Financial standards and economic development

FISCAL STANDARDS
AND ECONOMIC DEVELOPMENT
Leszek Balcerowicz
National Bank of Poland
World Bank Workshop
3 April 2006

Agenda:
I. Public finance and short-term economic
growth
II. Public finance and long-term economic
growth
1. General government balance
2. Tax system
3. Public expenditure

3
General government deficit (ESA’95, % of GDP, left scale) and GDP growth rate (%, right scale) in 1999-2004.
Source: Eurostat.
6.4
12.3
6.6
7.8
3.8
3.1
2.0
3.8
4.6 4.5
5.5
1.5
0
4
8
12
16
1999 2000 2001 2002 2003 2004
0
2
4
6
Slovakia
5.6
2.0
1.4
1.2
1.4
2.5
-1.7
3.9
7.2 6.8
10.5
7.0
1
3
5
1999 2000 2001 2002 2003 2004
-4
0
4
8
12
Lithuania
1.4
0.7
3.7
3.3
4.8
3.9
4.5
4.2
1.1
1.4
5.3
3.8
0
2
4
6
1999 2000 2001 2002 2003 2004
0
2
4
6
Poland
General Government budget deficit (ESA’95, in % of GDP) GDP growth rate (in %)
I. Public finance and short-term economic growth
The tightening of fiscal policy does not have to lead to a fall in GDP
growth in the short term because so-called non-Keynesian effects of
fiscal tightening may occur.

4
Non-Keynesian effect
Output
increase
Keynesian approach
rigid prices
Budget deficit
reduction
Drop in interest
rates
Change of private demand bigger and stronger
than change of government demand
Increase of interest
rates sensitive
private expenditure
Net export
increase
Depreciation
of domestic
currency
Dispelling of
concerns for
government
solvency
Increase of
cumulated
disposable income
expected in a
horizon of utility
maximization
Output
increase
in long
term
Non-Keynesian approach
Increase of
enterprise capability
and propensity to
invest
Improvement in
external
competitiveness
Positive supply
shock (cost fall)
flexible prices
Source: Rzońca A., Ciżkowicz P., Non-Keynesian Effects of Fiscal Contraction in
New Member States, ECB Working Paper, No. 519, September, 2005.

5
Selected conclusions on the non-Keynesian effects of fiscal
contraction drawn from empirical studies:
• Non-Keynesian effects occur more often when fiscal adjustment is large (see e.g. Francesco
Giavazzi and Marco Pagano, 1996) and lasting (see e.g. Alberto Alesina and Roberto Perotti,
1996) rather than small or transitory.
• Fiscal adjustments are more lasting and lead more often to non-Keynesian effects if they are
caused by curtailment of expenditures rather than by tax increases (see e.g. Alberto Alesina,
Roberto Perotti and Jose Tavares, 1998). Some studies show an opposite relationship, but
they mainly deal with the response of private consumption to negative fiscal impulses (see
e.g. Francesco Giavazzi, Tullio Jappelli and Marco Pagano, 1999).
• The manner of fiscal policy tightening is of far greater importance in terms of its aftermath
than the scale of deficit reduction. Among the successful fiscal adjustments, those that
focus on cuts in public sector wage expenditure and in transfers to households are
particularly frequent (see e.g. Alberto Alesina, Silvia Ardagna, Roberto Perotti and Fabio
Schiantarelli, 1999).
• The probability of the effects’ occurrence is greater when public debt is high (Rina
Bhattacharya, 1999) or fast growing (see e.g. Francesco Giavazzi, Tullio Jappelli and Marco
Pagano, 2000) rather than low, and, at most, slowly growing.

