countries
took steps to control spending, although few programs were eliminated.
Revenue growth also contributed significantly, but was generally
attributable to tax systems' response to economic growth and inflation.
Through these measures, five of the six countries reached fiscal balance
or surplus; Canada reduced its deficit but did not eliminate it. Despite
such progress, all but Mexico reported deficits in 1993. These
experiences show that significant structural improvement in fiscal
policy is possible in modern democracies, although such progress is
difficult to sustain.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: AIMD-95-30
TITLE: Deficit Reduction: Experiences of Other Nations
DATE: 12/13/94
SUBJECT: Foreign governments
Deficit reduction
Budget cuts
Fiscal policies
Economic analysis
Budget outlays
Balanced budgets
Economic growth
Tax administration
Budget deficit
IDENTIFIER: Australia
Canada
Germany
Japan
Mexico
United Kingdom
*******************************************************************************
* This file contains an ASCII representation of the text of a GAO *
* report. Delineations within the text indicating chapter titles, *
* headings, and bullets are preserved. Major divisions and subdivisions *
* of the text, such as Chapters, Sections, and Appendixes, are *
* identified by double and single lines. The numbers on the right end *
* of these lines indicate the position of each of the subsections in the *
* document outline. These numbers do NOT correspond with the page *
* numbers of the printed product. *
* *
* No attempt has been made to display graphic images, although figure *
* captions are reproduced. Tables are included, but may not resemble *
* those in the printed version. *
* *
* A printed copy of this report may be obtained from the GAO Document *
* Distribution Facility by calling (202) 512-6000, by faxing your *
* request to (301) 258-4066, or by writing to P.O. Box 6015, *
* Gaithersburg, MD 20884-6015. We are unable to accept electronic orders *
* for printed documents at this time. *
*******************************************************************************
Cover
========================================================================== COVER
Report to the Honorable
J. Robert Kerrey and the Honorable
John C. Danforth, U.S. Senate
December 1994
DEFICIT REDUCTION - EXPERIENCES OF
OTHER NATIONS
GAO/AIMD-95-30
Deficit Reduction
Abbreviations
========================================================================= ABBREV
ACTU - Australian Council of Trade Unions
CAP - Canadian Assistance Plan
CBO - Congressional Budget Office
CDU - Christian Democratic Union
CSU - Christian Social Union
CTB - Child Tax Benefit
CPP - Canada Pension Plan
EPAC - Economic Planning Advisory Council
EPF - Established Programs Financing
FDP - Free Democratic Party
FILP - Fiscal Investment and Loan Program
G-7 - Group of Seven
GDP - gross domestic product
GNP - gross national product
GRH - Gramm-Rudman-Hollings
GST - Goods and Services Tax
IMF - International Monetary Fund
JNR - Japanese National Railways
LDP - Liberal Democratic Party
MOF - Ministry of Finance
NTT - Nippon Telegraph and Telephone
OAS - Old Age Security
OBRA - Omnibus Budget Reconciliation Act
OECD - Organization for Economic Cooperation and Development
PACTO - Pact of Economic Solidarity
PAN - National Action Party
PEMEX - Mexican Petroleum Company
PRI - Institutional Revolutionary Party
PSBR - Public Sector Borrowing Requirement
SERPS - State Earnings-Related Pension Scheme
SNA - System of National Accounts
SPD - Social Democratic Party
VAT - value added tax
Letter
========================================================================= LETTER
B-259538
December 13, 1994
The Honorable J. Robert Kerrey
United States Senate
The Honorable John C. Danforth
United States Senate
As you requested, this report reviews the deficit reduction experiences of six
nations--Australia, Canada, Germany, Japan, Mexico, and the United Kingdom. We
identified the elements prompting these governments to engage in fiscal
austerity policies, what budget actions they took, and how they achieved
political agreement to take these actions.
All six countries took actions to control spending, although few programs were
eliminated. Revenue growth also contributed significantly, but was generally
attributable to tax systems' response to economic growth and inflation.
Through these measures, five of the six countries reached fiscal balance or
surplus; Canada made progress to reduce its deficit without eliminating it.
Despite such progress, all but Mexico reported deficits in 1993. These
experiences show that significant structural improvement in fiscal policy is
possible in modern democracies, although such progress is difficult to sustain.
This report was prepared under the direction of Paul L. Posner, Director of
Budget Issues, who may be reached at (202)512-9573 if there are any questions.
Charles A. Bowsher
Comptroller General
of the United States
EXECUTIVE SUMMARY
====================================================================== Chapter 0
PURPOSE
-------------------------------------------------------------------- Chapter 0:1
During the 1980s, several industrial nations took action to eliminate their
deficits. As requested by Senator Kerrey, who was subsequently joined by
Senator Danforth, GAO reviewed the experiences of five nations that reached
fiscal balance or surplus--specifically, Australia, Germany, Japan, Mexico, and
the United Kingdom. GAO was also asked to examine the experience of Canada, a
nation that, like the United States, has made some progress to reduce its
deficit without eliminating it. Specifically, GAO was asked to identify what
prompted these nations to engage in a policy of fiscal austerity, what budget
actions they took to reduce their deficits, how they achieved political
agreement to take these measures, and what could be learned from these nations'
experiences that might be applicable to the United States.
BACKGROUND
-------------------------------------------------------------------- Chapter 0:2
The President and the Congress have periodically acted to rein in large
deficits, and the deficit has been reduced from a high of 6.3 percent of gross
domestic product (GDP) in fiscal year 1983 to 3.0 percent in fiscal year 1994.
The Congressional Budget Office (CBO) projects further shrinkage to 2.3 percent
of GDP in fiscal year 1995. Although clear, near-term progress has been made,
the long-term deficit problem remains. CBO figures suggest that if no further
action is taken, the deficit will resume its upward path after 1998, to 3.6
percent of GDP in 2004, the last year for which a CBO projection is available.
Growing health care costs, the baby boom generation's eventual retirement, and
rising federal interest payments will continue to exert upward pressure on the
deficit well into the 21st century.
An earlier GAO report\1 noted that a higher rate of private investment would
support a more robust economy that will better enable the relatively smaller
cohort of workers to finance the needs of large numbers of retirees. The
surest way for the federal government to increase long-term economic investment
and growth is to increase national savings by reducing or eliminating the
deficit.
Although large deficits of the kind projected for the future in this country
pose distinct fiscal and economic problems, it is generally acknowledged that
it is very difficult for democratic nations to reduce or eliminate these fiscal
imbalances. Some believe that deficits persist because the benefits of budget
balance are long-range or economywide, while the short-term measures taken to
achieve balance may generate controversy and have immediate impact. This
situation has led some to believe that democracies will only deal with deficits
when forced to do so by external credit markets or by constitutional or other
legal requirements. They argue that, in the absence of these constraints,
elected leaders cannot be expected to act due to the perceived political risks.
Australia, Germany, Japan, Mexico, and the United Kingdom moved from fiscal
deficits as high as 16.9 percent of GDP to balance or surplus in the 1980s or
early 1990s (see figure 1). Yet, four of these countries have slipped back
into deficit, although cyclical economic changes account for at least part of
the return to
Figure 1: Reducing Deficits:
Shifts in Central Government
Financial Balances
(See figure in printed edition.)
\a For both Mexico and Japan, the most recent central government data available
also represent the greatest improvement in financial balance. OECD general
government data, however, suggest that deficits returned in 1994 in Japan.
Note: All data are for central governments, except Mexico, which is based on
all levels of government. Data include social security trust funds.
Source: OECD National Accounts, Volume II, and the Banco de Mexico.
--------------------
\1 Budget Policy: Prompt Action Necessary to Avert Long-Term Damage to the
Economy (GAO/OCG-92-2, June 5, 1992).
RESULTS IN BRIEF
-------------------------------------------------------------------- Chapter 0:3
The nations in this study instituted often painful measures to reach fiscal
balance or surplus while generating and maintaining political support. Control
of spending was the dominant policy tool used to achieve these goals, although
few programs were eliminated. Revenue growth also contributed significantly to
deficit reduction efforts in some countries but was generally attributable to
the response of nonindexed tax systems to economic growth and inflation. Tax
reform undertaken in the six countries was largely revenue neutral, as
governments sought to protect their revenue bases by combining tax cuts in one
area with revenue increases in another.
Various factors prompted governments to adopt deficit reduction strategies. Of
the six governments studied, only Mexico was forced to take deficit reduction
measures as a consequence of economic crisis and the reaction of external
credit markets. In all others, leaders defined the turning point in fiscal
policy rather than waiting for a financial crisis to trigger decisions. Some
reacted in part to fears of eventual negative external market reaction, but all
drew upon internal economic concerns such as inflation and interest rates.
Leaders used these themes to create a sense of urgency for reducing the
deficit.
Effective consensus-building was essential to creating public support crucial
to successful fiscal change. Governments brought key groups into the
decision-making process, devising austerity strategies that helped promote
support and reduce potential political opposition. Trading large cuts in one
program for improvements in other ones, targeting cuts to higher-income
beneficiaries, pursuing "shared sacrifice" strategies, and phasing in
reductions over time all helped to reduce the impact of cuts on current
beneficiaries. As the result of many factors and despite painful fiscal
measures, governments successfully eliminating deficits were returned to
office, in some cases several times.
The experiences of the case study countries show that significant structural
improvement in fiscal policy is possible in modern democracies, although such
progress appears difficult to sustain. Despite obvious cultural, political,
and economic differences, GAO believes that elements of other nations'
experiences may be of interest to the United States as it addresses this common
challenge.
GAO'S ANALYSIS
-------------------------------------------------------------------- Chapter 0:4
FISCAL ACTIONS FOCUSED ON
SPENDING CUTS
------------------------------------------------------------------ Chapter 0:4.1
Case study governments controlled the overall growth in spending such that
year-to-year spending growth generally declined during the 1980s. Figure 2
summarizes the spending actions governments took to reduce their budget
deficits.
Figure 2: Contribution of Spending
Actions to Deficit Reduction
(See figure in printed edition.)
All six governments departed from previous budgeting approaches and imposed a
"top-down" overall limit on government spending. The type varied, ranging from
limits on total budgetary spending in the United Kingdom and Canada, to
ceilings on growth in Japan, to broad fiscal goals in Germany, Australia, and
Mexico. Despite this variation, each represented a multi-year approach that
sought to reduce real overall spending.
Controlling spending meant restraining social benefit commitments in several
countries. Some permanently changed the linkage between program benefits and
inflation or suspended or delayed indexing for short periods of time. In other
countries, spending for social benefits was restrained by eliminating the
universality of certain benefits. For example, in the 1980s, Australia limited
the eligibility of its highest income groups for its pension and family
allowance programs.
Strategies involving capital spending cuts and cost shifting to lower levels of
government were also used. Reductions in capital spending occurred in most
countries, both as a result of this cost shifting and directly at the central
government level. Australia and Canada significantly reduced aid to their
states and provinces, respectively, and thereby shifted downward both some
fiscal stress and some of the difficult budget decisions.
Streamlining government and making the public sector more efficient were
consistent themes across all the case study countries. Public sector
employment was reduced; wage growth was slowed or wages frozen. In the United
Kingdom, the cut was dramatic: the number of public sector employees was
reduced by 26 percent between 1980 and 1992, partly reflecting privatization.
Privatization--shifting ownership from government to the private sector--of
previously public functions contributed to spending reduction by removing
subsidized activities from public budgets, while in many instances also
providing one-time revenue from sale of the assets. Case study countries,
however, privatized primarily to reduce the role of the public sector in the
economy and to make the remaining public sector more efficient. The United
Kingdom and Mexico were able to use this strategy to the greatest extent,
principally because these two countries had large nationalized industries at
the beginning of the 1980s.
REVENUE ALSO INCREASED
------------------------------------------------------------------ Chapter 0:4.2
Although few governments used tax legislation as a direct deficit reduction
strategy, revenue growth nonetheless contributed substantially to achieving
that fiscal goal. Strong economic growth in the mid-to-late 1980s increased
tax revenues in several countries. Furthermore, tax systems that were not
automatically indexed afforded governments the ability to retain revenue
resulting from inflation, a phenomenon often referred to as "bracket creep." As
a result, the combination of economic growth and inflation permitted these
governments to reap large tax revenue gains "automatically."
Most of the countries GAO studied enacted some form of tax reform during the
1980s. Although governments did not rely on such reform for deficit reduction,
they did attempt to structure tax changes to avoid revenue loss in both the
short and longer term. In general, tax reform included some combination of
reducing top tax rates, reducing tax expenditures (exemptions and exclusions
from the tax code), and increasing consumption taxes. Cuts in income tax rates
were generally offset by revenue increases from other sources. In some
countries, consumption tax increases were directly linked to offsetting income
tax reductions. Such changes were not generally depicted as part of a
government's deficit reduction strategy.
LEADERS HELPED CREATE TURNING
POINTS IN FISCAL POLICY
------------------------------------------------------------------ Chapter 0:4.3
Only in Mexico did economic crisis and the external financial pressure of
losing access to world credit markets prompt deficit reduction. Governments in
some of these countries acted to reduce their future vulnerability to such
events, while internal economic, cultural, or political pressures served as the
impetus for leaders in other countries to embark on deficit reduction. Leaders
often initiated action during economic downturns when deficits can increase and
prompt concerns among credit and currency markets. Balanced budget
requirements, present in Japan and Germany, neither prevented deficits nor
triggered deficit reduction.
Most leaders defined the benefits of deficit reduction and the costs of doing
nothing in sufficiently compelling terms to prompt action. Improving
international competitiveness and long-run fiscal health, reducing inflation,
stabilizing currency values, or reducing interest rates were elements of
arguments for implementing what were at times painful austerity measures. Each
government emphasized particular themes that appeared to resonate in that
nation.
For example, Japan's culture places a high value on savings. Emerging concerns
about debt levels and rising shares of the budget allocated to interest costs,
and their effect on the government's ability to finance the nation's pension
program in the long-term future, were important in driving the government to
action.
NEGOTIATIONS, TRADE-OFFS, AND
CAREFULLY DESIGNED CUTBACK
STRATEGIES FOSTERED SUPPORT FOR
AUSTERITY
------------------------------------------------------------------ Chapter 0:4.4
After making a compelling public case for deficit reduction, government leaders
sought to gain support or at least defuse potential opposition by bringing key
interest groups that would be affected into the decision-making process. In
part, the governments' success in redefining the political climate and making
deficit reduction appear inevitable helped bring these groups to the table.
Mexico and Australia, for example, both involved key economic groups in the
fiscal reform process, making fiscal sacrifice palatable in some cases by
providing other policy concessions.
The specific strategies used to reduce the deficit also helped. Approaches
such as reducing benefits instead of eliminating programs; targeting benefit
cuts to higher income groups; and deferring, shifting, or obscuring painful
adjustments all helped maintain political support for spending reductions.
Some countries adopted long-term strategies that phased in cuts so they largely
affected future beneficiaries. For example, the United Kingdom established a
ceiling on home mortgage interest deductions at a time when most taxpayers'
deductions were far below the ceiling; housing price inflation ultimately gave
the ceiling real impact.
Deficit reduction nonetheless remained a political challenge. Governments were
not always successful in eliminating or reducing opposition and on occasion had
to withdraw deficit reduction proposals. Moreover, such pressures affected
governments' abilities to sustain balance over the longer term. Yet, despite
these reduction measures, governments in the five countries that balanced their
budgets were re-elected, some several times. For example, the Australian Labor
government took over in 1983 and was returned to office four times in the next
decade, once only 2 months after announcing large expenditure cuts.
FISCAL AND ECONOMIC BENEFITS OF
AUSTERITY
------------------------------------------------------------------ Chapter 0:4.5
Deficit reduction provided significant fiscal benefits by slowing or reversing
the growth of public debt, thereby slowing or reversing the growth of
government interest costs. What had once been a "vicious" circle of rising
deficits, debt, and interest, which in turn can increase deficits, had become a
"virtuous" circle of falling deficits or rising surpluses, declining debt and
interest, and increased fiscal flexibility.
Figures 3 and 4 show the changes in debt and interest in the five countries
that reached balance. Figure 3 shows the improvement in net debt balances in
the five case study countries after deficit reduction. Figure 4 illustrates
the improvement in the interest "bite"--interest payments as a percent of total
expenditure--after deficit reduction.
Figure 3: The Benefits of Deficit
Reduction: Lowering Net Debt
(See figure in printed edition.)
Note: Mexico's 1992 data are preliminary.
Sources: OECD Economic Outlook, #55, and the Banco de Mexico.
Figure 4: The Benefits of Deficit
Reduction: Lowering the "Interest
Bite"
(See figure in printed edition.)
Sources: OECD Economic Outlook, #55, and the International Monetary Fund.
Economic benefits are longer term. The reduction of public debt can improve
economic growth in the long run by freeing capital for private investment, a
key element of long-term economic growth. Shorter-run effects can be
contractionary for the economy, yet many of the case study governments reported
economic improvements shortly after embarking on austerity policies. While
other economic policies and events may have acted to offset the contractionary
effects of deficit reduction, it is significant that leaders were able to
strengthen support by pointing to positive short-run economic changes.
Nonetheless, sustaining support for fiscal balance or surplus was clearly
difficult. Four of the five countries achieving balance or surplus have
returned to budget deficits in the 1990s. These countries appear, however,
better off fiscally and economically than if they had not reached balance. The
years of austerity left governments with lower debt levels than would otherwise
have been accrued. Furthermore, the increases in savings and investment
resulting from deficit reduction may have permanently boosted economic
prospects--some economists believe that the countries should experience
improvements in long-run living standards that would not have occurred
otherwise.
IMPLICATIONS
------------------------------------------------------------------ Chapter 0:4.6
The experiences of other nations provide insights that may help the United
States address the long-term nature of its deficit problem, despite obvious
political, cultural, and economic differences. Although progress has been
made, the aging of the U.S. population and rising health care costs are
projected to result in large future deficits.
The experiences of five of the nations indicate that eliminating deficits is
possible in modern democracies and that leaders can succeed in mounting the
case for prompt action before crisis ensues. Sustaining the sense of urgency
and the fiscal balance over the longer term, however, is difficult. The
experiences of these nations suggest that leaders are held accountable for
social policy goals and other pent-up demands which become more compelling once
fiscal balance or surplus is achieved.
This suggests that policymakers can strive to attain fiscal balance when
presented with windows of opportunity, as defined by unique cultural and
economic factors at work in each nation. Recognizing that such fiscal goals
are difficult to both achieve and sustain, deficit reduction strategies could
be designed to enhance the prospects for sustaining fiscal progress over the
long run. Achieving sustainable fiscal progress can be enhanced by strategies
that (1) address large and growing areas of the budget that drive deficits, (2)
maintain focus on the structural deficit, which can be masked by short-term
cyclical economic trends, and (3) exert positive long-term fiscal impact
through deficit reduction measures that grow over time.
INTRODUCTION
====================================================================== Chapter 1
During the 1980s and early 1990s, several advanced democracies eliminated large
fiscal deficits. Starting from annual maximum deficits ranging from
approximately 4 to 17 percent of gross domestic product (GDP), five of these
nations reached public sector balance and, in several cases, even surplus.
These achievements, remarkable for their difficulty, may provide insights to
U.S. policymakers as they continue to address the federal budget deficit.
Senator Kerrey, who was subsequently joined by Senator Danforth, asked us to
examine the deficit reduction experiences in five of the countries that
achieved annual balance in the 1980s and early 1990s--Australia, Germany,
Japan, Mexico, and the United Kingdom. We were also asked to study Canada, a
country that, like the United States, has made progress to reduce its deficit
but has not eliminated it.
DEFICITS AND THE LONG-TERM ECONOMIC
FUTURE
-------------------------------------------------------------------- Chapter 1:1
Deficits matter to all nations, regardless of the economy's size. Deficits
matter in the long run because they consume private savings that otherwise
would be available for private investment. In the absence of increased
national saving, such deficits must be financed either by a reduction in
private investment or by an influx of foreign capital. Because investment is
essential to long-term economic growth, reductions in private investment levels
threaten to reduce the growth of living standards. Reliance on foreign capital
may maintain investment levels in the short run, but profits and interest
payments will flow abroad in the future. Furthermore, should foreign
investment decline, the nation could face increased interest rates as the
reduced availability of capital raises its cost. Increasing national savings
would increase the resources available for investment, and the surest way to
increase national savings is to reduce budget deficits.
Deficits also matter in the shorter run because they reduce budget flexibility.
Large deficits can cause public debt to grow faster than the economy, and may
increase interest costs as a proportion of GDP, which would help drive deficits
further upward. The continued growth of interest costs squeezes funds
available to finance other priorities, limiting the government's flexibility to
respond to new or emerging needs.
In the United States, the federal government has a recent history of chronic
budget deficits. During the 1950s, the federal deficit averaged less than 1
percent of GDP, but by the 1970s the average rose to 2.2 percent. The highest
deficits occurred during the 1980s. The federal budget deficit peaked at 6.3
percent in 1983, and fell back to 4.0 percent by 1990.
The Congress and the President acted to reduce the deficit further through the
Budget Reconciliation Acts of 1990 and 1993. By imposing caps on discretionary
spending and maintaining restraints on expansion of entitlements and tax
benefits, the legislation has cut hundreds of billions of dollars from the
deficit's expected levels in the 1990s and in the longer-term future. In part
as a result of these actions, the deficit dropped to 3.0 percent of GDP in 1994
and the Congressional Budget Office (CBO) projects further shrinkage to 2.3
percent of GDP in 1995.
Although clear, near-term progress has been made, the long-term deficit problem
remains. CBO figures suggest that, if no further action is taken, the deficit
will once again resume its upward path after 1998, rising to 3.6 percent of GDP
by 2004, the last year of the CBO forecast available at this time. Debt held
by the public--that part of the gross federal debt held outside of the federal
government--is expected to grow from approximately 51 percent of GDP to 56
percent over the period. Growing health care costs, the baby boom generation's
eventual retirement, and rising federal interest payments will continue to
exert upward pressure into the 21st century. As we suggested in an earlier
report,\1 a different fiscal policy path would help prepare for the nation's
economic and demographic future.
Because deficit reduction represents one of the most pressing, yet most
difficult, policy issues facing the United States over the long term, exploring
the extent to which other governments have overcome comparable problems and
ways they succeeded may provide insights to policymakers in the United States.
--------------------
\1 Budget Policy: Prompt Action Necessary to Avert Long-Term Damage to the
Economy (GAO/OCG-92-2, June 15, 1992).
DEFICITS AND THE POLICY-MAKING
PROCESS
-------------------------------------------------------------------- Chapter 1:2
Although large deficits pose distinct fiscal and economic problems, most would
acknowledge the difficulty of democratic nations' reducing or eliminating these
fiscal imbalances. Some believe that deficits persist because the public
perceives the benefits of achieving budget balance to be less compelling than
the costs. The prospective benefits of such prudent fiscal policy--lower real
interest rates, a larger pool of domestic savings to finance productive
investment and, ultimately, improved prospects for living standards in the
future--are long-range and economywide. Decisionmakers and the electorate must
balance these against the immediate and concentrated cost of expenditure cuts,
increased taxes, and reductions in public services and government transfers.
Actions taken to achieve balance can therefore prove politically hazardous
because groups losing benefits can be readily mobilized against cutbacks, while
members of the general public who will eventually benefit through long-term
economic improvement only weakly perceive these advantages.
As a result, some commentators believe that democratically elected leaders
cannot be expected to embark on meaningful austerity policies without an
economic crisis characterized by pressures from external financial markets or
constitutional or other legal requirements for fiscal balance. They argue
that, in the absence of these constraints, leaders cannot be expected to act
due to the perceived political risks. The attainment of fiscal balance in the
advanced democratic countries we studied challenges these views.
CHARACTERISTICS OF THE SIX COUNTRIES
-------------------------------------------------------------------- Chapter 1:3
Figure 1.1 illustrates the largest annual deficits and surpluses at the central
level in the case study countries and the United States. Social security trust
funds are included. Mexico overcame the largest fiscal deficit: in 1982,
Mexico reported a general government deficit of 16.9 percent of GDP and by 1992
reported a surplus.\2 Japan maintained surplus for the longest period, from
1987 to 1991, as measured by the Organization for Economic Cooperation and
Development (OECD). Canada and the United States have both reduced their
deficits but have not yet eliminated them.
Figure 1.1: Reducing Deficits:
Shifts in Central Government
Financial Balances
(See figure in printed edition.)
\a For both Mexico and Japan, the most recent central government data available
also represent the greatest improvement in financial balance. OECD general
government data, however, suggest that deficits returned in 1994 in Japan.
Note: All data are for central governments, except Mexico, which is based on
all levels of government. Data include social security trust funds.
Sources: OECD National Accounts, Volume II, and the Banco de Mexico.
An examination of more recent fiscal history in the six countries reveals that,
based on projections, only Mexico remains in fiscal surplus. The United
Kingdom underwent the greatest fiscal slide, reaching a deficit of close to 8
percent of GDP by 1993, after having attained a surplus in 1988 and 1989. The
return to deficit in these countries suggests the difficulty of sustaining
fiscal progress.
Isolating the structural fiscal balance from cyclical influences alters the
fiscal picture somewhat.\3 Knowing how much of the deficit is structural and
how much is cyclical can be crucial in measuring the degree of fiscal distress.
Cyclical deficits, by their nature, decline as an economy improves and increase
when an economy slips into recession because of the sensitivity of revenue and
certain spending programs to the economy. Structural deficits require more
fundamental change to be increased or decreased. If the economy is growing
stronger, an improvement in the cyclical deficit could mask continuing
structural problems. Conversely, if the economy is weakening, the cyclical
deficit will grow, making the overall deficit appear larger and more urgent
than may be the case over the long run. Hence some estimate of the cyclical
vs. structural contributions to a fiscal deficit may help leaders determine
the most effective fiscal policy.
In general, economic conditions exaggerated the extent of the case study
countries' deficits at their "troughs," as well as the extent of improvement at
the countries' fiscal peaks. Similarly, the recent slide back to deficit, in
most instances, reflects cyclical change more than structural backsliding. The
United Kingdom is projected to have the largest negative structural deficit,
while Japan's figures suggest that its projected deficit is entirely due to
economic downturn.
--------------------
\2 Mexico's balances represent those of all levels of government. Central
government data are not available and subnational governments control a
relatively small portion of public sector revenue.
\3 Deficits in many countries are highly responsive to economic conditions.
During times of slow or negative growth, lower incomes and employment cause tax
revenues to fall and spending for social programs to rise. This automatic rise
in the deficit is cyclical. The structural deficit measures discretionary
fiscal policy and other noncyclical factors affecting the budget.
DEMOGRAPHIC AND ECONOMIC
DIFFERENCES
------------------------------------------------------------------ Chapter 1:3.1
The countries selected for case studies varied in size, in type of government,
and in the public sector's role (see table 1.1). Japan has both the largest
population and economy of the group, although substantially smaller than those
of the United States. GDP in Japan and Germany ranks below only the United
States among all OECD countries. Mexico is the second largest of the six case
study countries in population, but ranks second to last in terms of GDP.
Australia is the smallest of the six countries in terms of both population and
GDP.
Table 1.1
Characteristics of the Six Case Study
Countries and the United States, 1991
GDP Public
Population (in sector
(in billions outlays System of
thousands) $ US) (% GDP) government
---------- ---------- --------- ------- ----------------
Australia 17,292 280.0 36.6 Parliamentary/
federal
Canada 27,000 520.6 47.9 Parliamentary/
federal
Germany 63,889 1,257.8 44.2 Parliamentary/
federal
Japan 123,920 2,349.2 25.4 Parliamentary/
unitary
Mexico 81,250 329.0 26.9 Presidential/
(1990) (1992) federal
United 57,649 899.8 39.7 Parliamentary/
Kingdom unitary
United 252,160 5,610.8 36.7 Presidential/
States federal
------------------------------------------------------------
Five of the six case study countries have parliamentary systems of government.
Mexico, the exception, has a presidential system. The five parliamentary
systems differ in the relative power awarded the upper houses of parliament,
the power of the ruling party, and the roles of public interest groups. The
relationships between the central governments and the subnational governments
also vary considerably.
More detailed information on each of the six countries, their political
systems, their budget structures, and their fiscal policies is provided in
appendixes I-VI.
DEFINITIONS OF BALANCE
-------------------------------------------------------------------- Chapter 1:4
Countries' definitions of fiscal balance vary depending in part upon tradition,
relationships with subnational governments, and budget structure. Mexico and
the United Kingdom consider the entire public sector borrowing requirement;
Australia, Canada, and Germany focus on central, or federal, government
activities; while Japan focuses even more narrowly on only part of the central
government's fiscal activity. Specific definitions of balance, where
dramatically different from OECD general or central government balances, are
described in the country appendixes.
For purposes of comparability among countries, the most commonly used
standardized measures of fiscal deficits and surpluses are those for all levels
of government, or general governments, reported by the OECD from the United
Nation's System of National Accounts (SNA). However, fiscal deficits for all
general governments may not be exact proxies for budget deficits as they are
perceived in a particular country. In the case of a country with a unitary
governmental system, such as the United Kingdom, the deficit or surplus (the
public sector borrowing requirement) represents borrowing at all levels of
government. However, in some federal systems, such as Australia, Canada, and
Germany, the fiscal policy at the federal level may be perceived as largely
separate from the fiscal policy at the state or local levels. Governments in
this case may focus primarily on deficits at the federal level.
Moreover, Japan has large off-budget accounts for pensions and investment. In
this case, political debate over fiscal policy can use data that substantially
differ from those in the official SNA accounts. We used the definition each
nation used in its fiscal policy debate, where appropriate, when analyzing
deficit reduction in the case study countries, in recognition that a
government's own measures are the most relevant in understanding the actions
considered. To compare across nations, we used OECD data and definitions. As
Mexico only joined the OECD in 1994, OECD data were not available. Data for
Mexico were derived primarily from the Banco de Mexico, Mexico's central bank.
We did not independently verify either OECD, Banco de Mexico, or national data.
OBJECTIVES, SCOPE, AND METHODOLOGY
-------------------------------------------------------------------- Chapter 1:5
Senators Kerrey and Danforth asked us to review the deficit reduction
experiences of Australia, Canada, Germany, Japan, Mexico, and the United
Kingdom. Specifically, they asked us to identify what prompted these nations
to engage in a policy of fiscal austerity, what budget actions they took to
reduce their deficits, how they achieved political agreement to take these
measures, and what could be learned from these nations' experiences that might
be applicable to the United States.
To accomplish these objectives, we reviewed OECD and International Monetary
Fund (IMF) data on the case study countries' fiscal deficits, and in each
country we interviewed officials and analysts familiar with their government's
actions. We also interviewed and obtained documentation from government
officials to better understand not only what deficit reduction took place, but
how the countries' deficit reduction strategies were formulated and
implemented. We also interviewed and obtained data and information from OECD
officials, public policy critics, academicians, journalists, and members of the
main political opposition parties in the case study countries to obtain their
views. We reviewed a wide array of reports and economic analyses on deficit
reduction in general and in the specific case study countries.
We have presented the most significant deficit reduction actions, including
those that produced large savings or revenues, as well as those that were
significant for political or economic reasons. While this report cannot fully
detail all of the economic policies of the case studies countries in the 1970s
and 1980s, we outlined elements of the economic situation and policies which
most help to explain how the countries reduced their deficits.
Our work was conducted in the six case study countries and Washington, D.C.,
from May 1993 through August 1994 in accordance with generally accepted
government auditing standards. Experts on each country's fiscal and economic
policy reviewed each of the case study summaries, and experts in comparative
public policy reviewed our analysis and findings. The reviewers generally
agreed with our work, and we have incorporated their comments where
appropriate.
LEADERS DEFINED THE TURNING POINT IN
FISCAL POLICY
====================================================================== Chapter 2
While deficits experienced by governments in all six countries had similar
causes, the elements triggering government response to those deficits varied.
Only in Mexico did real economic crisis precipitate deficit reduction. A
variety of economic, political, and cultural pressures, none of them barring
the government from financing its needs in the near term, led to the fiscal
turning point in the other five countries. Political leaders in the case study
countries often succeeded in defining these pressures as a crisis warranting
fiscal sacrifice, at times even displacing other political or economic goals to
pursue deficit reduction.
DEFICITS IN ALL SIX COUNTRIES HAD
SIMILAR ROOTS
-------------------------------------------------------------------- Chapter 2:1
Officials in the six case study countries pointed to many of the same elements
leading to deficits in the 1980s: broadened public sector commitments in the
1960s and 1970s, slowed economic growth, and fiscal and economic reaction to
rapidly changing oil prices. The causes were interdependent and the effect of
each cannot easily be isolated, but together they were responsible for large
public sector deficits.
PROGRAM EXPANSION HELPED CREATE
FISCAL IMBALANCE WHEN ECONOMIES
CHANGED
------------------------------------------------------------------ Chapter 2:1.1
The fiscal deficits of the 1980s were rooted in decisions made in the 1960s and
1970s to create and enlarge public programs. Governments in most of the case
study countries increased spending under the presumption that the high economic
growth rates of the 1950s and 1960s would continue. By the time economic
growth rates slowed in the mid-1970s, many of these programs were entrenched.
In most of the countries, these programmatic expansions involved social welfare
commitments. In Canada, for example, the government had developed a strong
social welfare system since World War II, and in the mid-1970s, it began fully
indexing benefits for inflation. The government in the United Kingdom also
offered new benefits and expanded existing ones. In 1971, the government
introduced the Family Income Supplement, a new means-tested benefit, and then
raised the benefit periodically; a One Parent Benefit was added in the late
1970s. Similar social welfare expansion occurred in Germany and Australia.
Spending for many of these programs expanded during times of economic stress or
slower economic growth and thus had a stabilizing or countercyclical effect.
By expanding these commitments, and therefore the portion of the budget that
reacts automatically to cyclical movements in the economy, public budgets
became more vulnerable to economic swings.
ECONOMIC SLOWDOWN AND OIL PRICE
SHOCKS CONTRIBUTED
------------------------------------------------------------------ Chapter 2:1.2
All of the case study countries except Mexico experienced recession or
significantly slower economic growth in the 1970s. As shown in figure 2.1,
Japan, Canada, and Australia all experienced sizable reductions in their
average real GDP growth rates. Japan, for example, averaged 10.9 percent real
growth from 1960 to 1973, but dropped to 3.6 percent from 1974 to 1980. Such
reduced growth resulted in lower than anticipated revenue collections and
increased demand for social welfare spending, thereby creating or adding to
governments' budget deficits.
Figure 2.1: Real GDP Growth
Comparison
(See figure in printed edition.)
Note: Comparable data for Mexico were not available.
Source: OECD Economic Outlook, #55.
Initially, some governments seemed to view these changes as temporary, that is,
as part of the normal business cycle, and thus made few substantial fiscal
adjustments. Projections of government revenue and expenditure, and therefore
deficits, assumed a continuation of or return to the higher growth rates of the
past. These optimistic projections exacerbated the fiscal problem because the
economic slowdown of the early and mid-1970s in fact represented a longer term
decline in real growth rates. When the expected levels of economic growth did
not materialize, the governments found themselves overcommitted and facing even
larger deficits.
International economic policies may also have contributed to deficits.
Officials in Germany and Japan noted that the Group of Seven (G-7)\1 asked
Japan, Germany, and the United States to follow fiscal stimulus policies to
stimulate worldwide economic growth. As a response to this "locomotive theory"
that the 3 largest economies could provide the engines for growth in other
industrialized economies, Germany and Japan increased public spending.
In all but one of the countries we visited, officials reported that the sudden
increases in oil prices in the 1970s, in combination with other domestic and
foreign events, precipitated the slowdown in economic growth. The economies of
these five oil-dependent countries struggled to absorb the shock of higher
prices. Even the United Kingdom, which eventually reaped benefits from its oil
reserves, experienced the same dampening economic and fiscal effects initially.
Only Mexico, an oil-exporting country in the 1970s, benefited initially from
the price hike; however, Mexico became dependent on its new-found wealth to
finance public sector expansion and, ultimately, the volatility of oil prices
contributed to Mexico's economic crisis.
The shock to growth patterns in these countries proved profound. Japan, the
United Kingdom, Canada, Germany, and Australia reported continuous large fiscal
deficits after the mid-1970s; Mexico embarked on spending levels that proved
unsustainable when oil prices fell in the 1980s.
--------------------
\1 The G-7 includes Canada, France, Germany, Italy, Japan, the United Kingdom,
and the United States.
PRESSURE, NOT CRISIS, PRECIPITATED
ACTION IN FIVE OF THE SIX COUNTRIES
-------------------------------------------------------------------- Chapter 2:2
Some observers suggest that governments dependent on popular support will
undertake fiscal sacrifice only when it is clear that they have no alternative.
According to this line of thought, only when financial markets refuse to
continue financing a government's deficits will leaders be able to effectively
mobilize public support for spending cuts or tax increases.
Yet, of the six deficit-reducing countries we studied, only Mexico faced this
type of profound economic crisis--a loss of access to credit compounded by
triple-digit inflation. Governments in some of these countries acted to reduce
their future vulnerability to such events, while internal economic, cultural,
or political pressures served as the impetus for leaders in other countries to
embark on deficit reduction.
ONLY MEXICO LOST ACCESS TO CREDIT
MARKETS
------------------------------------------------------------------ Chapter 2:2.1
Although Mexico experienced some of the same factors that brought about other
countries' deficits, Mexico's vulnerability to the combination of volatile oil
prices and heavy reliance on debt for public sector financing ultimately
resulted in the government's inability to borrow, which in turn ensured that
deficit reduction would become a high public priority.
Mexico actually faced two distinct economic crises during the 1980s, when
deficits exceeded 16 percent of GDP. The first, in 1982, came about because
the Mexican government was relying increasingly on international borrowing to
support the deficit. Mexico's public external debt jumped from about $34
billion in 1980 to over $63 billion in 1983, higher than other developing
borrowers such as Brazil or Venezuela. When it could no longer obtain foreign
financing, the government was forced to adopt immediate deficit reduction
measures. Although the deficit was indeed reduced briefly, the measures taken
were largely temporary and by 1986 the deficit was again 16 percent of GDP.
Faced with triple-digit inflation, mounting debt and interest payments, and the
continuing threat of again losing access to credit markets, the Mexican
government adopted long-term, structural fiscal policy changes. Officials in
Mexico told us they had little choice.
OTHER COUNTRIES FACED ECONOMIC,
FISCAL, AND POLITICAL PRESSURES
------------------------------------------------------------------ Chapter 2:2.2
A variety of pressures influenced the governments in the other five countries
to take fiscal action. Of these, economic pressures such as rising inflation
or falling terms of trade consistently played a leading role in defining the
need for deficit reduction. At different stages and to different degrees,
governments and the general public became convinced that a stronger fiscal
position would improve each country's economic stability.
For each country, the factors that represent economic stability are different.
