Spending cuts work better than tax hikes to reduce debt in advanced countries, according to the IMF

The transfer of delegates, registrations and accreditations has returned to the Washington area where, starting this Monday, the spring meetings of the International Monetary Fund (IMF) and the World Bank are being held.

The managing director of the IMF, Kristalina Georgieva, already warned last week that a few years of more than discreet growth await the world.

Before the Fund's economists present their forecasts by country and region on Tuesday, two reports have come forward this Monday that emphasize the high burden of public debt after the pandemic and in full rate hikes.

In one of them, the IMF argues that spending cuts work better than tax increases to reduce debt in advanced countries.

One of the causes of the low growth forecast for the coming years is the weight of public debt, which skyrocketed during the pandemic to record levels, exceeding 100% of gross domestic product in the world as a whole.

Now, with that ballast still unreleased, rising interest rates and a stronger dollar are increasing the interest burden, which in turn weighs on growth and fuels risks to financial stability, the Fund explains.

With several economies already in debt distress, the IMF has devoted a chapter of its

report to analyzing which policies work best to durably lower government debt (or debt-to-GDP) ratios.

Its economists have taken historical data from two decades to conclude that an adequate fiscal adjustment of around 0.4 percentage points of GDP reduces the debt ratio by 0.7 percentage points in the first year and up to 2.1 percentage points after that. of five years.

However, the result improves when the adjustment occurs in a period of expansion, be it national or global, or when financial conditions are lax and uncertainty is low.

In addition, in advanced economies spending cuts work better than revenue increases, that is, tax increases.

Specifically, successful fiscal consolidations tend to be balanced between spending cuts and tax or revenue increases, while unsuccessful ones are skewed toward revenue and involve fewer spending cuts, the report explains.

This is in line with studies that indicate that tax increases hurt growth and debt ratios more than equivalent spending cuts in advanced economies, says the Fund, which clarifies that this is not the case in emerging countries. , especially in those with very low tax revenues.

The IMF adds that the chances of success also improve when fiscal consolidation is bolstered by growth-enhancing structural reforms and strong institutional frameworks, the Fund argues.

debt restructurings

The Fund's economists, however, warn that in some countries with financial difficulties the classic fiscal consolidation programs may not be enough and raises the specter of debt restructuring, that is, the renegotiation of liabilities.

“Restructuring is often used as a last resort.

It is a complex process that requires the agreement of domestic and foreign creditors and involves burden sharing among different parties (for example, between residents and banks in most domestic restructurings).

It can carry significant economic costs and there are reputational risks and coordination problems”, admits the IMF, aware of the stigma involved.

Although gradual fiscal consolidation is preferable, the Fund explains, "countries facing increased financing pressures or already in debt distress may have no viable alternative but substantial or rapid debt reduction."

“Fiscal consolidation will likely be necessary to restore market confidence and macroeconomic stability in these countries.

In addition, policy makers should also consider a timely debt restructuring.

If carried out, the restructuring will have to be deep to reduce the debt ratios, ”he adds.

In another early chapter of the

the IMF stresses that real interest rates (that is, after inflation) have risen rapidly in recent times, as monetary policy has tightened precisely in response to rising prices. prices.

The Federal Reserve has carried out the most aggressive rate hikes in more than four decades and the European Central Bank (ECB), the largest since the euro exists.

Economists explain that since the mid-1980s, real interest rates at all terms and in most advanced economies have continued to fall.

"These long-term variations in real rates probably reflect a decline in the natural rate, which is the real interest rate that would keep inflation on target and the economy operating at full employment, that is, neither expansionary nor contractionary," they point out. Jean-Marc Natal and Philip Barrett, Fund economists.

The natural rate is a benchmark for central banks, which use it to gauge the stance of monetary policy, and is also important for fiscal policy, because it helps determine the cost of borrowing and the sustainability of public debt.

The Fund's analysis concludes that the same factors that have reduced the natural interest rate in recent decades will continue, so natural rates in advanced economies will likely remain low, although it points to three risk factors: rising debt, the uncertain impact of the energy transition and commercial and financial fragmentation.

With all this, the fund believes that the recent rate hikes are temporary.

“When inflation comes back under control, central banks in advanced economies are likely to ease monetary policy and bring real interest rates back to pre-pandemic levels.

The degree of approximation to those levels will depend on whether alternative scenarios that imply a persistent increase in public debt and deficit or financial fragmentation materialize ”, he concludes.

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