6
‘‘In six out of the seven episodes of fiscal adjustment, output changed in the
opposite direction than a Keynesian approach would predict, that is to say,
one observed an acceleration in output momentum in comparison with the
previous period instead of its slowdown. GDP growth was, on average, faster
by 4.9 during and 4.2 a year after consolidation respectively, than a year
before the fiscal adjustment.
Moreover, actual GDP momentum during the tightening of fiscal policy was
almost twice as strong as generally expected at the onset of the fiscal
adjustment, although forecasts of GDP momentum were usually built under
the assumption of a far more lax fiscal policy than what was actually
implemented.”
According to recent research carried out at the National Bank of
Poland fiscal consolidation in the NMS in 1993-2002 triggered non-
Keynesian mechanisms, and as a result, was almost always
accompanied by an acceleration in output momentum.

7
The impact of fiscal policy on long-term economic growth may be
underestimated...
II. Public finance and long-term economic growth
Fiscal Position of
Government
Legal System and Property
Rights
Sound Money
Freedom to Trade
Internationally
Regulation of Credit, Labor
and Business
Developed countries Transition countries
Asian Tigers The poorest countries
Source: Fraser Institute.
The Fiscal Position of the Government (Size
of Government) index consists of:
• The share of general government
consumption in total consumption;
• Transfers and subsidies as a share of
GDP;
• Government enterprises and
investment as a share of gross
investment;
• Top marginal tax rate.
The higher the value of the index, the
more limited the size of the government.
For instance, it is not commonly known that one of the main differences
between the Asian Tigers and other countries is that the former
successfully restrained government expansion.
Fraser Institute Economic Freedom of the World Index

8
...and under-researched.
‘‘The recent growth literature makes relatively few references to public
finance even though some empirical work by Baro, Gordon and others has
isolated variables such as government consumption, the corporate tax rate,
and others that are found to retard growth.”
Source: Tanzi V., Public Finances and Long-Term Economic Growth: Toward a Warsaw Consensus?,
Paper presented at the Conference on „Fiscal Policy and the Road to the Euro”, Warsaw, 30
June – 1 July 2005.

9
GENERAL GOVERNMENT DEFICIT
Crisis Crowding out of investment
PUBLIC DEBT
Fall in the growth rate
or in the level of output
‘‘When national debts have once been accumulated to a
certain degree, there is scarce, I believe, a single instance of
their having fairly and completely paid. The liberation of the
public revenue, if it has ever been brought about at all, has
always been brought about by a bankruptcy; sometimes by
an avowed one, but always by a real one, though frequently
by a pretended payment.
The raising of the denomination of the coin has been the
most usual expedient by which a real public bankruptcy has
been disguised under the appearance of a pretended
payment.”
Adam Smith, An Inquiry Into The Nature and Causes of
The Wealth of Nations, Vol. 2, Methuen & CO. LTD.,
London.
‘‘the evidence appears to show that, on average,
deficits do “crowd out” investment, including
investment in plant and equipment in particular.”
Benjamin M. Friedman, Deficits and Debt in the
Short and Long Run, NBER Working Paper No.
11630, 2005.

10
In the long term, a high budget deficit hampers economic growth.
Source: World Economic Outlook, May 2000, IMF.
General government deficit in the years 1970-98 (% of GDP)
2.3
4.8
1
3
5
Countries at medium income level with
fast convergence divergence or slow growth
0.7
5.2
0
2
4
6
Countries at low income level with
fast convergence divergence or slow growth

11
There are also other important channels through which public
finance affects long-term economic growth.
Long-term economic growth
Level of taxes Structure of
taxes
TAX SYSTEM
Level of public
expenditure
Structure of public
expenditure
PUBLIC EXPENDITURE

12
TAX SYSTEM
Level of taxes (tax burden)
(% of GDP)
- official taxes;
- ‘‘corruption taxes”.
The problem of failed states.
Structure of taxes
- taxes on labour;
- taxes on capital;
- taxes on consumption.
2. Tax system