Only Mexico faced an immediate crisis, but some others feared that failure to
address these economic pressures would prompt an international crisis of
confidence either in the near or long term. Governments in countries which
relied heavily on trade were particularly vulnerable to external pressures such
as depreciating currencies. For example, the Australian government used
collapsing export prices, falling currency values, and the fear that
Australian's long-term standard of living was threatened as justification for
embracing strong fiscal restraint in the latter half of the 1980s. Rising
inflation--whether it was triple-digit inflation in Mexico, double-digit
inflation in the United Kingdom, or single-digit inflation in Germany--was a
consistent theme across the six countries.
Fiscal pressures, such as the level of debt and the related problem of
ballooning interest costs, also raised public concern. In Japan, rising public
debt and the expanding use of resources for interest payments brought into
question the government's ability to finance the nation's pension program in
the long term. Based on an international comparison, gross debt in Japan rose
from around 12 percent of GDP in 1970 to over 50 percent of GDP in 1980. By
1983, interest payments in Japan had surpassed every other budgetary
expenditure except social security in the general account budget. In Canada,
the government felt similar pressures, particularly since a large portion of
its public debt is foreign-held, and therefore may be subject to higher
interest rates.
Several governments also faced pressures of a uniquely political nature--the
Labor party in Australia provides the clearest example. According to a budget
expert, a Labor government in the 1970s ushered in large deficits due to
expanded spending initiatives; the government fell in 1975 when it lost a key
budget vote in the Senate. When the Labor party was returned to power in 1983,
many in the party believed they had to overcome a negative fiscal legacy held
over from the 1975 Labor government. Accordingly, they were receptive to
offering deficit reduction strategies when faced with economic pressures.
Historical or cultural traditions seemed to magnify the economic and fiscal
pressures felt by these governments. This proved particularly true in Japan
and Germany. Japan's culture places a high value on savings in preparation for
future needs. This tradition accentuated the fiscal pressure of high debt and
interest costs. In Germany, fear of inflation stemming from the period of
hyperinflation earlier in the century made 6 percent inflation a cause for
public concern. Each of these countries responded to a threshold of concern
that was unique and conditioned by their own situation.
Both of these nations had balanced budget requirements. In neither country did
these requirements prevent deficits, nor did they force action once large
deficits formed. In Japan, legislation stipulates that government finance
should be subject to the principle of a balanced budget, and the government may
only issue bonds if the funds are used for public construction, capital
contribution, or loans. However, this restriction did not effectively bar
deficits. Beginning in 1975, the government each year passed a resolution
allowing the issuance of deficit financing bonds to close the budget gap. The
German balanced budget requirement stems from the national constitution. As in
Japan, investment expenditures are exempt from the requirement. There can be
exceptions to the balanced budget requirement, however, if deficits are deemed
necessary to stabilize prices, maintain a high level of employment, and achieve
steady economic growth.
LEADERS DECIDED TO ACT
-------------------------------------------------------------------- Chapter 2:3
These pressures on the governments did not themselves force action. Political
leaders responded with deficit reduction proposals, creating a significant
turning point in each of their country's fiscal policy paths. It did not
appear easy: fiscal austerity represented a sharp change from the government's
preferred policy agenda in some countries; in many instances, fiscal
contraction was initiated during adverse economic circumstances as well, with
the accompanying political risk of increasing social unrest.
GOVERNMENTS PURSUED AUSTERITY
POLICIES DESPITE OTHER PRIORITIES
------------------------------------------------------------------ Chapter 2:3.1
With the exception of Mexico, most of these governments could have chosen not
to follow a deficit reduction path. Political leaders had several options to
choose from, including allowing the deficit to worsen, trying to address their
economic problems primarily through monetary policy, or addressing the deficit
in a "muddling through" fashion, where some actions are taken but little
permanent progress is made. Yet deficit reduction became a high priority as
leaders believed that the potential political and economic benefits would
outweigh the short-run sacrifice.
Conservative and liberal governments alike took on deficit reduction. Some
governments receiving election mandates took action immediately upon assuming
office. The best examples were the United Kingdom and Germany, where in 1979
and 1983, respectively, the conservative parties were elected on platforms that
focused on fiscal restraint. Once in office, some governments found that
deficit reduction superseded other economic or political goals. For example,
the Australian Labor government had not initially campaigned for fiscal
austerity nor was such policy emblematic of its political philosophy. However,
once elected, this government, feeling the pressure of currency depreciation
and convinced that currency stability depended on deficit reduction, chose to
adopt fiscal restraint. This choice is particularly significant given the fact
that in Australia, fiscal restraint had previously been associated with the
conservative opposition party.
Conservative governments, too, had to relinquish or defer other political goals
when they chose to reduce the deficit. The Conservative government in the
United Kingdom included deficit reduction as a fundamental party goal, but when
deficits worsened, it had to defer promised tax reductions and other of its
priorities until deficits were under control. The German government deferred
income tax reductions for several years until its deficit was under control.
LEADERS ACTED DURING ECONOMIC
DOWNTURNS
------------------------------------------------------------------ Chapter 2:3.2
Most economists would not advise contractionary fiscal policies such as major
deficit reduction during an economic downturn; if such policies are pursued,
they need to be closely coordinated with an accommodative monetary policy to
avoid weakening the economy. Conversely, such contractionary policy during
times of robust economic growth can help to offset the buildup of inflationary
pressures in the economy.
Contrary to this prescription, most governments began deficit reduction during
periods of slow economic growth or recession. Budget deficits in advanced
economies increase during economic downturns due to lower revenues and higher
spending on countercyclical benefit programs. These higher deficits spark
concerns by credit and currency markets that, if not addressed, could lead to
further economic problems such as higher interest rates or falling currencies.
From this perspective, deficit reduction takes on a particular urgency, which
makes policy action seem necessary to ward off other economic problems. Higher
deficits and the possibility of negative economic consequences helped leaders
convince the public of the need for action.
In four of the countries, policymakers responded to these pressures by
implementing deficit reduction during recessions or periods of slow economic
growth. For example, as shown in figure 2.2, the United Kingdom pursued its
deficit reduction program during a recession in order to stem inflation and
high interest rates. This action sparked controversy; 364 economists in the
United Kingdom wrote a letter to The Times (London) protesting the government's
tight fiscal policies in the depths of a recession, stating that the policies
would deepen the economic trough.
Figure 2.2: Deficit Reduction and
Economic Growth in the United
Kingdom, 1972-1993
(See figure in printed edition.)
SPENDING ACTIONS AND ECONOMIC GROWTH
COMBINED TO REDUCE DEFICITS
====================================================================== Chapter 3
Governments in the case study countries focused primarily on slowing spending
growth to attack budget deficits. By slowing the growth of spending, these
governments improved the structural balance between revenues and expenditures
in their budgets. Governments that maintained austerity for several years
after economic recovery was under way positioned themselves to maximize the
benefits of cyclical improvements and thus make quick progress toward
eliminating deficits and achieving budget surpluses.
Governments made significant tax changes in every country, but tax changes were
largely instituted in a revenue-neutral manner that did not immediately
contribute to deficit reduction. However, income tax rates in these countries
are not automatically indexed to fully adjust for inflation; therefore
inflation led to increased revenues and contributed to deficit reduction. Some
countries also benefited from privatization and oil revenues. The governments
most successful at reducing budget deficits made spending reductions appear
purposeful and revenue increases largely automatic.
GOVERNMENTS IN ALL SIX COUNTRIES
TOOK ACTION TO REDUCE SPENDING
GROWTH
-------------------------------------------------------------------- Chapter 3:1
Governments in the case study countries addressed deficits by controlling the
overall growth in spending. In general, growth in spending from year-to-year
declined during the 1980s. (See table 3.1.) Overall spending targets were
often used to ensure that spending growth was held below the growth in the
economy.
Table 3.1
Public Sector Outlays as Percent of GDP-
-1982, 1986, and 1989
Country 1982 1986 1989
--------------- ------------- ------------- -------------
Australia 33.0 37.3 32.8
Canada 44.8 44.6 43.1
Germany 49.0 46.4 44.8
Japan 33.0 32.0 30.9
Mexico 44.5 44.9 34.2
United Kingdom 44.5 42.4 37.5
------------------------------------------------------------
Although governments actively took steps to slow the growth of spending and
reduce deficits, for the most part, these actions did not represent major
changes in the roles and responsibilities of the central government.
Generally, these governments eliminated few programs. Instead, they made
spending cuts by reducing social benefits, payments to other levels of
government, capital spending, and the number of government employees. In one
area, privatization of government-owned enterprises, governments did shift a
portion of their responsibilities. However, while governments benefited from
one-time increases in revenues and permanently reduced liabilities,
privatization actions were taken primarily to reduce the government's overall
involvement in the economy rather than to reduce the deficit.
Figure 3.1 summarizes the spending actions governments took to reduce their
budget deficits.
Figure 3.1: Contribution of
Spending Actions to Deficit
Reduction
(See figure in printed edition.)
OVERALL LIMITS HELPED CONTROL
SPENDING
------------------------------------------------------------------ Chapter 3:1.1
All case study governments used some form of spending limit or target to
control aggregate spending. These overall targets were a departure from the
budgeting approaches of the past in that they imposed "top-down" limits on
central government spending.
There was wide variation in the nature of the spending limits. Governments in
the United Kingdom and Canada imposed limits on total budgetary spending. The
Japanese government froze or required negative growth in spending. The
governments of Germany, Australia, and Mexico used broad fiscal goals.
Although the nature and effectiveness of these limits varied, each represented
a multi-year approach that sought to reduce real overall spending and included
consideration of both discretionary and mandatory programs.
In the United Kingdom, the government used spending targets to manage its
budget and to ensure that overall spending did not exceed a ceiling. The
current target covers most of the budget, excluding interest, the cyclical
portion of social security programs, and privatization proceeds. The
government attempts to stay within the targets, and if spending in one area
grows faster than predicted, the government reduces spending in other areas to
stay under the limit. For example, although social spending grew faster than
other areas of the budget in the 1992 budget, the government had to cut other
programs. As a result of the spending targets implemented over the decade,
annual real growth in public expenditures in the United Kingdom averaged only
1.3 percent during the 1980s, representing a significant drop from 3.3 percent
during the 1970s.
The Japanese government used spending limits extensively by freezing, and
sometimes requiring decreasing levels of spending on a limited portion of
central budget general expenditures. In 1982, the Japanese government imposed
a "ceiling" that required a zero percent nominal increase in expenditures over
the previous year's budget on expenditures subject to the ceilings. In 1984,
the ceilings for the affected current expenditures were decreased by ten
percent from the previous year's level, and the ceilings for relevant
investment expenditures were decreased by five percent. Ceilings on current
expenditures decreased ten percent annually throughout the rest of the 1980s
and were still in place in 1993.
Other countries' governments used broad fiscal policy goals, rather than actual
spending limits, to reduce spending. In Germany, the goal was to hold the
growth in spending at all levels of government to not more than 3 percent each
year during much of the 1980s. The Australian government had a goal of not
allowing government expenditures to increase as a percentage of gross domestic
product, but it applied strict limits only to the 10 percent of its budget
associated with "running" or overhead costs and required federal agencies to
reduce these costs each year from the 1987-88 budget in exchange for greater
management flexibility.
The Canadian government established spending limits in 1992 which stated that
non-interest spending through the 1995-96 budget, including mandatory or
entitlement spending, could not exceed levels projected in 1991. The
legislation stipulated that if program expenditure rose above its projected
level for economic or policy reasons, the increase had to be offset by
reductions elsewhere in the budget. However, some experts questioned the
effectiveness of these limits, stating that the ceilings were too high and did
not force constraint. An expert suggested the spending limits may not be
renewed by the new government following their expiration in the 1995-96 budget.
Figure 3.2: Spending Limits in the
United States
(See figure in printed edition.)
SOCIAL PROGRAM SPENDING WAS
RESTRAINED IN SEVERAL COUNTRIES
------------------------------------------------------------------ Chapter 3:1.2
Social program spending was restrained in several countries by changing the way
benefits were adjusted for inflation and by reducing or eliminating benefits
for upper income recipients. Although inflation adjustments sometimes produced
only minimal short-term savings, they resulted in significant long-term
savings. Eliminating the universality of some benefits permitted governments
to realize savings and maintain or increase benefits to those in the greatest
financial need.
After coming into power in 1983, the Australian Labor government reduced
universality over the next several years in the areas of old age pensions,
family allowances, and unemployment benefits. For example, the government
re-established means-testing of old age pension benefits. In Australia, men
become eligible for the old age pension at age 65 and women at age 60.
Means-testing had been abolished in the mid-1970s. In November 1983, an income
test was re-established, and, in March 1985, an assets test for all pensioners
was restored. Only one test is applied--an individual's old age pension is the
lower of the amount determined by the income or assets test. As a result of
these changes, the percentage of seniors receiving old age pensions dropped
from 86 percent in 1983 to 76 percent by 1991. Although the universality for
the national old age pension system was reduced, the government later improved
the private pension system covering Australian workers referred to as
"superannuation."
The Australian government also realized budgetary savings in the second half of
the 1980s by means-testing family allowances and unemployment benefits as a way
to improve targeting. In announcing this change, the Australian Treasurer
justified such changes with the following statement: "It is clearly not
reasonable that the taxes of low and middle income families should continue to
fund benefits for the relatively well-off."
Some changes in social benefits were designed with a long-term perspective to
produce "wedge-shaped" budget savings--that is, savings from particular policy
changes that start out small and grow in future years. In the United Kingdom,
in 1979, the government changed the basis for calculating inflation adjustments
for its national old age pensions and other social security benefits from the
greater of wage or price increases to increases in prices. Although the
long-term effects of this change may not have been apparent at the time, it
slowed the growth in program spending because in the United Kingdom prices
increased more slowly than wages. The government also limited the mortgage
interest deduction by setting a nominal ceiling on the mortgage amount that
qualifies for the interest deduction, a change that brought in increasingly
more tax revenues as housing price increases drove the value of more homes
above the limit. The German government deferred indexation of pension benefits
for 6 months in 1983 and cut unemployment benefits to recipients without
children from 68 percent of their net wage to 63 percent in the 1984 budget.
As of October 1994, the Japanese government was considering legislation raising
the retirement age from 60 to 65 for its social security program beginning
early in the next century, a step that will result in long-term savings.
Several governments took steps to reduce or control health care spending. The
Australian government, after introducing universal health care in 1983, began
reducing benefits as part of its deficit reduction steps in the 1986-87 budget.
Over the next several budgets, health savings included reductions in medical,
hospital, and pharmaceutical benefits. Germany, which has universal health
insurance, moderated the growth in spending on physician care in the 1980s
through budget controls.\1 Faced with new spending pressure, in addition to
these controls, the German government initiated a 3-year emergency measure in
1993 to impose mandatory global budget limits on spending in the physician,
hospital, dental services, and prescription drug sectors of its health care
system.\2 Japan has also sought to moderate health care spending through
nationwide controls on health care prices and budgets.
Figure 3.3: Targeting Entitlements
(See figure in printed edition.)
--------------------
\1 Health Care Spending Control: The Experience of France, Germany, and Japan
(GAO/HRD-92-9, November 15, 1991).
\2 1993 German Health Reforms: New Cost Control Initiatives (GAO/HRD-93-103,
July 7, 1993).
CAPITAL INVESTMENT WAS REDUCED
------------------------------------------------------------------ Chapter 3:1.3
Officials in most countries told us that the central government reduced capital
spending as part of their deficit reduction strategy in the 1980s. In Mexico,
capital spending was cut in half as a percent of GDP between 1982 and 1991.
The German government reduced capital spending at all levels of government
between 1981 and 1984, even though investment spending is exempt from the
constitutional requirement to balance the budget. The Australian government
reduced its own capital outlays as well as capital assistance to the states.
Officials in several countries told us that reducing or slowing the growth in
capital spending was an easy and quick way to cut overall spending. Also, part
of the reduction in investment spending in some countries resulted from
privatization and the reduced responsibility of government to provide capital
investment for nationalized industries.
Japan represents the main exception to this trend; the ratio of public sector
investment spending to GDP did not decline. Although the central government
reduced capital outlays in Japan during the 1980s, local governments,
interest-free loans from the proceeds of privatization, and a national
investment program called the Fiscal Investment and Loan Program (FILP) have
kept capital spending from falling from its long-term average.
Regardless of how investment cuts were implemented, reducing capital spending
can be counterproductive to a nation if it continues for any significant length
of time. Economists agree that public and private investment is critical to
long-term economic growth. Moreover, cuts in capital investment only defer
eventual costs that will have to be addressed in future budgets. In the late
1980s, the Mexican government tried to address some of the more pressing
capital and social needs by implementing a development grant program for poorer
communities.
PAYMENTS TO LOWER LEVELS OF
GOVERNMENT WERE REDUCED
------------------------------------------------------------------ Chapter 3:1.4
The central governments in Australia and Canada sought to reduce their deficits
in part by reducing payments to the lower levels of government--states and
provinces. Officials at these lower levels and some budget experts portrayed
reduced transfers as a way of shifting deficits from the federal to the state
level. On the other side of the argument, federal officials in both countries
said that cuts in transfers to the states and provinces were necessary to share
the pain of deficit reduction, particularly when, at the time, some states were
enjoying relative fiscal health.
Figure 3.4: Federal Cuts to States
and Provinces
(See figure in printed edition.)
In the other federal systems in our study, Germany and Mexico, this shifting
was not as significant. The reluctance to make large reductions in transfers
to the states in Germany was due in part to the fact that the upper house of
parliament (the Bundesrat) is made up of state representatives. The German
constitution requires Bundesrat approval for all tax proposals and for spending
that affects state responsibilities such as education, crime, housing, and
family allowances. Since the Bundesrat is made up of representatives of state
governments, the interests of the states are given much weight in budget
deliberations. In Mexico, those we interviewed said federal payments to states
were not greatly affected by the deficit reduction efforts of the 1980s.
PUBLIC EMPLOYMENT REDUCED AND
WAGE INCREASES RESTRICTED
------------------------------------------------------------------ Chapter 3:1.5
Streamlining government and making the public sector more efficient were
consistent themes across all the case study countries. This was accomplished
by a reduction in public sector employment and freezing or limiting the growth
of public sector wages. In the United Kingdom, the number of public sector
employees was reduced by 26 percent between 1980 and 1992, from around 6.6
million to 4.9 million, partly reflecting privatization efforts. In Germany,
the government limited and delayed pay increases and hired larger numbers of
part-time employees in order to realize savings. In Canada, the government
reduced the number of public sector employees by roughly 4 percent and froze
public sector wages.
PRIVATIZATION WAS UNDERTAKEN TO
REDUCE GOVERNMENT'S ROLE IN THE
ECONOMY
-------------------------------------------------------------------- Chapter 3:2
Privatization--shifting ownership from government to the private sector--of
assets and agencies was undertaken by case study country governments primarily
for policy, rather than for fiscal, reasons. Governments benefitted from
one-time increases in revenues and permanently reduced liabilities as a result
of selling enterprises to the private sector, but they undertook privatization
primarily to reduce the role of the public sector in the economy and to make
the remaining public sector more efficient.
While most governments in our study engaged in some kind of privatization
program, the United Kingdom and Mexico were able to use this strategy to the
greatest extent, principally because they had large nationalized industries at
the beginning of the 1980s. Also, officials in Mexico described how the
government had been involved in industries or businesses that it could not run
effectively. In Mexico, the first stages of privatization were marked by the
closing of these nonviable firms.
The government in the United Kingdom is a clear example of privatization as
part of a political agenda. The Conservative government elected in 1979 stated
its goal was to reduce the role of the public sector in the economy. The fact
that the government excluded privatization proceeds from its spending limit
calculations suggests that the motivation for privatization was more political
than it was fiscal. The government sold nationalized industries to the private
sector, sold public housing to individual owners, and contracted out more
government services. By 1992, two-thirds of nationalized industries and over
930,000 jobs had been transferred to the private sector.
The Mexican privatization effort was aimed at improving the efficiency of the
economy and strengthening public finances. Industries and businesses were
privatized slowly over the decade in a deliberate effort to learn from both
direct experience and the experience of other nations. The number of public
enterprises dropped from 1,155 in 1982 to 217 in 1992. Revenue from
privatization equaling 6.3 percent of GDP has been realized since 1989.
MOST REVENUE ACTIONS WERE NOT LINKED
TO DEFICIT REDUCTION
-------------------------------------------------------------------- Chapter 3:3
Most revenue actions were not designed or initiated to reduce budget deficits
but were undertaken for reasons such as tax efficiency and equity. Although
tax changes were, on the whole, revenue-neutral, most governments in our study
retained the real revenue increases resulting from inflation by not fully
indexing income tax brackets for inflation every year. Moreover, several
countries shifted more of the tax burden from direct taxes to indirect
taxes--that is, by decreasing income taxes and increasing consumption taxes.
Figure 3.5 shows major tax policy actions taken by case study governments
during the 1980s.
Figure 3.5: Major Tax Actions
(See figure in printed edition.)
TAX REFORM INTENDED TO BE REVENUE
NEUTRAL
------------------------------------------------------------------ Chapter 3:3.1
Most of the countries we studied enacted some form of tax reform during the
1980s, but these changes were largely revenue neutral, as governments sought to
protect their revenue bases by combining tax cuts in one area with revenue
increases in another. In general, tax reform included some combination of
reducing top tax rates, reducing tax expenditures,\3 and increasing consumption
taxes. Increased tax enforcement was also an important factor, most noticeably
in Mexico.
Raising income tax rates did not seem to be a viable deficit reduction option.
In some cases, such as in the United Kingdom and Germany, the government was
publicly committed to lowering income tax rates. Analysts suggested that the
tax reforms undertaken by the United States during the 1980s, particularly
income tax rate cuts, influenced governments in other countries and made
raising income taxes politically unattractive. In an increasingly integrated
global economy, governments that raise tax rates above their international
competitors may suffer capital flight as multinational businesses seek to
locate operations and financial transactions in lower tax countries.
Although several governments reduced tax rates, they also sought offsetting
revenue from broadening the tax base or increasing consumption taxes to avoid
increasing the deficit in either the short or longer term. In some countries,
consumption tax increases were directly linked to offsetting income tax
reductions. For example, Japan reduced income tax rates in exchange for
instituting a 3 percent value added tax (VAT) in 1989. Three years after
reducing income tax rates, the Canadian government introduced a new value added
tax to replace its old manufacturers' sales tax.
Although tax reform was characterized by governments as revenue neutral, some
taxes were increased, and some tax expenditures were reduced for deficit
reduction purposes. For example, the Australian government instituted taxes on
fringe benefits and capital gains. In 1989, the Canadian government ended the
universality of its old age security pension by introducing a "claw-back" tax
on benefits. Canadian seniors were required to repay a portion of their old
age security pension for every dollar of net income above a certain threshold
up to 100 percent repayment of the benefit.
Tax expenditures were eliminated or modified in several of the case-study
countries. The German government raised revenue by reducing tax allowances and
loopholes between 1982 and 1990, eliminating 62 tax expenditures in 1990 alone.
The Australian government eliminated the deduction for entertainment expenses
and reduced tax concessions to the filmmaking and petroleum industries in its
1986-87 budget. Officials in Mexico said that tax reform in 1987 eliminated
major tax expenditures benefiting the agriculture and transportation sectors of
the economy.
--------------------
\3 Tax expenditures are revenues foregone, or revenue losses, due to
preferential provisions of the federal tax laws, such as special exclusions,
exemptions, deductions, credits, deferrals, or tax rates. See Tax Policy: Tax
Expenditures Deserve More Scrutiny (GAO/GGD/AIMD-94-122, June 3, 1994).
OIL REVENUE WAS IMPORTANT IN
MEXICO AND THE UNITED KINGDOM
------------------------------------------------------------------ Chapter 3:3.2
The governments of Mexico and the United Kingdom enjoyed significant revenue
from the sale of oil during the 1980s. While oil revenue did not preclude
other deficit reduction efforts, it did significantly affect the countries'
progress, in both positive and negative ways.
On the positive side, both Mexico and the United Kingdom benefited from oil
revenues throughout the 1980s. High oil prices allowed these countries to
bring in additional revenue. At its peak in 1984, North Sea oil proceeds in
the United Kingdom represented almost 8.5 percent of total tax revenues. In
Mexico, oil revenues were approximately one-third to one-half of total public
sector revenues between 1980 and 1990.
On the negative side, the Mexican government's dependence on oil seemed to
contribute to the country's deficit problems. Large oil reserves were
confirmed in the mid-1970s, and analysts argue that the new-found wealth
permitted the government to defer imposing fiscal austerity. Spending levels
in the late 1970s and early 1980s were increased to take advantage of high
projected oil revenues and were maintained, even when prices fell. However,
once spending was reduced, oil revenues contributed to improving the deficit
situation.
TAX SYSTEMS YIELDED INCREASED
REVENUE
-------------------------------------------------------------------- Chapter 3:4
Although few governments used tax legislation directly to significantly reduce
the deficit, revenues nonetheless contributed substantially to achieving this
fiscal goal. Total public sector revenues as a percent of GDP increased during
the 1980s in Canada, Australia, and Japan and remained relatively stable in the
United Kingdom, Germany, and Mexico.
Strong economic growth in the mid-to-late 1980s increased tax revenues in
several countries. Virtually all of the increased revenue was available to
reduce the fiscal deficit because by this time expenditures were in most
countries tightly controlled. Furthermore, unindexed tax systems, or tax
systems periodically indexed at the discretion of the government, afforded
governments the ability to retain revenue resulting from inflation, often
referred to as "bracket creep." As a result, governments could reap large tax
revenue gains automatically, which contributed substantially to the attainment
of budget balance or surplus.
Without indexation, governments may choose not to adjust income tax brackets to
reflect inflation, and "bracket creep" can occur. Individuals or businesses
may move to higher income tax brackets even though their real
(inflation-adjusted) incomes remain constant, thus raising real tax revenues
without directly changing tax rates. Countries used this bracket creep to help
bring in additional revenues. The Japanese government, which had previously
returned bracket creep in the form of tax cuts, has not done so since 1974.
The German government instituted tax rate cuts in the second half of the 1980s,
only after several years of fiscal restraint. A government in Australia
experimented with indexation of its tax system in the 1970s, but abandoned it
because it was too restrictive and mechanistic, and political leaders were
placed in the difficult position of having to take action to recoup lost tax
revenue.
A similar effect was achieved by suspending or modifying the indexation of
taxes. The government in the United Kingdom suspended indexation for one year,
lowering the income base on which future tax bracket adjustments were made.
The Canadian government modified the indexation formula so that tax bracket
adjustments are now made only when inflation exceeds 3 percent.
Table 3.2 provides information on the indexation of taxes in the case study
countries.
Table 3.2
Indexation of Taxes
Is Tax System Indexed?
------------ ----------------------------------------------
Australia No. Government periodically returns bracket
creep through tax rate cuts.
Canada Partial
Germany No. Government periodically returns bracket
creep through tax rate cuts.
Japan No. Japan used to return bracket creep in the
form of tax rate cuts, but has not done so
since 1974.
Mexico Yes
United Yes. Officially, indexation is automatic
Kingdom unless government takes action to set
indexation independently. In practice,
government sets rate each year.
------------------------------------------------------------
THE ROLE OF BUDGET PROCESS REFORM
-------------------------------------------------------------------- Chapter 3:5
The governments of two case study countries, Australia and the United Kingdom,
instituted changes in budget processes to help implement or fortify their
deficit reduction strategies. In contrast, the governments of Germany, Japan,
and Mexico were able to accomplish deficit reduction with the aid of relatively
little process change. Although the Canadian government instituted management
and budget process reforms during the late 1970s and the 1980s, it was not
successful in eliminating its budget deficits.
The Australian government used management and budget reforms to implement
deficit reduction and to maintain budget discipline during the 1980s.
Management reforms like the Financial Management Improvement Program were
coupled with budgetary reforms that centralized and made budget decisions more
transparent. Budgetary reforms included a top-down cost estimating process
called the "forward estimates," which helped rationalize fiscal policymaking by
defining a uniform baseline against which to assess agency proposals. A
"running costs" system was also instituted that accounted and budgeted for
administrative costs; in exchange for greater flexibility in allocating
resources within this category, agencies had to reduce administrative spending
by a certain percentage each year. In addition to their stated objectives,
these reforms also helped the government to promote deficit reduction as part
of a larger strategy to make both the government more efficient and the economy
more competitive.
A significant process change also occurred in the United Kingdom, where the
base for budgeting changed from volume planning to cash planning. Prior to the
change, program spending was estimated for a series of years based on the funds
needed to provide a constant level of services taking inflation into account.
When inflation or other demands caused department budgets to increase,
additional funds would generally be provided. This system provided little
control over total spending. Over the latter half of the 1970s and into the
early 1980s, the government gradually replaced volume planning with overall
spending totals and explicit cash limits for sectors of the budget. The Labor
government of the mid-1970s began the process of changing over, but the
Thatcher government fully implemented the system for the entire budget.
Although reforms played a part in the deficit reduction story of some of the
case study countries, we found that reforms alone did not guarantee successful
deficit reduction. The Canadian government sought to reduce public spending
and improve quality of public services by launching reforms during the 1980s in
a variety of program areas including social services. Although the central
government had some success in reducing program spending as a percent of GDP
between 1984 and 1990, it could not reduce its budget deficit below 3 percent
of GDP. Although reforms in some countries unquestionably aided governments in
controlling, implementing, and tracking their budget and policy decisions, most
did not rely on automatic mechanisms to make the tough budget choices.
DEFICITS HAVE RECURRED
-------------------------------------------------------------------- Chapter 3:6
As discussed in chapter 1, four of the five nations achieving balance or
surplus are projected to have budget deficits in 1994--Japan, Germany, the
United Kingdom, and Australia. According to OECD calculations, Japan's deficit
is entirely cyclical and not due to structural imbalance in the budget.
While budgets in Germany, the United Kingdom, and Australia were affected by
cyclical downturns in the early 1990s, the governments in these countries also
made policy decisions that caused an underlying structural deficit to reemerge.
The German government's budget moved back into deficit in large part as the
result of the unification of Germany in 1990. The Australian and United
Kingdom governments began "giving back" some of the benefits taken away under
the austerity programs of the 1980s.
This apparent retreat from fiscal discipline typically occurred during or after
periods of strong economic growth which benefited the budget beyond the
structural improvements already achieved. These cyclical dividends from
economic growth made the fiscal position appear better than warranted by the
fundamental structural balance. Political leaders, faced with apparent fiscal
prosperity and the easing of previous economic concerns, made budgetary
decisions that reduced the structural progress previously achieved. When
recessions struck in the early 1990s, these governments' budgets returned again
to large deficits.
This experience suggests it is difficult to sustain austerity over a prolonged
period of time. Demands and needs delayed or deferred during periods of fiscal
austerity reemerge on the public agenda, and leaders have a more difficult time
legitimizing constraint once budgets and the economy appear to be healthy.
Nevertheless, deficit reduction provided significant fiscal benefits by
reducing public debt and government interest costs. The countries' total debt
levels would be higher today if their current annual deficits were added to
bases not reduced by several years of austerity. In addition, some economists
believe that the countries, thanks to these earlier increases in savings and
investment, should experience improvements in long-run living standards that
would not occur otherwise.
Germany offers a particularly good example of the continuing benefits of even
temporary fiscal balance. Although the German budget has fallen back to
deficit, it has done so primarily as a result of the unification of the former
East and West Germanies. Fiscal strength certainly aided the West German
government's case for unification; although unification may have proceeded
regardless of West Germany's fiscal health, the fiscal austerity of the
mid-1980s not only facilitated union, it has also kept debt and deficit levels
lower than they would have been otherwise.
LEADERSHIP STRATEGIES PROMOTED BROAD
SUPPORT
====================================================================== Chapter 4
Political and public support proved crucial to successful fiscal change.
Government leaders fostered support for their policies by linking deficit
reduction with an improved economy and by building consensus with key interest
groups on how to approach deficit reduction. Additionally, deficit reduction
strategies themselves were designed not only to achieve fiscal balance, but
also to promote political support through trade-offs, shared sacrifice, and
deferred pain. Over time, despite tough fiscal policies, these governments
were returned to office, in some cases, several times.
DEFICIT REDUCTION LINKED TO CLEARLY
DEFINED ECONOMIC GOALS
-------------------------------------------------------------------- Chapter 4:1
Governments in most of the countries linked deficit reduction with perceived
short- as well as expected long-term economic gains. Although improving
international competitiveness and long-run fiscal health proved compelling
goals in some countries, most also pointed to shorter run benefits such as
reduced inflation, stabilized currency values, or reduced interest rates to
make the benefits of austerity more concrete. Improvements in living standards
that result from deficit reduction are normally realized only over the long
term. However, deficit reduction in most case study countries was only one
element of an overall economic strategy. In combination with the other
elements of the governments' economic policies, deficit reduction contributed
to reductions in inflation and interest rates, and increasing rates of economic
growth in the 1980s.
EMPHASIZING SHORTER TERM ECONOMIC
BENEFITS HELPED GARNER SUPPORT
------------------------------------------------------------------ Chapter 4:1.1
Linking the effects of deficit reduction with an improved economy appeared to
make fiscal sacrifice more palatable to the public. Several governments linked
fiscal deficits to inflation and identified deficit reduction as a means to
attack the problem. This occurred in the United Kingdom, where deficit
reduction was seen as part of a larger strategy to reduce inflation. In
Germany, too, deficit reduction was intended to address an unacceptable
inflation rate as well as reduce rising interest rates. Mexico, in crisis,
presented deficit reduction as the answer to triple-digit inflation. The
public in these countries seemed to understand that inflation would erode the
standard of living in the near term.
Other short- and medium-term economic concerns stimulating strong public
interest included strengthening the currency in some nations and reducing
interest rates in others. Governments took the position that reducing budget
deficits, along with other policies such as deregulation and free trade
policies designed to increase competitiveness, would be fundamental to
achieving these goals. This approach seemed to strengthen government arguments
that the benefits of deficit reduction outweighed the costs.
LONG-RANGE BENEFITS OF DEFICIT
REDUCTION WERE ALSO CLEARLY
COMMUNICATED IN SOME COUNTRIES
------------------------------------------------------------------ Chapter 4:1.2
Some governments were able to convince the public that sacrifice in the form of
deficit reduction, with other economic policy measures, would be rewarded with
long-term economic gain manifested in sharpened competitiveness and improved
growth in living standards. Although these arguments were buttressed by
discussion of short- and medium-term benefits as well, the governments of
Australia and Mexico successfully argued for deficit reduction in part as a way
to modernize these economies and ensure continued competitiveness in world
markets. In Australia in particular, concern that the fiscal deficit
compromised future living standards proved instrumental in building public
support.
Only the Japanese government focused primarily on the long run alone,
emphasizing both the problem of increasing budgetary inflexibility due to
rising interest commitments and the importance of building an operating surplus
to finance the needs of future retirees. This approach successfully appealed
to the public's high preference for savings.
MAIN ECONOMIC AND POLITICAL
INTERESTS INVOLVED
-------------------------------------------------------------------- Chapter 4:2
Leaders succeeded in using these various appeals to promote a new sense of
urgency about the deficit. Opposition parties and interest groups then had
little choice but to frame their policies in a fiscal austerity context. In
Australia, for example, the opposition party at times engaged in something of a
bidding war over whose policy alternatives promised the greatest amount of
deficit reduction. Some interest groups also reported that they felt they
could not credibly propose new initiatives without identifying a source of
funding at the same time.
Having made a politically compelling case for deficit reduction, governments in
many of the six countries then engaged in some form of consensus building to
create support for their fiscal policies. In these countries, key labor and
business interest groups affected by deficit reduction and instrumental to
achieving economic reform were successfully brought into the decision-making
process, although not without difficulty and cost. Interests representing
social welfare concerns were also consulted in some countries, but to a lesser
extent.
LABOR AND BUSINESS GROUPS
INVOLVED
------------------------------------------------------------------ Chapter 4:2.1
As we observed in chapter 1, deficit reduction involves imposing losses that
are directly and keenly felt to gain benefits that are widely dispersed. The
imposition of such loss constitutes, therefore, a potential political hazard
for the leaders attempting it. It is therefore remarkable that governments we
studied managed to bring the representatives of their countries' most important
political and economic interests "to the table" to negotiate economic policy,
including deficit reduction and, ultimately, the imposition of loss. Such
negotiation often required the government to grant concessions to these groups,
which sometimes increased spending in other areas.
In Australia, Mexico, and Germany, interest groups representing labor and
business participated in government efforts to build consensus for its fiscal
policies. The Mexican government formalized the consensus-building process by
creating a multi-interest group that met initially to adopt an overall fiscal
and economic strategy, and later to review agreements and priorities to ensure
continued progress. In Australia, the government interacted primarily with the
unions; business and social welfare interest groups were also consulted, but to
a lesser degree. In Germany, labor representatives held seats in the
legislature, so they were regularly consulted as part of intragovernmental
consensus building. Although the degree to which these groups were involved
varied, obtaining their support or at least preventing their active opposition
was important to the success of deficit reduction efforts in these three
countries.
The Japanese government worked closely with business interests through an
administrative reform commission in imposing spending reductions. By linking
austerity with the private sector's interest in efficiency and deregulation,
the Japanese government garnered support for its fiscal austerity measures,
which included tightly controlled spending levels.
Such alliances were limited in the United Kingdom and Canada. In the United
Kingdom, the Conservative government's large parliamentary majorities enabled
the government to undertake potentially controversial actions without the same
level of formal consultation seen elsewhere. However, Canada's Progressive
Conservative government, also elected on a platform that included reducing the
deficit, was reluctant to take strong unilateral measures and was unable to
produce consensus to pursue particular strategies. We were told that this was
the result of, in part, a fragmented political structure. The two levels of
government in Canada, the provincial and the federal, often have disparate or
competing incentives. For example, concerns about the potential secession of
Quebec have made it difficult for the government to undertake deficit reduction
measures that adversely affect the provinces.
CONSENSUS BUILDING WITHIN
GOVERNMENT WAS ALSO IMPORTANT
------------------------------------------------------------------ Chapter 4:2.2
Although party loyalty is often considered the hallmark of parliamentary
systems, such loyalty should not suggest imposing austerity is therefore easy
in such systems. Intragovernmental consensus building proved an essential
element in several countries' austerity plans. Such consensus building was
deemed necessary either to submit an austerity plan to parliament or to ensure
such a plan, once passed, would be implemented. Sometimes, government plans
were defeated or modified due to internal pressures.
Several examples help demonstrate this point.
Germany. Under the German system, state governments control the upper house of
parliament (the Bundesrat) and as a consequence had to be part of any fiscal
solution proposed by the governing party. The interests of the states are
given much weight in budget deliberations and influenced the Chancellor's
approach to deficit reduction.
Australia. Prime Minister Hawke's cabinet represented a range of Labor Party
ideology and interests; the strongest interests were represented in a small
group of Cabinet members convened to control spending, apparently to ensure all
were "on board" when politically difficult spending cuts were enacted.
Japan. Despite the apparent strength of the Ministry of Finance (MOF),
intragovernmental consensus building traditionally took place prior to final
budget submission to the Diet and involved the legislature, MOF, and the
spending ministries negotiating the details of final budget levels.
United Kingdom. Although the large parliamentary majority and election mandate
meant the Prime Minister could enact government proposals relatively easily,
achieving consensus within the government on such proposals was more difficult.
