Budget inflexibility

By Pauline Olson,2014-12-13 09:41
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Budget inflexibility

    Budget inflexibility


    Juan Carlos Echeverry

    Leopoldo Fergusson

    Pablo Querubín

    Universidad de los Andes

    Facultad de Economía-CEDE


    The study of budgetary institutions has long been an important topic in the economic literature. Nonetheless, the degree of rigidity or inflexibility in budget preparation, a prime preoccupation for policy makers and in particular for finance ministers since a long time ago, has been relatively unexplored. In this paper we show that budget inflexibility can take several forms and argue that it is likely to be closely related to various types of political conflict present in the budget process. Moreover, we study one particular form of budget inflexibility and its connection with one specific (but perhaps the most important) political force driving the budget process. More specifically, we discuss some of the consequences of "expenditure inflexibility," defined as the existence of transfers to special interests enjoying constitutional or legal protection which impede their modification in the short run, in a simple model of legislative bargaining that captures the Tragedy of the Commons present in public budget allocation.

1. Introduction

    Fiscal sustainability has been a prime preoccupation for developing economies for as far as there is a record of public finances and macroeconomic behavior. Most of the macroeconomic crises episodes have been characterized by public debt service problems, in turn related to excess expenditures or negative shocks to tax revenues. The reasons lie in the fact that emerging economies face considerable demands for aggressive public expenditure programs in order to respond to social aspirations on health, education, aqueducts, sanitation, roads, power generation and telecommunications, and finally social programs for the old, the unemployed and other vulnerable strata of population. Such expenditure programs have a structural character and can hardly be removed in the short run, when the public finances come under stress. If the country is temporarily blessed by access to world or domestic capital markets, the solution is the accumulation of public debt, which as time passes, and interest rates start to reflect the vulnerable financial position of sovereign credit, becomes itself an aggravating element. Indeed, weak financing structures, normally denominated in hard currencies, and short maturity expose fiscal finances to devaluation and sudden stops in public debt roll-over.

    In order to tackle stubborn growth underperformance and macroeconomic instability, during the nineties many Latin American countries adopted so-called market oriented reforms aimed at reducing the degree of state intervention on their economies, allowing goods and services' prices to be set by market forces, simplifying tariff


    structures, cutting inflation and granting central bank independence, boosting competitiveness and exports, opening room for private participation on sectors traditionally secured to public ownership, like utilities, decentralizing government and allowing capital flows a freer movement. These reforms implied a clearer focus for public sector intervention, specially oriented to wealth redistribution and poverty reduction. The new, narrower scope of the public sector and the enhanced role of sub-national public administration entities were thought to bring closer the public resources allocation decision to people who knew best their needs and could make the public officials accountable.

    In spite of the original appeal of this set of reforms and the trust on their positive impact on the economy, the macroeconomic vulnerability did not decline, and in some instances increased as short term capital flows made real and nominal variables fluctuate sharply in very short spans. In the favorable ambiance of the beginning of the nineties, public expenditure found windows of opportunity in the international capital markets to finance expenditures above short term revenues. However, a sequence of international crises set off by the 1994 Tequila Crisis and hopefully terminated by the December 2001 Tango crisis, the biggest default of public debt witnessed in history, created a quite unstable international environment. The effect of reforms was tarnished by a series of external shocks that impeded these economies to perform up to the expectations.

    Huge intellectual efforts have been devoted to tackle the issue of restoring credibility to public policies in these economies, to design credible strategies for reforming taxes, increasing revenues (i.e. improving the efficiency of the tax collection agencies), or reforming budgetary institutions. Following the example of seemingly successful fiscal framework adopted by the Clinton administration at the beginning of the nineties, many countries took to congress and approved the so-called Fiscal Responsibility Laws, also championed by the multilateral institutions. Such codes proposed a set of rules aimed at medium and long term fiscal sustainability. Most of the measures adopted consisted simply on making explicit the long term consequences of current expenditure and fiscal imbalances, the financial costs associated with borrowing, and the sustainability conditions of observed public debt levels. However promising and stable these laws looked at the outset, most of them could be reformed by the yearly budget law and could not avoid the issuing of new laws mandating expenditure. In democratic societies congresses would, and probably should, never surrender its competence for issuing expenditure-mandating laws. Hence, the fiscal responsibility framework depicted by such laws was as strong as the institutional consensus for fiscal prudence within their democratic institutions. Such consensus proved weaker than originally thought. Indeed, efforts to balance the budgets have systematically under-performed vis-à-vis the voracity of the executive and the legislative.

    Facing the capacity of the legislative for creating new expenditures and protecting them via law and constitutional stipulations, the economic authorities' attention turned from the aggregate imbalances to understanding the micro-structure of public expenditure. Short term inflexibility became a prime preoccupation. Many expenditures were protected by law or by the constitution and made quite difficult the rational design of the public budget.

