2.3. Fiscal policy framework

Taking into account the institutional role of the fiscal policy, the following aspects, which have a bearing on its formulation,
can be highlighted9:

Macroeconomic: consistency of great aggregates (saving-investment, balance of payments, activity and employment) and of key prices (type of exchange, interest rates, salaries, price level).

On the other hand, the relevant elements in the macroeconomic role of the fiscal policy include the following ones:

Passive fiscal policy: fiscal aggregates by the framework (activities, exchange terms, type of exchange, inflation).

Active fiscal policy: fiscal policy decision to affect the macroeconomic framework. It pursues macroeconomic objectives (zero deficit; structural surplus; reactivation and employment; stability of external accounts; pressure on the financial system; space to private expenditure, stabilization, adjustment, etc).

Fiscal governability: institutional capacity of the fiscal authority to set macroeconomic goals and to develop a fiscal policy consistent with those goals.

On the other hand, the exemplary conventional approaches include the following ones11:

2.3.1. Budgets and fiscal policy12

As mentioned before, the traditional analysis of fiscal policy usually implies an economic authority with an extraordinary capacity for analysis, management, decision and execution.

This character has been classified as that of a “benevolent dictator” who makes decisions about income and public expenditure by a rational analysis of the problems and their alternative solutions, implementing decisions with complete information and with neither delay nor difficulty.

This image is in contrast with the daily fiscal policy reality. In the management of public finance the authorities make their decisions with limitations similar to those of other agents: incomplete information, uncertainty, operative restrictions, uncertainty about the effect of their decisions. 13.

At the same time, the implementation of such decisions is subject to an especially complex institutional process that requires negotiations and agreements in Parliament as well as in the Executive Power itself.

Once such barriers are overcome, it is within the scope of multiple public organisms with varied administrative capacities to implement such decisions. It is not unusual that public organisms that have strongly struggled for a higher budget leave a portion of their resources unspent.

Thus, fiscal policy is not only the result of a decision-making process subject to important restrictions, but there are also multiple actors, with diverse interests, priorities and capacities.

For such reasons, the execution of the fiscal policy may be characterized as a dynamic process in which decisions are adopted at different stages, as the information available to the authorities is modified and new problems arise that need to be solved.

However, the almost universal adoption of an annual fiscal cycle imposes an arrangement that defines specific decisions and actions upon the fiscal policy design and execution process.

Two possible stages can be distinguished in this process:

The first one corresponds to the budget elaboration and approval, which comprises the series of resources that the government expects to receive and their distribution among different uses during the fiscal year.

The second stage corresponds to the execution of such budget, a stage during which the latter may undergo significant modifications.

In practice, the effective levels achieved by the large fiscal aggregates –income, expenses and balance– during the year, may largely vary with respect to the estimated budget even in relatively stable countries or more developed countries.

Such differences may be derived either from occasional factors or from structural changes beyond the control of authorities or political decisions. Each one of these options has different implications regarding the duration of their effects on public finances.

Fiscal governability may be defined as the governments’ capacity to carry out their fiscal policy in a sustainable and trustworthy manner, with the minimum possible cost for other public policy areas.

Fiscal governability therefore requires a certain harmony among the institutional, managerial and economic functions of the budget.

There is no fiscal governability when institutional arrangements or political conflicts hamper the achievement of long-lasting agreements on public finance. Even if the Executive Power succeeds in imposing fiscal measures at the expense of an institutional conflict, the existence of such conflict will give rise to doubts among the economic agents with respect to the sustainability of the goals achieved, endangering their effectiveness.

Neither does fiscal governability exist if the financial goals are attained by blocking the public sector. Reverting frequently to decreasing the salaries earned by state employees or drastically reducing the investment in facilities as part of the fiscal programs results in high costs, the consequences of which extend beyond fiscal emergency.

Therefore, the concept of fiscal governability adopted here gives a certain priority to the budget’s economic aspects.

Recent experience shows that this is not a matter of personal preferences but the main lesson of all recent fiscal adjustment experiences.

If fiscal unbalances are not timely prevented, subsequent adjustments end up being extremely detrimental to the group of political, institutional and administrative relations built with respect to public finance.

Nevertheless, experience also indicates that to achieve the fiscal policy priority goals, it is somehow necessary to answer the demands made by the State political and managerial system about the budget.

In order to achieve an adequate fiscal performance in a democracy, it is necessary for the policy and the administrative management to attain an adequate performance as well.

Such equilibrium, however, does not occur spontaneously, but it depends on the institutional framework in which the budget evolves and on the manner in which the availability of public resources is integrated to the management of the government entities.14.

2.3.2. Fiscal governability and budgets in developing countries 15

In developing countries and in Latin America in particular, the fiscal governability issues described in the previous section are especially serious. In fact, public finance in these countries is not only more vulnerable to exogenous factors, but the State’s financial institutionalism and the public entities management are also considerably more precarious.

Recent studies have estimated the effect of external shocks over public finances in developing countries. According to these studies, in countries such as Chile and Thailand these external shocks have brought about, over the past two decades, absolute variations in the fiscal deficit which, as an average, amount to some 2% of the GDP. In Colombia and Morocco, the effect of such external fluctuations amounts to approximately 1% of the GDP.

In their analysis about the causes and effects of the Latin American economic volatility, Hausman and Gavin (1995) do not only verify that the regional economies are more volatile than in developing countries as regards growth, inflation and currency exchange rate, but also that public finance plays a key role in the generation and spread of shocks towards the economy.

Thus, whilst the public sector acts as a means for the transmission of variations as far as exchange is concerned, the fiscal policy turnabouts, which are generally procyclical, largely explain the volatility of the actual exchange rate and of the monetary policy, due to the limited depth of the financial markets.