Members of the Cabinet opposed to strong fiscal measures--informally called
"the wets"--caused "the drys" to proceed cautiously on some particularly
contentious tax measures, forcing the drys to accept greater wet involvement in
the usually secret budget preparations. For example, a proposal to increase
the gasoline tax in the 1981 budget was met with considerable discontent by the
wets. The drys agreed to confine the duty increase to one specific type of
fuel indexed to the increase in inflation, and to increase the tobacco duty as
an offset to this. As a result of the compromise, the budget passed without
any overall change in the budget totals.
When governments were not able to negotiate a consensus within their own party,
we found many examples where the deficit reduction measures were not adopted.
For example, in Australia, the Labor government proposed in its August 1993
budget to eliminate optometry benefits from the health program and thus save an
estimated 345 million Australian dollars over 4 years. A group within the
Labor Party did not agree with the decision and forced the government to
reinstate the benefits before it would support the budget. In Japan, the
Liberal Democratic Party (LDP) government attempted to introduce a value added
tax in 1979, but the tax was highly unpopular, both with the public and with
various factions within the Diet. The lower house of the Diet was forced to
dissolve in 1980, largely due to the inability of its members to reach
consensus on the VAT issue. The government ultimately succeeded in passing the
VAT in 1989, but had to offer an income tax reduction and simplification in
exchange for the new tax.
One nation we visited--Canada--did not reach fiscal balance. Despite earlier
progress, the federal deficit in Canada grew to 4.6 percent of GDP in 1993.
While the central government in Canada has implemented a variety of deficit
reduction measures, there has been a lack of unanimity among government leaders
regarding deficit reduction, and the government has allowed other priorities to
inhibit its deficit reduction efforts. One reason for this may be the
fragmented political structure of the country, as epitomized by the threat of
Quebec secession, which has made it difficult for the government to build
consensus and carry out strong unilateral measures. The mixture of the
provinces' heavy fiscal dependence with their political independence has made
any fiscally meaningful deficit reduction measures appear politically hazardous
for central government leaders.
AUSTERITY STRATEGIES' DESIGN HELPED
DEFUSE OPPOSITION
-------------------------------------------------------------------- Chapter 4:3
The specific strategies used to reduce the deficit also helped promote support
and defuse or mollify potential opposition. Such approaches as trading off
program reductions for benefits (but retaining a net spending reduction);
pursuing "shared sacrifice" strategies; and deferring, shifting, or obscuring
painful adjustments all helped maintain support for governments' spending
reductions.
Moreover, success in maintaining support can also be explained by what was not
done--with the exception of privatization in the United Kingdom and Mexico,
significant changes in government roles and responsibilities did not occur.
Significant deficit reduction did not require elimination of major programs or
termination of significant benefits. Rather, reductions were largely achieved
through decremental actions reforming, targeting, or streamlining government
programs and operations.
TRADE-OFFS GAINED SUPPORT
------------------------------------------------------------------ Chapter 4:3.1
In some countries, the government made the pain of expenditure reduction
palatable to the affected groups through policy trade-offs. From the beginning
of its tenure in the 1980s, the Labor government in Australia seemed to
understand that its ability to marshall support for fiscal restraint in certain
program areas would be facilitated by making trade-offs in the form of expanded
or new benefits in other areas. For example, universal health coverage was
introduced in 1983 as part of the trade-off for wage moderation, even though
economywide wage restraint was not so much a budgetary savings as it was part
of the government's effort to improve Australia's competitiveness. By gaining
union support for its broader economic and fiscal reforms, the government paved
the way for substantive spending reductions in other social spending areas such
as pensions, family allowances, and unemployment benefits. The Australian
government used smaller-scale trade-offs to gain support for specific
programmatic changes; leaders added resources to some programs while cutting
larger amounts from others, "sweetening" the cuts and thereby gaining crucial
political support for net spending reduction.
The Mexican government also engaged in an economywide trade-off; workers
accepted lower real wages to avoid layoffs. Additionally, the government
introduced a program of grants to poor areas. In both Australia and Mexico,
the willingness of involved parties to make trade-offs seemed to stem from the
conviction that doing nothing to reduce the deficit would be the worst possible
policy choice.
The government in the United Kingdom engaged in trade-offs as the strength of
its political mandate waned. Subsidies to local authorities were increased to
deflect opposition to the proposed poll tax.\1 Also, offsetting compensation
was offered to pensioners and families on public assistance to reduce the
outcry against the extension of the VAT to domestic fuel.
--------------------
\1 The poll tax was a highly unpopular local residence tax levied on all
adults.
"SHARED SACRIFICE" WAS IMPORTANT
------------------------------------------------------------------ Chapter 4:3.2
In several of these countries the idea of "shared sacrifice" was instrumental
in forging the necessary consensus to reduce expenditures. Some of the
reductions described in chapter 3 called for "equal sacrifice" from interest
groups, programs, and/or government departments and fostered the appearance of
"horizontal equity." Groups or agencies were thought to be more likely to
acquiesce to deficit reduction if they did not feel unfairly disadvantaged in
relation to their competitors. For example, in Japan, we were told that MOF
embraced an across-the-board approach because it minimized political debate
over resource allocation.
Government operations generally absorbed their "share" of cuts, and in some
countries more than their share. As discussed in chapter 3, countries engaged
to varying degrees in efficiency improvements, which took the approach of
privatization, streamlining, consolidating, and reorganizing. Some of these
changes, as in the United Kingdom, resulted in large reductions in the number
of public employees. However, some governments, most notably Mexico, simply
reduced real public sector wages to reduce spending. Budget process and
management reforms also provided a way for governments to share in the
sacrifice of fiscal restraint.
Cuts that were targeted to upper income groups provided a type of "vertical
equity" or progressivity. Canada "clawed back" the old-age pension benefits
paid to the wealthy, while Australia means tested pensions and child
allowances, and, in addition, used some of the budgetary savings to increase
benefits to the poor.
SOME STRATEGIES DEFERRED OR
DEFLECTED COSTS OF DEFICIT
REDUCTION
------------------------------------------------------------------ Chapter 4:3.3
Some countries adopted longer term strategies that delayed the real pain
associated with deficit reduction. In these cases, policies were adopted that
did not significantly cut current benefits or beneficiaries but rather phased
in reductions affecting future beneficiaries. This kind of strategy was
thought to give future beneficiaries time to adjust their plans without unduly
disrupting the lives of current program recipients.
Such strategies were particularly important when cutting benefits that have
been, in effect, capitalized in the value of property or in expectations of
future retirement support. For example, the government in the United Kingdom
established a ceiling on home mortgage interest deductions at a time when most
taxpayers' deductions were far below the ceiling. However, because the ceiling
was not indexed, inflation has now made the ceiling an effective cap on the
deduction, without any subsequent action on the part of policymakers.
Countries used other strategies to defer or shift the pain associated with
deficit reduction. Officials told us that cuts in capital spending were easier
to make than cuts in government operations. Reductions in assistance to state
and local governments enabled national governments to, in effect, pass down the
burden of deciding how to allocate cuts. The devolution of responsibilities to
the private sector through privatization or to employers and employees through
private pension mandates also reduced present and future fiscal burdens on
national governments.
Policies regarding the indexation of taxes and benefits also served to lower
the visibility of fiscal sacrifice. On the revenue side, the absence of tax
indexation in many of these nations enabled governments either to reap the
fiscal dividends from inflation without overt tax increases or to give periodic
tax "cuts." Modifying the indexation of pensions and other entitlements also
proved to be a productive source of fiscal savings; the annual adjustments from
such changes can be quite small but the cumulative impact over time can be
substantial. For example, the shift in the basis of pension indexation in the
United Kingdom from wages to prices had a small initial impact, but by 1988 the
annual savings had grown to �4 billion as the differences between the two
indicators widened.
GOVERNMENTS RETURNED TO OFFICE
DESPITE DEFICIT REDUCTION
MEASURES
------------------------------------------------------------------ Chapter 4:3.4
During the period when these countries undertook fiscal austerity measures,
governments in the five countries that balanced their budgets were re-elected,
some several times. In Germany, the coalition government under Chancellor Kohl
took over after a vote of "no confidence" in 1982; it immediately instituted
its program of fiscal restraint and won general elections in 1983, 1986, 1990,
and 1994. The Australian Labor government took over in 1983 and was returned
to office four times in the next decade, once only 2 months after announcing a
budget with large expenditure cuts. The Conservative party retained power in
the United Kingdom throughout its deficit reduction efforts. Although the
relationship between these fiscal policies and re-election is unclear,
successful deficit reduction did not represent the electoral threat that some
might expect.
FISCAL AND ECONOMIC BENEFITS OF
AUSTERITY
-------------------------------------------------------------------- Chapter 4:4
Deficit reduction provided significant fiscal benefits to which leaders could
point in justifying painful measures. These benefits were realized by slowing
or reversing the growth of public debt, thereby slowing or reversing the growth
of interest costs. Moving from large deficits to surplus could turn what was
previously a "vicious circle" of deficits, debt, and rising interest costs into
a "virtuous circle" of surplus, debt reduction, and falling interest costs.
Once the virtuous circle is set into motion, the government regains the
flexibility, previously restricted under budget deficits, to address new or
emerging needs.
Figures 4.1 and 4.2 show the changes in debt and interest in the five countries
that reached balance. Figure 4.1 shows the improvement in net debt balances in
the five case study countries after deficit reduction. Figure 4.2 illustrates
the improvement in the interest "bite"--interest payments as a percent of total
expenditure--after deficit reduction.
Mexico offers the best example of the fiscal benefits. Where in 1986 debt was
81 percent of GDP, by 1992 it was 29 percent; interest costs, 50 percent of
total current spending in 1987, dropped to 19 percent in 1992. By 1992,
Mexico's debt levels were among the lowest of all the OECD countries.
Figure 4.1: The Benefits of Deficit
Reduction: Lowering Net Debt
(See figure in printed edition.)
Note: Mexico's 1992 data are preliminary.
Sources: OECD Economic Outlook, #55, and the Banco de Mexico.
Figure 4.2: The Benefits of Deficit
Reduction: Lowering the "Interest
Bite"
(See figure in printed edition.)
Sources: OECD Economic Outlook, #55, and the International Monetary Fund.
Reduction of public debt, in addition to the short-term effect of reducing
interest costs, can improve economic growth in the long run. When deficits and
debt fall, capital is freed for investment by the private sector, assuming no
change in the rate of private saving. Economists point to increased investment
as a key element of long-term economic growth and rising living standards.
Although not enough time has elapsed to observe such changes resulting from the
case study governments' deficit reduction, these benefits can be expected in
the long run.
Deficit reduction's shorter run effects can be contractionary for the economy.
However, many of the case study governments reported economic improvements
shortly after embarking on austerity policies. Fiscal restraint generally has
contractionary effects on demand in the short run, which can dampen economic
growth unless offset by other policies or events. Deficit reduction was, in
most instances, one of several changes in the economic policies of the case
study countries, and none of these governments reported such interim downward
effects. Other economic policies and events may have acted to offset the
dampening effects of deficit reduction. Government leaders were, however, able
to point to positive changes that were a result of this mix of economic
policies, such as reductions in inflation and interest rates and increasing
rates of economic growth. For example, inflation in Germany dropped from 6.3
percent to -0.1 percent from 1981 to 1986, and long-term interest rates in the
United Kingdom declined from 14.9 percent to 9.6 percent from 1981 to 1987.
IMPLICATIONS
====================================================================== Chapter 5
The experiences of the case study countries show that significant structural
improvement in fiscal policy is possible in modern democracies, although such
progress is difficult to sustain. Each country's story demonstrates a
different approach to deficit reduction, formed in part by the nation's
political structure, economy, history, and culture. Similarly, fiscal policy
in the United States also reflects unique cultural, political, and economic
factors. However, particular elements of other nations' experiences may help
the United States continue to address this common challenge.
TRANSFERABILITY OF OTHER NATIONS'
EXPERIENCES
-------------------------------------------------------------------- Chapter 5:1
Some might express skepticism about the transferability of deficit reduction
experiences between different systems of government. Parliamentary systems are
thought to facilitate controversial political action by consolidating power in
the hands of the governing party. In contrast, the U.S. system's separation
of powers is thought by some to present leaders with greater obstacles to
political agreement.
Yet imposing fiscal sacrifice is a difficult task for any democratically
elected government, irrespective of obvious differences between political
systems. Prime Ministers, no less than Presidents, depend for their
effectiveness on support both from the general public and interest groups.
Political leaders in our case study countries had to assemble coalitions to
support deficit reduction just as Presidents and congressional leaders do in
the United States for their own fiscal plans, and they had to retreat from
proposals in several notable cases when the political opposition grew too
heated. However, the form of consensus-building differs. Political bargaining
in parliamentary systems generally occurs within the government, out of the
public limelight and prior to the presentation of the budget, whereas
bargaining in the U.S. system often occurs in public forums following the
submission of Presidential or congressional proposals.
It may also be argued that economic differences affect transferability of
fiscal experiences. The United States economy has no peer. As the world's
largest and most diverse economy, it remains less vulnerable than others to the
pressure of international financial markets. The large stock of accumulated
wealth in the United States permits more borrowing than in smaller countries;
similarly, a deficit of a given percentage of GDP may affect the United States
less than much smaller economies. Thus, despite the chronic and large fiscal
deficits of the 1980s, the United States had to worry less about sudden and
sharp reductions in the availability of capital than did some of the other
economies we studied.
Despite these differences, deficits do matter to the U.S. economy as they do
elsewhere. High real interest rates, expectations of rising inflation,
declining value of the currency, decreased fiscal flexibility, and inadequate
investment to support long-term economic growth can and have been linked to
fiscal deficits, whether in smaller economies we studied, or the United States.
Although leaders governing smaller economies such as Australia may feel
external pressure to take action against deficits, leaders in larger economies
such as Japan and Germany took decisive fiscal action partly in response to the
kinds of concerns about the domestic economy expressed in the United States.
Thus, many of the same pressures prompting action by other nations also concern
U.S. policymakers--the differences appear largely in timing and magnitude.
REACHING AND SUSTAINING LONG-TERM
FISCAL PROGRESS
-------------------------------------------------------------------- Chapter 5:2
In the United States, progress has been made in recent years to lower the
deficit path, but projections suggest that the deficit problem worsens
dramatically over the long run, particularly as the baby boom generation
retires. Addressing this long-term problem thus presents the challenge of
further reducing the structural deficit as well as sustaining such fiscal
progress.
The experiences of five of the six nations suggest that resolving deficits is
possible in modern democracies. Leaders succeeded in mounting the case for
prompt action before crisis ensued, but they found sustaining the sense of
urgency and the fiscal balance over extended periods problematic, in part
because pent-up demands became more compelling once fiscal goals were achieved.
This suggests that policymakers can strive for fiscal progress and even fiscal
balance when presented with windows of opportunity, as defined by cultural and
economic factors that are unique to each nation. Although such fiscal goals
will be difficult to sustain, deficit reduction strategies can be designed in a
way to enhance the budget's long-term capacity to sustain fiscal progress.
The experience of the other nations and recent U.S. fiscal history suggest
that prospects for reaching and sustaining balance can be affected by strategic
fiscal decisions, including the following.
Addressing the large and growing areas of the budget. As we have observed
previously, meaningful long-term deficit reduction will be difficult to achieve
if any of the significant deficit "drivers" or other major areas of the budget
are not considered. Most case study countries kept both discretionary and
mandatory spending programs available for reduction, even though health and
pension programs did not always "drive" expected deficit growth as they do in
the United States. Spending on entitlements by the United States has proven to
be one of the most important deficit drivers, constituting almost half of
non-defense federal spending in 1993.\1 Governments in several case-study
countries nevertheless reduced major benefit programs by deploying three
principal strategies: (1) involving affected groups in the decision-making
process, (2) targeting benefit reductions to higher income groups, and (3)
phasing in program changes to defer pain but ensure long-term fiscal
improvement.
Maintaining focus on the structural deficit. Cyclical economic growth provides
fiscal dividends that can mask continued structural fiscal imbalances,
fostering pressure to weaken austerity measures. Governments in other nations
slackened their grip on structural deficits during periods of strong economic
growth--the very times austerity policies are easiest for the economy to absorb
and are often appropriate to contain the threat of rising inflation. This
weakening of austerity in turn created structural deficits that became visible
once again when cyclical growth receded. While not a panacea, a greater focus
on structural deficit estimates could help policymakers better gauge the nature
of the deficit problem by separating out the influences of short-term cyclical
trends from the underlying policies driving longer term fiscal outcomes.
Choosing strategies with positive long-term fiscal impact. Program changes
that maintain or expand their positive fiscal effects over the long term are
critical to sustaining fiscal progress. Some governments we studied employed
strategies that expanded in impact over time. These "wedge-shaped" savings
often had little effect at the time they were approved, but became fiscally
more important as beneficiaries aged, inflation altered the impact of nominal
floors or ceilings, or economies changed. Phasing in cuts affecting future
beneficiaries also helped these governments ease the transition for affected
groups, thereby promoting greater public support. Choosing such strategies
calls for a fiscal planning horizon extending into the longer term future.
Generating public support for these strategies is also critical to long-term
progress. Leaders in other nations were able to find the formula that
succeeded in mobilizing support for deficit reduction while minimizing the
opposition of those bearing fiscal sacrifice. Making compelling arguments for
austerity, employing effective fiscal strategies, and persevering on a fiscal
path that successfully reached balance formed a basis for this achievement.
Although it is never easy for leaders to ask their electorate to sacrifice
benefits or income in the interests of broader goals, demonstrable and
convincing progress on fiscal and economic goals ultimately helped leaders in
other countries justify these fiscal sacrifices.
--------------------
\1 Entitlement spending in the United States includes many programs, the
largest of which are Social Security, Medicare, Medicaid, federal retirement,
and unemployment compensation.
COMMONWEALTH OF AUSTRALIA
===================================================================== Appendix I
The government of the Commonwealth of Australia made budget deficit reduction
one of its highest priorities in the latter half of the 1980s in response to a
widely perceived economic crisis caused by collapsing commodity prices, an
overall deterioration in the terms of trade, and a fall in the value of the
Australian dollar. Deficit reduction measures coupled with strong economic
growth resulted in 4 consecutive years in which the budgets of the central
government and the entire public sector were balanced or in surplus. (See
figure I.1.)
Figure I.1: General Government
Financial Balance in Australia,
1978-1992
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
By stressing the fall in the value of the currency, the government made
Australians focus on how the government's fiscal imbalance could reduce their
purchasing power and long-term standard of living. The sense of crisis and
urgency was combined with a "bargained consensus" approach to decision-making
to achieve a central government budget surplus in 1987 for the first time in
over 35 years.
The Labor Party took control of the government in 1983 with an agenda focused
on controlling inflation, reducing unemployment, restraining wages on an
economywide basis, and establishing universal health care. Before the end of
the decade, however, the Labor government had also allowed the value of the
currency to float, deregulated financial markets, targeted pension and
unemployment benefits towards the poor, restrained other government
expenditures, increased some taxes and reduced others, and improved
government's efficiency and effectiveness through management and budgetary
reforms.
BACKGROUND
------------------------------------------------------------------- Appendix I:1
The Commonwealth of Australia is a federation with three tiers of government:
the national Parliament and government; 6 state governments; and about 900
local government bodies at the city, town, municipal, and shire level. The
Commonwealth Parliament was established by the Constitution, which took effect
on January 1, 1901, and is made up of the House of Representatives (148
members) and the Senate (76 members--12 from each state and 2 from each of the
two most populous territories). The party or coalition of parties with a
majority in the House of Representatives becomes the government and provides
the Prime Minister. Cabinet Ministers can be selected from either the House or
the Senate.
The two largest political parties in the Commonwealth Parliament are the
Australian Labor Party and the Liberal Party of Australia. The Labor Party
generally represents union interests while the Liberal Party represents more
conservative constituencies. The other parties are the Australian Democrats,
the National Party of Australia, and independents.
The Australian Council of Trade Unions (ACTU) enjoyed a close relationship with
the Labor government during the 1980s. ACTU is an umbrella organization
representing Australian unions, making it a large, centralized, and important
interest group. Throughout its tenure in the 1980s, the Labor government
negotiated formal wage and price agreements with ACTU and consulted with ACTU
leadership on many issues. ACTU, in turn, supported many of the fiscal policy
decisions made by the Labor government. The cooperation between the Labor
government and ACTU during the 1980s is attributed in part to (1) the desire to
overcome the popular perception that the previous Labor government (1972-1975)
had been weak in matters of fiscal policy and (2) the general recognition that
Australia needed to become more competitive internationally.
RESPONSIBILITIES OF DIFFERENT
LEVELS OF GOVERNMENT
----------------------------------------------------------------- Appendix I:1.1
Commonwealth budget responsibilities include national defense, immigration,
postal and telecommunications services, social security,\1 and welfare. State
responsibilities include most public sector spending on education, health,
public safety, and infrastructure. Local responsibilities include local roads
and parks, libraries, and land use planning.
In Australia, the Commonwealth government collects more than three-quarters of
the public sector revenue but is responsible for only about half of public
sector expenditures. Commonwealth revenues come primarily from income taxes,
sales taxes, and custom and excise duties. State revenue comes mainly from
payroll taxes, business franchise taxes, and stamp duties. The Commonwealth
government also transfers revenue to the states in the form of general and
specific purpose grants. Local government revenue comes from property taxes,
charges, and fines and a portion of the Commonwealth grants to the states.
--------------------
\1 The term "social security" refers to old-age pensions. Old-age pension
payments are funded out of the general fund, and neither employers nor
employees make contributory payments.
BUDGET PROCESS
----------------------------------------------------------------- Appendix I:1.2
The budget is put together by the ruling party government. While Cabinet
Ministers and their departments are involved in submitting "bids" for funding,
the Treasurer and the Minister for Finance are responsible for the budget.
Because tough budget decisions need the eventual support of the entire Cabinet
and the Parliament, the Labor government often used a subgroup of the Cabinet
called the Expenditure Review Committee to make decisions on where to make
budget cuts during the second half of the 1980s.
Generally, government budgets are passed largely intact by the Parliament. If
the Parliament cannot pass the government's budget, it is viewed as a vote of
no confidence and a new government must be formed. In 1975, a "double
dissolution" of the Labor government under Prime Minister Whitlam and the
sitting Parliament occurred when the Senate refused to pass the funding bills
for government operations.
IMPETUS FOR REDUCING THE DEFICIT
------------------------------------------------------------------- Appendix I:2
After coming to power in 1983, the Labor government's goals were to reduce
unemployment, control inflation, and stimulate the economy. The government
entered into an agreement with ACTU to restrain wage growth in exchange for the
"social wage" of increased social benefits. The government's economic reforms
included allowing the value of the Australian dollar to float on world currency
markets and deregulating the financial markets. By late 1984, however, the
Labor government turned its attention to the budget deficits and was promising
to reduce both the deficit and overall spending as a percentage of GDP.
Interviewees cited several factors that prompted the Labor government to take
action to reduce budget deficits during the 1980s. Trade-related factors
included large trade deficits and falling currency values. Other factors
included the need to maintain international confidence and the decision to use
primarily fiscal, rather than monetary, policy to address economic problems.
During the 1980s, deficit reduction efforts of the Commonwealth focused on both
the deficit of the central government and on the total public sector borrowing
requirement. Figure I.2 shows how OECD's deficit measure referred to as "net
lending" compares for the central government and for state and local
governments during the 1980s.
Figure I.2: Net Lending in
Australia, 1979- 1991
(See figure in printed edition.)
Source: OECD National Accounts, Volume II.
DEFICITS WERE ENTRENCHED
----------------------------------------------------------------- Appendix I:2.1
Before achieving a budget surplus in its 1987-88 budget year, the Commonwealth
of Australia ran deficits almost every year since the 1953-54 budget. Although
Commonwealth deficits were entrenched, they were relatively small--in the range
of 0.5 to 2.5 percent of GDP--between 1953-54 and 1973-74. Fiscal restraint
and deficit reduction had been discussed by the Labor government under Gough
Whitlam (1972-1975) and some spending restraint undertaken by the Liberal
government under Malcolm Fraser (1975-1983), but Commonwealth deficits were
between 3 and 5 percent of GDP in the middle and late 1970s.
The oil shock in 1979 and the subsequent world recession, high wage-driven
inflation, and a severe drought slowed progress on bringing down the deficit in
the late 1970s and early 1980s. Experts we interviewed attributed high
inflation of the early 1980s to a "wage blowout" of the late 1970s and early
1980s in which wages increased by as much as 20 percent in a single year.
While wage increases were large, unemployment was also high, reaching almost 10
percent of the workforce by 1983. An ACTU official told us that during this
time, the Australian worker saw that large wage increases did not translate
into a higher standard of living, but rather simply fueled inflation.
1983 THROUGH 1985: INCREASED
SPENDING AND ECONOMIC GROWTH
----------------------------------------------------------------- Appendix I:2.2
When the Labor government came to power in 1983, it had no formal plans to
balance the budget nor to make deficit reduction a major priority. The 1984-85
Commonwealth budget reflected a real increase of 6.1 percent in outlays over
the previous year due to the first full year of health care funding and
election-year spending. In the 1983-1984 time frame, the Labor Government was
trying to make room for new programs to which it was committed. Between 1983
and 1985 inflation decreased from 10.1 percent to 6.7 percent, unemployment
fell from 9.9 to 8.2 percent of the labor force, and GDP growth was strong as
the economy bounced back from a recession in 1982.
1985 AND 1986: ECONOMIC CONCERNS
AND PERCEIVED CRISIS
----------------------------------------------------------------- Appendix I:2.3
Although the economy continued to grow, by 1985 there was widespread
recognition that Australia's debt and trade positions were worsening.
Government debt held by foreigners was increasing rapidly. In addition to
mounting external debt, Australia's trade balance was in large deficit, and
commodity export prices were falling. These factors caused concern over
Australia's international competitiveness and future standard of living levels.
To combat these problems, Prime Minister Bob Hawke had put forth a set of
fiscal goals referred to as the "trilogy" during the 1984 election campaign.
The trilogy was a promise by the government that over the life of the next
Parliament (1) there would be no increase in tax revenue as a percent of GDP,
(2) government expenditure would not increase as a percent of GDP, and (3) the
budget deficit would be reduced. The Commonwealth government set forth these
goals officially in the 1985-86 budget in order to "cut back on public sector
activity to provide scope for, and to encourage expansion in the private
sector."
Deficit reduction became paramount in 1986 as a sense of economic crisis grew.
As shown in figure I.3, the value of the Australian dollar declined by more
than 30 percent against an OECD index of member-country currencies between 1984
and 1986. Australia's terms of trade--the ratio of export to import
prices--fell by about 10 percent between mid-1985 and the end of 1986. The
current account deficit--the value of exported goods and services less the
value of imported goods and services--increased from 3.7 percent in 1983 to 5.5
percent in 1986. In May 1986, the Treasurer, Paul Keating, said publicly that
Australia risked becoming a "banana republic" if it did not address its trade
and budget imbalances.
Figure I.3: Effective Australian
Exchange Rates, 1981-1991
(See figure in printed edition.)
Note: Index is average of daily rates with 1991 = 100.
Source: OECD Economic Outlook, #55.
At the end of July 1986, the Australian dollar dropped from 63 U.S. cents
through the "psychological floor" of 60 U.S. cents to a low of 57 U.S. cents.
Australian officials we interviewed, including the Minister of Finance during
this period, said that the Labor government believed it was imperative to
reassure foreign capital markets that something would be done to correct the
problems. The world financial community did not see this situation as one that
Australia could simply borrow or grow out of.
According to a senior official, in the midst of the crisis, Australian
policymakers decided to reduce the federal budget deficit rather than raise
interest rates. He said this was perceived by the international finance
community as being a novel approach. The traditional response to this problem
by other nations seemed to be to raise interest rates, prop up the currency,
and cut demand. The Australian government decided to focus on the budget
deficit because its leaders felt the economic problem was structural and long
term and its resolution would only be postponed by raising interest rates.
1986 TO 1989: SUSTAINED
EXPENDITURE RESTRAINT AND
ECONOMIC GROWTH
----------------------------------------------------------------- Appendix I:2.4
As shown in figure I.4, outlays for the entire public sector decreased from
37.3 percent of GDP in 1986 to 32.8 percent in 1989. As shown in figure I.5,
outlays for the Commonwealth government dropped from 28.8 percent of GDP to
23.8 percent over the same period. This was accomplished by keeping growth in
Commonwealth budget outlays below the level of inflation (negative real
growth), reducing investment spending and transfers to the states, and reaping
the revenue benefits of a period of economic growth.
Figure I.4: General Government
Revenues and Expenditures in
Australia, 1978-1992
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
Figure I.5: Central Government
(Commonwealth) Revenues and
Expenditures in Australia, 1978-1992
(See figure in printed edition.)
Source: Australian Budget Paper No. 1, 1993-94.
Figure I.6 and I.7 show that overall public sector debt was reduced as a
percentage of GDP and that net interest payments were reduced as a percentage
of total public sector expenditures during the late 1980s.
Figure I.6: General Government
Gross and Net Debt in Australia,
1988-1992
(See figure in printed edition.)
Note: Data not available prior to 1987. Data for 1992 are estimates.
Source: OECD Economic Outlook, #55.
Figure I.7: General Government Net
Debt Interest Payments in Australia,
1987-1992
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
Although ACTU endorsed deficit spending as a fiscal stimulus to combat
recession in the first half of the 1980s, it also endorsed reducing government
expenditure once recovery was under way. An ACTU official stated that one of
the Whitlam Labor government's biggest mistakes was to not significantly cut
back spending during economic recovery. These officials emphasized that this
was a mistake that the Labor government did not want to repeat in the 1980s.
DEFICIT REDUCTION ACTIONS
------------------------------------------------------------------- Appendix I:3
When the Labor government came into power in 1983, it persuaded ACTU to agree
to real wage cuts in exchange for a "social wage" which included universal
medical coverage, some increased social spending, and stimulation of the
economy. When the Labor government moved its policies towards deficit
reduction in the years 1985-1988, it generally maintained benefit levels but
improved the targeting of those benefits through asset and income testing. In
several social programs, targeting of recipients was tightened, including the
family allowance, unemployment benefits, tuition assistance, and pharmaceutical
benefits. Other important elements of the government's deficit reduction
strategy were cutting grants to the states, reducing investment spending, and
selling assets. As figure I.4 shows, most deficit reduction came on the
spending side after 1986. However, revenues had been allowed to increase as a
percentage of GDP between 1983 and 1987 as a result of economic growth and an
unindexed tax system.
SPENDING ACTIONS
----------------------------------------------------------------- Appendix I:3.1
The government made significant spending reductions over the 4 budget years
from 1986-87 through 1989-90. In each of these years, growth in total outlays
from the previous year was less than the rate of inflation. Measures taken to
reduce budget deficits on the spending side included better targeting of
benefits, improved administration and eligibility reviews for benefit programs,
elimination of some programs, cuts in defense, cuts in capital spending, and
reduced payments to the states.
A major package of deficit reduction measures was undertaken in the 1987-88
budget. For this budget, the Treasurer announced a set of measures projected
to reduce the 1987-88 Commonwealth budget by over A$4 billion or almost 5
percent of total estimated outlays. The "savings" were divided between
expenditure reductions of A$2.6 billion, which included reductions in
Commonwealth general purpose payments to the states of A$1 billion and proceeds
from the sale of government-owned assets of A$1 billion. The Treasurer stated
that these measures reduced growth in total Commonwealth government spending to
2 percent below the rate of inflation, which represented "the biggest fall in
30 years."
TARGETING BENEFITS
--------------------------------------------------------------- Appendix I:3.1.1
One of the goals of the Labor government was to improve targeting of social
benefits to those with the greatest financial need and to pay for it by taking
away benefits from those deemed less needy. The introduction of means testing
for pensions and family allowances, the replacement of unemployment benefits
for 16- and 17-year-olds with a job search allowance, narrowing the eligibility
requirements for the single parent's pension, and more rigorous eligibility
reviews of those receiving benefits were ways in which the Labor government
redirected benefits to the most needy. A 1992 study conducted by the
Australian Bureau of Statistics provided data on government benefits and taxes
on Australian households in 1984 and 1989 that supported the Labor government's
claim that better targeting was achieved. Figure I.8 shows how net government
benefits increased for families in the first three income deciles and decreased
for families in the fourth through tenth income deciles.
Figure I.8: Net Benefits by Income
Decile in Australia, 1984 and
1988-89
(See figure in printed edition.)
Note: Net benefits are calculated by subtracting total taxes from total weekly
benefits (in 1989 Australian dollars).
Source: The Effects of Government Benefits and Taxes on Household Income,
1988-89, Australian Bureau of Statistics, No. 6537.0.
Officials and experts we interviewed said that the term "entitlements" is not
often used to describe social spending programs in Australia. Australian
workers do not contribute to a public pension and expect that public old-age
pension benefits will be means tested. Government pensions are paid out of the
government's general fund.
A brief description of major targeting efforts follows.
Means testing pension benefits. Soon after coming into power, the Labor
government established means testing of pension benefits. In Australia, men
become eligible for the old age pension at age 65 and women at age 60. In
November 1983, an income test for pensioners was re-established after having
been abolished by the Whitlam Labor government 8 years before. In March 1985,
an assets test was restored after it had been abolished by the Fraser Liberal
government. One or the other of these tests apply so that the pension payable
is the lower of the rates determined by the income or assets test. It has been
reported that as a result of these changes, the percentage of those eligible
who receive pensions dropped from 85.6 percent in 1983 to 75.6 percent in 1991.
Means testing family allowance benefits. In November 1987, an income test took
effect for family allowance benefits. Prior to the enactment of this change,
family allowances had been given to anyone with eligible children. At an
income level of A$50,000 per year, a family would have its allowance reduced
until a family with two eligible children would receive no payment once its
income exceeded A$55,156 per year. The narrower targeting of family allowance
benefits removed families in the top two income deciles from the rolls. In
announcing this change, the Treasurer said, "It is clearly not reasonable that
the taxes of low and middle income families should continue to fund benefits
for the relatively well-off."
Unemployment benefits. Changes to the unemployment system starting in January
1988 included replacing unemployment benefits for those under the age of 18
with a job search allowance to reduce the financial incentive for young people
to leave the education system, increasing the waiting periods for beneficiaries
without dependents under the age of 21, and introducing an assets test for
those 25 years and over. The assets test was put in place to help ensure that
applicants would have to draw down their own assets before being eligible for
public assistance and to ensure that unemployment benefits would not be used as
a supplement for early retirement. The Australian Bureau of Statistics
estimated that between 1985 and 1989 the percentage of unemployed under the age
of 18 receiving unemployment benefits dropped from over 90 percent to 63
percent.
Sole parent benefit. In the 1987-88 budget the government decided that only
single parents with children under the age of 16 would be eligible for the
benefit. Previously, the definition of a qualifying child also included
dependent full-time students aged 16 to 24 who were not receiving another
pension or benefit.
REDUCTIONS IN PAYMENTS TO
STATES
--------------------------------------------------------------- Appendix I:3.1.2
Part of the Commonwealth government's strategy to reduce its budget deficit
during the mid- and late-1980s was to reduce transfer payments to the states.
Between budget years 1986-87 and 1988-89 Commonwealth payments to the states
declined. All six Australian states had lower revenues as a percent of gross
state product between 1983 and 1990, due in part to reductions in payments from
the Commonwealth. Some budget experts believe that reduced funding to the
states resulted in state deficits increasing during the latter half of the
1980s. Some observers told us, however, that reduced payments from the
Commonwealth imposed needed fiscal discipline on the states.
When the Commonwealth government cut payments to the states, it reduced the
general purpose part of such funding. General purpose payments represent the
states' share of general tax revenues and can be used by the states as they see
fit. At the same time the Commonwealth was reducing general purpose payments,
it was increasing the amount of specific purpose payments. Specific purpose
payments are made if the state meets certain conditions and ensures that the
funds are used for a specified program. State budget officials we interviewed
stated that increases in specific purpose payments did not make up for
decreases in general purpose payments because special purpose payments reduce
flexibility in state spending, amount to just a pass-through of money to
Commonwealth programs, and must be matched with state funds for some programs.
State government budget officials also said that the federal government should
allow states additional taxing authority to provide more flexibility to meet
program demands.
Since the beginning of the Commonwealth, meetings between the State Premiers
and the Prime Minister and Cabinet Ministers have been held at least once a
year. The Premiers' Conference affords state leaders the opportunity to
discuss financial and intergovernmental issues. Held in conjunction with the
Premiers' Conference is the Loan Council, in which levels of Commonwealth and
state debt are agreed to and the terms and conditions are established.
Although these annual meetings provided for direct interaction between the
Commonwealth and the states, Commonwealth government decisions to cut general
purpose payments to the states were virtually unilateral.
REDUCTIONS IN INVESTMENT
--------------------------------------------------------------- Appendix I:3.1.3
The level of public investment decreased in the last half of the 1980s. One
official said that it is always easier to reduce deficits by cutting capital
spending rather than cutting spending on operations.\2 He said, however, that
capital spending had increased over the 1970s and early 1980s, especially for
schools, universities, and electrical power plants.
--------------------
\2 Australia does not have a capital budget. The budget contains a
presentation of capital outlays, but no depreciation charges are calculated.
REVENUE ACTIONS
----------------------------------------------------------------- Appendix I:3.2
Although spending restraint was the core of the Labor government's deficit
reduction efforts, tax reform also played a role. Base broadening measures
were taken to increase revenues and included the introduction of a fringe
benefits tax and a capital gains tax and the elimination or modification of
some tax concessions. On the other side of the equation, however, income tax
rates were reduced during the 1980s and a value added tax was discussed but
never imposed.
Figure I.4 shows that receipts for all levels of government increased from 31.4
percent of GDP in 1983 to 35.2 percent in 1990. However, figure I.5 shows that
revenues at the Commonwealth level rose from 25.3 percent of GDP in 1983 to
27.8 percent in 1986 then decreased to 25.8 percent by 1990.
ASSET SALES
--------------------------------------------------------------- Appendix I:3.2.1
In the 1987-88 budget, the government announced that the revenue from the sale
of assets would be used to reduce the budget deficit. In 1987-88, revenue from
this source was about A$1 billion, and assets sold included part of the
Australian Embassy site in Tokyo, the former ambassadorial residence in Paris,
and the assets of the National Materials Handling Bureau. In the 1988-89
budget, proceeds from further asset sales for budget years 1988-89 through
1990-91 were estimated to be an additional A$2.5 billion.
TAX INDEXATION WAS TRIED, THEN
REJECTED
--------------------------------------------------------------- Appendix I:3.2.2
During the 1975 election campaign, Malcolm Fraser promised to introduce full
indexation of the tax system. After winning the election, Fraser's Liberal
government indexed the tax system in 1976. However, in 1978, taxes were
partially de-indexed in response to continued budget deficits, and, in August
1979, the budget delivered to Parliament abandoned indexation indefinitely. An
expert stated that although Prime Minister Fraser had to defend himself against
charges of broken promises, the government gave up on indexing taxes because it
cost too much and because they had to work too hard to find spending cuts to
pay for it. The expert also stated that politicians concluded that indexing
tax brackets to adjust for inflation amounted to a tax cut for which they
received no political credit.