13
2. Tax system
Authors Publication Research area Extent of impact
Willi Leibfritz,
John Thornton,
Alexandra Bibbee.
Taxation and Economic Performance,
OECD WP 176, 1997.
OECD countries in
the years 1965-
1995.
10 pp increase of taxes-
to-GDP ratio lowers
GDP growth by 0.5-
1.0%.
Michael F.
Bleaney, Norman
Gemmell., Richard
Kneller.
Fiscal policy and growth: evidence from
OECD countries, Journal of Public
Economics, 74, 1999.
17 OECD countries
in the years 1970-
1994.
1 pp increase in the
distorting-tax revenues-
to-GDP* ratio lowers
GDP per capita growth
by 0.4 pp.
Stefan Folster,
Magnus
Henrekson.
Growth Effects of Government
Expenditure and Taxation in Rich
Countries, European Economic Review,
45, 2001.
Sample of most
affluent countries of
OECD and outside
OECD in the years
1970-1995.
10 pp increase in the
taxes-to-GDP ratio
lowers GDP growth by
about 1%.
Eric M. Engen,
Jonathan Skinner.
Taxation and Economic Growth, NBER
WO 5826, Cambridge 1996.
United States and a
sample from OECD
countries.
2.5 pp increase in the
taxes-to-GDP ratio
reduces economic
growth by 0.2-0.3%
Source: Skrok E., Taxation and Long-Term Economic Growth: Analysis of Poland’s Tax
Policy Against the Background of International Theory and Experience, 2004.
* distorting tax revenue – revenue from taxes on income and profit, social security contribution, tax on payroll,
tax on property.
Empirical research confirms the negative impact of high taxes on
economic growth.

14
2. Tax system
Source: Smith A., An Inquiry Into The Nature and Causes of The Wealth of Nations,
Vol. 2, Methuen & CO. LTD., London.
The structure of taxes matters because taxes differ in their
contribution to distorting incentives:
• to work
‘‘If direct taxes upon the wages of labour have not always occasioned a proportionable
rise in those wages, it is because they have generally occasioned a considerable fall in the
demand for labour. The declension of industry, the decrease of employment for the poor,
the diminution of the annual produce of the land and labour of the country, have generally
been the effects of such taxes.”
• to invest
‘‘The proprietor of stock is properly a citizen of the world, and is not necessarily attached
to any particular country. He would be apt to abandon the country in which he was
exposed to a vexatious inquisition, in order to be assessed to a burdensome tax, and
would remove his stock to some other country where he could either carry on his
business, or enjoy his fortune more at his ease. By removing his stock he would put an
end to all the industry which it had maintained in the country which he left.”

15
2. Tax system
Laszlo
Goerke
Taxes and Unemployment, Kluwer
Academics, Boston, 2002.
Taxes have a negative impact on employment. The
magnitude of the tax policy’s influence on employment
depends on the labour market’s institutional conditions.
Vincent
Hogan
Do Taxes Cause Unemployment?,
University College Dublin, 2001.
The burden of higher taxes is spread among employees
and employers, and in turn leads to higher unemployment.
Even a temporary (up to 1 year) tax increase leads to
higher unemployment which persists for several years.
Edward C.
Prescott
Tax Not Culture Explains Why
Europeans Work Less, The Wall Street
Journal, 21 Oct 2004.
‘‘I determine the importance of tax rates in accounting for
(...) differences in labor supply for the major advanced
industrial countries and find that tax rates alone account for
most of these differences in labor supply.”
Empirical research confirms the negative impact of high taxes on
employment...

16
...and investment.
Michael Funke
Determining the taxation and
investment impacts of Estonia’s
2000 income tax reform, Bank of
Finland Working Paper no. 15,
2000.
Differences in tax systems explain a large proportion of
differences in economic growth. The tax reduction in
Estonia in 2000 will lead in the long run to a 6% increase in
the capital stock.
Robert
Douglas, Holtz-
Eakin,
Mark Rider,
Harvey S.
Rosen
Entrepreneurs, Income Taxes, and
Investment, NBER Working Paper
No. 6374, 1998.
The level of corporate income tax has a significant influence
on companies’ investment decisions.
A 5 percentage point increase in the marginal rate of
taxation in the USA would lead to a 10 per cent decrease in
investment.
Eric M. Engen,
Jonathan
Skinner
Taxation and Economic Growth,
NBER Working Paper No. 5826,
1996.
In the USA an average tax-rate change of 2.5 percentage
points leads, by means of a positive impact on employment,
investment and productivity dynamics, to a 0.2-0.3
percentage point economic growth acceleration per year.
Reint Gropp,
Kristina Kostial
The Disappearing Tax Base: Is
Foreign Direct Investment (FDI)
Eroding Corporate Income Taxes?,
IMF Working Paper No. 173,
2000.
The tax level has a significant impact on the value of foreign
direct investment. Lower taxes are linked with a larger
inflow of FDI.
2. Tax system