    Furthermore, other worrisome inflexible outlays were found, the so-called skeletons of public finances: infrastructure investment guarantees, established at the boom of such outlays at the beginning of the nineties, when energy PPA, traffic guarantees for roads and assurances on number of calls in telecommunications were provided. Also burdensome and generous pension schemes, which became unsustainable as an aging population was coupled with a decline in the birth rate, and a reduction in young people entering the labor force, affected also by informality and low rates of contribution to pay-as-you-go pension systems. Finally, a series of contingent claims that could turn a sustainable fiscal position into an unsustainable due to changes in court rulings or sudden changes in the exchange rate.

    With this findings, the flow approach to fiscal imbalances was revealed limited since the origin of excess expenditure seemed to be grounded in the balance sheet of the public sector more than in its flow accounts (see Echeverry and Navas, 1999; Polackova and Schick, 2002; Echeverry et al., 2002). Once policy-makers, the academia and the multilateral institutions reached a comprehensive understanding of the variety of problems that plagued fiscal finances in Latin-American economies, it became evident that confronting them would need an


    all-inclusive strategy aimed to tackle deep long-term contracts like pensions, public debt and infrastructure guarantees; revenues side troubles like insufficient value added and income tax bases; tax collection deficiencies, cumbersome tax rates structures and exemptions; and finally the lack of flexibility of public expenditure.

    In contrast to most of the issues mentioned, public expenditure inflexibility has received little attention in the theoretical and applied economic literature. Moreover, although the study of budgetary institutions has long been an important topic for academics, recent research has emphasized the importance of a number of features of the budget process, such as its degree of transparency, the extent of centralization or decentralization of budgetary power in the Executive vis-à-vis the Congress, the role of regions and the central government, and the existence of "balanced budget rules", whereas the degree of rigidity or inflexibility in budget preparation has been relatively unexplored. This paper aims at filling this gap. Budget inflexibilities are known to policymakers and in particular to finance ministers since a long time ago. Indeed, complaints against other members of the cabinet and the congress' insatiable appetite for expenditure are to be found in many old writings of the officials in charge of the 1public finances. Hence, it is remarkable the lack of formal treatment of this issue in the specialized literature. We need a better understanding of the political economy mechanisms behind budget inflexibilities.

    The fact that budget inflexibility is currently an issue concerning policymakers, at least in Latin America, is confirmed by a recent IMF report on the Macroeconomic Perspective of the region since the 1990s. The report points out that budget inflexibility was an important obstacle to imposing fiscal discipline in a number of Latin American countries. It emphasizes that the failure to reform fiscal institutions undermined efforts at fiscal consolidation. Most importantly, underlying weaknesses and rigidities in revenue and spending systems were not addressed. In addition, problems with intergovernmental relationships led to distorted incentives and additional rigidities. As a result, recourse to ad hoc adjustment efforts without dealing with these issues undermined longer-term economic growth prospects, exacerbating sustainability problems." (IMF, 2004, p.73). The report also adds that while the measures creating inflexibility were intended to protect key spending categories, they impaired allocative efficiency and fiscal flexibility. With about 80 percent of public spending in Brazil being nondiscretionary by the end of the 1990s, the ability to adapt to changing macroeconomic circumstances was compromised" (p.63). In another paper (Echeverry et al., 2004) we have studied in detail the case of Colombia and have confirmed this diagnosis.

    But, what exactly is "budget inflexibility"? In general, we can define it as the impossibility for policymakers to change the composition or size of the budget in the short run (whether it be on the revenue or expenditure side) due to the existence of constitutional or legal protection for certain revenues and/or expenditures of the government. Of course, there are a number of additional budget items which are "naturally" inflexible in the sense that the government cannot renege on them except under extreme circumstances. Such is the case of the public sector wage bill, public debt service and pensions. However, budget inflexibility can take many other forms: measures to earmark revenue to specific expenditures, constitutional and legislative mandates setting floors on different types of spending, measures linking expenditures to the movement of certain macroeconomic variables, etc.

    In this sense, one way to classify budget inflexibilities is between inflexibilities stemming from the revenue and the expenditure side. On the revenue side, the most frequent source of inflexibility is earmarking of revenues to specific expenditures (legal mandates whereby the revenue of specific sources is compelled to be destined to particular and predetermined expenses). This is a source of inflexibility in the sense that not all government revenues constitute a single pool of resources which can be discretionally allocated among different uses. A recent noteworthy example from Colombia (where this sort of earmarking is referred to as "rentas de destinación específica") is the "impuesto a la seguridad democrática" (democratic security tax), a tax on wealth to be destined exclusively to military purposes. Another revenue-side inflexibility is the granting of a right to certain

     1In Echeverry et al. (2004) it is shown that, in the case of Colombia, the issue of budget inflexibility was a recurrent subject in

    finance ministers' reports since the nineteenth century. The topic is still a current preoccupation for policy makers, as evident

    from press articles and other statements of recent and current policy makers (see, for instance, Restrepo, 2003, Sanguinés, M. and E. Fernández, 2003, and Hernández, 2003).


    groups/associations to levy taxes to finance their specific activities. Among these so-called "parafiscales" the most frequent example is the granting of these rights to agricultural marketing boards that levy taxes on producers in exchange for services directly related to their productive activities. Consider for instance, the case of the National Federation of Coffee Growers in Colombia. This is clearly a source of inflexibility to the extent that these resources never enter the common pool of tax revenues to be allocated discretionally by authorities.

