June 27, 2018
How much leeway national policymakers have for increasing spending or cutting taxes has been hard to assess. It is a critical question during periods of economic downturn when the government is asked to stimulate the economy. But it is also an equally important question in a time of cyclical upswing such as we’re now experiencing because the answer is critical to understanding how fast a nation should rebuild buffers.
Regardless of the circumstances, for the answer to be useful, it needs to come in the form of an estimate of “fiscal space,” or the amount of room countries have for temporarily increasing their budget deficits without jeopardizing their access to markets or the sustainability of their debt.
The IMF staff has developed a new framework for measuring fiscal space and tested it during 2017-2018 across a number of Article IV consultations, the Fund’s annual review to monitor countries’ economic and financial policies.
Having fiscal space is like having money in the bank.
Measuring fiscal space
When a government looks to temporarily increase spending or reduce taxes, it needs to gauge whether it will be able to fund the resulting budget gap without risking an unfavorable reaction from financial markets or undermining the longer-term health of public finances. The more confident it can feel about this, the more fiscal space it has. Conversely, the riskier a country’s market and fiscal outlook, the more limited the government’s ability to actively use fiscal policy.
Fiscal space is not determined just by a country’s level of public debt, nor is it a static concept. It can vary with market and economic conditions, sometimes quite quickly and substantially. For instance, when a country undertakes a well-executed fiscal stimulus, the dynamic boost to economic activity could outweigh the initial deterioration in its fiscal position. As a result, its public debt-to-GDP ratio could actually improve over time, creating additional fiscal space. Thus, our framework avoids any single metric, relying instead on a multi-faceted approach using indicators and tools developed over many years. Among others, the framework encompasses the composition and trajectory of public debt; financing needs and ease of borrowing; assets that can be drawn upon; future spending commitments; the effectiveness of fiscal policy; and the strength of fiscal institutions.
Our framework also considers the existence of fiscal rules, which some countries use to rein in discretionary fiscal policy. These rules can also play an important role in enhancing credibility, market access, and ultimately fiscal space itself. It is important that these rules be well designed and regularly reviewed to ensure that they meet their objectives. Good rules help build and preserve fiscal space by encouraging building buffers in good times while allowing their sensible use when warranted.
Overall, the framework allows us to arrive at an assessment of the degree of fiscal space any given country has at any given time, built around four stages, which are illustrated in the video below.
Who has it and who doesn’t
Based on the application of the framework in recent IMF reports, Australia, Germany, the Netherlands, and Sweden are some of the countries with substantial fiscal space. Among other things, this reflects their access to stable and cheap funding from financial markets, healthy public finances, and strong institutions.
At the other end of the spectrum, fiscal space is severely constrained in Brazil, Italy, and Pakistan, for example. This limited fiscal space reflects to varying degrees elevated risks related to funding from financial markets and relatively high levels of debt, financing, or debt servicing needs. Depending on the degree of strain, countries with limited space would run into risks, such as loss of market access, to actively use fiscal policy.
In between are countries where fiscal space exists but is not extensive, including China, the Philippines, Thailand, Russia, Saudi Arabia, and the United States. Such countries have some fiscal space because the risks they face to funding or debt sustainability are not severe.
Using fiscal space
Whether a country should use its fiscal space is a totally different question. Having fiscal space is like having money in the bank. It can be drawn upon in times of need but should not be used recklessly and without taking into account other opportunities. It is a government’s responsibility to build adequate fiscal space and use it judiciously, without impairing the long-term economic health of the country. In many instances, there can be perfectly good reasons for a country to have fiscal space but choose to keep its powder dry or even build more.
Our framework is silent on the issue of use. That decision should be based on a separate cost-benefit analysis, including whether there is a legitimate need that can best be met through fiscal policy rather than other measures, and the extent to which the existing space is adequate given the risks the economy faces.
This distinction between having fiscal space and using it is reflected in the IMF’s policy advice. Fiscal consolidation was recommended not only in all the countries with limited fiscal space, since they had no option but to adjust, but also in several countries with some or substantial fiscal space. This was generally either because an economy was in relatively strong position or there was a need to rebuild buffers based on risks on the horizon.
At the same time, where there was at least some fiscal space and a strong case existed for using it, IMF staff recommended its use. For instance, our advice was to use the fiscal space in support of longer-term growth in Germany, the Netherlands, the Philippines, and Thailand, to offset some of the potential costs from a needed phase of strong structural reforms in China, and to allow a slower pace of fiscal adjustment for some oil producers.
Looking ahead, our road map for how to assess fiscal space should help provide all the Fund’s membership with a sense of their room for maneuver on a regular basis and assist them in making the right policy choices for their individual circumstances.