In view of these extreme conditions of vulnerability and uncertainty on public finance, the budget is an instrument that in many developing countries has been reduced to a legal document of little practical value.

Inflation, external shocks, financial crisis and the need of fiscal adjustment frequently make the budget –which is necessarily drafted far in advance– obsolete even before its own approval, thus requiring modifications as from the beginning of its execution.

Nevertheless, the budget elaboration and approval continues to involve a lengthy and detailed discussion and negotiation process in many countries. The parliament approval process is many times extended after the commencement of the fiscal year, transient statutory provisions being required in order to allow the State to operate in the meantime.

Due to the uncertainty concerning public finance, a significant part of the negotiations regarding the budget turns out to be from the political pressure to protect specific expenditure components.

Such protection may take the form of special funds, affected taxes, extra budgetary operations, benefits indexation, thus restricting the action sphere of the budget and the fiscal policy to only a fraction of the public resources.

Thus, it is common that a disproportionate part of the fiscal adjustment weight falls upon sectors with less protection or influence, or that the efforts to control expenditures, being restricted to the areas covered by the budget, become overwhelmed with unbalances in the sectors excluded from it.

Nevertheless, as the countries have overcome the fiscal adjustment emergency, a growing concern has arisen in Latin America about the institutional and administrative problems of public management and, particularly, about the strengthening of the governability bases.

Fiscal governability deserves, undoubtedly, a priority position regarding such worries.

2.3.3. Chile’s case

Chile is not a country alien to fiscal stability, budgetary and managerial problems.
The Chilean public sector, despite structural reforms of recent years, is among the largest in Latin America 16.

The central government expenditure represents about 21% of the GDP. If municipalities and the public companies’ operational balance are added, the proportion is around 25% of the GDP.

Public investment represents about one fourth of the gross formation of the fixed capital in the economy 17.

Budget institutionalism has been of great importance in Chile’s history and has been developing and modifying according to the conflicts and challenges it has had to face, which is the result of different crisis coming from abroad and which have had a direct impact on the economy.

As opposed to other countries, Chile does not seek power equilibrium about fiscal matters, but has chosen a system in which the initiative and responsibility for the State financial administration are assigned to the executive power, and the legislative power knows, authorizes and audits, but it is not a co-administrator, which avoids the dissolution of responsibilities in public finance management.

Another characteristic of the Chilean budget institutionalism is that, besides granting the executive power the responsibility for the state administration, it also provides it with mechanisms to execute the budget within reasonable and flexible margins, since the budget is set forth for un uncertain future, when it is essential to count on mechanisms that allow adapting such plans and adjusting estimates to reality and concrete needs. 18.

From the beginning of the Asian crisis at the end of 1997, public finance suffered a severe impairment that was translated into successive fiscal deficits. However, in 2004, it could be foreseen as early as May that the situation would be substantially different, if during the last eight months of the year the recovery pace of the domestic activity was kept and if the prices of the main Chilean commodities continued to rise in the foreign market. 19.

It was in this scenario that economists and the economic team forecast a positive balance for the central government, the first in the last six years.

Most analysts foresaw that in 2004 the national treasury would close with surplus on an accrued basis in the range of 1% and 1.5% of the GDP. Although the executive power was confident in getting a positive balance, it reviewed its calculations to submit them during a special session of the Budgets Mixed Permanent Committee, in June 2004.

The fiscal balance depended on income and expenditure and the minister committed himself to submit an updated projection of income and expenditure in June 2004. But it was clear that the fiscal balance would have a definitely positive figure.

At that time, official estimates for 2004 anticipated a central government effective deficit on an accrued basis of 1% of the GDP.

This new method, which replaced the cash flow and which had been suggested by the IMF, showed the best income and expenditure of the fiscal balance.

Private economic agents shared the same criterion: they expected an accrued fiscal surplus of 1.2% for 2004. Chile’s economic reactivation during 2004 and the expansive phase in raw materials’ prices did not pass unnoticed by the Treasury’s purse.

For the first time since the beginning of the Asian crisis, Chile was able to generate a positive balance of its public account.

A fiscal surplus on an accrued basis was estimated at around 1% of the GDP for 2004, with a forecast of product growth of 4.5%. There were still some uncertainty factors for the government to submit a new estimate of the fiscal balance. However, in general, both the market and the economic team were fairly right about their estimates.

At the same time, the Comisión Chilena del Cobre (CoChilco) (Chilean Copper Committee) fixed the new average price of the metal for the next 10 years between 90 and 92 cents/dollar per pound. This figure was between two and four cents above the long-term value of 88 cents/dollar, which the government had included in the 2004 budget law and with which it had projected the fiscal expenditure of the coming years, according to the structural balance rule of 1% of the GDP. 20.

Chile was making positive calculations for 2004, estimating that the income from the rise in copper would be far more than the greater expense the country was incurring due to its oil imports.

Sector experts forecast that in 2004 the copper income would reach US$ 4,000 million, since for each cent that the annual average of the metal increases, exports increase between US$ 100 million and US$ 120 million. 21.

As in 2003 the copper ended up with an average value of US$ 0.80 per pound and for the year 2004 an average of US$1.2 was forecast, there were US$ 0.40 extra for Chile. If this became true in the year 2004, the industry would export a record US$ 13,000 million.

The oil, the main import product, was the other side of this coin. A barrel of oil was at around US$ 40 and estimates were not favorable. It was forecast that the annual average would be US$ 35, that is to say, US$ 5 more than the average in 2003.

How did this affect Chile? For each dollar that increased the annual average of oil, US$ 60 or 70 million were spent on imports. Therefore, extra purchases would be at around US$ 400 million.

Thus, the difference between the more copper exports and the increase in oil imports represented a positive balance of around US$ 3,500 million. 22.

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Notes