TAX REFORM IN 1985 AND 1988
--------------------------------------------------------------- Appendix I:3.2.3
Tax reform efforts in 1985 and 1988 were undertaken primarily for structural,
rather than budgetary, reasons. In general, tax reform was about improving and
rationalizing the tax system; increasing government revenue was only a
secondary benefit, largely from reducing tax avoidance under the prior fringe
benefits tax.
During the 1984 campaign, Prime Minister Hawke promised that if he were
re-elected, the government would hold a tax reform summit. In July 1985, the
National Tax Summit was held in Canberra. The discussions on reforming the tax
system were based on several principles, which included not increasing the
overall tax burden, providing cuts in personal income taxes, reducing tax
avoidance and evasion, and making the tax system fairer. Consumption taxes
were to be considered, but any new indirect tax had to be acceptable to ACTU
and others responsible for wage restraint and have wide support of all summit
participants.
Two significant tax changes in 1985 were the introduction of a capital gains
tax and of an employer-paid fringe benefits tax. Tax revenue increases from
these two changes were estimated to be as much as A$850 million for the 1987-88
budget year, or about 1 percent of total Commonwealth revenues. Government
officials told us that prior to reform, the value of fringe benefits was
supposed to be reported by each individual taxpayer on a single line of the tax
form, but most people did not do so--tax avoidance was a problem. After the
1985 reform, employers were required to pay tax on the value of fringe benefits
paid to their employees, including zero or low interest loans; employer-paid
health benefits; and employer-provided cars, houses, and parking privileges.
An official told us that prior to its passage, there was a great deal of
concern over how the fringe benefits tax could devastate the restaurant and car
sales industries, but these dire predictions did not come true.
Another significant aspect of tax reform in 1985 was the elimination or
reduction of a number of tax expenditures. The deduction for entertainment
expenses was eliminated, saving an estimated A$310 million in the 1986-87
budget. Tax concessions for the filmmaking and petroleum industries were
reduced as were tax breaks for foreign-sourced income and soil and water
conservation.
As set out in the goals for the Tax Summit, the tax reforms in 1985 did not
increase the overall tax burden, thanks to substantial personal tax cuts
provided in 1986 and 1987 which returned the revenues gained from reforms to
the taxpayers. The government also cut tax rates in exchange for real wage
reductions from the unions. The tax reform effort in 1988 focused mainly on
reducing the corporate tax rate, closing additional tax loopholes, and changing
the way some retirement income was taxed.
Among OECD countries, only Australia, the United States, and Switzerland do not
impose a value added tax. Imposition of a broad-based goods and services
consumption tax was discussed but not implemented as part of the 1985 tax
reforms. The Treasurer supported a proposed 12.5 percent consumption tax to
replace the existing wholesale sales tax. However, the consumption tax was not
fully supported by the groups at the Tax Summit for various reasons. Some
within the Labor Party, ACTU, and welfare groups objected to a consumption tax
because it would hit the poor the hardest. Although the business community had
in the past indicated support for a consumption tax, it did not support any of
the Labor government's proposed options because of the additional costs imposed
on business. As a result of the controversy caused by the proposal, the Prime
Minister decided to proceed with tax reform without the inclusion of a
consumption tax.
MEDICARE LEVY
--------------------------------------------------------------- Appendix I:3.2.4
The introduction of universal health insurance coverage (referred to as
"Medicare") in 1983 resulted in Commonwealth outlays for health increasing 40
percent over the previous year. In February 1984, the Labor Government
introduced a levy of 1 percent of taxable income to help cover the cost of the
new program and then raised the levy to 1.25 percent in December 1986. In July
1993, the levy was raised to 1.4 percent. An official we interviewed said that
the Medicare levy did not defray the full cost of the program.
REACHING AGREEMENT
------------------------------------------------------------------- Appendix I:4
The decision-making approach used by the Labor government during the 1980s has
been characterized as "bargained consensus" and as "neo-corporatist." These
terms were used to describe the importance the new Labor government placed on
achieving some level of consensus with ACTU, business, and other groups upon
taking office in 1983. Although it was applied with varying levels of effort
and success at different times, consensus and consultation was the Labor
government's preferred decision-making approach during the 1980s.
Management and budgetary reform also played a role in Australia's deficit
reduction story during the 1980s. The intent of management reforms was to
shift the focus away from government inputs to achieving government objectives
in an efficient and effective manner. Budgetary reforms were introduced to
make budget decisions more transparent and to centralize control of outlay
totals. In addition to their stated objectives, these reforms also helped the
government promote deficit reduction as part of a larger strategy to make the
workings of the government more efficient.
An important aspect of the deficit reduction story during the 1980s and early
1990s was the number of times that the Labor Party was re-elected. After its
victory in March 1983, the Labor Party was returned, sometimes narrowly, to
office four times--in 1984, 1987, 1990, and 1993. Labor was re-elected in July
of 1987, only 2 months after announcing tough measures to reduce the budget
deficit by A$4 billion. We were told that the election results indicated that
a majority of Australian citizens supported the Labor government's austere
fiscal policies and that deficit reduction was not necessarily a political
liability. Also, political opposition was somewhat neutralized by the Labor
Party's movement into the political middle ground of fiscal restraint.
CONSENSUS WITHIN THE RULING PARTY
----------------------------------------------------------------- Appendix I:4.1
Observers note that the leaders of the Labor Party made philosophical shifts
during the 1980s in order to gain and maintain control of the government and to
move the Labor Party into the political center. Many in the Labor Party
believed that the Party had to overcome a negative fiscal legacy held over from
the Whitlam Labor government, which fell in 1975 when the Australian Senate
held up government funding. In a philosophical shift some have called
"economic rationalism," the Labor government decided to restrain wage growth,
let the value of the currency float, deregulate financial markets, reduce trade
tariffs, and reduce budget deficits. Prior to winning the national election in
1983, the Labor Party signed an agreement with ACTU that promised a "social
wage" that included universal health care and tax cuts in exchange for wage
concessions. However, in some policy areas, such as its support of regulated
wage settlements, the Labor government did not significantly change its
traditional position during the 1980s.
Although its leaders were changing the way the Labor Party approached certain
sectors of the economy, consensus within the ruling party and at the Cabinet
level was critical. Because the Cabinet and the ruling party can remove the
Prime Minister, it was important for the Prime Minister to seek agreement on
most issues. The Labor Party had its conservative, moderate, and liberal
factions and the interests of all had to be considered under the Labor
government's consensus approach to decision-making.
Because difficult budget decisions needed the support of the entire Cabinet and
the Parliament, the Labor government relied heavily on the Expenditure Review
Committee, a subgroup of Cabinet Ministers, to make decisions on where to make
budget cuts. At the beginning of the budget process, the full Cabinet
formulated and communicated the government's overall policies to the spending
ministries. However, the Expenditure Review Committee resolved budget
conflicts and decided on reductions after consulting with the appropriate
Ministers. In this way, departments within government were forced to frame
their requirements within the overall framework of fiscal restraint.
According to a former Minister of Finance, the Expenditure Review Committee
spent great amounts of time considering how and where to make cuts. He said it
made more sense from a policy-making perspective to consider each reduction
separately than to rely on an arbitrary mechanism such as across-the-board
cuts. Another former government official told us that while across-the-board
budget cuts have been considered from time to time in Australia, they have
never been used. He said across-the-board cuts would be seen as a surrender of
decision-making power and a violation of the agreement between the government
and the public on appropriate program spending levels.
It was possible for groups within the party but outside the government to force
changes in the budget. For example, in the budget proposed in August 1993, the
Labor government tried to eliminate optometry benefits from its health program,
thus saving an estimated A$345 million over the next 4 years. However, a group
of Labor Party members who were not part of the government (referred to as
"backbenchers") disagreed with their own Party's government and forced the
government to reinstate the optometry benefits before they would vote to pass
the budget. One observer told us that optometry benefits were not the real
issue, but the Party caucus used this issue to demand more influence over the
policy details.
OPPOSITION'S RESPONSE WAS MUTED
----------------------------------------------------------------- Appendix I:4.2
Although the opposition party is not formally involved in budget preparation,
it can become influential by opposing the ruling party government's fiscal
policies, as was shown in the fall of the Labor government in 1975. However,
the Liberal Party of Australia, the opposition party during much of the 1980s,
was neutralized to some extent by the Labor government's approach to deficit
reduction. Opposition members of Parliament we interviewed indicated that the
Labor government had taken over the "middle ground" of fiscal restraint in the
middle and late 1980s. On the whole, the opposition supported the Labor
government's efforts to hold down spending and attempts to better target
benefits to the poor, although opposition members argued that spending should
have been cut further. There was disagreement, however, over tax changes such
as introduction of the capital gains tax.
INTEREST GROUP INVOLVEMENT
----------------------------------------------------------------- Appendix I:4.3
During the 1980s, the Labor Government gained consensus from key interest
groups. To obtain this consensus, however, the government had to institute new
programs that prompted higher government spending in certain areas. Although
the interest group with the most direct influence on the Labor government was
ACTU, other groups were consulted periodically.
UNIONS
--------------------------------------------------------------- Appendix I:4.3.1
As the umbrella organization of Australian unions, ACTU represents a large and
centralized interest group. ACTU's membership includes people in roughly the
third through the eighth income deciles.
The ACTU leadership took the position in the mid- to late-1980s that deficit
reduction was important to Australia's overall economic growth and that only
economic growth would increase workers' standard of living over the long term.
ACTU leaders were able to convince their constituents to accept real wage
reductions. However, the tradeoff was a higher "social wage" in the form of
increased government benefits such as universal health care coverage, a new
retirement system called superannuation,\3 and tax rate cuts. ACTU also
supported the government's introduction of means testing for pensions, the
family allowance, and unemployment benefits in order to better target benefits
to the needy.
--------------------
\3 Superannuation is the term used for the private pension system covering
Australian workers. Improved superannuation was one of the concessions given
for wage restraint in 1985 and 1986. In the 1991-92 budget, the Labor
government introduced a superannuation guarantee levy on employers that were
not complying with requirements to fund private retirement plans.
OTHER INTEREST GROUPS
--------------------------------------------------------------- Appendix I:4.3.2
Other interest groups were also consulted on budgetary matters during the 1980s
but on a less frequent and direct basis. At the beginning of its tenure in the
1980s, the Labor government convened what was called the National Economic
Summit. The Economic Summit was held in April 1983 in Canberra and those in
attendance included the Prime Minister and several of his Cabinet, the State
Premiers, and leadership from the Council of Local Government Associations,
ACTU, the Confederation of Australian Industry, business and professional
organizations, and the Australian Council of Social Services.
This widely diverse group came away from the 4-day conference agreeing that,
among other things, reducing unemployment and controlling inflation should be
high government priorities. The group also agreed that some amount of fiscal
stimulus was needed along with an effective policy to control wages and prices.
They recommended that a group be formed to represent various interest groups in
future consultations with the Labor government. This group was called the
Economic Planning Advisory Council (EPAC) and was made up of union, business,
government, construction, farming, and social welfare leaders. EPAC continues
to offer advice to the government on its policies. Although deficit reduction
was not yet a priority in 1983, the Economic Summit conveyed the message that
the Labor government was interested in building consensus for its fiscal
policies.
The Labor government did not consult with the Australian business community as
closely nor as often as it did with ACTU, but business confidence did play a
role in deficit reduction during the 1980s. Business leaders were in
attendance at the National Economic Summit in 1983, and the business community
was familiar with the Prime Minister from his previous position as president of
ACTU and member of the Reserve Bank Board. Although business did not always
publicly support the Labor government, experts said the business community
believed the Labor government offered the best prospects for moderating wage
levels. They also pointed out that corporate profitability increased
significantly between the years 1983 and 1988.
BUILDING SUPPORT FOR DEFICIT
REDUCTION
------------------------------------------------------------------- Appendix I:5
The Labor government used several strategies both to convince the public that
deficit reduction was necessary and to make deficit reduction more palatable.
These strategies included stressing longer-term economic concerns when asking
for short-term sacrifice, offering trade-offs for spending cuts, and
instituting management and budgetary reforms to deliver government services in
a more efficient and open manner.
Political leadership was also key to successful deficit reduction. The Labor
government during the 1980s promoted deficit reduction to the public and
followed through once elected. The government convinced the public that
failing to act would be worse than accepting actions such as means testing
benefits and introducing capital gains and fringe benefits taxes.
STRESSING LONG-TERM ECONOMIC
CONCERNS
----------------------------------------------------------------- Appendix I:5.1
From the time it took over the government in 1983, the Labor Party, along with
government leaders, began to stress longer-term macroeconomic themes such as
reducing inflation, creating jobs, and improving international competitiveness.
During the 1984 campaign and in the 1985-86 budget, the Labor government made
its "trilogy" promise not to increase taxes, government expenditure, or the
deficit as a percent of GDP over the life of the next Parliament. The Labor
government's stated reason for setting these goals was to make room for
expansion of the private sector.
In May 1987, 1 year after the Treasurer made the comment that Australia was in
danger of becoming a "banana republic," the Labor government announced a budget
containing A$4 billion in deficit reduction measures. In announcing these
measures, the government emphasized that weakened trade and economic positions
would result in a long-term decline in the Australians' standard of living.
Because exports and imports were a significant part of Australia's economy,
changes in terms of trade and currency values were perceived by Australians to
have immediate effects on their purchasing power and standard of living.
The government effectively linked budget deficit reduction to improving
international competitiveness and raising long-term standards of living. Two
months later, in July 1987, the Labor government was returned to office in the
national election. One official told us that part of the political
effectiveness of the Labor government of the 1980s was its ability to tie
long-term problems like the budget deficit into short-term crises so that
politicians, labor leaders, and the voting public would deal with them.
Interviewees told us that the Labor government turned economic concepts into
household words during the 1980s. They said that Australians pay attention to
export prices, exchange rates, and other economic indicators. A member of the
political opposition told us that many Australians felt "mugged by reality" in
the mid-1980s and believed that spending cuts were essential to improving
Australia's competitive position in the world.
CHANGING THE TERMS OF DEBATE
----------------------------------------------------------------- Appendix I:5.2
By focusing on reducing government expenditures and Commonwealth deficits as a
percent of GDP, the Labor government changed the way in which interest groups
had to frame their claims on budgetary resources. An advocate for the poor,
elderly, and disabled told us that his organization published several papers in
the late 1980s and early 1990s that put forward a broad agenda, not only in the
area of social policy but also in the area of tax reform. By addressing the
revenue side of government, the group framed its proposals in terms of how to
pay for them. This approach was necessary because the terms of the budget
debate had shifted by the late 1980s to focus on ways of reducing the budget
deficit. Arguments for spending on new or improved social programs had to be
made in the context of Australia living within its budgetary constraints.
TRADE-OFFS
----------------------------------------------------------------- Appendix I:5.3
From the beginning of its tenure in the 1980s, the Labor government seemed to
understand that its ability to marshall support for fiscal restraint in certain
program areas would be facilitated by making trade-offs in the form of expanded
or new benefits in other areas. For example, universal health coverage was
introduced in 1983 as part of the "social wage" trade-off for wage moderation,
even though economywide wage restraint was not so much a budgetary savings as
it was part of the government's effort to improve Australia's competitiveness.
The Labor government was able to initiate new programs during the 1980s, even
as overall budgetary spending was being cut. A recent study of Commonwealth
budgets between 1983-84 and 1992-93\4 found that, in years in which large-scale
savings measures were introduced, substantial spending measures were also
introduced, resulting in a kind of churning or re-ordering of policies within
and between budgetary functions. One of the possible explanations the author
of the study gives for this policy "churning" was related to the government's
interaction with interest groups and the inherent difficulty of introducing
savings measures over a short period of time. Savings measures that required
sacrifice from politically potent interest groups were often combined with what
were called expenditure "sweeteners." For example, the government introduced
means testing of family allowances in 1987 to remove the wealthy from the roles
while it increased family allowance benefits to the poor.
--------------------
\4 Geoff Dixon, "Managing Budget Outlays 1983-84 to 1992-93," Federalism and
the Economy: International, National and State Issues, ed. Brian Galligan
(Canberra: Australian National University, 1993).
MANAGEMENT AND BUDGET REFORM
----------------------------------------------------------------- Appendix I:5.4
The Labor government of the 1980s was interested in instituting management and
budgetary process reforms. These reforms were intended to make delivery of
government service more efficient and to highlight budgetary decisions and make
them more transparent. Reforms were also considered by some to be a part of
the trade-offs made by the government for deficit reduction. An ACTU leader
told us that the Labor Party promised to make the government more efficient
prior to taking over in 1983. We were also told by opposition leaders that the
minority parties in Parliament generally supported the reforms.
Governmentwide management reforms included introduction of the Financial
Management Improvement Program in 1984, a general restructuring of the
government in 1987, and implementation of Program Management and Budgeting in
1988. These reforms were put in place to encourage managerial efficiency and
initiative by providing departments with greater discretion over resources.
Budgetary reforms under the Financial Management Improvement Program umbrella
included introduction of a top-down cost estimating process called the "forward
estimates" and establishment of a running costs system for tracking
administrative expenses along with the requirement of an annual "efficiency
dividend" to improve administrative efficiency.
Some observers credit the management and budget reforms of the 1980s with
helping promote and implement deficit reduction. For some, reform was part of
the trade-off that the government made in exchange for budget cuts. Brief
descriptions of these management and budget reforms follow.
Forward estimates. After taking office in 1983, the Labor government began to
publish "forward estimates"--estimated budget outlays for ongoing programs for
over a rolling 3-year period. Forward estimates are outlay estimates based on
decisions made in the previous budget year with no future policy
changes--similar to the "baseline" in the U.S. budgeting lexicon. Forward
estimates are generated by the Department of Finance rather than by each
spending department. Prior to the 1983-84 budget, each spending department
came up with its own cost estimates, and experts have referred to this practice
as "wish list" budgeting. We were told by interviewees that the forward
estimates have made the Australian budget process more open and disciplined and
have become a powerful tool for holding down spending.
Running cost system and efficiency dividends. A new system for managing
salaries and administrative costs was introduced called the "running cost"
system in 1987-88. Its purpose was to provide managers greater flexibility in
using administrative funding, including the ability to carry a certain
percentage of unspent administrative funds from one fiscal year to the next.
The results of the running cost system have been reported to be generally
favorable in improving resource management.\5
In the 1986-87 budget, the government required a savings of 1 percent on
administrative expenses and 0.5 percent in salaries to be achieved through
increased efficiency. In the 1987-88 budget, the government increased the
"efficiency dividend" requirement on running costs from 1 percent to 1.25
percent and announced it would reduce the number of staff years over a 2-year
period by 3,000 as a result of restructuring departments. Efficiency dividends
continue to be required. A senior official stated that the efficiency dividend
amounts to an across-the-board cut, but only on running costs, which make up
about 10 percent of total spending.
Government restructuring and program management and budgeting. In 1987, the
government reduced the number of departments from 28 to 18 and generally
realigned them into ministerial "portfolios." Observers said this change
resulted in better integration and more effective management.
Program Management and Budgeting was also instituted in 1987. This program was
intended to complement reforms under the Financial Management Improvement
Program with focus on defining government policy objectives, establishing
program structures to facilitate the achievement of the objectives, and
determining appropriate performance measures.
--------------------
\5 For a more detailed discussion, see Management Reforms: Examples of Public
and Private Innovations to Improve Service Delivery (GAO/AIMD/GGD-94-90BR,
February 11, 1994).
BUDGET DEFICITS DURING THE 1990S
------------------------------------------------------------------- Appendix I:6
Beginning with the 1991-92 budget year, the Commonwealth budget slipped back
into deficit of 2.4 percent of GDP and a year later the deficit had reached 3.6
percent. According to OECD calculations, roughly half of the overall public
sector deficit in 1992 was due to the cyclical effects of a recession during
1991. The remaining deficit can be attributed to structural imbalances that
have developed since the late 1980s. Experts told us that the Labor government
had cut spending as far as it was willing to, given its priorities, and that it
had started to give back benefits such as new child care payments and further
tax cuts. There was also some agreement that budget balancing action in the
future would need to focus on increasing revenues as well as cutting spending.
At the time the 1993-94 budget was printed, the government planned to bring the
budget deficit down to 1 percent of GDP by fiscal year 1996-97.
CONCLUSION
------------------------------------------------------------------- Appendix I:7
Deficit reduction in Australia during the 1980s was the result of both policy
decisions and economic growth. The Labor government opened up the Australian
economy to more international influence by floating the currency, reducing
tariffs, and deregulating financial markets. In 1986, the government pointed
to the fall in commodity prices and exchange rates as an economic crisis that
needed to be addressed through tighter fiscal policy. The government promoted
its plan of austerity on the grounds that it would improve Australians'
long-term standard of living. Structural changes were made so that when
Australia's economy rebounded strongly in the latter half of the 1980s, budget
deficits were reduced quickly and surpluses were achieved. Although deficits
have re-emerged in the 1990s, several observers stated that the deficit
reduction actions and reforms of the 1980s imposed an increased level of
discipline on the Australian budget process.
CANADA
==================================================================== Appendix II
The general government\1 deficit in Canada and both net and gross public debt
are currently among the highest of the G-7 countries.\2 In 1993, the federal
government deficit was 4.6 percent of GDP. The federal government in Canada
has taken many actions on both the revenue and expenditure sides of the budget
since the mid-1980s in an attempt to reduce the deficit, and benefited from
strong economic growth following the recession of 1982. The government's
measures have not succeeded in reversing the cycle of deficits, debt, and high
interest costs that have become a part of the Canadian economy.
--------------------
\1 OECD defines general government as all levels of government combined,
including social security trust funds.
\2 The G-7 includes Canada, France, Germany, Italy, Japan, the United Kingdom,
and the United States.
BACKGROUND
------------------------------------------------------------------ Appendix II:1
Canada is a federal system composed of a central government, 10 provincial
governments, and 2 territories. It has a parliamentary system of government,
which is composed of the Senate and the House of Commons. The Prime Minister
is the leader of the political party that has the majority of seats in the
House of Commons. Senators are appointed by the Prime Minister, while House of
Commons members are elected by popular vote. The provincial legislatures are
composed of a single house, the legislative assembly, which is also elected by
popular vote. At the federal level, the Liberal party won general elections in
1968, 1972, 1974, and--following a brief minority Progressive Conservative
administration--in 1980. The Progressive Conservative party captured the
majority in general elections in 1984 and 1988, but the Liberals returned to
power in 1993.
RESPONSIBILITIES OF DIFFERENT
LEVELS OF GOVERNMENT
---------------------------------------------------------------- Appendix II:1.1
Constitutionally, Canada has two levels of government, the federal and the
provincial. The municipal, or local level, falls under the jurisdiction of the
provincial government. The responsibilities of the two levels of government
are detailed in table II.1. Provinces levy sales taxes but over the years, due
to the heavy social responsibility carried by the provinces, a variety of
federal-provincial agreements that distribute federal revenues to the
provinces, have also developed.
Table II.1
Responsibilities of the Two Levels of
Canadian Government
Responsibilities of the
federal Responsibilities of the
government provincial governments
----------------------------- -----------------------------
Defense Health care
Foreign aid Education
Unemployment insurance Social assistance
Old-age pensions
Family allowances
(subsequently converted to a
child tax benefit)
------------------------------------------------------------
TRANSFERS TO THE PROVINCES
-------------------------------------------------------------- Appendix II:1.1.1
The three major federal transfer programs to the provinces are (1) Established
Programs Financing (EPF), (2) the Canadian Assistance Plan (CAP), and (3) the
fiscal equalization program. In budget year 1992-93, the total of all transfer
payments to other levels of government equaled approximately 18 percent of
total federal budgetary expenditures.
Through EPF, the federal government provides financial assistance on an equal
per capita basis to all of the provinces for health care and post-secondary
education. The growth in EPF payments was originally tied to the growth rate
of the economy, but the increase was capped below the growth rate several times
during the 1980s.
Through CAP, the federal government provides contributions for income support
and other social services for those in need. Under the original CAP plan,
federal payments equaled 50 percent of eligible provincial expenditures, and
the payment was open-ended. In 1990, the federal government placed a 5 percent
cap on the annual rate of growth of CAP payments to the three wealthiest
provinces--Alberta, British Columbia, and Ontario.
To ensure that provincial governments can provide comparable levels of public
services at reasonably comparable levels of taxation, the federal government is
responsible for provincial equalization. Provinces with below-standard fiscal
capacities are provided payments to bring them up to a five-province standard
based on the economies of Ontario, British Columbia, Quebec, Saskatchewan, and
Manitoba.
THE BUDGET PROCESS
---------------------------------------------------------------- Appendix II:1.2
Canada has a budget process that is relatively closed to the public as well as
to Members of Parliament. The Cabinet makes decisions on government priorities
for the upcoming year and must come to consensus on the overall size of the
budget and on the amount of dollar changes that will be needed to reach that
goal. Once the Cabinet reaches agreement on revenue and expenditure targets,
however, the budget work is turned over to the Ministry of Finance, the
Treasury Board, the Privy Council Office, and the Office of the Prime Minister.
The Ministry of Finance has primary responsibility for preparing the budget,
the Treasury Board monitors the management of the budget and serves as a budget
scorekeeper, and the Privy Council facilitates the passage of proposals through
the Cabinet committees and the full Cabinet.
The full Cabinet does not know the outcome of the budget until the day it is
released. In the past, by tradition, if any budget material was leaked in
advance, the Minister of Finance was required to resign. The closed nature of
the budget process has elicited considerable criticism, and recent governments
in Canada have supported proposals to open up the process to more public
scrutiny and involvement.
The Canadian budget is composed of statutory and nonstatutory items. Programs
which receive continuing authority, and which cannot be changed without
Parliamentary approval, such as interest on public debt, and most transfers to
provinces and individuals, are examples of statutory programs and are similar
to mandatory programs in the U.S. budget. In 1992, statutory expenditures
accounted for more than two-thirds of total net annual expenditures. Programs
that do not receive continuing authority and that do not require Parliamentary
approval before the Ministry of Finance or the Treasury Board can change their
level of funding are nonstatutory and are similar to discretionary programs in
the United States. The estimates for program changes that do not require
statutory approval, however, usually do not change once submitted by the Board
of Estimates.
SIZE AND CAUSES OF THE DEFICIT
------------------------------------------------------------------ Appendix II:2
The government was able to decrease but not eliminate the federal budget
deficit between 1984 and 1988, reducing it from 6.6 percent to 3.2 percent of
GDP, as illustrated in figure II.1.
Figure II.1: Federal Government
Financial Balance in Canada,
1970-1993
(See figure in printed edition.)
Source: Economic and Fiscal Reference Tables, Department of Finance, Canada,
September 1994.
Since 1988, however, the federal budget deficit has been increasing, and as of
1993, it had risen to 4.6 percent of GDP. Provincial government deficits were
relatively small throughout the 1980s but quickly expanded at the beginning of
the 1990s. Both federal and provincial debt and deficits in Canada have a
significant impact on the national economy. By 1993, the general government
deficit had risen to 6.8 percent of GDP, and both net and gross general
government debt were the second highest among the G-7 countries at 61.9 percent
and 92.3 percent of GDP, respectively. Figure II.2 shows the growth in net and
gross debt since 1980, while figure II.3 illustrates the change in debt-related
interest costs.
Figure II.2: General Government
Gross and Net Debt in Canada,
1980-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
Figure II.3: General Government Net
Debt Interest Payments in Canada,
1978-1992
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
Economic factors as well as internal policy decisions led to annual deficits in
Canada beginning in 1975. This imbalance between revenues and expenditures
occurred due to a slowdown in economic growth, which occurred at the same time
that program spending increased, and because social programs as well as the
federal income tax were fully indexed to inflation.
Following 1973, and the shock to the world economy due to the rise in oil
prices, the real rate of economic growth began to slow in Canada. A severe
recession that began in 1981 accelerated this slowdown. Figure II.4 shows real
GDP growth between 1971 and 1993. According to experts, the government also
overestimated future growth in the economy and continued to implement fiscal
policies based on an anticipated higher rate of growth.
Figure II.4: Real GDP Growth in
Canada, 1970-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #55 and #47.
Following World War II, the Canadian government committed itself to social
programs on a scale previously unknown in that country. Since that time,
Canada has developed a strong social welfare system, which includes old-age
pensions, family benefits, and universal healthcare. Beginning in the
mid-1970s, social programs were indexed for inflation, which created a built-in
rather than a periodic increase in program spending. In 1966-67, social
expenditures were 8.6 percent of gross national product (GNP), while by
1987-88, they had risen to 17.1 percent. Inflation was high up to the
mid-1980s but was reduced to about 4 percent by 1984. Figure II.5 illustrates
the levels of inflation between 1978 and 1993.
Figure II.5: Consumer Price
Inflation in Canada, 1978-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
At the same time that expenditures were increasing in the second half of the
1970s, revenues were decreasing. This decrease in revenues was due not only to
the declining economic growth rate but was also a result of significant changes
to the indexation of taxes. The personal income tax brackets and exemptions
were indexed to inflation in 1974. This reduced revenues because the
government could no longer benefit from the "inflation tax" that resulted from
people moving to higher tax brackets. During the same period, the government
increased tax expenditures, and reduced the sales tax rates and base.
IMPETUS FOR REDUCING THE DEFICIT
------------------------------------------------------------------ Appendix II:3
The federal government in Canada undertook deficit reduction in the 1980s to
reduce the growing debt and to bolster both domestic and international investor
confidence in its economy. Canada has never experienced an economic crisis in
which the government was unable to sell its bonds, but the country has
experienced currency depreciations, high interest rates, and lowered bond
ratings at both the federal and provincial levels.
CONCERNS ABOUT THE EFFECT OF DEBT
ON THE ECONOMY
---------------------------------------------------------------- Appendix II:3.1
In 1984, the Canadian government acted to reduce the fiscal deficit in response
to concerns over the growing public debt and its adverse effects on the
economy. The Progressive Conservative government came into power at the end of
1984 with a platform that included reducing the public sector deficits and
debt, and reducing government intervention in the economy. The Progressive
Conservatives expressed concern, in particular, over the adverse effects of
debt on domestic and international investor confidence in the Canadian economy.
The Progressive Conservative Finance Minister, who was strongly committed to
deficit reduction, illustrated these concerns in the Progressive Conservatives'
platform paper, A New Direction for Canada: An Agenda for Economic Renewal.
INCREASED DEBT LED TO INCREASED
EXTERNAL BORROWING
---------------------------------------------------------------- Appendix II:3.2
The large deficits in Canada contributed to increased foreign borrowing, which
in turn increased the country's vulnerability to foreign markets and currency
instability. Borrowing abroad results in a flow of interest payments from the
country. Interviewees said that such borrowing places a large amount of debt
in the hands of foreigners, whose actions can have a significant effect on the
value of the currency and on interest rates. Canada has experienced several
currency depreciations over the past decade. In 1986, the effective exchange
rate\3 in Canada fell from 92.7 to 86.7, a 6.5 percent drop, and in 1993, it
fell from 93.4 to 88.4, a 5.4 percent drop. The 1986 budget contained more
revenue measures than expenditure constraints, including a new temporary
federal income surcharge, added partially in response to the fall of the
Canadian dollar. This "temporary" surcharge was subsequently raised as part of
the 1989 budget. According to one expert, the tax changes in 1986 were
accepted because of a sense of crisis on the part of the public.
Despite the government's commitment to reduce Canada's reliance on foreign
borrowing, Canada's foreign debt has more than doubled since the early 1980s,
and in 1994, Canada had the highest level of foreign-held debt relative to GDP
of all of the G-7 countries.\4 Experts have stated that Canada's continued
dependence on foreign capital has left its markets exposed to sudden shifts in
investor confidence, which has depressed the currency and caused interest rates
to rise. The large size of the debt itself has also contributed to higher
interest rates as both domestic and foreign lenders require higher rates of
return to support the increased risk created by the rising level of debt.
Figure II.6 shows the change in both short- and long-term interest rates
between 1980 and 1993.
The Bank of Canada has maintained a tight monetary policy, which has resulted
in low levels of inflation. When inflation rose again in the late 1980s, the
government set targets aimed at reducing inflation to 3 percent by the end of
1992, and to less than 2 percent by the middle of the decade. These targets
have not only been met, but inflation has been lower than required. According
to the Ministry of Finance, this low level of inflation has contributed to a
recent decrease in interest rates and debt-related interest costs, as
illustrated in figures II.3 and II.6.
Figure II.6: Short- and Long-Term
Interest Rates in Canada, 1980-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
--------------------
\3 OECD calculates the effective exchange rate with a base of 1991 = 100.
\4 This foreign debt includes debt issued by governments and private
corporations and direct foreign investment in Canadian companies.
DEFICIT REDUCTION ACTIONS
------------------------------------------------------------------ Appendix II:4
The federal government has taken a variety of measures to reduce the deficit
since 1984, on both the expenditure and revenue sides of the budget. The
government succeeded in constraining expenditure growth, but this was not
sufficient to eliminate the deficit and reduce the overall debt.
The most systematic deficit reduction efforts did not begin until the
Progressive Conservative government came into power in 1984. To control
inflation in the early 1980s, the Liberal government under Prime Minister
Pierre Trudeau had introduced a system of wage limits, as well as imposed
ceilings on the indexing factors for a number of transfer programs. However,
in 1982, the Liberal government responded to the worsening recession with an
expansionary fiscal policy. The Liberal government was successful in reducing
inflationary pressures, but the wage controls came to an end shortly after the
Conservative government took over from the Liberals in 1984.
At the end of 1984, the Progressive Conservatives came into office on a
platform of reducing government intervention in the economy and curtailing the
fiscal deficit. The government quickly outlined a strategy to streamline the
government and reduce the deficit. The major part of deficit reduction was to
come from expenditure cuts and cost reduction from improved efficiency, and
from reducing the size of government.
The Finance Minister, Michael Wilson, stated that the immediate goal was to
reduce the deficit through expenditure reductions and not through major tax
increases. According to the Ministry of Finance, restraint on program spending
held annual average spending growth to 3.9 percent between 1984-85 and 1991-92,
while average inflation during this period was 4.6 percent. On the revenue
side, the government increased taxes between 1984 and 1992. According to one
economist, taxes on the household sector\5 increased by 6.7 percent of GDP
between 1984 and 1991, a larger increase in the tax burden than in any of the
other G-7 countries. This growth came largely from increases in federal
commodity taxes and income surtaxes. Between 1985 and 1991, total tax revenue
excluding social security rose by 3 percentage points of GDP. Figure II.7
illustrates the change in federal government expenditures and revenues between
1975 and 1993. The federal government budget deficit fell from 6.6 percent of
GDP in 1985 to 3.2 percent of GDP in 1988.
Figure II.7: Federal Government
Revenues and Expenditures in Canada,
1975-1993
(See figure in printed edition.)
Source: Economic and Fiscal Reference Tables, Department of Finance, Canada,
September 1994.
Economic growth was very strong in Canada after the country recovered from the
1981-82 recession. Despite the deficit reduction actions taken by the
government, a variety of experts stated that Canada missed an opportunity by
not implementing greater austerity measures in a period of economic growth.
OECD stated that a more rapid pace of fiscal consolidation would have been more
desirable given the strong economic environment.
The Progressive Conservative government succeeded in making reductions to the
deficit in its first several years in office, but cutting became more
difficult, according to one expert, as the public in general and interest
groups in particular became more adroit at dealing with the federal government.
According to another expert, the approaching election of 1988 also contributed
to a weakening of stringent fiscal measures. Both the federal and the general
government deficit began to increase after 1988.
In its 1990 budget, the government introduced the Expenditure Control Plan,
which grouped together and systematized many of the government's deficit
reduction measures. In 1991, the government implemented the Spending Control
Plan, which placed ceilings on overall program spending for 1991-92 through
1995-96 at the levels projected in the 1991 budget. The government's deficit
reduction measures since the mid-1980s have resulted in improvements to the
structural component of the general government deficit, which is the component
of the deficit that increases or decreases based on direct policy actions as
opposed to the effects of the business cycle. The structural deficit was
approximately 6.7 percent of GDP in 1985, while it fell to 3.4 percent of GDP
in 1993, but the overall general government deficit and debt have continued to
rise. (See figure II.8.)
Figure II.8: General Government
Overall and Structural Deficits in
Canada, 1978-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
--------------------
\5 The household sector is defined to include taxes on individuals, social
security contributions, and indirect taxes.
SPENDING ACTIONS
---------------------------------------------------------------- Appendix II:4.1
Expenditure constraint at the federal level helped restrain the rate of
spending growth. The government accomplished this restraint by reducing the
size of the public workforce and constraining public wage increases, limiting
discretionary spending on government programs and operations, and modifying the
indexation of benefit and transfer programs.
Reduced size and wages of public workforce. Public service employment was
reduced by approximately 4 percent between 1984-85 and 1990-91. The Ministry
of Finance estimates the savings at Can$1.5 billion. In 1991, wage increases
for public service employees were frozen and limited to no more than 3 percent
for 1992 and 1993.
Reduced foreign assistance and defense. The two primary discretionary programs
in Canada are defense and foreign aid. Cash payments for Official Development
Assistance (foreign aid) were reduced in 1985 through 1989 and program growth
was restricted beginning in 1991. The Ministry of Finance estimates savings on
foreign assistance between 1985-86 and 1991-92 at Can$5 billion. Reductions in
real growth were made in the defense program in 1986, and in 1989, reductions
in spending were enacted. Annual caps were placed on spending growth in
1990-91. In 1992, the Ministry of Finance projected savings of more than Can$3
billion since 1985-86.
Modified the indexing of benefits. The government modified the indexation
formulas for several social programs. In 1985, the government limited the
indexation to the amount by which inflation exceeded 3 percent for Family
Allowances, a universal program for families with children.
Targeted program benefits. Family Allowances were ultimately eliminated and
replaced with the Child Tax Benefit (CTB). The Family Allowance program was a
universal spending program, while CTB is a means-tested tax credit.
Shift in costs to provinces. The government limited the growth of the
provincial transfer program, EPF (health care and post-secondary education),
several times during the 1980s and capped the growth of CAP (welfare) in 1990.
Provincial deficits as a whole remained relatively small throughout the 1980s
but quickly expanded at the beginning of the 1990s. Comparative information on
federal and provincial financial deficits and surpluses between 1970 and 1993
is presented in figure II.9. In 1980, transfers to other levels of government
equaled 20.9 percent of total federal expenditures; by 1993, transfers had been
reduced to 18.3 percent of federal expenditures.
Figure II.9: Federal and Provincial
Financial Balances in Canada,
1970-1993
(See figure in printed edition.)
Source: Economic and Fiscal Reference Tables, Department of Finance, Canada,
September 1994.
Some experts stated that because transfer programs were previously open-ended,
provinces may have had little incentive to control costs before limits were
imposed. The limits placed on CAP and EPF require the provinces to either
constrain provincial expenditures, borrow additional funds, or pay more for
services out of their own budgets. One expert also stated that the provinces
are fiscally healthier than the federal government and are better prepared to
grow out of their deficits. As a result of these reductions, however, deficits
and debt at the provincial level have increased significantly, and provincial
bond ratings have been lowered several times during the 1990s.