    On the expenditure side, inflexibilities take the form of mandatory transfers to special interests. These transfers enjoy constitutional or legal protection which impedes their exclusion from the budget or even their reduction in the short run. Typically, the largest items in this category are mandatory and often constitutional 2transfers to subnational governments. However, they also take the form of transfers to narrower and more specific

    interests ranging from associations for the prevention of specific diseases to ethnic minorities. In this paper we will focus on the study of this sort of inflexibility and its role in a model that captures in a stylized manner two key features of the political forces behind the budget process: the tragedy of the commons and the process of legislative bargaining. This is obviously far from a comprehensive analysis of budget inflexibility since, as argued in the following section, budget inflexibility is closely related to all forms of political conflict present in the budget process. Nevertheless, this is a first step in attempting to understand the consequences of budget inflexibility for policy and the political forces behind it.

2. Related literature

    Surprisingly, the topic of budget inflexibility seems to have been overlooked by the academic literature on fiscal policy. Indeed, to our knowledge there is no theoretical work on the effects of budget inflexibility. Thus, although as shown in the introduction practitioners are indeed concerned with the problem, there are little (direct) theoretical grounds to discuss whether budget inflexibility is a desirable or undesirable feature of the budget process. However, the (growing) literature in the field of "new political economy" provides a number of insights regarding the possible origins and (dis)advantages of this phenomenon.

    In this section, we take advantage of some of the recent contributions to the political economy literature on the determinants of fiscal policy to interpret the issue of budget inflexibility. The main conclusion that can be drawn is that inflexibility, like budget issues in general, is likely to be the result of deep political conflicts. Furthermore, political conflict often leads to the adoption of policies that turn out to be economically "inefficient". From this perspective, it is possible to argue that there are several political motivations that might lead, in equilibrium, to "excessive" budget inflexibility. The political economy literature also emphasizes that "institutions"--the set of rules of the game shaping the incentives of economic (and political) agents involved in the budget process--are a key determinant of overall economic results. Thus, another message stemming from this literature is that it is important to modify budget institutions so as to reduce the incentives and opportunities to generate inflexibility, rather than simply eliminate some expenses, which will, most likely, reappear in the future.

    However, from another point of view, it is possible to argue that a certain degree of inflexibility is desirable in that it isolates certain important expenditures from political and fiscal fluctuations. The validity of this argument is examined and criticized in the second part of this section, where we discuss the topic of time inconsistency" in economic policy.

2.1 Political models of fiscal policy

    The literature on the political economy of fiscal policy is hardly new. Yet, recently there has been a renewed interest in incorporating political variables in the explanation of fiscal policy. This interest has been motivated

     2In Colombia, these transfers to subnational governments, channeled through the Sistema General de Participaciones, are not only inflexible in terms of their level. The allocation of transferred resources is also regulated.


    mainly by the fact that strictly economic theories on the way economic policy should behave have been relatively unsuccessful in explaining real-life decision making by policymakers. Of course, this is not surprising since these normative" theories are based upon the premise that the purpose of policymakers is to maximize "social welfare". However, in practice, these decisions arise from the interaction of various groups of society with disparate interests. Political models on the determination of economic policy explicitly incorporate the role of these groups and the implications for resulting policies of their interaction. Moreover, an important contribution of this perspective consists in examining the role that different institutional environments or rules of the game" might have on equilibrium policies.

    As we highlighted earlier, the new political economy has not studied in detail the specific problem of budget inflexibility. Nevertheless, there is a large literature on the political economy of public debt which is potentially useful for analyzing budget inflexibility, since, like debt, inflexible headings in the budget can be interpreted as an obligation that the government acquires with different groups in society. Moreover, purely economic theories on public debt give relatively little justification to the existence of inflexibility, especially if it leads to a persistent excess of expenditure over revenue. Such is the case of the tax smoothing" theory of government deficits which implies that governments should only accumulate debt during wars or recessions in order to distribute over time the costs of distortionary taxation. As shown by Roubini and Sachs (1989) and Alesina, Roubini and Cohen (1992), the experience of OECD economies during the last three decades seems to be inconsistent with this theory which suggests that public debt should serve as a shock absorber in case the economy is hit by unexpected (income or expenditure) shocks. On the contrary, the overall trend in OECD economies has been towards public debt 3accumulation, even during times of peace and economic growth (Alesina and Perotti, 1994). Developing

    countries have also run budget deficits systematically since the 1970s, and this has often led to unsustainable debt accumulation. (Tornell and Velasco, 1995; Larraín and Selowski, 1991). Meanwhile, several empirical studies have found that political variables play a crucial role in the determination of public debt (see, for example, Roubini and Sachs, (1989) for industrialized countries and Edwards and Tabellini (1991) and Roubini (1991) for developing countries).