17
Public expenditure and
long-run economic growth
Level of expenditures Structure of expenditures
expenditures on public goods
The theoretical concept of public
goods is misused in its
application to the real world
(Coase versus Stiglitz)
other expenditures
- government
consumption
- transfers
- public investment

18
Public sector expenditure in West European countries in 1950 and in Poland in 2004 (% of GDP).
Source: Middleton R., Britain’s economic problem: too small a public sector?, Centre for
Contemporary British History, 1995.
Eurostat.
16.2
18.0 19.0 19.8
22.2 22.6
26.5 27.6 28.6
32.0 32.1
36.0
43.0
10
20
30
40
S
w
e
d
e
n
A
u
s
t
r
i
a
D
e
n
m
a
r
k
S
w
i
t
z
e
r
l
a
n
d
I
t
a
l
y
B
e
l
g
i
u
m
N
e
t
h
e
r
l
a
n
d
s
N
o
r
w
a
y
F
i
n
l
a
n
d
G
e
r
m
a
n
y
U
n
i
t
e
d
K
i
n
g
d
o
m
F
r
a
n
c
e
P
o
l
a
n
d
2
0
0
4
It is a mistake to associate the fast development of many Western
economies with their currently high public expenditure levels because
they achieved their highest economic growth in years when their
expenditures were low.
The present level of public expenditure in Poland is much higher than
it was in today’s highly developed countries in the middle of the 20th
century.

19
Source: Heitger B., The Scope of Government and Its Impact on Economic Growth in OECD
Countries, Kiel Working Paper No. 1034, April 2001.
30.0
37.5
44.5
46.3
4.0
2.0
1.7
1.5
20
25
30
35
40
45
50
1960s 1970s 1980s 1990s
Public
expenditure
(in
%
of
GDP)
1
2
3
4
GDP
per
capita
growth
rate
(in
%)
Public expenditure GDP per capita growth rate
Public expenditure and GDP per capita growth in OECD countries.
The increase of public expenditure at a pace exceeding the GDP growth
rate has been an important source of GDP growth slowdown in OECD
countries since the middle of the 20th century.

20
Source: Heitger B., The Scope of Government and Its Impact on Economic Growth in OECD
Countries, Kiel Working Paper No. 1034, April 2001.
Empirical research suggests that expanding general government
expenditures in OECD countries have worsen the structure of
expenditures.
As Heitger states, in OECD countries the expenditure share in core
categories* is about or below 14% of GDP. This is true even in countries
where the scope of government is relatively large.
‘‘The empirical analysis of national accounts of the main OECD countries revealed that
the supply of public goods in the 90s only accounted for about 14 percentage points of
gross domestic product. Given the observation that the scope of government in
European OECD countries, as measured by government shares, on average accounted
for about 50 per cent of gross domestic product one may suggest that these countries
have significantly surpassed the „optimum“ of government activities and thus,
accordingly to the hypothesis, should have reduced the growth potential of their
economies considerably.”
* Core government expenditures consist of expenditures on public order and safety, national defence, education
and transportation/communication.

21
Source: Tanzi V., Schuknecht L., Reconsidering the Fiscal Role of Government: The
International Perspective, The American Economic Review, Vol. 87, No. 2, 1997.
‘‘(...) the large increase in public spending (...) that occurred especially after 1960 does
not seem to have contributed much to social welfare. This leads us to conclude that by
the time countries reach the level of public spending shown by the small governments,
namely, between 30 and 40 percent of GDP, much of the potential social gain from
public spending has been obtained. Spending beyond that level does not contribute
much.”
It is a mistake to claim that a higher level of public expenditure is the
cure for the societal problems and leads to higher well-being.