Since the early 1970s, health care costs in Canada have not been as steep as in
the United States. Yet, Canada ranks second highest among OECD countries,
behind the United States, in health expenditures per capita. In 1971, Canada
and the United States spent about the same share of GNP on health care. By
1989, the Canadian share of health care spending was 8.9 percent of GNP, while
the U.S. share was 11.6 percent. The federal government used EPF reductions
to help control the central government deficit, but as health care is primarily
a provincial responsibility, these costs have continued to contribute to the
provincial budget deficits.
Since 1990, some of the provincial governments have taken significant fiscal
restraint measures. For example, Ontario has reduced health care spending from
10 percent growth a year in the 1980s to 1 percent in 1993. Universal health
care is still legislatively mandated, but in Ontario health care spending is no
longer open-ended, and the Ministry of Health negotiates with the medical
community regarding what will and will not be covered. Ontario has also
negotiated a social contract with its public sector workers, and employees
agreed to accept salary reductions and furloughs.
Reduced capital expenditures. The federal government reduced capital
expenditures through reductions to the capital budgets of nondefense related
departments in the federal government.
Implemented systematic deficit reduction programs. In 1990, the government
implemented a broadbased restraint program, called the Expenditure Control
Plan, which reduced, froze, or limited spending growth in every area except
major transfers to persons. Major transfers to persons include elderly
benefits, family benefits, veterans' allowances and pensions, unemployment
insurance benefits, and equalization and Canada Assistance Plan transfers.
Many of the exempted social programs, however, are subject to reductions which
lie outside of the plan--for example, the tax on elderly benefits, which is
described below. The control program was originally planned to last 2 years
but was extended to 5 years in the 1991 budget.
In 1992, the government implemented the Spending Control Act, which placed
legislated limits on total program spending. The act stipulates that
noninterest spending, with a few limited exceptions, cannot exceed the levels
projected in the 1991 budget through 1995-96. According to the Spending
Control Act, if a program expenditure rises above its projection for economic
or policy reasons, it has to be offset by reductions elsewhere and cannot be
funded through increased taxes or increased borrowing. Spending that was
subject to the Spending Control Act exceeded the limit during 1992-93. The act
specifies, however, that underspending in 1 year may be carried forward to
offset overspending in other years. In 1991-92, spending subject to control
was sufficiently below the limit to offset the overage in 1992-93.
One expert stated that it is possible that the Spending Control Act may not be
renewed after 1995. Some experts believe that the ceilings are too high and do
not force restraint. Others said that tough spending decisions in Canada are
made by elected officials rather than by a spending control mechanism.
Reformed the unemployment insurance program. High unemployment has been a
recurring problem in Canada: the unemployment rate in Canada ranged from 10.4
percent to 11.8 percent between 1982 and 1985, has not been below 7.5 percent
since that period, and rose again above 11 percent during the 1990-91
recession. Prior to reform in 1990, revenues for the unemployment insurance
program in Canada came from a combination of employer and employee premiums and
contributions from the federal government. In 1990, reforms ended the
government's direct contribution and the program is now funded entirely from
employer and employee premiums. The government will now only contribute to
unemployment insurance financing in a severe economic downturn when it would be
difficult to raise premiums. While the program is on a payroll basis, the
general public appears to view the unemployment insurance premiums as a tax and
is concerned about the size of the program, the generosity of the benefits, and
the cost to the taxpayer.
Until recently, the expenditure and revenue activities of the unemployment
insurance program were not part of the general budget, but operated through an
off-budget fund. Today, the general budget reflects both the gross outlays and
offsetting revenues for the program.
REVENUE ACTIONS
---------------------------------------------------------------- Appendix II:4.2
The federal government took a variety of actions on the revenue side of the
budget as well, beginning in 1984, ranging from partially de-indexing income
tax schedules and exemptions to implementing a deficit-neutral consumption tax.
Revenues as a share of GDP in Canada declined slightly between 1974 and 1981,
following the tax measures introduced in the 1970s. Total revenues began to
show steady improvement, however, at the beginning of the 1980s.
TAX REFORM
-------------------------------------------------------------- Appendix II:4.2.1
The government undertook substantial tax reforms in the 1980s. In 1985, the
government modified the indexation formula for the personal income tax to take
advantage of revenue increases due to inflation. Personal income tax schedules
and exemptions were partially de-indexed and are now adjusted only when
inflation exceeds 3 percent.
In 1988, the government reduced top personal income tax rates, replaced tax
exemptions with credits, reduced corporate tax rates, and reduced or eliminated
a variety of investment allowances. The tax reforms were intended to be
revenue neutral, while increasing the efficiency of the tax system.
The government reformed indirect taxes in 1991 by replacing the manufacturers'
sales tax with a 7 percent value added tax called the Goods and Services Tax
(GST). The GST is imposed at all levels of production, and the consumer pays
the last stage of it at the cash register. The manufacturers' sales tax caused
distortions and erosion of the tax base, and its multiple rate structure
increased administrative costs. The government believed the GST would broaden
the tax base, enhance efficiency gains by reducing price distortions, and lower
administrative costs. The GST is broadly based, but certain items are exempt,
such as basic groceries and medical supplies.
Public dissatisfaction with the GST has been evident. One reason for the
dissatisfaction is the contrast with the manufacturers' sales tax. This sales
tax was an invisible tax on manufactured goods, which means that the tax was
incorporated into the final sales price whereas the GST is a visible tax.
Because the federal VAT is not integrated with provincial retail taxes, except
in the province of Quebec, the tax appears on sales receipts in addition to the
provincial sales taxes. According to current and former public officials,
political leaders wanted visibility to prove to the public that they were not
planning to raise rates in the future.
Poor timing also contributed to public dissatisfaction with the GST.
Originally the federal government intended to implement the GST at the same
time it reduced income taxes. However, income taxes were reduced in 1988 but
the GST was not implemented until 1991. Because of the delay in implementing
the GST, and because of the invisibility of the prior manufacturers' sales tax,
the public perceived the GST as a new tax. One official stated that the
government did not make clear that the tax was designed to replace revenues
lost by reductions in the income tax, nor did it adequately promote the
benefits of the GST.
Many Canadians believe that tax evasion is becoming a serious issue and
perceive the underground economy to be growing. Public officials as well as
the press have stated that a large part of this evasion is due to the
introduction of the GST. The GST also levies a tax on services, which appears
to have created an incentive for people to pay cash under the table. This
results in a loss to the government of the income tax that would have been
levied on these payments as well as the loss of the GST.
Net GST revenues, along with the proceeds from privatization and gifts to the
Crown earmarked to debt reduction, are credited to the Debt Servicing and
Reduction Account. This account, established through legislation, and
introduced in the 1991 budget, is used to pay interest on the public debt and
to ultimately pay down the national debt if budget surplus is achieved.
TAX INCREASES
-------------------------------------------------------------- Appendix II:4.2.2
Some public policy analysts and economists characterized the tax increases as
quite significant during the period the Progressive Conservatives were in
office. Successive increases were made in the rate of the manufacturers' sales
tax, which was at 13.5 percent before it was replaced by the GST in 1991. Tax
brackets and exemptions were partially de-indexed. Excise taxes on gasoline,
tobacco and alcohol were increased, and a federal income tax surcharge was
imposed on personal income. Between 1985 and 1991, total tax revenue excluding
social security rose by 3 percentage points of GDP in Canada.
TAXATION OF BENEFITS
-------------------------------------------------------------- Appendix II:4.2.3
The government, in effect, ended the universality of Old Age Security (OAS), a
noncontributory pension program, at the end of the 1980s. In Canada,
pensioners become eligible at age 65 to receive both OAS benefits and benefits
from the Canada Pension Plan (CPP), a wage-based contributory pension plan. In
1989, the Canadian government introduced a "claw-back" tax on OAS benefits.
This meant seniors were required to repay a portion of their OAS pension for
every dollar of net income above a certain threshold. In 1991, seniors with
net incomes of Can$50,000 or less did not pay the claw-back; those with net
income between Can$50,000 and Can$76,332 made a partial repayment; and seniors
with net incomes above Can$76,332 paid the entire amount of their OAS benefits
back to the federal government.
PRIVATIZATION
-------------------------------------------------------------- Appendix II:4.2.4
Between 1984 and 1992, the government privatized or dissolved over 20
government-owned commercial enterprises (Crown corporations), but, according to
officials, the revenue and savings realized through privatization have not been
significant in terms of deficit reduction. Since 1990, by legislation,
proceeds from privatization are to be credited to the Debt Servicing and
Reduction Account, but experts with whom we spoke stated that the sale of
government-owned corporations has been primarily to improve efficiency and stop
the drain of finances that the Crown corporations have incurred, rather than to
significantly increase federal revenues.
POSSIBLE REASONS WHY CANADA HAS BEEN
UNABLE TO REACH BALANCE
------------------------------------------------------------------ Appendix II:5
Although the Progressive Conservatives came into office on a platform that
emphasized deficit reduction, the government did not succeed in controlling the
deficit. The Progressive Conservative government undertook many deficit
reduction measures, but public officials and policy analysts have stated that
the government did not effectively promote many of its policies to the public,
and allowed other provincial and constituent priorities to supersede its
efforts. Some of the possible reasons why the Canadian government may not have
been able to achieve sustained deficit reduction are explored in the following
sections.
Deficit reduction was difficult to sustain. Current and former officials told
us that although the Progressive Conservative party came into office on a
platform to reduce the deficit, there was a lack of unanimity on the part of
the Mulroney government regarding deficit reduction. The government also
backed off from making hard spending reduction decisions, for example, in the
areas of de-indexing old-age pensions and carrying out unemployment reforms in
the 1980s that affected the provinces. Officials also told us that the
Progressive Conservative government initially undertook reductions that could
be easily accomplished and that did not involve eliminating or restructuring
programs. An example of the government's somewhat limited commitment to
reducing the deficit can be seen in the disbanding of the Expenditure Review
Committee, which was created in 1989 to prioritize expenditures and ensure that
expenditure control contributed to deficit reduction. The ministers on the
committee were reluctant to cut programs, however, particularly those that
affected their departments or regions, and the committee was ultimately
disbanded.
The two levels of government have had difficulty reaching consensus. Canada is
essentially a regional system, and the two levels of government are often
driven by different incentives. A fragmented political structure has developed
in response to this in which it is extremely difficult to reach consensus.
Canada is a loose federation composed of 10 provinces and 2 territories that
are relatively autonomous in their areas of jurisdiction. Policy analysts
stated that provinces in Canada tend to be concerned about their own internal
issues, sometimes to the detriment of Canada as a whole. For example, when the
unemployment insurance system, a federal program, was modified in 1990 to make
it more difficult to qualify for benefits, provincial governments were not
pleased because more people were then able to qualify for social welfare, which
is a provincial responsibility. The federal Cabinet usually contains one
Minister from each of the provinces, which often makes reaching consensus very
difficult.
Canada is officially a bilingual country. Canada is composed of two linguistic
groups, the French and the English speakers. Approximately 25 percent of the
population is French speaking and is largely concentrated in the province of
Quebec. The Separatist party in the French-speaking province of Quebec held
and lost a referendum in 1980 on the sovereignty of Quebec, and the Separatist
Party won the majority in the 1994 elections in Quebec. Experts told us that
due to Canadian political fragility, the federal government has been somewhat
reluctant to take difficult deficit reduction measures that might affect the
provinces. Quebec is a large spending region that receives significant
transfer payments from the federal government, but currently, according to
experts, political leaders have been hesitant to challenge the spending
practices of the province.
Prolonged deficits have increased the level of debt and the size of the
"interest bite," making future deficit reduction even more difficult. The
continuous deficits in Canada have placed the country in a "vicious circle" of
deficits, debt, and high interest costs. Achieving budget surplus allows a
country to reduce its public debt, and ultimately its interest costs, freeing
up budgetary resources for other spending priorities. In Canada, the prolonged
deficits have accumulated into a massive public debt, which has resulted in
large interest costs that in turn increase the annual deficit. This problem
was exacerbated in the 1980s and early 1990s by interest rates that were
exceptionally high and which exceeded the annual rate of growth in the economy.
To illustrate the size of the interest payments on the debt, the Canadian
government uses a measurement it calls the "interest bite" to express interest
payments as a percentage of revenues.\6 This measure reflects the amount of
money Canadian taxpayers give to the government in the form of taxes and user
charges. In 1992, the interest bite for the Canadian federal government was 33
percent, up from 13 percent in 1968. This means that in 1992, for every dollar
collected, 33 cents went towards the interest payment on the debt.
Special interests have played a small but growing role in opposing elements of
deficit reduction. Interest groups in Canada often come together for specific
issues, then disband after accomplishing their specific agenda. These groups,
however, can be quite vocal and visible. For example, when the federal
government tried to partially de-index benefits for the elderly in 1985, senior
citizens staged a well-publicized demonstration on Parliament Hill, compelling
Prime Minister Mulroney to back down. These old-age benefits remain fully
indexed for inflation, but they are now taxed, as described previously. Some
Canadians believed that this episode illustrated that the Prime Minister could
not be counted on to make unpopular reductions, and that interest groups could
make a difference.
--------------------
\6 Report of the Auditor General of Canada to the House of Commons, 1993.
THE CURRENT SITUATION
------------------------------------------------------------------ Appendix II:6
Prime Minister Mulroney's public approval ratings were low at the beginning of
the 1990s. Experts have stated that the GST was one of the primary factors
leading to Mulroney's low public approval, but during the previous decade,
Canadians had also endured expenditure restraint and tax increases while
receiving few additional benefits in return. Mulroney stepped down early from
his position as Prime Minister and was replaced by Kim Campbell, who served as
Prime Minister for only 4 months. The Liberal government won a majority in the
federal election held in October 1993, and Jean Chretien became the new prime
minister. The Progressive Conservative party not only lost its majority
standing but only retained two seats in the House of Commons.
During the campaign, the Liberals promised to reduce the deficit to 3 percent
of GDP by 1996-97 and strongly emphasized job creation, while the Progressive
Conservatives ran on a platform to reduce the deficit to zero within 5 years.
Once in power, the Liberals were faced with a growing fiscal deficit, due
primarily to a weak economy in which revenues had leveled out, but expenditures
had not. The Liberals quickly promoted deficit reduction to a higher level of
priority. The Chretien government initiated a number of reviews calling for
fundamental change, including a review of the social welfare system, a review
of the GST, and a review of the basic roles and responsibilities of the federal
and provincial governments.
CONCLUSION
------------------------------------------------------------------ Appendix II:7
The Canadian government has made structural improvement to the general
government deficit based on policy initiatives begun in the mid-1980s. The
actions taken by the government have not, however, succeeded in controlling the
deficit, and Canada remains enmeshed in a cycle of deficits, debt, and high
interest costs. Tax rates are high in Canada, particularly in relationship to
the United States, and many experts believe that tax evasion is becoming a
serious issue. The Chretien government has begun a thorough review of programs
and governmental activities, which is intended to be a precursor to considering
fundamental structural changes.
FEDERAL REPUBLIC OF GERMANY
=================================================================== Appendix III
During the 1980s, deficit reduction became a national priority in Germany as
many government leaders, experts, and citizens became concerned with rising
levels of government debt and the increasing portion of the budget needed to
service the debt. Those concerned worried that the mounting debt would limit
the federal government's budgetary and political maneuverability to implement
new policies and respond to emerging social and economic needs.
A new center-right coalition government took power in 1982, pledging to reduce
the budget deficit. Figure III.1 shows that the federal government reduced the
public sector deficit\1 over the next 7 years. Figure III.2 shows that deficit
reduction was achieved by restraining expenditure growth. To reduce public
sector spending, the federal government secured the cooperation of state and
local governments to contain the growth in expenditure to no more than 3
percent per year over the next several years. The government's tax reform in
the latter half of the 1980s was done for reasons other than reducing the
deficit and focused on reducing income tax rates. However, the government's
deficit reduction effort benefited from economic growth in the second half of
the 1980s as revenue levels were bolstered by a strong economy.
Figure III.1: General Government
Financial Balance in Germany,
1978-1992
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
Figure III.2: General Government
Revenues and Expenditures in
Germany, 1978-1992
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
--------------------
\1 The Organization for Economic Cooperation and Development defines general
government as all levels of government combined, including social security
arrangements imposed, controlled, or financed by the government.
BACKGROUND
----------------------------------------------------------------- Appendix III:1
The 1949 German Constitution, or "Basic Law," established a political system
composed of federal, state,\2 and local governments. The popularly elected
lower house of the federal Parliament is called the Bundestag. The Bundestag
elects the Federal Chancellor, who exercises executive powers along with the
Federal Ministers. The upper house is called the Federal Council or the
Bundesrat. Its members are appointed by the governments of each state.
Since 1949, the West German federal government has been formed by coalitions of
the four largest political parties--the Christian Democratic Union (CDU), the
Social Democratic Party (SPD), the Free Democratic Party (FDP), and the
Christian Social Union (CSU). Table III.1 provides information on the ruling
coalitions from 1949 through 1994. The coalition government of Chancellor Kohl
replaced the government of Chancellor Schmidt in 1982 when the Free Democrats
aligned themselves with the Christian Democrats and the Christian Social Union
in a vote of no confidence that brought down the government. The CDU/CSU-FDP
coalition won a general election in 1983 and was re-elected in 1986 and 1990.
Table III.1
Coalition Governments in Germany, 1949
to 1994
Coalition Political
Time period government characterization
-------------------- ------------------ ------------------
1949-1966 CDU/CSU-FDP Center-right
1966-1969 "Grand Coalition" Center
of CDU/CSU-SPD
1969-1982 SPD-FDP Center-left
1982-1994 CDU/CSU-FDP Center-right
------------------------------------------------------------
--------------------
\2 In October 1990, the 5 states of the German Democratic Republic (East
Germany) united with the 11 states of the Federal Republic of Germany (West
Germany). Unless otherwise stated, references and figures concerning the
states refer to the 11 western states.
BUDGET PROCESS
--------------------------------------------------------------- Appendix III:1.1
Although the German federal budget is created by the ruling party government
and normally approved by Parliament, the federal budget process has built-in
mechanisms for ensuring consensus. One important mechanism is the requirement
that the Bundesrat approve the annual budget. The Constitution requires
Bundesrat approval for all tax proposals and for spending that affects state
responsibilities such as education, crime, housing, and family allowances.
Since the Bundesrat is made up of representatives of state governments, the
interests of the states are given much weight in budget deliberations. In
addition to providing the states with a way to influence the federal budget,
the Bundesrat can also give the opposition party a chance to make budgetary
changes if it controls the upper house. If the Bundestag and Bundesrat cannot
agree on budgetary changes, a mediation committee composed of members of both
bodies meets to work out a compromise.
Another way in which consensus is introduced into the budget process is through
the recommendations of the Financial Planning Council. The Council, which
includes Finance Ministers from the state and federal levels and local
representatives, meets periodically to recommend courses of action during
federal budget preparation to coordinate federal, state, and local plans. The
Chancellor and the Ministry of Finance must take into account the
recommendations of the advisory Financial Planning Council although they are
not bound by its suggestions. In the early 1980s, the Financial Planning
Council recommended that annual growth in overall government spending should be
limited to no more than 3 percent.
The need for consensus on deficit reduction policy also existed within the
federal government itself. While the Chancellor of the ruling coalition that
enacted most of the deficit reduction policies in the 1980s had a majority in
the Bundestag and Bundesrat, that was not always sufficient to ensure his
policies would prevail. A study of German politics stressed that government by
coalition forces the German Chancellor to seek consensus for economic and other
policies from Cabinet Ministers and coalition partners.\3
--------------------
\3 Peter J. Katzenstein, Policy and Politics in West Germany: The Growth of a
Semisovereign State (Philadelphia: Temple University Press, 1987).
IMPACT OF SOCIAL SECURITY ON THE
BUDGET
--------------------------------------------------------------- Appendix III:1.2
The extensive social security system needed to meet the requirement in the
Basic Law that each citizen be guaranteed a minimum standard of living, with
state assistance if necessary, has a major impact on the budget. According to
OECD data, the German social security system accounted for between 24 and 27
percent of total GDP in the 1980s and is supported both by insurance funds and
by government expenditures. The three basic insurance programs for
unemployment, retirement pensions, and health care are funded equally by
employee and employer contributions. All employees are required to belong to
the unemployment and pension insurance funds, and 90 percent of all workers
contribute to the state health insurance plan. Spending for social benefits is
the largest expenditure category in the federal budget by far, comprising about
37 percent of the total 1993 budget of DM458 billion.
RESPONSIBILITIES OF DIFFERENT
LEVELS OF GOVERNMENT
--------------------------------------------------------------- Appendix III:1.3
The German government's efforts to control budget deficits in the 1980s
required the central, state, and local levels to coordinate their deficit
reduction efforts. The financial autonomy granted each level of government
under the Basic Law meant that this coordination required a high degree of
consensus between the different levels. The Constitution allocates and mixes
responsibilities, tax authority, and expenditures at all three levels. The
federal government's responsibilities include defense and transportation. The
states' responsibilities include police, education, and welfare. Local
governments are responsible for most public infrastructure investment and
public utilities. Major sources of governmental revenue include the income
tax, the value added tax and other consumption taxes, and business taxes.
These revenues are shared among the three levels of government.
IMPETUS FOR REDUCING THE DEFICIT
----------------------------------------------------------------- Appendix III:2
The West German economy grew steadily and its federal government generally ran
small deficits or small surpluses in its budgets between 1949 and 1969.
However, beginning in the late 1960s, changing economic and political
circumstances resulted in budget deficits, which generally increased between
1974 and 1981. When the center-left SPD-FDP coalition government assumed power
in 1969, it increased spending in an effort to stabilize the economy and to
expand the role of the state. Expansionary fiscal policies, combined with the
recessionary effects of two oil price shocks during the 1970s, led to large
increases in public sector deficits between 1974 and 1981. Deficits were also
compounded by all three levels of government basing their budget plans on
overly optimistic growth expectations.
In the early 1980s, the federal government abandoned its approach to countering
recession through fiscal expansion and adopted a medium-term strategy advocated
since the mid-1970s by the German Board (or Council) of Experts for the
Assessment of Overall Economic Trends.\4 This approach focused on reducing
budget deficits as important for combating inflation, promoting long-term
economic growth, and providing the federal government with more fiscal room to
respond to emerging needs.
--------------------
\4 The Board (commonly referred to as the Council of Economic Experts or the
"Five Wise Men") consisted of a top economist from five of the six leading
German economic institutes. The Council was established in 1967 to provide
economic forecast reports to the Ministry of Finance every year. This report
and the Minister's response form the starting point for the Bundestag's yearly
budget debates.
GROWTH OF GOVERNMENT SPENDING
DURING THE 1970S
--------------------------------------------------------------- Appendix III:2.1
In 1969, a center-left government, the Social Democratic Party in coalition
with its Free Democratic Party partners, took control of the government.\5 They
implemented policies that increased government expenditure from 39.1 percent of
GNP to 48 percent over the 1970s, and increased social security expenditures
from about 11.2 percent of GNP in 1970 to 15.8 percent in 1979. The government
expanded welfare benefits and public employment, boosted investment, and
increased educational spending. It introduced a child benefit program that
provided universal payments for families, regardless of income levels. Between
1970 and 1980, the government increased public investment and increased the
total public workforce (excluding military) by nearly one quarter to 3.17
million.
According to a German government document, budgetary policy was used in the
1970s to "steer demand by increasing intervention in the workings of the
economy" and "to keep aggregate demand at an adequate level, thus assuring high
growth rates."\6 This policy required increasingly high levels of government
spending as the economy entered recessions after both the 1973 and 1979 oil
price shocks. Economic growth rates slowed, and unemployment and inflation
increased during the decade.
At the end of the 1970s, the other G-7 countries (the United States, Canada,
Japan, France, the United Kingdom, and Italy) encouraged Germany to increase
its public investment in the belief that if the United States, Japan, and
Germany stimulated their economies, worldwide economic growth would result.
Germany agreed to expansionary fiscal measures equivalent to 1 percent of GNP.
German funding commitments to the European Community also grew in the 1970s,
from about 2.5 percent of general government revenue to about 3.5 percent by
1987.
The deficit problem was also aggravated by the tendency of central, regional,
and local governments to base budget estimates on the relatively higher average
economic growth rates of the late 1960s and early 1970s. When actual growth
slowed and revenues fell short of projections, deficits grew.
By the end of the 1970s, the deficit and the interest payments on the debt had
increased to the point that government leaders felt they had to reverse the
losses in fiscal and political "maneuverability" (that is, the ability to fund
their social and economic programs and stabilize the economy). Furthermore,
unemployment and inflation had reached crisis levels in the view of the public,
who were sensitive to Germany's history of hyperinflation and economic turmoil
in the first half of the 20th century.
The SPD-FDP government began to implement policies designed to reduce the
deficit and restore political maneuverability. However, deficits continued to
grow and the Christian Democrats made them a key issue in their successful
effort to gain control of the government in 1982. The new CDU/CSU-FDP
coalition government won the general election in 1983 pledging to reduce the
deficit and stating that deficit reduction was a necessary precondition to
controlling inflation, implementing tax reform, and reducing the government's
role in the economy.
--------------------
\5 The coalition remained in power from 1969 to 1982 under the leadership of
Chancellors Brandt (1969-1974) and Schmidt (1974-1982).
\6 The German Budgetary System, Ministry of Finance, 1991.
LEADERS SHAPED CONCERNS
--------------------------------------------------------------- Appendix III:2.2
By the early 1980s, a number of economic pressures were beginning to force the
SPD-led federal government to change its economic policies and give budget
deficit reduction greater priority. These factors included the recession
induced by the second oil shock, high inflation, high unemployment, high
interest costs, and a general loss of political "maneuverability." Government
officials told us that although public sector deficits in the early 1980s were
lower as a share of GDP in Germany than deficits in other countries, the German
public was very concerned about deteriorating economic conditions which
included recession and high inflation and unemployment levels. Episodes of
hyperinflation and economic collapse earlier in the century greatly contributed
to the public's sensitivity about the government's financial problems. One
German political party official stated that this sensitivity was the most
important aspect of Germany's fiscal policy. Furthermore, the independent and
influential Bundesbank was calling for deficit reduction to put public finance
back on a sound footing in order to restore confidence in the economy.
THE SECOND OIL SHOCK AND
RECESSION
------------------------------------------------------------- Appendix III:2.2.1
Government officials and experts told us that the increase in oil prices in
1979 was a catalyst for a change in the early 1980s. This second oil price
shock of the 1970s triggered a recession in 1981. The government at first
underestimated the extent to which the sudden upsurge in the price of oil
affected the economy and continued to overestimate economic growth rates in
their budget planning. The government also attempted to reverse the downturn
by using the same countercyclical and demand-led approach it had used during
the recession following the previous oil shock. The general government deficit
grew from 2.4 percent of GDP in 1978 to 3.7 percent in 1981.
INFLATION AND UNEMPLOYMENT
------------------------------------------------------------- Appendix III:2.2.2
Inflation and unemployment were serious concerns in the late 1970s and early
1980s. During this time, inflation had been increasing, peaking at 6.3 percent
in 1981. Unemployment had increased from 1.6 percent in 1974 to 5.9 percent in
1982, and in 1981 unemployment had passed the significant barrier of 1 million
persons. Although the German inflation rate was somewhat less than the rates
being experienced in most other western economies at that time, it seemed high
to the inflation-sensitive German public. In the year before the 1983
election, inflation remained at the relatively high level of 5.3 percent,
before dropping to 2.4 percent in 1984. (See figure III.3.)
Figure III.3: Consumer Price
Inflation in Germany, 1978-1991
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
REDUCED FISCAL AND POLITICAL
MANEUVERABILITY RESULTING FROM
INCREASING INTEREST PAYMENTS
------------------------------------------------------------- Appendix III:2.2.3
German government officials agreed that the loss of fiscal and political
"maneuverability" was one of the most significant factors in prompting the
government to pursue budget deficit reduction as a top priority--although this
effect was not perceived widely outside of economic and government circles.
The "maneuverability effect" was the most immediate problem posed by the debt
burden because it seriously limited the political system's ability to respond
to public needs, such as public investment and social policy initiatives.
The effects of high deficits began to make themselves felt in the early 1980s,
when the compounding interest on the debt accumulated. The public debt more
than tripled from DM125.9 billion in 1970 to DM468.8 billion by 1980, and the
annual debt service became a deficit driver. Increases in long-term interest
rates during early 1980 and 1981 put pressure on the financial system and
raised fears that the higher rates would crowd out private spending and
investment.
Figure III.4: General Government
Gross and Net Debt in Germany,
1978-1992
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
Figure III.5: General Government
Net Debt Interest Payments in
Germany, 1978-1992
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
Figure III.6: Long-Term Interest
Rates in Germany, 1980-1991
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
CHANGE OF GOVERNMENT: DEFICIT
REDUCTION AS A POLITICAL
MANDATE
------------------------------------------------------------- Appendix III:2.2.4
A coalition government of the Christian Democrats and the Free Democrats under
Chancellor Helmut Kohl assumed power in October 1982, but it had to win
approval from the public in the March 1983 general election. The campaign
leading up to the general election provided a critical impetus for deficit
reduction. Chancellor Kohl had pledged to do more to reduce the deficit than
the Social Democrats, and he had to demonstrate that fact in time for the
election. Upon assuming power, his government passed a supplementary act to
accompany the 1983 budget which expanded the previous government's deficit
reduction proposals. Kohl's coalition won a majority in the Bundestag in the
election.
THE GERMAN BALANCED BUDGET
REQUIREMENT
--------------------------------------------------------------- Appendix III:2.3
The German Constitution's balanced budget requirement did not preclude budget
deficits. Article 110 of the Basic Law states that "the budget must be
balanced as regards revenue and expenditure." However, article 115 defines a
balanced budget as one where expenditures do not exceed the sum of revenues
plus net borrowing for investment purposes.
Additionally, the Constitution allows exceptions to the balanced budget
requirement. These are defined in the 1967 Law to Promote Economic Stability
and Growth. The law gave German governments greater discretion for running
deficits. The law requires the federal and state governments to orient their
budgeting towards the economic objectives of price stability, high employment,
balanced foreign trade, and steady economic growth. According to a Ministry of
Finance official, the Basic Law and the Law to Promote Economic Stability and
Growth contain criteria which justified high deficits during the recessions of
the 1970s as the government tried to reduce unemployment through deficit
spending.
Germany's Constitutional Court also affects federal budgetary decision-making.
The court has ruled on the constitutionality of tax laws and income
redistribution and on whether the federal government was in compliance with the
balanced budget requirement. In 1982, the Christian Democrats, then in the
opposition, brought suit against the Social Democratic government for exceeding
the constitutional limit on borrowing. In its 1988 ruling, the court decided
that the need to stabilize the economy warranted borrowing in excess of
investment. In a case decided in 1991, the court reinstituted a tax on
investment income abolished by the federal government the year before. The
court judged that it was unfair to exempt one form of income from taxes. In
1993, the court ruled that two state governments in budgetary difficulties were
entitled to federal assistance to help balance their budgets.
DEFICIT REDUCTION ACTIONS
----------------------------------------------------------------- Appendix III:3
The German government took steps in the first half of the 1980s to restrain
public expenditure and boost revenues. These actions, combined with economic
growth in the late 1980s that boosted tax revenues and the social security
surplus, eliminated the German general government deficit by 1989.
Coordination and cooperation among levels of government helped bring down the
deficit as each level of government took actions to ensure that total
expenditure grew by no more than 3 percent annually in nominal terms. The
Bundesbank estimated that the legislative packages enacted in 1982, 1983, and
1984 by the federal government resulted in a reduction in the general
government deficit by DM55 billion or just over 3 percent of GNP in 1984.
Other sources estimate the savings to be higher.
In the second half of the 1980s, the government did not pursue deficit
reduction and expenditure restraint as consistently as it did between 1982 and
1984. Expenditure growth at the state and local levels of government generally
exceeded the 3 percent goal between 1985 and 1989. However, the federal
government kept its expenditure growth below 3 percent per year until 1989 as
increased individual contribution rates to social insurance and the reviving
economy reduced the pressure on social security in the federal budget. The
federal government also reduced income tax rates three times between 1986 and
1990.
Despite tax cuts, overall revenues continued to rise at an average nominal rate
of nearly 4 percent from 1985 to 1988 as the economy expanded. In 1989, the
year the general government budget showed a slight surplus, tax revenues jumped
by 9.3 percent over the prior year as a result of the booming economy and
because the German tax system was not indexed for inflation.
SPENDING ACTIONS
--------------------------------------------------------------- Appendix III:3.1
Building on the deficit reduction proposals inherited in October 1982, the
Christian Democratic-led coalition government under Chancellor Kohl made a
concerted, sustained, and generally successful effort to constrain overall
expenditure during its first 3 years in office. After 1985, new expenditure
reduction initiatives were few and relatively modest. Overall, however,
spending constraints in the years 1983 through 1985 had longer-term effects:
public expenditure as a percentage of GDP fell to a low of 44.8 percent of GDP
in 1989, down from 49.0 percent in 1982.
Table III.2 shows some of the estimated savings from expenditure actions taken
by the Schmidt and Kohl governments between 1981 and 1985, and brief
descriptions of the actions follow the table.
Table III.2
Estimated Impact of Selected Federal
Expenditure Actions Leading to Public
Sector Budget Savings in Germany
(Deutsche marks in millions)
Type of
savings 1981 1982 1983 1984 1985 Total
------------ ------ ------ ------ ------ ------ ------
Public 3,120 5,070 3,850 1,020 0 13,060
investment
reductions
Limits on 0 3,500 4,000 4,000 4,000 15,500
unemployment
benefits
Public 0 2,300 2,500 2,700 2,900 10,400
employee
wage and/
or hiring
freezes
Child 0 1,700 1,800 1,800 1,800 7,100
benefits
reduction
Subsidy 0 3,400 1,800 1,500 1,400 8,100
reductions
Other 9,000 700 1,000 400 500 11,600
expenditure
savings
Annual total 12,120 16,670 14,950 11,420 10,600 65,760
expenditure
reductions
Savings as 1.6 2.1 1.9 1.4 1.2 1.6
percent of
total
public
sector
outlays
------------------------------------------------------------
Sources: Ministry of Economics, Council of Economic Experts, and OECD.
Public investment. The most substantial reductions in expenditures made in the
1980s occurred in public investment. Total public investment was the only
budget category cut in nominal terms each year between 1981 and 1984.
According to a government official, the federal government eliminated a
multiyear investment program in 1982, but the great majority of the investment
reductions occurred at the local government level. All levels of government
realized over DM13 billion in estimated budget savings between 1981 and 1984.
The Bundesbank noted that this area is the easiest way for any German
government to make immediate budget cuts for two important reasons. First,
public investment in Germany is discretionary in nature and not subject to
statutory commitments (unlike other current expenditures) and therefore can be
cut back "drastically" in times of fiscal difficulties. Second, local
authorities make about 70 percent of total public investments, and they can be
compelled to reduce investment spending under public budget law.
Unemployment benefits. The federal government restrained the growth in the
unemployment and short-term work benefits Federal Institute for Employment.
Between 1982 and 1985, the Council of Economic Experts estimates that the
government saved DM15.5 billion in this area. Approximately DM2.5 billion of
these savings resulted from cutting benefits for unemployed recipients without
children from 68 percent of their net wage to 63 percent in the 1984 budget.
Public employment costs. According to a German economist, the Schmidt
government froze civil service wages in 1981 and 1982, and the Kohl government
limited pay increases to no more than 2 percent in 1983 and delayed the
scheduled 1984 pay raise by 1 year. The government sharply curtailed civil
service recruitment in the 1980s, choosing instead to hire lower paid part-time
employees as needed. Altogether, public payroll savings worth DM10.4 billion
were realized between 1981 and 1985.
Child benefits. Universal child benefits paid to families for each child
became means tested in 1982. Starting in 1983, the Kohl government eliminated
tax relief for child care expenses and further reduced child benefits. The
combined budgetary savings of these actions amounted to an estimated DM7.1
billion between 1982 and 1985. However, in 1986, Chancellor Kohl introduced a
child-raising allowance of DM600 per month for the first 6 months with
additional means-tested payments available up to 12 months and raised the tax
allowance for each child. These actions went into effect in 1986.
Subsidies. The government saved over DM8 billion between 1982 and 1985 by
reducing subsidies. According to officials, the government reduced subsidies
for hard coal, the aerospace industry, public housing, and farmers. However,
increasing subsidies for shipping, agriculture, and miner's income support
offset these savings in the 1980s.
Other expenditure savings. The Schmidt government reported that it made DM9
billion worth of unspecified savings in the 1981 budget. Between 1982 and
1985, the Kohl government saved over DM2 billion by reducing or postponing
military and civilian pension benefits. The government also converted
university student grants to no-interest but time-limited loans, and cut
subsidies for student housing rents.
REVENUE ACTIONS
--------------------------------------------------------------- Appendix III:3.2
The government under Chancellor Kohl continued revenue actions initiated by the
previous government as well as initiated its own. However, a number of
economists and government officials told us that deficit reduction was not
achieved by increased revenues. They said revenue increases were generally
offset by measures taken to meet other policy objectives such as the income tax
rate reductions in the second half of the 1980s. Revenues for all levels of
government declined from 45.7 percent of GDP in 1982 to 44.9 percent in 1989.
Although many of the revenue increases were offset by spending in other areas,
the Bundesbank estimates that the following actions helped reduce public sector
deficits during the 1980s.
Federal consumption taxes. The Schmidt government raised taxes on fuel oils,
gasoline, and alcohol by DM2.5 billion in 1981. It also increased taxes on
tobacco, spirits, and sparkling wine, raising DM11.5 billion between 1982 and
1985. The government's "coal-penny" tax raised DM21 billion between 1981 and
1987, but it was used to offset the cost of mining subsidies. In 1989, the
Kohl government increased excise taxes on petroleum products, tobacco,
insurance, and diesel-engine automobiles, and imposed a new tax on natural gas,
to raise an estimated DM8.5 billion.
Value added tax (VAT). Kohl's government increased revenues between 1982 and
1990 by raising the value added tax rate from 13 percent on most goods and 6.5
percent on special goods to 14 percent and 7 percent, respectively. This
raised about DM3 billion in additional revenues in 1983; rising to DM10 to 15
billion each year thereafter, according to one estimate.
Tax expenditures. The Kohl government raised about DM21.2 billion between 1982
and 1990 by reducing tax allowances and loopholes. In 1990, the government
reduced or abolished 62 tax allowances, for a net savings of DM18 billion.
Investment income tax. As a result of a Constitutional Court ruling, the Kohl
government imposed a 10 percent investment income tax in 1989 that raised an
estimated DM8 billion its first year, but banking officials and some economists
noted that widespread tax evasion limited the value of this measure.
Privatization. The government's efforts to privatize some of its assets had
relatively little impact on reducing the deficit in the 1980s. The government
raised about DM10 billion through privatization, largely through sales of
government shares in private companies.
ECONOMIC GROWTH AND INCREASED
SOCIAL SECURITY CONTRIBUTIONS
--------------------------------------------------------------- Appendix III:3.3
Strong economic growth in the latter part of the 1980s contributed to
elimination of the general government deficit by 1989. The social security
budget surpluses increased as the government increased the contribution rates,
while improving economic conditions reduced unemployment from 7.1 percent in
1985 to 4.8 percent in 1990. In 1989, the unusually large social security
surplus offset the lowest combined federal, state and local government budget
deficit of the decade, resulting in an overall budget surplus. Figure III.7
shows the OECD deficit measure referred to as "net lending" for federal, state
and local, and social security funds during the 1980s.
Figure III.7: Net Lending in
Germany, 1979-1991
(See figure in printed edition.)
Source: OECD National Accounts, Volume II.
Concurrent with strong economic growth, tax revenues increased significantly in
1989. According to some officials, the three income tax rate reductions made
between 1986 and 1990 were necessary to compensate for the "fiscal drag" that
occurred when rises in incomes due to inflation placed people in higher tax
brackets. Although the first two income tax rate reductions--in 1986 and
1988--reduced net revenues by DM25 billion, OECD reported that overall direct
tax revenues still grew by over DM27 billion, or 10.8 percent, between 1988 and
1989. Indirect tax revenues increased by just over DM21 billion in 1989, or
8.3 percent, almost double the growth rate of indirect tax revenues in 1988.
REACHING AGREEMENT
----------------------------------------------------------------- Appendix III:4
According to a German official, the Social Democratic leaders were unable to
generate the needed support for deficit reduction within their own party and
from their coalition partners in the early 1980s. The opposition Christian
Democrats and the media criticized the government's deficit reduction efforts
as insufficient. In October 1982, the Free Democrats switched sides and joined
the Christian Democrats and the Christian Social Union in a vote of no
confidence that brought down the government.
The Kohl government gave immediate priority to deficit reduction, then later
followed with tax rate reductions. The government's goal over the medium term
was higher economic growth with a smaller government. The government focused
on reducing expenditures to ease pressure on the credit markets and to make the
terms for private investment more favorable.
The government's strategy included securing the cooperation of the various
levels of government and the Bundesbank, which independently controls monetary
policy. Chancellor Kohl capitalized on the sense of economic crisis to secure
the cooperation of state and local governments to voluntarily keep expenditure
growth within the 3 percent growth target recommended by the Council of
Economic Experts. Government economic experts agreed that as a result of
spreading public concern about high interest rates, "crowding out" effects, and
the general fear about financial instability, the new government had little
difficulty in convincing the state and local authorities to reduce their
deficits.
Chancellor Kohl's government introduced the majority of the deficit reduction
efforts for Bundestag approval between late 1982 and 1984. The task of the new
government in obtaining consensus for its deficit reduction policies was
assisted by a pre-existing belief shared by many policy makers, economists,
journalists, and much of the general public that the lost budget flexibility
required a new economic strategy which included budget deficit reduction.
Securing the cooperation of the Bundesbank was important for the success of
this budget strategy. Expenditure and tax reduction policies brought fiscal
policy into line with the anti-inflationary monetary policy the Bundesbank
pursued in the 1970s and throughout the 1980s. According to Bundesbank
officials, convergence of the two policies had favorable effects on the
economy. The reduction of public expenditure as a percentage of GDP helped to
ease inflation and encouraged the bank to bring down the high interest rates it
had maintained to control the inflationary pressures of the late 1970s. As
interest rates came down, growth in debt interest costs also declined from a
high of 22.8 percent in 1982 to 4 percent in 1988.
Officials we interviewed disagreed on the extent to which Chancellor Kohl was
involved in securing the cooperation of the powerful national trade unions.
One economist said the government used the economic crisis to secure restrained
wage demands from the public unions and then used the results to influence the
wage demands of private sector unions. Other observers stated that the
pressures of the recession were much more influential in restraining union wage
increase demands than the government's policies.
COST SHIFTING WAS NOT A MAJOR
DEFICIT REDUCTION STRATEGY
--------------------------------------------------------------- Appendix III:4.1
Shifting of responsibilities and program costs among levels of government as a
deficit reduction strategy did not seem to occur in Germany to the degree that
it did in some of the other case study countries such as Australia and Canada.
According to one economist, cost shifting from the federal to other levels of
government was not a major factor during the 1980s because tax revenues shared
by the state and federal government were high. Local officials argued,
however, that the federal deficit was reduced, at least in part, at the expense
of local government.
Federal officials told us that the states have benefited more from increases in
the VAT than the federal government: in 1980, the federation received 67.5
percent of VAT revenues, and the states received 32.5 percent; in 1990, the
ratio was 65 percent to 35 percent. One official also stated that the
proportion of total income tax revenues allotted to the local governments rose
from 14 percent to 15 percent in the 1980s. Furthermore, according to a
government official, the federal government pays the entire German contribution
to the European Union out of its portion of VAT funds, leaving it only about 50
percent of the total VAT revenue for its own use.
One local government official stated that because local governments control
approximately two-thirds of all investment-type expenditures, they had to
sacrifice when the federal government reduced investment spending. He also
said local governments had trouble paying operations and maintenance costs on
earlier investment projects when federal investment was reduced.
BUDGET DEFICIT REDUCTION WAS ALSO
ASSISTED BY FACTORS OUTSIDE
GOVERNMENT CONTROL
--------------------------------------------------------------- Appendix III:4.2
One leading economic institute official said the government's budget deficit
reduction efforts were assisted by the fortuitous timing of external factors
during the 1980s. These factors included (1) increased exports to the United
States, which contributed to the reversal of the current account deficit to a
surplus by the end of the decade, and (2) the U.S. stock market crash of
October 1987, which spurred the Bundesbank to lower interest rates beyond what
it might otherwise have done.
In addition, the Bundesbank's annual profits had a measurable impact on the
deficit because they are turned over to the government to augment current
revenues. The bank's profits grew from DM2.3 billion in 1981 to DM12.7 billion
in 1986, dropped to DM200 million in 1988, and then increased to DM10 billion
in 1989 and 1990. Since 1990, a maximum of DM7 billion can be included in the
annual budget, and the rest must be used to reduce the overall debt.
BUDGET DEFICITS DURING THE 1990S
----------------------------------------------------------------- Appendix III:5
The general government budget balance went from a surplus of 0.1 percent of GDP
in 1989 to a deficit of 3.3 percent of GDP in 1993. In addition, gross public
debt increased from 43.2 percent of GDP to 48.5 percent of GDP. The increase
in budget deficits and debt was the result of the unification of Germany in
1990 and the worldwide recession which overtook Germany in 1992. It was also a
result of a breakdown in consensus over expenditure restraint at the three
levels of government.
CURRENT DEFICIT REDUCTION
STRATEGY
--------------------------------------------------------------- Appendix III:5.1
Revenue increases have played a large part in the government's deficit
reduction strategy during the early 1990s. As the deficit began to grow
rapidly through large expenditure increases, the government took steps to
control the growing deficit by raising revenues in 1991. The federal
government imposed a 1-year 7.5 percent "Solidarity" income tax surcharge in
July 1991, and increased tobacco, mineral oil, and insurance taxes. It raised
the social security contribution as well, raising pension contributions by 1.7
percentage points in 1993 to reduce the shortfall between actual contributions
and the statutory minimum fund level. The government also cut expenditures,
mainly by cutting defense and reducing some funding for communities along the
old inner-German border.
After 3 years of reduced cooperation on deficit reduction, the three levels of
government adopted the Solidarity Pact in May 1993. The governments agreed to
increase levies, retool government, and consolidate the budget. This pact
targeted social benefits and personnel costs. These measures were expected to
reduce the federal budget deficit by cutting expenditure, increasing revenue
through minor tax changes, and cancelling a planned reduction in the
unemployment fund contribution rate. The federal government secured this pact,
according to one OECD economist, by agreeing to turn more of its VAT funding
over to the states.
While states have agreed to again constrain expenditures, according to a
government official, a 1993 Constitutional Court decision may give states less
incentive to control deficits in the future. The court ruled that the two West
German states of Bremen and Saarland have a right to get help from the federal
government to overcome their financial problems. Thus, some observers believe
this Constitutional Court decision guarantees payment by the federal government
of state and local debt.
Government officials pointed out that Germany faces serious demographic
problems. The population is getting older, and there are fewer working age
people to support the pension insurance system. Nonwage benefits continue to
keep the cost of hiring additional employees high for employers. Rising public
health care expenditures are also of concern to the government. A number of
economists and government officials believe that further budget deficit
reduction should come through expenditure reduction because they believe that
the economy has reached the upper limit of what it can bear in taxation.
CONCLUSION
----------------------------------------------------------------- Appendix III:6
The federal government capitalized on the sensitivity of the public to the
economic turmoil in Germany's past and on its political majorities at the state
and federal level to mobilize consensus for deficit reduction, and to secure
the cooperation of the other levels of government. The federal, state, and
local governments agreed to contain the growth in expenditures to no more than
3 percent per year over the medium-term future. Although tax reform included
income tax rate reductions, the lack of indexation of income taxes, increases
in other taxes, and economic growth contributed to strong government revenues.
JAPAN
==================================================================== Appendix IV
Japan experienced general government\1 budget deficits between 1975 and 1986,
which peaked at 5.5 percent of gross domestic product (GDP) in 1978. The
fiscal deficits were a result of the oil price-induced recession of 1973 in
combination with a general worldwide decline in economic growth rates. These
factors influenced the economy of Japan at the same time that (1) social
welfare spending commitments increased and (2) the country was asked by the
other industrialized nations to undertake stimulus spending in an attempt to
boost the world economy.
The Japanese government took action to reduce the deficit because of concerns
about the long-term implications of growing levels of debt and the rising share
of the budget allocated to interest costs. These problems, rather than an
economic crisis, such as a loss of access to credit markets, appeared to have
prompted the government to undertake fiscal measures to reduce the deficit.
Japan was able to accomplish significant deficit reduction primarily by taking
advantage of strong economic growth during the late 1980s, which dramatically
increased tax revenues, and by imposing long-term expenditure ceilings on
certain discretionary components of the budget that remained in place during
times of both growth and recession. Since Japan's tax system is not indexed
for inflation, inflation-induced bracket creep also contributed to the rising
level of government revenues. The ratio of income taxes to the national income
rose from approximately 3.6 percent in fiscal year 1965 to 7.3 percent in
fiscal year 1990, as a result of automatic increases caused by economic growth
and inflation. Strong revenue growth combined with expenditure ceilings that
permitted either zero nominal growth or actual declines in certain classes of
expenditures enabled the Japanese government to convert its deficits to
surpluses by 1987. Japan is projected to have returned to deficit in 1994.
Figure IV.1 illustrates Japan's general government deficits and surpluses,
while
figure IV.2 provides data on receipts and outlays.
Figure IV.1: General Government
Financial Balance in Japan,
1980-1994
(See figure in printed edition.)
Note: Data for 1994 are based on OECD projections.
Source: OECD Economic Outlook, #55.
Figure IV.2: General Government
Revenues and Expenditures in Japan,
1980-1994
(See figure in printed edition.)
Note: Data for 1994 are based on OECD projections.
Source: OECD Economic Outlook, #55.
--------------------
\1 The Organization for Economic Cooperation and Development defines general
government as all levels of government combined, including social security
trust funds.
BACKGROUND
------------------------------------------------------------------ Appendix IV:1
It is difficult to appreciate the deficit reduction actions and strategies
taken by the Japanese government without understanding the political and
budgetary context in which they took place. The budget process and structure,
and the relationship between the budget and political process, are especially
complex in Japan. This background section, therefore, provides detailed
information on the budget process and structure and on the political system in
Japan in an attempt to provide a meaningful context for the deficit reduction
actions and strategies of the Japanese government.
The constitution in Japan is based on a system of parliamentary democracy. The
Japanese parliament, the Diet, is composed of two chambers, the House of
Representatives (known as the lower house) and the House of Councillors (known
as the upper house), both of which are directly elected by the public. The
Prime Minister is normally the president of the majority party in the House of
Representatives and is elected by the Diet. Both Diet chambers have similar
duties, but the House of Representatives has the final word if differences
exist between the two chambers and has the power to force the government to
resign.
From 1955 to 1993, a conservative party, the Liberal Democratic Party (LDP)
consistently held the majority and, accordingly, controlled the government.
During the 1980s, despite the stability of the LDP, six different individuals
held the office of Prime Minister. The LDP lost to a reform-minded coalition
government in 1993, but this government was subsequently replaced by a
Socialist/LDP coalition government in 1994. The deficit reduction actions on
which we focus in this report fall entirely within the period of the LDP
majority.
RESPONSIBILITIES OF DIFFERENT
LEVELS OF GOVERNMENT
---------------------------------------------------------------- Appendix IV:1.1
The public sector in Japan is composed of the central government and the local
governments, which consist of 47 prefectural and 3,200 municipal governments.
Local governments are responsible for the maintenance and management of
facilities for health, welfare, and education, and for water supply, sewage,
and sanitation services, as well as for ensuring the safety and welfare of
residents.
Japan is a unitary system--the principal powers are held by the central
government. The central government controls most local government activities
through guidelines, standards, and regulations, and all local borrowing is
controlled at the central level. However, the central government does delegate
functions to the local governments; as of 1993, more than half of the functions
performed by prefectural governments were delegated from above.
Private enterprises in Japan supplement the role of government, which helps to
reduce the government's social welfare burden. Employers often provide
extensive social benefits; for example, lifetime employment is still provided
by some large corporations. Unemployment rates are low in Japan by
international standards; in 1993, the unemployment rate was 2.5 percent.
BUDGET PROCESS
---------------------------------------------------------------- Appendix IV:1.2
In Japan, ministries and other agencies begin to prepare individual budgets for
the following year shortly after the beginning of the fiscal year on April 1.
The Constitution states that the annual budget is to be prepared by the
Cabinet, but the Public Finance Law of 1947 assigns the responsibility of
actual preparation to the Ministry of Finance (MOF). MOF controls the main
components of the budget process--for example, it formulates the budget
guidelines and expenditure ceilings, which are then finalized by the Cabinet.
Experts have stated that the allocation of resources in the budget is,
therefore, primarily based on administratively predetermined levels of funding.
Traditionally, the Diet does not amend the budget once it has been submitted
for approval by MOF. This does not mean, however, that Diet members have no
influence on budgetary decision-making. Extensive discussion takes place
behind the scenes throughout the budget cycle involving MOF, politicians,
private interest groups, and the ministries. Traditionally, senior Diet
members have formed "Zoku," which translates as "tribes" or "clans," to lobby
MOF on behalf of the spending ministries within their domain. While former
Prime Minster Morihiro Hosokawa has been quoted as describing the policy-making
process in Japan as collusive, analysts have stated that the basic goal of the
budget process in Japan is to reach consensus. Consultations conducted by MOF
during budget formulation serve to establish a consensus before the budget is
presented to the Diet, and the Diet does not normally change the budget once it
has been submitted by MOF.
Observers have noted the importance of consensus in Japanese society, and
consensus is central to its budgetary and political decision-making. In
practice, the Diet determines not only procedural matters but also policy
matters by consensus. This can sometimes make it difficult for the government
to pass controversial initiatives. For example, the government's attempt to
introduce a form of consumption tax in 1979, called a value added tax (VAT),
foundered because the tax was unpopular both with the public and with various
factions within the Diet. The lower house of the Diet was forced to dissolve
in 1980, primarily because of the inability of its members to reach consensus
on the fate of the VAT. The VAT ultimately passed the Diet in 1989.
BUDGET STRUCTURE
---------------------------------------------------------------- Appendix IV:1.3
The definitions of budgetary balance used by Japan to develop its fiscal and
budgetary policies differ significantly from those used by the Organization for
Economic Cooperation and Development (OECD). In Japan, the term budget
normally refers only to the general account of the central government. In
contrast, OECD normally uses general government data in its country analyses
and determines deficit and surplus based on all accounts at all levels of
government and social security funds. The government of Japan, however, does
not consider social security or local government budgets as part of the general
account budget.
The general account budget is composed of general expenditures, national debt
service, local allocation tax grants, and transfers to the industrial
investment special account. Figure IV.3 illustrates the components of the
general account budget. The expenditure side of the general account consists
of 13 major programs, including social security, education and science,
national defense, public works, and economic cooperation. The general account
is financed primarily by direct and indirect tax revenues and proceeds from
public bonds. In fiscal year 1993, it totaled approximately 72.4 trillion yen.
Figure IV.3: General Account Budget
Components in Japan
(See figure in printed edition.)
Note: Based on the 1993 initial budget.
Source: The Japanese Budget in Brief, 1993.
The central government budget consisted of 38 special account budgets in 1993
in addition to the general account. Some special accounts are established for
specific projects, such as highway and airport construction; others are created
to fund specific purposes with specific revenues. Some of these accounts have
their own source of revenues, and some may use revenues obtained from
borrowing. In fiscal year 1993, the special account budgets were approximately
three times the size of the general account budget; however, there are
significant cash flows between the general account and the special account
budgets.
The budgets of the 11 government-affiliated agencies are also considered part
of the central budget but not part of the general account budget. These are
public corporations which are closely tied to government policies and whose
budgets are subject to approval by the Diet. In fiscal year 1993, the total of
their budgets was 7.2 trillion yen. Figure IV.4 displays all of the components
of the central government budget.
Figure IV.4: Central Budget
Components in Japan
(See figure in printed edition.)
Note: Based on 1993 initial budget.
Source: The Japanese Budget in Brief, 1993.
THE FISCAL INVESTMENT AND LOAN
PROGRAM (FILP)
---------------------------------------------------------------- Appendix IV:1.4
Another important funding source in Japan is an investment program called the
Fiscal Investment and Loan Program (FILP). FILP is 60 percent the size of the
general account budget, at 45.8 trillion yen, and is often referred to as
Japan's second budget. Figure IV.5 displays the sources of government funding.
The FILP budget is submitted to the Diet for approval at the same time as the
general account budget, but FILP funds are administered solely by the Ministry
of Finance. Compared with the general account budget, the government has
greater discretion to use FILP without requesting approval from the Diet. FILP
lending is not reflected in the general government balance; according to OECD
calculations, if FILP were included in Japan's debt figures, gross debt would
rise by approximately 1 percent of GDP.
Figure IV.5: Government Funding
Sources in Japan
(See figure in printed edition.)
Note: Based on the 1993 initial budget.
Source: The Japanese Budget in Brief, 1993.
Funding sources for FILP include public funds that are collected through the
postal savings system, which is comprised of personal savings deposits and
government annuity and pension plans. FILP invests, finances, or guarantees
debt to government-affiliated financial institutions, such as the Government
Housing Loan Corporation, the Export-Import Bank of Japan, and the Metropolitan
Expressway Public Corporation, which then invest primarily in projects that
generate profits.
An MOF analyst stated to us that the goal of FILP is to finance and promote
public policies that the private sector will not finance due to low rates of
return. FILP funds are used specifically to (1) promote policy priorities,
such as housing, social welfare, and environmental protection, and (2) promote
public works that have a positive rate of return, such as airports, railway
lines, and toll roads.
While many of the other case study countries significantly reduced capital
investment expenditures during the 1980s, in Japan, overall government
investment--including FILP--did not decline. According to OECD, while
investment as a share of central government expenditures declined, the ratio of
general government investment to gross national product did not decrease due to
increased investment expenditures by FILP, interest-free loans using the
proceeds from privatization (described in the following section), and increased
investment expenditures by the local governments.
CAUSES OF DEFICITS DURING THE 1970S
AND 1980S
------------------------------------------------------------------ Appendix IV:2
Japan experienced significant general government deficits between 1975 and
1986. The deficit reached its peak in 1978, at 5.5 percent of GDP and slowly
began to decrease after that point. A number of factors contributed to the
growth of deficits in Japan, including a long-term decline in the economic
growth rate, oil-price shocks and recession, and an increase in social welfare
spending. Following World War II, Japan underwent a period of extremely high
growth as it recovered from the devastation of its economy during World War II.
Productivity increased at a rapid pace during that period, but by 1970, these
productivity gains began to slow, and the oil price-induced recessions of 1974
and 1979 deepened the effects of slowing economic growth. Prior financial
commitments to expand social welfare programs and stimulative spending
undertaken at the request of other industrialized nations required Japan to
issue deficit financing bonds in 1975 to cover a growing budgetary gap.
SLOWDOWN IN ECONOMIC GROWTH AND
OIL PRICE SHOCKS
---------------------------------------------------------------- Appendix IV:2.1
The rate of economic growth in Japan was extremely high during the 1960s;
between 1960 and 1973, average annual real economic growth was 10.9 percent.
By the mid-1970s, however, the growth rate of the economy began to slow both in
Japan and in other advanced countries; between 1974 and 1980, the average
annual growth rate had dropped to 3.6 percent. Figure IV.6 illustrates the
growth rate in the economy between 1969 and 1994.
Figure IV.6: Real GDP Growth in
Japan, 1969-1994
(See figure in printed edition.)
Note: Data for 1969 through 1977 are presented as a percent of GNP. Data for
1994 are based on OECD projections.
Source: OECD Economic Outlook, #46 and #45.
The disruption of oil supplies in 1973 led to a recession in 1974 and a
long-term slowdown in economic growth, which resulted in significantly reduced
tax revenues.
EXPANDING SOCIAL RESPONSIBILITIES
---------------------------------------------------------------- Appendix IV:2.2
In the 1970s, the Japanese government made extensive additions to its social
security system.\2 For example, it introduced free medical care for the elderly
and subsidies for expensive medical treatments. The Japanese government also
introduced the children's allowance during this period, which is a nationwide
system covering families with children who have not yet completed compulsory
education. The government also raised the ratio of old-age public pensions
from about 20 percent of the average salary to 43 percent. Social welfare
benefits were indexed to inflation in the early 1970s; the rapid inflation that
occurred in the following year caused a significant increase in benefit costs.
Health care costs are expected to increase in Japan in the next century due to
the rapidly increasing proportion of the population that is over 70 years of
age and the high concentration of health care spending devoted to the elderly.
Improvements in medical technologies are also expected to contribute to
increases in health care costs. Japan has a system of universal health care
that is limited to basic services, which imposes price controls as well as
limits on overall health spending to help control spending growth.\3 In Japan,
public expenditures on health (as defined by OECD) increased by 0.2 percent of
GDP between 1980 and 1991. In the United States, public expenditures on health
rose by 2 percent of GDP during the same period.
--------------------
\2 The social security system in Japan is made up of public assistance, social
welfare, social insurance (medical-care insurance, public pensions,
unemployment insurance, and workers' accident compensation insurance), public
health services, and measures for the unemployed.
\3 Health Care Spending Control: The Experience of France, Germany, and Japan
(GAO/HRD-92-9, November 15, 1991).
STIMULUS SPENDING
---------------------------------------------------------------- Appendix IV:2.3
Stimulus spending in the late 1970s also contributed to the growth of the
deficit. In 1977, the industrial countries formulated the "locomotive theory,"
the belief that the United States, Japan, and Germany could and should
simultaneously stimulate their economies in order to increase world growth.
Japan agreed to implement policies that would increase real gross national
product and deliberately increased spending in excess of revenues.
DEFINING BALANCE
------------------------------------------------------------------ Appendix IV:3
Budgetary balance, according to the Japanese government, refers to the balance
of the central government general account budget. The Public Finance Law of
1947, the basic budget law in Japan, states that the Japanese government can
issue bonds only if the funds are to be used for public works, investment, and
governmental loans. The Japanese culture places a high priority on savings,
and prior to 1965, the Japanese government chose not to issue construction
bonds. In 1965, the government issued construction bonds for the first time,
in response to a slowdown in economic growth, and has issued them ever since.
In 1975, Japan's expenditures exceeded its revenues. In exception to the
Public Finance Law, the Japanese government began issuing special deficit
financing bonds to close the general account budget gap and to finance current
expenditures. The Diet was required to pass a special resolution in order to
permit the issuance of the deficit financing bonds. In 1980, the government
announced that its goal was to reduce the accumulation of outstanding
government bonds by terminating the issuance of all new deficit financing bonds
by 1984. The government ultimately succeeded in reaching this goal in 1990.
Despite the different labels, construction bonds and deficit financing bonds
are essentially the same. A fairly clear delineation between capital and
current spending, however, has permitted the government to place separate
spending ceilings, as described below, on each type of expenditure. Officials
told us, however, that the government has been broadening its definition of
capital, which has resulted in a rapid increase in the types of things that can
be financed with construction bonds.
The accumulating deficits resulted in an increase of gross debt from
approximately 12 percent of GDP in 1970 to 52 percent in 1980. The Japanese
government was able to reduce gross debt between 1987 and 1991, but the debt
began to rise again in 1992, reaching close to 75 percent of GDP in 1993. Net
debt in Japan, which is calculated by netting out the large assets held by the
social security fund, is significantly lower than in most other industrialized
nations; in 1993, it was 5.3 percent of GDP, compared to 39.3 percent in the
United States and 33 percent for the OECD average. MOF has stressed that gross
debt provides a more accurate representation of the budgetary situation in
Japan than net debt since gross debt reflects all of the government's
liabilities, including future pension costs. Figure IV.7 illustrates the
levels of both gross and net public debt in Japan.
Figure IV.7: General Government
Gross and Net Debt in Japan,
1980-1994
(See figure in printed edition.)
Note: Data for 1993 and 1994 are based on OECD projections.
Source: OECD Economic Outlook, #55.
IMPETUS FOR REDUCING THE DEFICIT
------------------------------------------------------------------ Appendix IV:4
Our discussions with Japanese officials suggest that a combination of factors
led the Japanese government to end its reliance on deficit financing; however,
the long-term concern over the aging of the population and the resulting growth
in health and pension costs were essential components of this decision.
Government officials told us that it was imperative to build reserves for
future pension outlays. In addition, there was concern that the growing
interest payments were limiting the government's ability to make budgetary
choices. The government also emphasized to the public that increased taxation
would be necessary if spending control measures were not promptly undertaken.
Interviewees said that the Japanese government was very concerned about future
pension obligations and the rapid aging of the Japanese population. The social
security system is in surplus in Japan because the ratio of pension recipients
to contributors is relatively low. The population is aging rapidly, however.
Approximately 12 percent of the population was over 65 in 1990, and this is
expected to rise to 25.5 percent by 2020. This is a function of factors such
as increased life expectancies and declining fertility rates. OECD has
calculated that the present value of future net pension liabilities amounts to
200 percent of GDP in Japan compared to 43 percent in the United States.\4
Thus, although the social security system currently has annual cash surpluses,
on an actuarial basis it would be in deficit.
Interest payments on outstanding bonds nearly doubled between 1980 and 1985,
and by 1983 interest payments surpassed every expenditure except social
security in the general account budget. Figure IV.8 illustrates the change in
general government debt-related interest costs. Japanese economists said they
believed that the debt and its associated interest costs were beginning to
crowd out private investment, and government officials and business leaders
reached the consensus that it was essential to control the deficit and the
growing debt.
Figure IV.8: General Government Net
Debt Interest Payments in Japan,
1978-1994
(See figure in printed edition.)
Note: Data for 1994 are based on OECD projections.
Source: OECD Economic Outlook, #55.
--------------------
\4 OECD Economics Department Working Paper #142, Pension Liabilities in the 7
Major Economies, 1993.
DEFICIT REDUCTION ACTIONS
------------------------------------------------------------------ Appendix IV:5
Successful deficit reduction in Japan was heavily dependent on the strong
economic growth that occurred in the late 1980s. Japan's tax system is not
indexed, and real growth as well as inflation-induced bracket creep
significantly increased Japan's revenues. Strict spending ceilings that MOF
placed on some government expenditures within the general account budget also
contributed to deficit reduction, although the significance of these
expenditure reductions has been debated. Ceilings were set at rates below
inflation, but budget experts stated that the budget reductions were to a large
extent superficial. While expenditure growth was constrained, some costs were
shifted to the local governments, and social security contributions were
increased.
Tax reform did not play a significant role in deficit reduction. When the
government attempted to implement a value added tax in 1979, it met with
extreme opposition from Diet members, the public, and the business community.
In 1980, the lower house of the Diet was forced to dissolve, largely due to its
inability to come to a consensus on the issue of the VAT. The VAT was
reintroduced in 1986 but did not pass the Diet until 1989, when it was promoted
and implemented as a revenue-neutral tax. It was introduced at 3 percent,
which is low compared to VATs in other OECD nations. At the same time that the
government introduced the VAT, it reduced the base corporate tax rate and
lowered and simplified personal income tax rates. The new tax was intended to
broaden the tax base as well as shift more of the weight of taxation from
direct taxes, such as the income tax, to indirect taxes, such as the
consumption tax. The government does not index tax rates, but it did provide
annual tax cuts prior to 1974 to compensate for automatic tax rate increases.
The following is a more detailed description of some of the major contributors
to deficit reduction during the 1980s.
Economic growth. Strong economic growth and high asset prices during the late
1980s, referred to as the "bubble period," dramatically increased tax revenues
and were essential in helping Japan reduce its dependance on deficit financing
bonds. Japan experienced its second-longest boom since World War II, which
lasted from 1987 to 1990.
Expenditure ceilings. Since 1961, MOF has set budget guidelines for the budget
requests for each ministry and agency within Japan. The guidelines, or
ceilings,\5 are in nominal terms, apply to only a portion of the expenditures
within the general account budget and use as their base the previous year's
budget. In principal, the guidelines are applied equally to all expenditures,
but each ministry determines its own expenditure priorities within the
determined ceilings.
In the 1960s, the budgets were allowed to grow quickly, but at the end of the
1970s, MOF significantly increased the stringency of the budget requests. In
1961, for example, the budget request was permitted to increase up to 50
percent over the previous year's budget. This growth, however, was gradually
reduced until spending was frozen in 1982. Table IV.1 provides detailed
information on the annual levels of these ceilings on nominal budget growth.
In 1984, the growth limit for those current expenditures under the ceilings was
reduced 10 percent from the previous year's rate of increase, while the ceiling
for applicable investment expenditures was reduced by 5 percent. Growth of the
applicable current expenditures has been reduced by 10 percent from the
previous year's growth each year up through 1993.
Table IV.1
Guidelines for Budget Request Increases
in Japan, 1961-1993
Fiscal year(s) Nominal increase/decrease
----------------------------- -----------------------------
1961-1964 Maximum 50 percent increase
1965-1967 Maximum 30 percent increase
1968-1975 Maximum 25 percent increase
1976 Maximum 15 percent increase
1977 General administrative
expenses:
Maximum 10 percent increase
Other expenditures:
Maximum 15 percent increase
1978-1979 General administrative
expenses:
Current office expenses-0
percent
increase
Other-maximum 5 percent
increase
Other expenditures:
Maximum 13.5 percent increase
1980 General administrative
expenses:
0 percent increase
Other expenditures:
Maximum 10 percent increase
1981 General administrative
expenses:
0 percent increase
Other expenditures:
Maximum 7.5 percent increase
1982 0 percent increase
1983 Current expenditures:
5 percent decrease
Investment expenditures:
0 percent increase
1984-1987 Current expenditures:
10 percent decrease
Investment expenditures:
5 percent decrease
1988-1993 Current expenditures:
10 percent decrease
Investment expenditures:
0 percent increase
------------------------------------------------------------
Source: The Japanese Budget in Brief, 1993.
In 1987, approximately 32 percent of general account general expenditures were
subject to the ceilings; after 1987, only 11 percent was covered. General
expenditures that are categorized as "exceptional" are exempt from the
ceilings. These include personnel expenses, pensions, Official Development
Assistance (foreign aid), energy-related measures, and enforcement of
international treaties. While exceptional expenditures are exempt from the
ceilings, MOF's goal has been to hold the level of all general expenditures at
or below the previous year's nominal level, and it annually determines the
budget increase to apply to the exceptional expenditure total. Obligatory
items such as interest subsidies and reserves are also excluded from the
cutback policy.
Actual general expenditure growth within the general account budget remained
below 1 percent of GNP between 1983 and 1986, as illustrated in figure IV.9,
and increased at an average rate of 1.9 percent between 1987 and 1991.
Inflation remained low during the 1980s, as shown in figure IV.10.
Figure IV.9: Growth of General
Expenditures in Japan, 1979-1991
(See figure in printed edition.)
Note: These are actual general expenditure figures.
Source: The Japanese Budget in Brief, 1993.
Figure IV.10: Consumer Price
Inflation in Japan, 1970-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
Capital spending reductions. Central government investment did not expand at
all between 1981 and 1985, but as explained above, while central government
investment as a share of total expenditure declined, the ratio of general
government investment to gross national product did not. During the
high-growth period of the late 1980s, the government began to increase public
works spending to stimulate demand. In 1988, investment spending was no longer
subject to nominal reductions, as were other expenditures, but was frozen,
rather than reduced. Despite this commitment to capital spending, Japan is
still lacking in what the Japanese refer to as social infrastructure--for
example, adequate sewer services.
Postponing payment obligations and shifting costs to other levels of
government. The central government is required to distribute, through grants,
a 32 percent share of estimated revenues from individual income, corporate, and
liquor taxes to the local governments. In addition, the local governments
receive tax transfers and subsidies from the central government which are to be
used to promote specific projects or to carry out programs on a nationwide
basis.
During the 1980s, MOF postponed subsidies to local governments, along with
other "exceptional measures," such as suspending obligatory payments to a fund
which is used to redeem outstanding bonds. MOF also required local governments
to undertake capital projects which would normally be the responsibility of the
central government. This enabled the government to both lower its deficit and
reduce the amount of bonds it issued.
Other deficit reduction measures included the following.
Health insurance co-payment. In 1984, health insurance for public and private
sector employees was changed from paying all costs to requiring all but the
elderly to pay a co-payment of approximately 10 percent of the cost per
service.
Privatization. The Japanese government privatized three major government-owned
corporations between 1985 and 1988: Japan Tobacco and Salt, Nippon Telegraph
and Telephone (NTT), and Japanese National Railways (JNR). Privatization was
undertaken primarily to improve the management and economic efficiency of the
corporations, but privatization has also provided some short-term revenues to
the government. Between fiscal years 1988 and 1991, the government earmarked
$10.4 billion a year from the sale of NTT shares for public works spending.
Also, proceeds from the NTT privatization were used to redeem outstanding
public debt. JNR, in contrast, has a large amount of debt, and experts have
stated that the government may, in the long-run, be required to cover these
costs.
--------------------
\5 In Japan, the term "ceiling" refers not to a nominal currency amount but to
the limit on growth permitted from year to year.
REACHING AGREEMENT
------------------------------------------------------------------ Appendix IV:6
Some have argued that the government in Japan was successful in promoting and
carrying out its fiscal austerity measures largely because of a strong Ministry
of Finance which has considerable control over the budget process, a receptive
public which prefers saving to borrowing, and a business community that
supported the government's deficit reduction actions.
MOF has a wide range of responsibilities and strong influence over other
government organizations. According to an analyst specializing in Japan, MOF
holds a combination of powers similar to those held by the Treasury, the
Securities and Exchange Commission, the Office of Management and Budget, and
some aspects of the Federal Reserve in the United States. An academic stated
that MOF generally has a very strong positive image in Japan, but qualified
this by stating that MOF has been heavily criticized at times--for example, for
inaction in response to the recession of the 1990s.
Interviewees told us that MOF was successful in implementing long-term budget
reductions not only because of its authority, but also because of (1) the
administrative nature of the budget process, (2) the uniformity of the
expenditure ceilings, and (3) the incremental nature of the reductions under
the ceilings, which did not appear to significantly affect any particular
segment of the population.
MOF has minimized political debate by applying budget ceilings uniformly to
each of the ministries and leaving decisions about individual programs to the
relevant ministry. We were told that this type of approach can have negative
as well as positive effects. For example, one economist said necessary outlays
have been reduced in Japan while unnecessary ones retained. This approach also
results in minimal change in the allocation of resources, as can be seen by the
fact that the distribution of spending across categories has been stable since
the early 1980s.
Several of the experts we interviewed stated that the public was only minimally
affected by the austerity measures in the 1980s. One academic said, however,
that reduced funding for education expenditures in the areas of research and
construction affected the science and engineering departments of universities.
An economist also said that the burden of social insurance on the public has
increased.
Interviewees said that the LDP succeeded in appealing to the public's
preference for savings over borrowing to convince many Japanese that deficits
in the 1980s were detrimental for the country. High rates of saving in Japan
suggest that the public believes it is important to save and that borrowing
should be avoided. The household savings rate in Japan is very high:
according to OECD data, between 1980 and 1990, it averaged 15.8 percent of
disposable household income. In contrast, the household savings rate in the
United States averaged 6.5 percent during the same period.
The government also worked hard to convince the public of the seriousness of
the deficits. One channel that MOF used was the media. Bureaucrats educated
reporters and editors on the negative consequences of borrowing, and they
passed this on to their audience.
THE ADMINISTRATIVE REFORM
COMMISSION
---------------------------------------------------------------- Appendix IV:6.1
The creation of the Administrative Reform Commission at the beginning of the
1980s led to involvement by the business community in the deficit reduction
efforts of the government; this helped the government gain additional support
for fiscal austerity from the general public. Interviewees said that the
Commission was formed in response to pressure from the private sector, led by
"Keidanren," the powerful lobby for big business in Japan. We were told that
the private sector reformers preferred reduced expenditures to tax increases
and wished to reduce the size of the government. The Commission was a
temporary coalition between business interests and the government which
advocated austerity and sound fiscal policy through deregulation, reform of the
political system, a smaller government, and privatization.
The Administrative Reform Commission succeeded in creating some consensus among
the leadership; however, actual changes were relatively small. For example,
although the number of government employees was reduced by approximately 3
percent at the beginning of the 1980s, by the middle of the decade, the
employee level had again increased to close to its original level. MOF did not
promote deregulation. Although the Commission's recommendations resulted in
some privatization and reduction in expenditure growth, there was no widespread
deregulation or reduction in the size of the government.
BUDGET DEFICITS DURING THE 1990S
------------------------------------------------------------------ Appendix IV:7
The tight fiscal policy of the 1980s placed pressure on monetary policy to
stimulate the domestic economy. The resultant loose monetary policy and low
interest rates helped create a climate for high domestic asset prices in the
late 1980s and early 1990s, and what the Japanese refer to as the "bubble
period." The bubble burst in the beginning of the 1990s and was accompanied by
recession.
Although actual figures for 1994 were not available when we completed our work,
OECD projected a general government deficit of 1.9 percent of GDP in Japan for
1994. This was the first year that general government balances were negative
since 1986. OECD data also suggest, however, that the deficit is entirely
cyclical rather than structural--that is, due to economic downturn. Figure
IV.11 illustrates the structural component of the deficit.
Figure IV.11: General Government
Structural Balances in Japan,
1978-1994
(See figure in printed edition.)
Note: Data for 1994 are based on OECD projections.
Source: OECD Economic Outlook, #55.
Observers said that MOF appears to find it crucial to support a fiscal policy
that promotes balance in the general account. The inability to sustain balance
has been attributed by some to a combination of the collapse of the revenue
bubble and an erosion in the political consensus to continue fiscal austerity.