22
Especially destructive are the „welfare states” in less developed
economies.
• ‘‘(...) while governments devote about a third of their budgets to heath and
education, they spend very little of it on poor people. (...) Public spending on health
and education is typically enjoyed by the non-poor.” (World Bank, 2004).
• Examples:
 Mexico
In 1989 execution of the ‘‘National Solidarity Program” was started. The possible reduction of poverty
was forecasted at 64%, but the real reduction had amounted only to 3% until 1995. The cost of the
program came to 1.2% of GDP. The simple distribution of such an amount of money to all people
(including wealthy people) would reduce poverty by 13%.
 Bangladesh
74% of teachers employed in public education system do not attend classes.
 Brazil
The economic growth of Brazil is hampered by the high costs of doing business (including tax wedge)
caused by the excessive welfare state.
 India
The transfers originally directed to the poor peasants are taken over by wealthy farmers.
The prohibition to fire the worker, even in private enterprise, leads to high unemployment in India.
Source: World Development Report: Making Services Work for Poor People, World Bank 2004.

23
Fall in the labour supply caused by social traps depends on:
• the level of social benefits
• The cut of the replacement rate in unemployment insurance from 80 percent to 75
percent in Sweden in 1995 caused an increase in the transition rate of employment
of roughly 10 percent. (Carling, Holmlund, Vejsiu 1999)
• the entitlement period
• The results of econometric analysis have shown that the prolongation of entitlement
periods and its extension to successively younger age groups in West Germany in
the 1980s has increased unemployment durations for males. (Steiner, 1997)
Sources:
Carling K., Holmlund B., Vejsiu A., Do benefit Cuts Boost Job Findings? Swedish Evidence from
the 1990s, 1999.
Steiner V., Extended Benefit – Entitlement Periods and the Duration of Unemployment in West
Germany, 1997.
A high level of social spending discourages people from active
participation in the labour market (social traps).

24
Source: Hagglund P., Effects of Changes in the Unemployment Insurance Eligibility Requirement
on Job Duration – Swedish Evidence, 2000.
• availability and conditions to exercise social benefits
 The extension of the number of weeks a person must work to become eligible for
unemployment insurance benefits on the Swedish labour market from 80 days
to 6 months between 1996 and 1998 caused an approximate 2.9-week
extension in average employment duration. (Hagglund, 2000)
 Changes in the conditions to exercise social benefits in the United States in
1996 (obligatory to work or participate in training courses, eliminating part of
the social programs, etc.) led to a 56% decrease in social benefits recipients in
the years 1996-2001.

25
Sources:
Afonso A., Schuknecht L., Tanzi V., Public sector efficiency: an international comparison, ECB
Working Paper No. 242, 2003.
A., Schuknecht L., Tanzi V., Public Spending in the 20th Century: A Global Perspective,
Cambridge University Press, 2000.
The average level of public sector performance was set to 1. The public sector performance indicator is based on
measures of administrative performance of government, education, health performance, public infrastructure,
income distribution, economic stability and economic performance.
Public sector efficiency in 2000 *
1.26
1.03
0.90
0.8
1.0
1.2
1.4
"Small" governments "Medium" governments "Big" governments
* Efficiency indicators for the public sectors of 23
industrialised OECD countries.
• „small” governments: public spending less than
40% of GDP;
• „medium” governments: public spending between
40% and 50% of GDP;
• „big” governments: public spending greater than
50% of GDP.
To conclude, an expansion of public expenditure from a relatively low
level leads to a decline in the economic growth rate. As Schuknecht
and Tanzi state, in the years 1980-2000 the expansion of public
expenditure in relation to GDP led to lower values of the quality-of-life
indicators, including the economic growth rate.

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