The Japanese government is under internal and external pressure to stimulate
the economy, while MOF continues to advocate continued fiscal discipline. The
outlook for Japan's fiscal balance remains unclear.
CONCLUSION
------------------------------------------------------------------ Appendix IV:8
Japan successfully reduced a significant fiscal deficit in the 1980s and
sustained a budget surplus for approximately 7 years. Japan's budget is
currently in deficit, but this is primarily a result of cyclical rather than
structural deterioration. Observers told us that the Japanese government was
able to eliminate its deficit by appealing to the underlying values of the
Japanese public, taking advantage of economic growth, and implementing
long-term, incremental expenditure reductions that "spread the pain" evenly
throughout the population. A strong Ministry of Finance that represented a
stable government was instrumental in ensuring that policies promoting balance
were undertaken in the 1980s, and MOF remains committed to fiscal balance in
its tax and expenditure recommendations. Experts have noted, however, that
Japan's government is experiencing a period of change and uncertainty that is
unprecedented since World War II, and that, as a result, the outlook for
Japan's fiscal balance is as yet unclear.
MEXICO
===================================================================== Appendix V
Although its deficit reduction efforts were hampered by continuing economic
troubles, a shifting fiscal policy focus, a major earthquake, and a drop in
revenues due to the fall in oil prices, Mexico had a surplus in the general
government\1 financial balance by 1992 and remained the only case study country
with a surplus at the time we concluded our work. Mexico's success lies in
turning its "vicious circle" of deficits, increasing debt and the budgetary
constraints of rising interest costs into a "virtuous circle" of fiscal
surplus, decreasing debt, and increased fiscal flexibility.
The Mexican government first adopted deficit reduction in 1983 as part of an
overall plan to stabilize the economy, reduce inflation, and renew private
sector and international confidence after a severe economic crisis. After a
few years of limited success, the deficit grew, an economic crisis again
threatened, and the government initiated a second, more successful round of
deficit reduction.
The government reduced its deficit by maintaining revenues while cutting public
expenditures. (See figure V.1.) The process involved spending cuts, both
targeted and across-the-board, a social pact of wage and price controls to
reduce inflation, large scale privatization, and debt renegotiation. Of the
six case study countries included in this report, Mexico experienced the most
severe economic crisis, reaching triple digit inflation and facing exclusion
from international credit markets. As one government official said,
"...something had to be done."
Figure V.1: Budgetary Public Sector
Revenues and Expenditures in Mexico,
1980-1992
(See figure in printed edition.)
Source: Banco de Mexico.
--------------------
\1 General government refers to all levels of government combined. State and
local governments control a relatively small portion of public sector revenue
in Mexico. Therefore, this appendix will focus on data for general government.
In addition, for the other countries in this report, we relied to some extent
on data from the Organization for Economic Cooperation and Development (OECD).
However, since Mexico only joined OECD in early 1994, OECD data were not
available. Data for this appendix were primarily from the Banco de Mexico,
Mexico's central bank.
BACKGROUND
------------------------------------------------------------------- Appendix V:1
Mexico is a federal republic with an executive, a legislative, and a judicial
branch. The executive branch, headed by the President, promulgates all laws
and essentially controls the distribution of federal revenues. Presidential
elections are held every 6 years. The executive branch also includes the
central bank, Banco de Mexico, although a constitutional amendment was
implemented on April 1, 1994, to make the central bank more independent of
government control.
Mexico's legislature is made up of an elected Senate (64 members) and Chamber
of Deputies (500 members) whose membership is determined by a mix of majority
vote and proportional representation of minority parties. The Mexican public
sector includes the federal government, the state and local government
(including the federal district encompassing Mexico City), and public
enterprises. Eleven public enterprises were still under budgetary control in
1994, including the national oil company (PEMEX) and the Federal Electricity
Commission.
The two primary political parties in Mexico have historically been the
predominant Institutional Revolutionary Party, or PRI, and the National Action
Party, or PAN. PRI has had a monopoly on presidential power, although in 1988
an opposition candidate from the National Democratic Front, representing a
coalition of smaller parties, won a significant portion of the popular vote.
However, PRI retained the presidency and control of the Congress. PRI again
won the presidency in the 1994 election. PAN has reasserted itself as the main
opposition party, but opposition parties do not seem to play a major role in
policy-making at this time. However, rising social unrest was evident in early
1994 in Chiapas, Mexico. This may change the political bargaining power of
opposition groups in the future.
BUDGET PROCESS
----------------------------------------------------------------- Appendix V:1.1
The Mexican Secretariat of Finance and Public Credit in the executive branch of
government largely controls the federal budget. For the most part, budget
decision-making is a top-down process controlled by the Secretariat, which
develops the budget, shares it with the other secretariats, and presents it to
the Congress. The public enterprise budgets subject to government control are
developed independently and must be approved by a board of directors composed
of officials from relevant secretariats. The federal budget is debated to a
limited extent in the legislature and usually is passed as presented.
According to one official, the legislature first added programs which had not
been included in the proposed budget in 1992. No recent budget process reform
has taken place.
BUDGET STRUCTURE
----------------------------------------------------------------- Appendix V:1.2
The Mexican budget is composed of programmable and nonprogrammable
expenditures. Expenditures completely controlled through annual appropriations
by the federal government, including the budgets for public enterprises, are
considered programmable. Nonprogrammable expenditures are those expenditures
over which the central government has no control, such as revenue sharing to
the states, which is determined by formula, and interest payments.
Social spending does not play as large a role in the Mexican budget as it does
in the other countries in this study. Social spending represented about one
third of programmable spending and one quarter of total spending in 1980. The
social security system is relatively limited and was not identified as a
deficit driver by most interviewees. One budget expert suggested that the
social security system could be considered a deficit driver if one considers
the potential liabilities it may face in the future.
Health care, pensions, and other social services, known in Mexico as "social
security" are primarily provided to workers and their families through a
complex series of government, union, and private sector institutes, each with
their own range of benefits and eligibility. The institutes are funded jointly
by employees, employers, and the government. There is no national agency that
coordinates or supervises all the existing social security institutes, funds,
or programs. In 1992, the Mexican government established a Retirement Savings
System to provide pensions and limited unemployment, disability, and housing
construction assistance. This is financed by taxes on employers and voluntary
employee contributions and replaces some aspects of the previous social
security structure.
According to interviewees, Mexico has no large entitlement programs or
comprehensive social safety net. Extended families furnish a safety net for
upwards of one third of the population due in part to the limited social
security system and limited unemployment compensation. Interviewees said
public expectations are low for the social security system. Many individuals
eligible for the public system choose private health care, and pension payments
have been eroded over time by inflation. One interviewee suggested that this
situation represents a significant transfer of responsibility between the
public and private sectors, allowing the government to continue reducing its
social benefits.
STATE AND LOCAL GOVERNMENTS HAVE
LIMITED RESPONSIBILITIES
----------------------------------------------------------------- Appendix V:1.3
The federal government is responsible for all major public sector functions in
Mexico. In the mid-1980s, the federal authorities accounted for some 72
percent of general government expenditure (including public enterprises), the
31 states and the federal district accounted for 23 percent, and the local
authorities for 5 percent. Most expenditure at the state and local levels,
however, comes from federal revenue sharing. States turn over the majority of
their tax revenue to the federal government, and in return receive federal
transfers. In 1992, these transfers amounted to around 20 percent of total
federal expenditure, almost double the percentage state and local governments
received in 1988. The increase in revenue sharing is due to the improved
financial situation of the federal government and the move to decentralize some
public services. Local agencies depend on state agencies for funds, which in
turn depend on the federal government. Federal agencies own and supervise
large public enterprises, whereas state and local governments manage mostly
small utilities and other service operations.
DEFINING BUDGET BALANCE
----------------------------------------------------------------- Appendix V:1.4
The primary balance and the financial balance, or Public Sector Borrowing
Requirement (PSBR), are two commonly used measures of budget deficits in
Mexico.\2 The financial balance represents the difference between total revenue
and total expenditure of the general government and thus the effect of the
deficit or surplus on the economy. For Mexico, the PSBR shows a deficit of
16.9 percent of GDP in 1982 and approximate balance in 1992. All further
references to deficits in this appendix refer to the PSBR.
The primary balance represents the overall public sector balance excluding
interest, revenue sharing to states, and net transfers to entities not under
budgetary control, which according to a budget expert, currently represent 10
public enterprises or institutions, such as the National University. As shown
in table V.1, under this measure, the Mexican government had a deficit of 8.0
percent of GDP in 1981 but achieved a surplus of 4.2 percent of GDP by 1983.
Table V.1
Public Finance Indicators as a Percent
of GDP in Mexico
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992
-- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
Pr - - - 4.2 4.8 3.4 1.6 4.7 8.0 7.9 7.8 5.3 5.6
i 3.0 8.0 7.3
m
a
r
y
b
a
l
a
n
c
e
PS - - - - - - - - - - - - 0.5
BR 7.5 14.1 16.9 8.6 8.5 9.6 16.0 16.0 13.0 5.6 3.9 1.5
--------------------------------------------------------------------------------
Note: Data for 1991 and 1992 exclude privatization proceeds.
Source: Banco de Mexico.
Figure V.2 shows these two indicators over a 28-year period. The difference
between the two approximates interest payments, federal revenue sharing, and
transfers to entities not included under budgetary control.
Figure V.2: Public Finance
Indicators in Mexico, 1965-1992
(See figure in printed edition.)
Note: Data for 1991 and 1992 exclude privatization proceeds. Data for 1992
are preliminary.
Source: Banco de Mexico.
--------------------
\2 Privatization proceeds are usually included in both measures. However, the
most recent years' data are reported without fully accounting for privatization
proceeds, perhaps because the sale of a large asset can take several years.
IMPETUS FOR DEFICIT REDUCTION
------------------------------------------------------------------- Appendix V:2
While economic pressure, in combination with a change in political parties or
political philosophy, played a role in the other five countries we examined,
only Mexico adopted deficit reduction solely in response to an economic crisis.
Two distinct phases characterize Mexico's deficit reduction. The first was a
response to the 1982 economic crisis, when a series of adverse events
culminated in the refusal of international banks to roll over short-term
credit. The second phase of deficit reduction responded to the failure of
initial austerity policies to alleviate the economic troubles, such as high
inflation and stagnating growth, that persisted through the mid-1980s. The
following sections describe the development of Mexico's deficits and how
government action was prompted in 1982 and again in 1987.
DEFICITS STARTED IN RESPONSE TO
1970S SOCIAL, POLITICAL UNREST
----------------------------------------------------------------- Appendix V:2.1
Mexico's leaders first built up deficits in the late 1960s and throughout the
1970s in efforts to maintain political popularity, but they were rapidly
increased by a slowing economy, patterns of high spending built on expectations
of continuing oil revenues, and the willingness of foreign banks to finance the
deficit.
At the end of the 1960s, Mexico had a 30-year tradition of stable government
and high economic growth (6.8 percent annual average). In 1968, however, the
situation changed. Student riots caused concern about the stability of the
political system. When President Luis Echeverria came to office in 1970,
government policy responded to the new social demands for both economic growth
and income redistribution with increased public spending. One analysis of this
time stated that rather than choosing or discriminating among various
investment projects, the Echeverria government spent on all of them.\3 A budget
expert in Mexico stated that a proposed tax reform plan to pay for the
investment spending was never approved. The high public spending resulted in
growing deficits throughout the 1970s, financed by both domestic and foreign
debt, and contributed to rising inflation.
Under L�pez Portillo (1976-1982), Mexico's budget deficit initially stabilized
but high government spending returned with high oil revenues, as the economy
grew over 8 percent annually from 1978 to 1981. Although oil revenues then
started to decline, the expansion of government continued. Portillo tried to
maintain the high level of economic activity by relying on increased foreign
borrowing.
--------------------
\3 Luis Rubio F. and Francisco Gil-Diaz, A Mexican Response (New York, N.Y.:
Priority Press Publications, 1987), p. 18.
HIGH DEBT FOSTERED SPIRALING
DEFICITS
----------------------------------------------------------------- Appendix V:2.2
Heavy reliance on debt for public sector financing clearly had a negative
impact on Mexico's financial stability. The size of Mexico's public debt, from
both domestic and foreign sources, and how it was financed greatly affected the
deficit situation in Mexico.
Starting in the early 1970s, foreign borrowing became one of the major sources
of government financing, primarily due to the rapid growth in government
spending, which domestic savings were unable to finance. External borrowing
was facilitated by the willingness of international banks to provide resources.
As seen in figure V.3, external debt grew until 1987.
Figure V.3: Total Net Debt of the
Public Sector in Mexico, 1980-1992
(See figure in printed edition.)
Note: Data include debt incurred by the federal government, government
enterprises and entities, development banks, and official trust funds. Data
for 1992 are preliminary.
Source: Banco de Mexico.
INTEREST PAYMENTS BECAME DEFICIT
DRIVERS
----------------------------------------------------------------- Appendix V:2.3
The composition of the public debt made the situation worse. By 1982,
short-term debt (with maturity of less than 1 year) rose to one third of total
debt outstanding. This made the Mexican economy vulnerable to adverse economic
developments that occurred in the international community, such as the sharp
increase in international interest rates. With high interest rates, high
inflation, and deteriorating confidence in the Mexican economy, the costs of
debt servicing increased through 1987, even in the face of tighter fiscal
policies. Interest payments became the primary "deficit driver." (See figures
V.4 and V.5.)
Figure V.4: Interest Rates in
Mexico, 1980- 1992
(See figure in printed edition.)
Note: Data represent the average cost of term deposits for banks.
Source: Banco de Mexico.
Figure V.5: Share of Interest in
Total Current Spending in Mexico,
1980-1992
(See figure in printed edition.)
Note: Data for 1992 are preliminary.
Source: Banco de Mexico.
OIL REVENUES POSTPONED ACTION ON
DEFICIT
----------------------------------------------------------------- Appendix V:2.4
The changing price of oil also strongly affected the deficit situation in
Mexico, prompting increased public sector spending when high and reducing
government revenue when low. Oil has played a major role in government
policy-making in Mexico since the beginning of the Portillo administration
(1976-1982), when the government confirmed the existence of large oil deposits.
Oil revenues were approximately one third to one half of total budgetary public
sector revenue between 1980 and 1990.
One analysis of the Mexican economy states that the discovery of the oil
deposits and the large oil price increases in the late 1970s postponed a true
fiscal adjustment after Mexico's economic troubles in the mid-1970s.\4 The
government's annual revenue law has a specific section for PEMEX, although it
is not subject to the regular tax system. As described by a budget expert,
PEMEX serves as a type of franchise operation that pays the government for oil
extraction rights. PEMEX transfers approximately 50 to 60 percent of its
revenues to the government each year.
From 1981 to 1985, average export oil prices fell from over $33 per barrel to
$25.50 per barrel. However, the most dramatic impact of oil prices came in
February 1986, when oil prices dropped below $10 per barrel. Although the
price of oil rose again in the second half of the decade, the severe drop in
oil prices and the corresponding stress it placed on government revenues in
1985 strengthened the view that fundamental changes in the Mexican economy were
needed. Fluctuating oil prices contributed to the economic crisis that served
as the impetus for deficit reduction.
--------------------
\4 Luis Rubio F. and Francisco Gil-Diaz, A Mexican Response, pps. 13 and 14.
1982 ECONOMIC CRISIS FORCED
GOVERNMENT ACTION
----------------------------------------------------------------- Appendix V:2.5
As declining oil revenue increased the fiscal deficit, the government began to
rely more on foreign debt to finance the fiscal gap. Domestic savings could
not finance the deficit because individuals with mobile capital were nervous
about the economic situation, and capital flight occurred--investors sent
capital out of the country, draining available resources for government
borrowing. When international banks refused to roll-over short-term credit,
Mexico no longer had access to international credit markets and thus could no
longer finance its deficit. Under the circumstances, Mexico was forced to
adopt a deficit reduction policy immediately.
An overvalued peso had exacerbated the problem. Up to 1982, the Mexican
government was reluctant to devalue the peso. With financial markets believing
that the peso was overvalued and that devaluation was imminent, capital flight
and deposits in dollar-denominated accounts increased. The impact of capital
flight on growth was not perceived to be severe until Mexico's access to
international credit was restricted in 1982. Capital flight coupled with lack
of international credit reduced funds available for economic growth. In
response to these pressures, the government devalued the peso twice in 1982.
Since government spending financed by foreign debt could no longer support
economic growth, the Mexican economy went from growth rates of over 8 percent
for the previous 3 years into recession. In September 1982, private banks were
nationalized and exchange rate controls introduced. Inflation reached triple
digits (a then-historic high of 117 percent per annum in April 1983), and
Mexico announced it was suspending payments due on its foreign debt.
1987 RECORD INFLATION TRIGGERED
RENEWED DEFICIT REDUCTION EFFORTS
----------------------------------------------------------------- Appendix V:2.6
The Mexican government was compelled to address a large deficit in the second
half of the decade as well. Austerity measures described below were
implemented by President de la Madrid's administration when he took office in
1982. However, after some success in 1983, the deficit returned to 16 percent
of GDP by 1986. Analysts report that the public's perception that the size of
the public debt and the continuing economic crisis were related became a major
source of support for the second phase of deficit reduction. Officials said
the public realized the depth of the economic crisis when inflation again
reached triple digits after several years of austerity. The public understood
that the fiscal problems were structural and would not be solved with
short-term policies. People we interviewed said the short-term solutions had
not worked and the economic situation was worse. At one point in 1987, the
annual inflation rate was about 200 percent. Sky-rocketing inflation,
illustrated in figure V.6, was the trigger for renewed efforts to reduce the
deficit.
Figure V.6: Consumer Price
Inflation in Mexico, 1978-1990
(See figure in printed edition.)
Source: Mexico: The Strategy to Achieve Sustained Economic Growth,
International Monetary Fund, 1992.
DEFICIT REDUCTION ACTIONS
------------------------------------------------------------------- Appendix V:3
Mexico adopted deficit reduction in 1982 as part of an overall plan to
stabilize the economy, reduce inflation, and renew private sector and
international confidence. The deficit was eliminated by 1992 by maintaining
revenue levels while cutting expenditures. The largest savings came from debt
renegotiation, which reduced interest costs, and the privatization of
money-losing nationalized industries. The process also involved government
spending cuts, both targeted and across-the-board, and an increase in revenues
from enhanced income tax enforcement and increases in prices on goods
controlled by the government, such as electricity.
The government pursued deficit reduction in two distinct periods in the 1980s.
The first phase, 1983 to 1984, focused on short-term efforts, but faltered
after an impressive first year. In 1985 and 1986, the deficit again increased.
President de la Madrid shifted the policy focus in 1987 to a more structural,
long-term approach. President Salinas (1988-1994) continued this approach, and
from 1988 the deficit declined rapidly, until surplus was reached in 1992.
Because of their different natures, the period before the economic crisis of
1987 and the period after are discussed separately below.
1982-1986: PLANS FOR ECONOMIC
STABILITY
----------------------------------------------------------------- Appendix V:3.1
In 1982, the new de la Madrid administration started deficit reduction under
the Program for Immediate Economic Reordering; two of its goals were lowering
inflation and cutting the deficit to 3.5 percent of GDP by 1985. The program
was successful in achieving its first year's reduction targets, but then lost
momentum. Although revenue was raised through tax and public-good price
increases, the majority of fiscal adjustment came from the spending side of the
budget, cuts in investment, lower real wages, and some trimming of the public
sector. Total noninterest public sector outlays, including investment, were
reduced in real terms by 11 percent in 1983. The International Monetary Fund
estimates that revenue contributed only 1.5 percentage points to the 10
percentage points of adjustment in the primary deficit (total deficit excluding
interest payments) between 1982-1987. The following provides details on
deficit reduction actions.
Investment. Public investment was the major casualty of the cuts in spending
over the 1980s, particularly in the first half of the decade. As shown in
figure V.7 and table V.2, capital expenditure was more than halved as a percent
of GDP between 1982 and 1991. Non-oil investment as a proportion of GDP
reached its lowest level since World War II. Capital maintenance was also
severely neglected, especially for roads, sewers, and water systems.
Figure V.7: Capital Expenditures in
Mexico, 1980-1992
(See figure in printed edition.)
Note: Data for 1992 are preliminary.
Source: Banco de Mexico.
Table V.2
Investment Spending in Mexico, 1982 and
1991
1991 as a
percent of
1982
Consolidated public sector expenditur
expenditures 1982 1991 e
------------------------------ ------- ------- ----------
Capital expenditure 10.5 4.4 42
Public enterprises (excluding 2.5 1.3 52
PEMEX)
PEMEX 2.9 0.9 31
Federal government 5.1 2.2 43
------------------------------------------------------------
Source: OECD Economic Survey, Mexico: 1991/1992, p. 130.
Public sector wages. The government held public sector wages below inflation
by tying wages to a target inflation rate rather than to past price increases.
Not only did this reduce real wages, but it attempted to reduce self-fulfilling
inflationary pressures. Between 1982 and 1988, federal government salaries
dropped by around 50 percent in real terms. Wages in public enterprises fell
by 30 to 35 percent in real terms. Over the decade, the federal government
wage bill as a percent of GDP was cut by 20 percent.
Cuts in programs. Government officials and policy analysts, while
acknowledging that deficit reduction included important spending cuts overall
on discretionary-type programs, overall did not feel that specific programs
were targeted for cuts. Spending reductions included lower personnel costs,
and sometimes across-the-board reductions. Throughout the 1980s, social
spending's share of both programmable and total spending dipped and then rose,
reflecting strict spending policies during the middle of the decade and a
re-emphasis on social spending at the end. Social spending contracted early in
the decade. However, social spending was increased at the end of the decade in
line with the Salinas' government increased emphasis on social welfare.
Figure V.8: Social Spending in
Mexico, 1980-1992
(See figure in printed edition.)
Note: Social spending includes education, health, and the Solidarity program,
which provides grants to low-income communities.
Source: Coordinador de Asesores Economicos.
Tax increases. Direct and indirect taxes were increased during this time.
Measures included raising the value-added tax (VAT) rate to 15 percent from the
previous rate of 10 percent, applying a 10 percent surtax to all taxpayers who
earned more than five times the national average minimum wage, and eliminating
tax exemptions for gasoline stations, transportation, and wood-using
industries.
Public sector price increases. The government reduced subsidies to bring
publicly administered prices in line with production costs or international
prices. Items supported by general food subsidies included bread, tortillas,
beans, eggs, milk, and cooking oil. The price for these items is set by the
government and the producer is provided with subsidized inputs. The government
eliminated or reduced some of general subsidies to both the public and
industry. In 1982, subsidy reduction resulted in price increases of 100, 50,
30, and 12 percent for bread and tortillas, gasoline, electricity, and natural
gas respectively. Although subsidies overall were cut, some subsidies were
replaced with more targeted programs.
THE 1987 ECONOMIC CRISIS
----------------------------------------------------------------- Appendix V:3.2
The economic stability hoped for at the start of this process had not been
achieved by 1985. The PSBR was reduced by 8.5 percentage points of GDP in the
initial year of the program, but other economic targets set by the government
were not achieved. Output contracted rather than stabilized, and inflation did
not fall as expected. The deficit as a share of GDP started to rise again and
financial markets grew increasingly nervous--capital flight continued, the peso
declined, and inflation accelerated.
In 1985 and 1986, an earthquake and a drop in oil prices made continuing
deficit reduction difficult. A major earthquake hit Mexico City in 1985,
making budget plans obsolete. Then oil prices collapsed in 1986, dropping more
than 50 percent. The loss in oil revenues was 4 percent of GDP, at that time
about a 13-percent reduction in public sector revenues. Interest payments
continued to absorb a significant portion of the budget. Inflation again
accelerated, and the government financed its deficit by forced borrowing from
the nationalized banks at artificially low interest rates. By 1986, Mexico
again had trouble servicing its debt. Confidence in the Mexican currency
suffered again, triggering another massive outflow of capital, when the world
stock market crisis of October 1987 caused Mexican stock market prices to
collapse.
1987-PRESENT: SUCCESSFUL DEFICIT
REDUCTION
----------------------------------------------------------------- Appendix V:3.3
The year 1987 marked a shift in policies to address the deficit and stabilize
the economy. The government, facing a second economic crisis, decided that a
significant policy shift was necessary to break the cycle of credit market
pressure and triple digit inflation, and adopted different deficit reduction
measures. While it is difficult to determine the relative impact of the
measures, the most important included debt renegotiations, the Pact of Economic
Solidarity agreement (commonly known as PACTO), increased privatization,
continued cuts in government spending, tax reform and stronger tax enforcement,
and continued increases in public sector prices. Unlike other countries in
this study, Mexico did not cut transfers to states. In fact, between 1983 and
1990, transfers under the revenue-sharing arrangement rose by about 40 percent
as a share of GDP. The following provides details on deficit reduction actions
taken during the latter half of the 1980s.
Debt renegotiation. Throughout the 1980s, Mexico was able to renegotiate its
debt to ease the pressure of interest payments, but significant savings did not
occur until the second half of the decade.
Interest payments on the public debt comprised the largest single spending
reduction in the Mexican budget in the second phase of deficit reduction. One
former government official described this as a result of turning the "vicious
circle" of deficits adding to debt and increasing interest payments into a
"virtuous circle" of paying off debt and reducing interest payments. From a
high of 19.6 percent of GDP in 1987, interest payments dropped to 3.9 percent
of GDP in 1992. Of the total difference in public expenditure between 1987 and
1992, 18.7 percentage points of GDP, interest payment cuts represented 15.7
points.
The drop in interest payments was due to debt renegotiation, lower interest
rates as confidence in the Mexican economy improved, and debt repayment when
the budget finally reached a general government surplus. Through a variety of
mechanisms, debt renegotiation packages sought to improve the terms and payment
profile of public debt. One package, the 1989 Brady Plan, resulted in the
cancellation of $14 billion, or 15 percent of the face value of gross foreign
debt.
In addition, the agreements greatly enhanced the credibility of Mexican policy
in the eyes of foreign creditors and the public in general. Interest rates
fell by more than 30 percentage points in one year (see figure V.4), lowering
the burden of annual interest payments. When Mexico's deficit was finally
eliminated in 1992, the growth of the debt, and any resulting increase in
interest payments, was reversed.
PACTO. In 1987, the government initiated the Pact of Economic Solidarity, a
renewable wage and price agreement with leaders of the main sectors of the
economy (labor, agriculture, and business) with the objective of curtailing
inflation without causing a recession. Although the focus was broader than
just deficit reduction, interviewees consistently described PACTO as being
essential to the government's success in deficit reduction.
The PACTO agreements outlined the actions to be taken by both the government
and the private sector. All parties agreed to a target inflation rate. As
part of the PACTO agreement, on the public sector side, government continued to
increase publicly administered prices and implement additional structural
reforms. For example, in 1987, prices for energy, fertilizers, steel products,
and sugar increased 85, 82, 33, and 81 percent, respectively, while train
tariffs and telephone fees increased by 17 and 81 percent, respectively. On
the private sector side, business agreed to control prices and workers agreed
to accept constrained wages. The parties have renewed the PACTO, with similar
measures, numerous times since.
Privatization. Large scale privatization was an important part of deficit
reduction and the redefinition of the public sector. The government's
privatization program was intended to both raise revenue and reduce the role of
government, thereby increasing economic efficiency. It involved the closure of
unprofitable plants and businesses and the privatization of others. Although
the major privatizations did not occur until 1988, the closing of unprofitable
enterprises saved money throughout the decade. From 1983 to 1985, small,
nonviable enterprises were merged or closed. From 1986 to 1988, small- to
medium-sized firms were sold. Between 1982 and 1992, the government closed,
sold, or merged 1,008 out of 1,155 public enterprises. Mexico includes
revenues from privatization in its estimation of PSBR. Revenue from
privatization equaling 6.3 percent of GDP has been realized since 1989.
Figure V.9: Number of Public
Enterprises in Mexico, 1982-1992
(See figure in printed edition.)
Source: Banco de Mexico.
One official told us that the initial slow pace of privatization was
deliberate--Mexico wanted to learn from the experience of other countries
undergoing the same process. This allowed the government to gain experience
and build political and domestic and international business confidence. Along
with privatization, the government pursued deregulation, achieving savings in
the process by eliminating government offices and staff.
In December 1990, with proceeds from the privatization of the Mexican telephone
company, the government created the Contingency Fund with the purpose of
protecting the economy from a possible drop in oil prices following the Persian
Gulf conflict. The fund subsequently received proceeds from other public
enterprise sales, based on the belief that one-time revenues should be set
aside as reserves to face external shocks or to cancel public debt. Since
September 1991, resources from the Contingency Fund have been used to pay back
public debt, rendering a permanent benefit to public finances.
Further cuts in overall government spending. As seen in table V.3, government
spending was constrained in the 1980s. Government expenditure (excluding
interest) as a whole was cut dramatically, although interviewees did not
identify specific programs or budget areas (other than investment) that had
been targeted for cuts. As mentioned above, it appears that reductions were
mainly achieved through across-the-board cuts and reductions in personnel and
real wages. As shown in table V.3, all levels of government cut public current
expenditures (as opposed to capital). Part of the drop in spending for public
enterprises may be due to the privatization that occurred throughout the 1980s.
Table V.3
Noninvestment Public Sector Spending in
Mexico, 1982-1991
1991 as a
1982 1991 percent of
(Percen (Percen 1982
Consolidated public sector t of t of expenditur
expenditures GDP) GDP) e
------------------------------ ------- ------- ----------
Current noninterest 27.5 17.2 63
expenditure
Public enterprises 8.4 4.3 51
General government 19.1 12.9 68
Federal government 13.5 10.0 74
State/local government 5.6 2.9 52
------------------------------------------------------------
Source: OECD Economic Survey, Mexico: 1991/1992, p. 130.
As seen in Figure V.10, within the overall reductions, the government took care
to preserve or shift funding to health and education. Some funding for rural
development may have been switched to the smaller Solidarity program, a program
of development grants and government assistance for low-income areas. While
the overall volume of subsidies declined, the remainder was increasingly
focused on health, education, and basic food supply: the share of these items
in total transfers rose from 31 percent in 1983 to 51 percent by 1990.
Figure V.10: Programmable Spending
in Mexico in Selected Years
(See figure in printed edition.)
Note: Other represents expenditures for fishing, communication,
transportation, commerce, tourism, industry, administration, justice and
security, the Solidarity program, and other small programs.
Source: Coordinador de Asesores Economicos.
Taxes. A major reform of the tax system took place in 1987. This was in
response to revenue shortfall from the oil price collapse in 1986 and the
erosion of real personal and corporate income tax revenues by rapid inflation
due to collection lags. Mexico changed its tax system in three major ways:
(1) it increased enforcement on both the personal and corporate levels, (2) it
eliminated major tax breaks, such as exemptions for the agricultural and
transportation sectors, and (3) it simplified and reduced rates while widening
the tax base. As shown in table V.4, although overall revenues have not
dramatically increased as a share of GDP, the share of public sector revenue
from PEMEX, other public enterprises, and the federal government tax system has
shifted.
Table V.4
Shifts in Public Sector Revenue Sources
in Mexico
Shares of total public sector revenue
------------------------------------------------------------
1982-84 1985-87 1988-91
--------------- ------------- ------------- -------------
PEMEX 39 33 26
Other public 18 21 18
enterprises
Federal and 43 46 56
other taxes
============================================================
Total 100 100 100
------------------------------------------------------------
Source: OECD Economic Survey: Mexico, 1991/1992, p. 134.
Although tax reform has incorporated rate changes and base broadening, numerous
officials said increased tax enforcement represented an important tax-related
element of deficit reduction. Income tax evasion used to be a common
occurrence, and officials said corporate tax was often not paid. A series of
highly visible actions led the way for increased enforcement, including the
arrest of several high-profile people, including a union official, for tax
evasion. In another example, to increase corporate tax compliance, the
government implemented a 2 percent tax on all business assets, which could be
deducted from corporate income tax. The new tax served to bring more
businesses into the tax system.
REACHING AGREEMENT
------------------------------------------------------------------- Appendix V:4
The same political party, the PRI, has been in power in Mexico since 1929, even
in the face of a significant political challenge in the 1988 elections and
social unrest in early 1994. The 1987 economic crisis, however, forced the
government to pursue deficit reduction as a means of breaking spiraling
inflation. The government gained support for this in ways that involved
working with all the affected groups--through the PACTO agreements, trade-offs
to protect constituents, and expanding traditional political power bases.
PUBLIC PERCEPTION OF CRISIS
IMPORTANT
----------------------------------------------------------------- Appendix V:4.1
As described previously, a crisis atmosphere is credited with motivating the
Mexican government to make structural changes to reduce its deficit and with
making the general population understand that deficit reduction was necessary.
One official said it is easy to promote deficit reduction when you have
triple-digit inflation.
Interviewees said public support was very important to Mexico's deficit
reduction actions. The 1982 crisis occurred in the same year that a new
administration took office. Domestic and international confidence in Mexico's
ability to manage its economy had eroded. The government saw rebuilding this
confidence with prompt action to reduce the deficit as a necessary ingredient
to successfully stabilizing the economy.
The perception of the problem's depth, however, distinguished the second
deficit reduction phase from the first. The first stage was characterized by
the conditions under which it was adopted--as a result of a major economic
crisis--and the seemingly short-term focus of the solution. Although there was
a severe economic crisis, most Mexicans believed that there would be some years
of austerity, after which austerity would end and growth would return. Current
and former government officials said structural changes, rather than holding
down wages, employment, and investment spending, were not considered until the
second phase when it was clear that the economy was not responding to
short-term policies.
PACTO BUILT ON CONSENSUS AND
CREDIBILITY
----------------------------------------------------------------- Appendix V:4.2
In part, expectations and a lack of national and international confidence in
the government's ability to control the economy drove high inflation. The
drive to break inflationary expectations and rebuild confidence is best
exemplified in the PACTO agreements. These agreements were a particularly
important factor to the public's acceptance of deficit reduction.
The government emphasized consensus building and consultation with the PACTO
agreements. PACTO members, representing both the public and private sectors,
agreed to a target rate of inflation and indexed wages and prices to that
target rate. Members agreed to meet periodically to examine compliance with
the agreement and to discuss economic goals and further measures to be taken.
Analysts said credibility in the PACTO agreements and among its members was
established gradually.
With PACTO, the government used the idea of shared sacrifice and commitment to
garner support for a joint effort from both the public and private sectors to
reduce inflation. Part of the success of PACTO came from the atmosphere of
economic crisis existing at the time. The government's willingness to absorb
cuts also made it easier to sell austerity to the public.
Even before PACTO, policy-making involved consensus building. Unions play a
strong interest group role in Mexico, although their role has been diminishing.
They traditionally support government policy and value cooperative
relationships with the executive branch. Our interviews indicated that other
organized interest groups, labor unrest, and political opposition did not play
a visible role in influencing government policy, except perhaps in pressure for
social spending in the 1970s and in strengthening political opposition in the
1988 election.
The relationship between PACTO and the government's deficit reduction goals was
mutually beneficial. For PACTO to be successful, the government needed to keep
its commitment of reducing the public sector budget. At the same time, by
agreeing to keep wage and price growth low, business and labor helped dampen
inflation. The initial and subsequent PACTO agreements' success in bringing
down inflation helped to stabilize the economy, thus creating a better
atmosphere for debt renegotiation, increasing domestic and international
confidence and investment, and lowering interest rates and debt-servicing
pressure on the budget.
SOME CONSTITUENCIES WERE
RELATIVELY PROTECTED FROM
AUSTERITY MEASURES
----------------------------------------------------------------- Appendix V:4.3
The Mexican government used trade-offs to help gain acceptance of deficit
reduction and alleviate the effects of some of the resulting austerity
measures. As mentioned previously, the government took steps to replace
certain general subsidies with targeted ones. For example, in 1984, the
government eliminated the general subsidy for corn tortillas, but over the next
several years, replaced it with other programs whereby low income groups could
receive discounts on or free tortillas. Although spending on the targeted
subsidies rose in 1988 and 1989 as a result of the PACTO agreements, total
spending on general food subsidies distributed through the public sector's food
distribution chain declined in real terms.
Interviewees said that the government worked to gain support and to lessen
opposition. For example, since privatization was politically and ideologically
sensitive, the government moved slowly, closing smaller firms first. In
addition, the government worked with unions to protect employment levels by
seeking wage reductions rather than staff cuts as a way to reduce personnel
costs. Many of the people we interviewed, including a union official,
emphasized the importance of this trade-off to the acceptance of government
policies at the time. Since the government did not provide any unemployment
insurance, people prefer employment, even at lower wages, over increased or
stable wages with fewer jobs.\5
In the late 1980s, President Salinas instituted programs responsive to the
rural and urban poor. Salinas instituted the Solidarity program, a development
grant program targeted to extremely poor areas. The program is highly popular
with the electorate. Salinas also pointed to his administration's success in
achieving its stated economic targets. One government official said the
population needed to see that the government was "not just talking, but
acting."
--------------------
\5 This may account for the relatively low unemployment rate, which fluctuated
between 2.7 and 6.1 percent between 1980 and 1991.
STRONG POLITICAL PARTY STILL
ENCOUNTERED CONFLICT
----------------------------------------------------------------- Appendix V:4.4
While the stability of the PRI party in the executive branch allowed budgets to
pass easily, it did not protect the party from internal dispute over the pace
and direction of deficit reduction. The Mexican political system remained
relatively cohesive for decades. Up to 1988, no one seriously challenged the
PRI candidate in a presidential election, and the executive branch faced few
political constraints in formulating or passing a budget from the legislative
branch.
Conflict did take place, however. Former and current government officials
described serious conflicts over the amount of cuts required of secretariats in
the de la Madrid administration. Some government officials at the time
believed that the budget must be in surplus to reduce inflation, and started to
focus more on long-term, structural change. Others in the government felt that
the pace of change was too fast and the cuts too great. The heads of some
sub-secretariats balked at continued cuts in their budgets, and according to
interviewees, two undersecretaries left the government. However, the President
firmly supported continued deficit reduction.
HIGH DEFICITS LEFT A LEGACY OF UNMET
NEEDS
------------------------------------------------------------------- Appendix V:5
While the budget currently remains in a surplus and the economy is stable
relative to the past decade, the Mexican government will face increased
budgetary pressures for social and investment needs in the coming years. In
addition to the specific items discussed below, Mexico, unlike the other case
study countries, faces the serious challenge of raising the standard of living
for its population. Partly for this reason, the government intends just to
maintain a balance in the coming fiscal year, rather than remain in surplus.
Even before the social unrest in the southern Mexican state of Chiapas in early
1994, Salinas' government and the presidential candidates emphasized reducing
the surplus by boosting spending in social programs. Interviewees suggested
that the public, after a decade of austere public sector budgets, might
increase pressure to spend some of the benefits of the new-found fiscal health.
Contrary to the experience of some other case study countries, according to a
recent analysis,\6 it appears that all but the highest level of Mexican income
earners were adversely affected by the inflation and deficit reduction policies
of the 1980s. Capital mobility allowed those with substantial assets to avoid
the pain (or even benefit) from the fiscal adjustment. Wage and salary earners
in the middle deciles were hurt by the fall in real wages, and the rural poor
who rely on income from agriculture suffered, because agricultural wage and
nonwage income deteriorated substantially from 1986 on.
In addition, the government will have to address the depleted reserves of the
national pension fund. Interviewees told us that the national pension fund
surplus had been depleted in the 1980s to fund current government operations.
A budget expert in Mexico was also concerned about public entities that are not
controlled in the budget. According to the expert, these entities, such as the
National University, while not large in number, do require a significant and
growing amount of public funding.
The fiscal adjustment left Mexico with other unmet needs. Deferred capital
maintenance will only result in deferred costs. Some analysts argue that the
type of investments made during Mexico's 1970s boom years were not necessarily
productive or economical, such as investments in petrochemical plants, which
are highly capital intensive and require only skilled labor, when petrochemical
products were available at low prices in world markets. Analysts argue that
this type of spending did not address the country's employment needs. In
addition, the investment cuts of the 1980s delayed important basic
infrastructure maintenance. For example, as of 1992, only one third of
Mexico's 265 sewerage plants were operating.
--------------------
\6 Nora Lustig, Mexico, The Remaking of an Economy (Washington, D.C.: The
Brookings Institution, 1992).
CONCLUSION
------------------------------------------------------------------- Appendix V:6
Mexico was forced to implement deficit reduction when it faced a severe
economic crisis. When an initial, short-term effort to address the deficit and
stabilize the economy was unsuccessful, the government adopted a more
structural, long-term approach. The Mexican government eliminated its deficit
by maintaining revenues while cutting spending. By working with affected
groups, the government gained support for its efforts and gradually established
credibility for its policies. Deficit reduction helped turn the circle of
deficits, rising interest costs and expanding debt into a circle of fiscal
surplus, shrinking debt, and increased fiscal flexibility. At the conclusion
of our work, Mexico maintained a surplus of approximately 1 percent of GDP.
UNITED KINGDOM
==================================================================== Appendix VI
From a deficit of nearly 5 percent of gross domestic product (GDP) in the
mid-1970s, the United Kingdom reached surplus in its general government
financial balance by 1988.\1 Deficit reduction occurred primarily on the
spending side of the budget but can be attributed to a variety of government
actions and fortuitous economic circumstances. Government actions included
expenditure restraint, tax reform, privatization, and the sale of North Sea
oil. A sustained period of economic growth compounded the effects of these
actions during the late 1980s. While public sector borrowing has risen again
in the 1990s, the government is seeking ways to bring the budget back towards
balance.
A budget process tightly controlled by the central government, strong
parliamentary majorities, and limited interest group involvement gave the
government substantial leverage to develop and carry out fiscal austerity
policies. Nonetheless, officials sometimes had difficulty reaching agreement
and at times had to reverse or modify proposals in response to strong
opposition from within the government.
Figure VI.1: General Government
Revenues and Expenditures in the
United Kingdom, 1970-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #51 (1970-1977) and #55 (1978-1993).
--------------------
\1 The Organization for Economic Cooperation and Development (OECD) defines
general government as all levels of government combined. For ease of
comparability, this appendix relies primarily on OECD data. Where applicable,
differences between national and OECD data or definitions are explained.
In addition, local government controls a relatively small portion of public
sector revenue in the United Kingdom. Therefore, this appendix will focus on
data for general government.
BACKGROUND
------------------------------------------------------------------ Appendix VI:1
The United Kingdom is a unitary state composed of England, Scotland, Wales, and
Northern Ireland. Local governments, called local authorities, are responsible
mainly for education, housing, and social services. Local authorities account
for around one quarter of all public expenditure in the United Kingdom,
although a substantial percentage of this is financed by the central
government.
The government is a parliamentary system, with a Parliament composed of two
chambers--the House of Lords and the House of Commons. The House of Lords
(approximately 1,200 members) is composed primarily of hereditary and life
peers and has relatively limited powers. The House of Commons (651 members) is
elected and is responsible for the passage of legislation and scrutiny of
public administration. The government is headed by a Prime Minister, who is
the leader of the majority party in the House of Commons, and an appointed
Cabinet of around 20 members.
The Conservative party came to power in 1979 and has been re-elected three
times since. For most of the time covered by this study, Margaret Thatcher was
Prime Minister. Labor, the main opposition party, held 264 seats in Parliament
to the Conservative party's 333 seats as of October 10, 1994.
THE BUDGET PROCESS
---------------------------------------------------------------- Appendix VI:1.1
The governing political party effectively controls the entire budget process.
Spending and tax decisions are made primarily within the Treasury and by its
head, the Chancellor of the Exchequer. The governing party also controls
fiscal policy through its influence over Parliament and its control of the
central bank of England and local authorities.
The Treasury has controlled budget resources in two ways: through an overall
spending target for total government spending and through cash limits for
specific programs. The spending target covers the majority of the budget,
excluding interest, privatization proceeds, and the cyclical portion of social
security. The latter represents social security spending resulting from a
downturn in the economy, such as increased unemployment compensation. Included
in the spending totals is an amount set aside for a reserve fund controlled by
the Treasury. The government attempts to stay within this overall target--if
spending in one area grows faster than predicted, the government reduces
spending in other areas.
While the spending target applies to overall outlays, cash limits affect
specific programs. Over the last 15 years, the government has expanded the
number of programs under cash limits. If a program exceeds its cash limit for
any noncyclical reason, including higher than expected inflation, the
department must request and provide justification for additional funds from the
Treasury reserve fund. Aside from the cash limits that affect spending for
particular programs, cash limits on budget items, such as "running costs" (pay
and administrative budgets), for both discretionary and entitlement programs
are also set.
DEFICIT MEASUREMENT
---------------------------------------------------------------- Appendix VI:1.2
In measuring its deficit, the United Kingdom focuses on the public sector
borrowing requirement (PSBR), which includes receipts and expenditures at all
levels of government, including borrowing by nationalized industries, debt
interest, and privatization proceeds. However, fiscal goals are often
presented both with and without privatization proceeds.
In principle, the measure used by the Organization for Economic Cooperation and
Development (OECD)--general government financial balance--is also the
difference between public sector receipts and outlays. Due to methodological
differences, however, the two measures are not always the same. The basic
trends, however, are similar, as seen in figure VI.2. This appendix relies
primarily on OECD data.
Figure VI.2: OECD and United
Kingdom Measures of Deficit/Surplus,
1978-1993
(See figure in printed edition.)
Note: PSBR is measured on a fiscal year basis. General government financial
balance is measured on a calendar year basis.
Sources: OECD Economic Outlook, #55, and Bill Robinson, Social Market
Foundation Report: Britain's Borrowing Problem (Surrey, England: The Social
Market Foundation, 1993).
IMPETUS FOR REDUCING THE DEFICIT
------------------------------------------------------------------ Appendix VI:2
Although deficits grew steadily over time as a percent of GDP, they remained at
relatively modest levels until the mid-1970s when expanding social welfare
spending and deteriorating economic conditions worked together to drive up
public sector borrowing. A currency crisis in the spring of 1976 spurred
efforts to tighten fiscal policy for a few years, but continuing economic
problems brought back increasing deficits.
SOCIAL SPENDING INCREASES
---------------------------------------------------------------- Appendix VI:2.1
Social reforms introduced in the 1960s and 1970s created a comprehensive social
welfare system with graduated, noncontributory benefit programs and benefits
indexed to offset the effects of inflation. Social security in the United
Kingdom includes housing and child benefits; pensions; and income support for
the unemployed, sick, disabled, and low-income and one-parent families.
According to the United Kingdom's Department of Social Security, policy changes
combined with demographic, economic, and social factors to drive up benefit
costs, as shown in figure VI.3. Demographic factors included a larger number
of elderly persons, higher unemployment, and an increasing number of single
parents.
Figure VI.3: Selected Public
Spending Components in the United
Kingdom, Share of GDP 1975-1990
(See figure in printed edition.)
Source: Robinson, Social Market Foundation Report: Britain's Borrowing
Problem.
Social security spending was the fastest growing and the largest social
component of the budget, rising from 5.1 percent of GDP in 1950 to almost 13
percent in 1985. While social spending as a whole increased, spending for
housing declined dramatically due to government policies that scaled back
public housing.
DETERIORATING ECONOMIC CONDITIONS
---------------------------------------------------------------- Appendix VI:2.2
A series of oil price increases pushed inflation upward, first in 1973 and
again in 1978 and 1979 (see figure VI.4). Unemployment, shown in figure VI.5,
rose from around 2 percent in the early 1970s to over 5 percent in 1977, and
the country experienced a recession in 1974 and 1975. These factors
exacerbated public concern over the United Kingdom's economic growth, seen in
figure VI.6, which had been lagging behind other industrialized countries for
some years.
Figure VI.4: Consumer Price
Inflation in the United Kingdom,
1975-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #55.
Figure VI.5: Unemployment Rate in
the United Kingdom, 1972-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #51 (1972-1977) and #55 (1978-1993).
Figure VI.6: Real GDP Growth in the
United Kingdom, 1972-1993
(See figure in printed edition.)
Source: OECD Economic Outlook, #51 (1972-1976), and #55 (1977-1993).
In 1974 and 1975, public expenditure climbed to nearly 50 percent of GDP, and
the government ran the largest deficits of the postwar period. Fears of the
deficit and economic instability contributed to a speculative currency run in
1976. The value of the pound stood at 1.93 against the dollar in May 1976, but
dropped to 1.56 against the dollar by September of the same year. To secure
the value of the pound, the government borrowed over �1.1 billion from the
International Monetary Fund (IMF); deficit reduction was one condition for the
loan. According to OECD data, the deficit fell to 3.2 percent of GDP in 1977.
However, the government then loosened fiscal restraint and the deficit rose to
4.3 percent of GDP in 1978, despite an economic upturn.
TURNING POINT IN FISCAL POLICY
---------------------------------------------------------------- Appendix VI:2.3
Although the previous Labor government took some deficit reduction actions, the
election of the Conservative government in 1979 formed a significant turning
point in fiscal policy. Treasury documents state that the new government's
medium-term economic objectives sought to bring down the rate of inflation and
interest rates to create conditions for sustainable growth of output and
employment. According to the Conservatives, this was to be done through
control of the money supply, which was affected by the public sector deficits.
The government supported the theory that the United Kingdom's economic problems
and large deficits were interrelated and that very large deficits would lead to
continuous economic distress. The Thatcher government made a commitment to
pursue deficit reduction over a period of years, as stated in the 1980-1981
Budget:
"The consequence of the high level of public sector borrowing has been high
nominal interest rates and greater financing problems for the private
sector...If interest rates are to be brought down to acceptable levels, the
PSBR must be substantially reduced as a proportion of GDP over the next few
years."
DEFICIT REDUCTION ACTIONS
------------------------------------------------------------------ Appendix VI:3
Overall, deficit reduction during the 1980s was accomplished by constraining
the growth of public expenditure. Although spending across government programs
was held down, spending in certain areas was protected more than in others.
Deficits were also reduced by the effects of privatization and oil sales,
strong economic growth, and lower inflation, which reduced debt interest
payments and indexation costs. Tax reform actions were generally revenue
neutral, but some changes did generate additional revenue. Management and
budget reforms also helped deficit reduction.
REAL GROWTH IN TOTAL SPENDING
HELD TO LOW LEVELS
---------------------------------------------------------------- Appendix VI:3.1
During the 1980s, annual real growth in total public expenditure averaged 1.3
percent--a significant drop from the 1970s level of 3.3 percent. Although the
drop was substantial, the government made few major structural changes and did
not eliminate programs to achieve this change; rather, existing programs were
trimmed and modified in a decremental fashion.
These fiscal decisions were framed by targets that were set to control overall
expenditure growth. Within the overall growth targets, programs could grow at
different rates. For example, demand-led programs could grow faster. Social
security spending increased at an average annual rate of 3.8 percent in real
terms from fiscal years 1978-79 to 1992-93 while overall expenditures under the
spending target increased only 3.1 percent. Former officials and analysts told
us that although the targets were not always met and that cuts were not
necessarily done in the most efficient or lasting way, they served to help
restrain overall spending growth.
SPENDING ACTIONS
---------------------------------------------------------------- Appendix VI:3.2
Savings came from many areas of government. In terms of programs, savings were
achieved by cutting spending in the areas of transportation, trade and
industry, and housing. According to the former Chancellor of the Exchequer,
these areas were cut 5.8, 38.2, and 67.0 percent, respectively, in real terms
between fiscal year 1979-80 and fiscal year 1989-90.\2 In addition to the
spending cuts listed below, higher economic growth and a system of spending
limits also contributed to overall savings. Privatization contributed to lower
recorded spending levels by bringing in revenue which is included in the United
Kingdom's budget as negative expenditures.\3
--------------------
\2 Nigel Lawson, The View From No. 11 (New York: Doubleday, 1993), p. 301.
\3 In some countries, privatization also contributes to deficit reduction by
eliminating areas of spending in the budget, such as subsidies to national
industries or investment. However, according to one analysis, spending on the
nationalized industries which were the main targets of the privatization
program was not counted officially as government expenditure. (Bill Robinson,
Social Market Foundation Report: Britain's Borrowing Problem (Surrey, England:
The Social Market Foundation, 1993), p. 27.)
INVESTMENT CUT SIGNIFICANTLY
-------------------------------------------------------------- Appendix VI:3.2.1
Like most other countries in this report, the United Kingdom cut investment
spending significantly in the 1980s. Although some investment cuts involved
delaying capital expenditure and improvements on public infrastructure, about
half of the reduction relative to GDP was due to the withdrawal of the public
sector from the housing market as part of its privatization efforts. The
public sector had played a significant role in the provision of rental housing,
but in order to promote home ownership, the government sold part of the public
housing stock and reduced public housing construction considerably. A recent
study suggests that the decline in the deficit as a percent of GDP in the 1980s
was associated with a similar decline in net public sector capital spending.\4
Analysts told us that while spending on public infrastructure was easier to cut
than current spending, capital spending increased after 1988 because
improvements could not be delayed any longer. (See figure VI.7.)
Figure VI.7: Net Capital Spending
in the United Kingdom, 1970-1993
(See figure in printed edition.)
Source: National Institute of Economic and Social Research.
--------------------
\4 Nigel Pain, Garry Young, and Peter Westaway, "The State of the Public
Finances," National Institute Economic Review (London: National Institute of
Economic and Social Research, 1993), pps. 32-35.
SOCIAL SPENDING GROWTH SLOWED
IN LATE 1980S
-------------------------------------------------------------- Appendix VI:3.2.2
Primarily economic growth, rather than government actions to reform the social
welfare system, slowed social program spending. Economic growth can reduce the
number of beneficiaries for social programs that react to economic cycles, such
as unemployment. Although the government instituted numerous changes in social
programs, spending cuts were limited in scope. Some of the beneficial effects
of economic growth were offset by other factors, however. Pension spending
rose rapidly throughout the 1980s from growth in the number of beneficiaries
and the introduction of some new benefits.
The social security system in the United Kingdom includes a variety of social
welfare programs in addition to pensions. The social security contributions,
or National Insurance, go into a special fund for all contributory benefits.
The fund is supported on a pay-as-you-go basis, with current contributions
supporting retirees and other beneficiaries, although contributions do not
always match benefits and at times must be supplemented by general funds.
Contributions account for about one half of the total funds required to finance
social security programs, with general tax revenues supporting the rest.
Some examples of the policy actions the government took to reduce social
spending are outlined below.
Indexation of pensions and other social security benefits. The most
significant social spending reduction came from the 1980 change in the formula
for indexing basic pensions and other social security benefits. The revised
indexation formula tied increases solely to price, rather than the greater of
price or wage increases as was done previously. Since prices normally increase
more slowly than wages over the long run, this change resulted in long-term
budget savings. Although the year-to-year adjustments were small, the
cumulative impact proved substantial. By 1988, the change meant, for example,
an almost 20 percent lower pension for a married person, and it lowered
government expenditures by �4 billion a year. One analysis suggests that
political opposition to this change was muted both because of the technical and
decremental nature of the change and the weakness of the pensioner lobby.\5
State Earnings-Related Pension Scheme (SERPS). The SERPS program provides a
pension over and above the basic national pension with the additional amount
based on an individual's earnings. SERPS benefits were scaled back in 1986 by
reducing the level of the pension from 25 percent of the annual average of the
highest 20 years' earnings to 20 percent of the annual average of an
individual's lifetime earnings, with half rather than the whole pension passed
to the surviving spouse. While the costs of the transition will not allow
great savings in the short run, by 2021, SERPS expenditures are projected to
drop more than 50 percent compared with pre-reform estimates.
Single-Payment Social Fund. This program had allowed people receiving social
security benefits to apply for a single cash payment to buy expensive items,
such as washing machines. To check escalating program costs and widespread
abuse, the system of single payments was replaced by a cash-limited Social Fund
empowered to make loans to the poor in appropriate circumstances.
--------------------
\5 Paul Pierson, Dismantling the Welfare State? Reagan, Thatcher and the
Politics of Retrenchment (Cambridge, United Kingdom: Cambridge University
Press, 1994), p. 59.
PUBLIC SECTOR PAYROLL REDUCED
-------------------------------------------------------------- Appendix VI:3.2.3
After fulfilling campaign promises to increase public sector wages, the
government moved to reduce labor costs and increase productivity and
efficiency. By 1986, the civil service payroll had fallen by almost 20
percent. According to OECD, by mid-1992 the public sector employed 4.9 million
people, nearly 1.7 million (26 percent) less than in 1979.\6 This was
accomplished by privatizing public industries and by mandating cost reduction
in smaller agencies whose work could be contracted out.\7
--------------------
\6 The public sector includes local government services, public corporations,
the National Health Service, the armed service, and the civil service. The
civil service accounts for about 10 percent of all public sector employees.
\7 The personnel and public wage reductions from privatization were separate
from a large-scale management initiative implemented by the government in the
latter half of the 1980s called "Next Steps." "Next Steps" involved delegating
functions to newly formed separate executive agencies to be run more like
businesses. Although it was related and likely saved money, the main purpose
of the "Next Steps" initiative was to promote efficiency and "value for money"
rather than reduce spending directly.
LOCAL AUTHORITY SPENDING
-------------------------------------------------------------- Appendix VI:3.2.4
Controlling local government expenditure addressed two of the government's
policy objectives in the 1979 elections--reducing both the size of general
government and the general government deficit, which includes local
governments' financial balance. Local governments finance their spending
through taxes, central government grants, and borrowing. A government official
told us that in the early 1980s, the central government tried to moderate local
spending by reducing central government grants. Although the ability of local
governments to borrow was limited, local governments could increase spending by
increasing tax rates. In response, the central government introduced a system
of local tax rate caps. While the official felt that these mechanisms did not
contribute in a significant way to deficit reduction, he said the mechanisms
did slow the growth of local government expenditure.
The continuing difficulty of controlling local authority spending and the
desire to tie local spending decisions to local tax rates led to a change in
1989 and 1990 in two sources of local financing: business and residential
property taxes. The locally set business property tax was replaced by a
centrally determined flat rate tax across all local authorities. The Community
Charge, generally referred to as the "poll tax," replaced property taxes and
was a flat rate tax on all adults. The tax was determined by each local
authority, with certain rebates and limited exemptions. The tax was criticized
by analysts because the overall impact of the new system of local government
finance involved a movement in the tax burden from richer to poorer
communities.
Moreover, the individual tax burden proved to be greatly underestimated--in
1988, the government envisaged a poll tax averaging �200 per person, but �400
was required by 1990. In 1991, the poll tax was replaced with a new Council
Tax, based largely on property values. Interviewees said the end result of the
poll tax policy was to increase central government transfers to local
government, rather than reduce spending, since the central government provided
substantial subsidies to local authorities to mitigate the effects of the poll
tax. The subsidies were financed by an increase in the value added tax (VAT)
from 15 percent to 17.5 percent.
BUDGET PROCESS REFORM
-------------------------------------------------------------- Appendix VI:3.2.5
The government's switch from volume planning and budgeting to cash planning and
limits was the main budget process reform of the last 20 years. Before the
mid-1970s, the government had used what was termed "volume" planning to
estimate expenditure. The future costs of programs were planned in volume
terms. Interviewees described the system as one where budgets ended up being
set in terms of the volume of goods needed by the program, such as the number
of schools or number of books per student, without means of controlling overall
costs. If inflation or other demands caused department budgets to increase,
additional funds would be provided to cover the difference.
After the currency crisis of 1976, in an effort to better control spending, the
government introduced its system of cash limits. While only some programs were
under the cash limits system at first, the new Conservative government brought
more programs under the system and then abandoned volume budgeting altogether.
Under the cash planning system, outyear budgets take into consideration
projected inflation. As mentioned earlier, if actual inflation is higher than
projected, departments must seek and provide justification for additional funds
from the reserve maintained by the Treasury.
PRIVATIZATION
-------------------------------------------------------------- Appendix VI:3.2.6
The sale of public assets in the United Kingdom included privatization of both
nationalized industries and public housing. The Conservative party supported
privatization in its 1979 election manifesto, which outlined the party's main
policy positions. Privatization was seen as a way to increase private sector
involvement in the economy and to improve overall economic efficiency.
According to a government official, the privatization effort was undertaken
because it was in line with the political philosophy of the Conservative party
and not necessarily to raise revenue. In addition, according to a Treasury
document, the nationalized industries had a disappointing performance record.
A number of nationalized industries recorded losses in the early 1980s.
The United Kingdom undertook privatization starting in 1979, with the sale of
shares in British Petroleum. Between 1979 and the end of fiscal year
1993-1994, the government raised about �56 billion from the sale of state-owned
industries. (See figure VI.8.) Additional revenues were expected in the 1990s,
but proceeds have been gradually decreasing.
Figure VI.8: Revenue from
Privatization in the United Kingdom,
1979-1993
(See figure in printed edition.)
Source: HM Treasury (United Kingdom).
In addition to the one-time revenue gained by these sales, privatization also
permanently reduced the public sector costs associated with supporting the
industries. By the 1992 general election, approximately two thirds of the
formerly state-owned industries had been transferred to the private sector,
including industries in telecommunications, oil, gas, electric utilities, and
aerospace. The sale of these nationalized industries, because of accounting
conventions, count as negative spending rather than revenue, and serve to
reduce total government expenditure. In its budgets, the government shows
government spending both with and without privatization receipts from these
industries. The privatization proceeds offset is not considered when the
government establishes its spending objectives.
The sale of public housing, called council houses, also started in 1979.
Beginning with the start of the Thatcher administration, local authorities were
compelled to sell council housing on attractive terms to those tenants who
wished to buy them. Not only did this lead to an increase in home ownership,
but it raised revenue from �750 million in 1979 to over �5.5 billion in 1989.
The sale of council housing also aided deficit reduction by saving money
normally spent on building or maintaining public housing.
REVENUE ACTIONS
---------------------------------------------------------------- Appendix VI:3.3
The government relied more on spending actions than direct tax actions to
reduce the deficit. However, increased revenue from changes in the tax system,
economic growth, privatizations, and oil revenue contributed to deficit
reduction. According to OECD data, general government receipts increased at
first, reaching approximately 42 percent of GDP in 1982, but then drifted
slowly down to between 38 and 39 percent at the end of the decade.
TAX REFORM
-------------------------------------------------------------- Appendix VI:3.3.1
Tax reform played a mixed role in deficit reduction under the Conservative
government. It was considered an important element of the Conservative
government's economic growth strategy, and revenues from different sources
increased at different times. Tax reforms were initially described as broadly
revenue neutral and were designed to place more emphasis on consumption based
taxes. The government increased the VAT but reduced tax rates on income,
savings, and corporation profits. Other changes raised revenues. Lower tax
allowances for some groups and the 1-year suspension of inflation indexation
are two examples.
Government action over the 1980s affected revenue policy in the United Kingdom
in three ways--through changes in tax rates, changes in corporation tax
allowances that fostered an increase in corporation tax revenues, and changes
in other tax allowances and indexation. Oil proceeds and economic growth in
the late 1980s also helped maintain tax receipts.
VAT RATE INCREASED, INCOME TAX
RATE DECREASED
-------------------------------------------------------------- Appendix VI:3.3.2
In 1979, the new government shifted the emphasis of the tax system from income
taxes towards VAT. The government was committed to lower income tax rates,
arguing that the change would reduce disincentives to work and save. The basic
income tax rate was initially reduced from 33 percent to 30 percent in the
fiscal year 1979-80 budget. In the second half of the 1980s, basic income tax
rates were reduced further, in three steps--in the 1986-87, 1987-88, and
1988-89 budgets--from 30 percent to 25 percent, while the top rate was reduced
from 98 percent (83 percent rate plus a 15 percent surcharge on investment
income) to 40 percent. Revenue from income taxes drifted slightly down during
this period, from between 10 and 11.5 percent of GDP in the first half of the
1980s, to between 9 and 10 percent of GDP in the latter half.
These changes were designed to be deficit neutral: the government raised the
consumption tax rate to offset the income tax rate cut. The government
increased two existing VAT rates, the standard 8 percent rate and the 12.5
percent rate on certain luxury goods, to a single 15 percent rate. The VAT
rate was increased again to 17.5 percent in April 1991. Revenue from VAT taxes
has more than doubled as a percent of GDP since fiscal year 1978-79, from 3.1
percent to 6.5 percent of GDP.
Table VI.1
Shifts in Public Sector Revenue Sources
in the United Kingdom
Shares of total public sector revenue
------------------------------------------------------------
Fiscal year Fiscal year
Public sector revenue source 1978-79 1993-94
------------------------------ ------------- -------------
Income tax and National 45 43
Insurance contributions
Excise and local taxes 28 25
Non-tax and North Sea oil 11 5
revenue
Non-oil corporation tax and 8 8
capital tax
Value added tax (VAT) 8 18
============================================================
Total 100 100
------------------------------------------------------------
Note: Totals may not add due to rounding.
MULTIPLE FACTORS RAISED
CORPORATION TAX REVENUES IN
MID-1980S
-------------------------------------------------------------- Appendix VI:3.3.3
Revenue from corporation taxes increased significantly during the 1980s, as
seen in figure VI.9. Analysts said this was due to both economic growth and a
series of reforms adopted over the decade which focused on reducing distortions
in the corporation tax system. The reforms included changes in corporation tax
allowances and cuts in corporation tax rates. Tax allowance changes included
raising taxes on capital gains and reducing the value of capital depreciation
allowances. A 1-year write-off of plant and machinery was replaced by a new
system that lengthened the write-off period. Because of the longer write-off
period, the value of allowances fell sharply, producing a large--but
temporary--increase in tax revenues.
Figure VI.9: Non- Oil Corporation
and Capital Taxes in the United
Kingdom, 1978-79 to 1993-94
(See figure in printed edition.)
Source: Robinson, Social Market Foundation Report: Britain's Borrowing
Problem.
Reductions in the corporation tax rates also affected revenue levels. Between
1980 and 1988, the tax rate for small firms was cut from 40 percent to 25
percent. A cut in the standard corporation tax rate was adopted in 1984 and
phased in over 4 years, reducing the rate from 50 percent to 35 percent. The
rate was further reduced in 1990 to 34 percent and in 1991 to 33 percent.
According to several sources, the rate cuts encouraged both domestic and
international corporations to expand their operations in the United Kingdom,
increasing both profits and tax receipts. One analysis suggests that the lower
corporation rates created a temporary competition between industrialized
countries over attracting corporation business, which generated high revenues
in the United Kingdom until other countries cut their corporate rates.\8
Cyclical economic growth in the late 1980s also contributed to increased
revenues. Between 1980 and 1989, the corporation tax share of GDP more than
doubled from 2 percent to 4.1 percent, but then slowly declined as economic
growth declined and the value of the tax allowances gradually climbed back to
their pre-reform levels.
--------------------
\8 Robinson, Social Market Foundation Report: Britain's Borrowing Problem,
pps. 15-16.
CHANGES IN OTHER TAX
ALLOWANCES AND INDEXATION:
EXAMPLES OF "WEDGE-SHAPED"
SAVINGS
-------------------------------------------------------------- Appendix VI:3.3.4
Although the savings are difficult to quantify because of multiple
interactions, some long-term gains were achieved by instituting policies with
"wedge-shaped" savings profiles: small at the beginning but increasing over
time.
An official used the tax allowance on mortgage interest as a particular
example. In the United Kingdom, the tax allowance on owner-occupied housing is
based on the value of the mortgage and set in nominal terms, but not
automatically indexed. The government last increased the allowance in 1983 but
have held it at its 1983 level of a �30,000 mortgage. As housing prices
increased during the mid- to late-1980s, the value of the allowance fell in
real terms and represented a growing source of savings to the government. The
value of the allowance was further decreased in 1988 by confining the tax
allowance to �30,000 per residence rather than per mortgagor. Previously,
several people could take the deduction for the same property. In 1988, the
deduction for interest on home improvement loans was abolished.
Long-term revenue increases were also achieved by a 1-year suspension of the
indexation of the tax system. Since the 1970s, the United Kingdom's statutory
law has provided for indexation of the tax system to offset the effects of
inflation. An amendment to the statute provided for indexation of personal
allowances and a procedure for the government to seek parliamentary approval to
override "automatic" indexation provisions in any given year. In practice, the
government often takes advantage of the procedure to set indexation rates, both
above or below that required by inflation. In 1980, personal income tax
allowances were raised by 18 percent in line with inflation. But in 1981, the
amendment was invoked to hold personal allowances and tax thresholds constant.
With inflation above 11 percent, indexation was suspended to help hold down
public sector borrowing. This action increased 1982 total tax revenues by
almost �2 billion and lowered the base on which future tax adjustments would be
made. In other years (1982, 1984, and 1985), the government chose to raise
personal allowances more than what was required by the inflation indexation
provisions. Other specific tax allowances, such as the capital allowance for
corporations, are not automatically indexed.
NORTH SEA OIL PROVIDED REVENUE
-------------------------------------------------------------- Appendix VI:3.3.5
During the 1980s, North Sea oil was a significant source of public sector
revenue through both taxes and royalties. At its peak in 1984, North Sea oil
proceeds were more than 3 percent of GDP, representing almost 8.5 percent of
total tax revenues. Between 1975 and 1981, the United Kingdom moved from a net
importer to a net exporter of crude oil, but since the mid-1980s, oil revenues
have been gradually diminishing due to lower oil prices and production. As
seen in figure VI.10, North Sea oil provided substantial revenue over the
1980s.
Figure VI.10: Revenues From North
Sea Oil, 1979-93
(See figure in printed edition.)
Source: Robinson, Social Market Foundation Report: Britain's Borrowing
Problem.
REACHING AGREEMENT
------------------------------------------------------------------ Appendix VI:4
The Conservative government tied its deficit reduction policies to its overall
economic policy when campaigning for office in 1979. Thanks to a large
parliamentary majority after the election and the nature of the budget process,
the government did not have to seek acceptance of its economic policies to the
extent necessary in other case study countries. However, acceptance of
austerity measures was not automatic, and at times, the government had to make
concessions or reverse proposed policies. According to former and current
government officials, the government at times tried to institute policies in a
way that minimized public opposition. Public commitments to reduce the deficit
helped the government by putting pressure on Ministers to stay within stated
budget targets.
DEFICIT REDUCTION LINKED TO
OVERALL ECONOMIC POLICY
---------------------------------------------------------------- Appendix VI:4.1
The task of promoting deficit reduction took place more during the 1979
election than after. Deficit reduction constituted an important element of the
Conservative party's economic policy election platform. The government
proposed using a combination of monetary and fiscal policies which it felt
would bring down inflation, reduce interest rates, and create conditions for a
sustainable growth of output and employment. The key to the government's
policies involved controlling the money supply. The government reasoned that
deficits affected the money supply and, therefore, to control the money supply,
the country needed to control its deficits. In this way, the government
presented deficit reduction as a necessary tool to improve the economy.
Moreover, the government stated that it could not reduce unemployment and
sustain economic growth until inflation was brought under control. In
addition, deficit reduction served as a tool to reduce the role of government
in the economy, a fundamental Conservative party goal.
In the 1979 election, the Conservative party capitalized on public concern that
poor economic conditions would lead to a further financial crisis and promised
to set an entirely new course that would bring economic gains. At first, the
government's goal was to reduce the deficit, but the government later
redirected its strategy to maintaining a balanced budget over the medium term.
According to one former government official, the Conservative party took
"strong action and made a virtue of it."
DEFICIT REDUCTION DIFFICULT
DESPITE STRONG PARLIAMENTARY
MAJORITIES
---------------------------------------------------------------- Appendix VI:4.2
The government's ability to impose fiscal sacrifice was strengthened in the
early 1980s by a large Conservative party majority in the House of Commons.
For example, after the May 1979 election, the Conservative party used its
strong political position to gain support for controversial tax initiatives,
despite rising unemployment, strikes by miners, and general unrest in the
country's labor market. Later, in the middle of a deep recession in 1981,
plans were announced for controlling public expenditure by suspending tax
indexation for 1 year, effectively raising taxes. The government continued
with the plans in the face of strong public opposition. In March of that year,
364 of the country's leading economists signed a letter to The Times (London)
newspaper deploring the policies being pursued and predicting dire consequences
if they were continued.
Despite the Conservatives' large majorities, achieving consensus within the
government on some proposals was still difficult. The government had to make
significant concessions and reversals throughout its tenure, and sought to
minimize potential opposition by phasing in certain measures. An early example
of a concession often cited in interviews was a campaign commitment in the 1979
election to adhere to the public sector wage increase recommendations of an
independent commission. In another example, a proposal to increase the
gasoline tax in the 1981 budget met with considerable discontent by members of
the Cabinet opposed to strong fiscal measures--informally called "the wets."
Their counterparts, "the drys," compromised by agreeing to confine the duty
increase to one specific type of fuel indexed to the increase in inflation and
to increase the tobacco duty as an offset to this.
The government engaged in more trade-offs at the end of the 1980s. For
example, subsidies to local authorities were increased to deflect opposition to
the poll tax. In the last few years, as part of efforts to extend the VAT tax
to domestic fuel, the government promised offsetting compensation for all
pensioners and for families receiving social benefits.
While a number of interest groups existed and met with party leaders, their
ability to influence spending and tax decisions was limited due to the secrecy
of budget decision-making and the political strength of the Conservative party
during the 1980s. Traditionally, the strongest interest group in the United
Kingdom has been the trade unions. However, the Conservative party believed in
limiting the power of the unions, and through the 1980s, union power and
membership declined.
However, public pressure forced the government to sometimes reverse or change
its proposals. For example, by the 1980s, the earnings-related pension, SERPS,
promised to substantially increase public spending. Although initially opposed
to any changes in the program, in 1985, the Conservative government proposed to
abolish SERPS over a lengthy transition period, promoting private sector
earnings-related pensions instead. Due to heavy opposition from interest
groups and concerns within the Conservative party, the government reversed its
decision, but still lowered benefits, as described above, while continuing to
encourage private sector alternatives. In addition to policy reversals, the
government protected certain sectors from budget cuts. Health, education, and
some social program spending, including middle class benefits such as student
grants and child benefits, was generally preserved.
The government enacted some changes in a way that provoked little opposition
but which produced significant future budgetary savings. This strategy was
particularly important when cutting benefits that have been, in effect,
capitalized in the value of property or in expectations of future retirement
support. For example, the change in the indexation base of pension benefits
from wage growth to price growth was done at a time when wages and prices were
growing at the same rate. But when prices fell behind wages, the government
benefited from the lower index rate. The limit on the mortgage interest
deduction, discussed earlier, is another example. The limit was placed on the
deduction in the early 1970s, at a time when most mortgages were under the
limit. Except for a 1-year increase in the limit in 1983, the government
continued the nominal limit on mortgage interest deductions. Because the
ceiling was not indexed, inflation has now made the ceiling an effective cap on
the deduction, without any subsequent action on the part of policymakers.
PUBLIC COMMITMENTS
---------------------------------------------------------------- Appendix VI:4.3
Policy documents which stated the government's long-term goals were used as
mechanisms to strengthen the deficit reduction commitment and to maintain
momentum for difficult policies during downturns, such as during the
unexpectedly severe recession in the early 1980s. Although it was sometimes
forced to make concessions or reverse proposals, by stating its intention to
pursue deficit reduction and adhere to its spending targets, the government
raised the political cost of policy reversals and put pressure on Cabinet
ministers to stay within the agreed-upon targets. A former official attributed
success in reducing deficits to maintaining deficit reduction "year-in and
year-out," even during the 1980-81 recession.
BUDGET DEFICITS DURING THE 1990S
------------------------------------------------------------------ Appendix VI:5
In the late 1980s, the United Kingdom's economy seemed so much improved that
the public began talking about an economic "miracle." The idea emerged that the
character of the economy had been changed from business cycles of "booms and
busts" to a longer-term pattern of economic growth. Some analysts argue that,
as a result, the government loosened fiscal constraints with the expectation
that economic growth would continue, providing increasing revenue to finance
fiscal expansion. However, the economy entered its longest recession in
postwar history in 1990. Public sector borrowing increased rapidly, and public
finances are once again a central economic problem facing the United Kingdom.
The deficit reached 8 percent of GDP in 1993 according to OECD.
A recent study\9 of the current deficit situation in the United Kingdom
outlined four main reasons for the rapid deterioration in public finances:
increases in discretionary spending prior to an election, such as an increase
in the Child Benefit; an economic recession; a decrease in tax receipts due to
changes in the tax system; and rising debt interest costs. The government has
renewed deficit reduction efforts, including strong restrictions on public
sector pay and spending reductions in defense, housing, and transportation, to
meet a medium-term goal of approximate balance by fiscal year 1998-99.
--------------------
\9 Robinson, Social Market Foundation Report: Britain's Borrowing Problem, p.
10.
CONCLUSION
------------------------------------------------------------------ Appendix VI:6
The 1979 election of a new government in the United Kingdom served as the major
turning point in fiscal policy. The government, which had campaigned on a
platform including deficit reduction, eliminated the deficit by 1988 by
constraining the growth of spending. The government's efforts were helped by
revenues from privatization, North Sea oil sales, and a sustained period of
economic growth. A large parliamentary majority gave the government greater
leverage in implementing its policies, but officials nonetheless had to reverse
or modify some proposals due to internal and external opposition. Despite
success in the 1980s, the government could not sustain its surplus; due to
increased discretionary spending and a recession, the United Kingdom
experienced a deficit of 8 percent of GDP in 1993.
MAJOR CONTRIBUTORS TO THIS REPORT
=================================================================== Appendix VII
ACCOUNTING AND INFORMATION
MANAGEMENT DIVISION WASHINGTON, D.C.
----------------------------------------------------------------- Appendix VII:1
Barbara D. Bovbjerg, Assistant Director, (202) 512-5491
Thomas M. James, Evaluator-in-Charge
Maureen M. Berner, Evaluator
Hannah R. Laufe, Evaluator
OFFICE OF THE CHIEF ECONOMIST
----------------------------------------------------------------- Appendix VII:2
Richard S. Krashevski, Senior Economist
EUROPEAN OFFICE
----------------------------------------------------------------- Appendix VII:3
Patricia M. Riggle, Site Senior
B. Patrick Hickey, Evaluator
*** End of document. ***