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INSIGHT

Understanding the Nexus between Fiscal Policy and Sustainable Development

The COVID-19 pandemic will likely trigger larger fiscal expansions than previous shocks to provide emergency relief and boost economic recovery. Photo credit: Asian Development Bank.
The COVID-19 pandemic will likely trigger larger fiscal expansions than previous shocks to provide emergency relief and boost economic recovery. Photo credit: Asian Development Bank.

Published: 28 May 2021

Each country must follow its path in leveraging fiscal resources for sustainable development.

Introduction

COVID-19 is a major fiscal stress test for countries. Saving lives and rescuing the economy are the priorities of fiscal measures the world over. Yet, developing countries cannot lose sight of the long-term objectives of inclusive and sustainable development. There is constant feedback between fiscal resources, fiscal policy, and long-term sustainable development.

Large episodes of domestic resource mobilization provide a rough, first-order guide to the link between fiscal policy and sustainable development. Fiscal adjustment and stimulus may include reforms of indirect taxes and exemptions, tax administration, and transfer programs. Inclusive growth that reduces poverty and improves health and education may enhance tax capacity, spending efficiency, and resource mobilization (e.g., greater compliance, higher income, and lower informality).  Higher tax revenue mobilization, in turn, can help finance pressing social spending, thereby strengthening social development.

Case Studies of Four Emerging Markets

To start getting a handle on the fiscal resources–sustainable development nexus, we can look at selected country cases, and ask the following questions. First, what is the relationship between economic structure and the composition of government revenues and expenses? Second, what is the association between large fiscal episodes and sustainable development? Third, did past changes in the budget’s specific components lead to fiscal expansions and adjustments? And, which future changes in budget items do fiscal expansions and adjustments tend to depend on?

Detailed information on fiscal resources and sustainable development indicators are available for some developing countries. To illustrate, we look at Chile, Poland, South Africa, and Thailand, all of which have sufficient fiscal data. For these economies, industry accounts for a third while the services sector contributes half of the gross domestic product (GDP). But they also have structural differences.

Chile’s largest exports are metals, minerals, and agricultural products. South Africa’s largest exports are stone, minerals, and agricultural products. The fiscal conditions of their economies are vulnerable to commodity price fluctuations.

Poland’s largest exports are machinery, services, and agricultural products. Thailand’s largest exports are services, machinery, electronics, vehicles, and chemicals. Their fiscal conditions are sensitive to global industrial production.

Thus, different terms of trade shocks, depending on the ratio of export prices to import prices, may be responsible for large episodes of fiscal expansions and adjustments for the four economies.

Key Lessons

If we dissect fiscal revenues and expenses into smaller components and study their linkages with sustainable development indicators, several lessons emerge. First, different countries face different fiscal challenges depending on their economic and institutional structure. Value-added tax revenues in the four countries vary widely from 30% to 60% of total fiscal revenues. The fiscal resources of commodity-exporting countries are more vulnerable to commodity terms of trade shocks. On the other hand, the fiscal conditions of manufacturing-based exporting countries are more dependent on the global business cycle.

Second, the association between fiscal resources and sustainable development outcomes differs across countries. Focusing on fiscal episodes (loose/expansion versus tight/adjustment) helps us understand the linkages between fiscal aggregates and domestic resource mobilization on one hand and inclusive growth and sustainable development on the other. In the county case studies, large fiscal episodes accounted for one-sixth of the sample periods. We identified twelve episodes of large fiscal expansions and adjustments in 1995–2018. Many of these occurred during the 2008–2009 global financial crisis.  COVID-19 will likely trigger even larger fiscal expansions, testing the fiscal space of these economies and many other developing economies.

Third, it follows that domestic resource mobilization should consider the time paths of different taxes and expenditures. Empirically, this knowledge should render the linkages between fiscal reforms and sustainable development outcomes more tractable.

Fourth, it is useful to have a toolkit or template for tracing and budget-tagging the association between fiscal statistics and sustainable development indicators to track the fiscal footprint of sustainable development. Future analysis should also explore incorporating alternative data. For instance, if unemployment is not a suitable indicator for economic cycles in some countries, we can look instead at proxies like employment and electricity consumption.

Finally, more standardized cross-country data may shed more light on the correlations between fiscal conditions and domestic resource mobilization for sustainable development in the coming years. Because of the pandemic, the level of fiscal resources, the sustainability of public debt, and the quality of governance will become even more critical for sustainable development in the post-COVID-19 world.

To sum up, the relationship between fiscal resources and sustainable development is country-specific and time path-dependent. Different economic structures will lead to different associations, as will different histories of taxes and expenditures. At a broader level, our knowledge of the nexus is still rudimentary, and more and better data on fiscal variables and sustainable development hold the key to sharpening our understanding. The COVID-19 crisis reflects the growing exposure of an increasingly congested global commons to nature’s shocks, including global warming, pandemics, storms, and earthquakes.  Greater resilience calls for higher infrastructure and social investments and increasing fiscal capacities that would be tested in turbulent times.

Resources

A. Alesina and R. Perotti. 1995. Fiscal Expansions and Adjustments in OECD Countries. Economic Policy. 10 (21). pp. 205–248.

J. Aizenman et al. 2021. Large Fiscal Episodes and Sustainable Development: Some International Evidence. NBER Working Paper 28740. Cambridge: National Bureau of Economic Research.

United Nations Development Programme. 1999. Knowing What You Spend: A Guidance Note for Governments to Track Climate Change Finance in Their Budgets. Climate Change Financing Framework Technical Note Series. New York: UNDP.

Ask the Experts

  • Joshua Aizenman
    Dockson Chair in Economics and International Relations and Professor of International Relations and Economics, University of Southern California

    Joshua Aizenman joined the faculty at USC in 2013. He is also a research associate for the National Bureau of Economic Research, and co-editor of the Journal of International Money and Finance. Other affiliations have included teaching and research positions at UC Santa Cruz (served as a Presidential Chair of Economics), Dartmouth, Hebrew University of Jerusalem, University of Chicago GSB, and University of Pennsylvania. Consulting relationships include the IMF, World Bank, IADB, ADB, and Federal Reserve Bank of San Francisco.

  • Yothin Jinjarak
    Senior Economist, Economic Research and Regional Cooperation Department, Asian Development Bank

    Yothin Jinjarak is a senior economist at the Macroeconomics Research Division. His recent research covers fiscal capacity in developing economies, sovereign risks of emerging markets, and macroeconomic policies during the pandemic crisis. He has work experiences in New Zealand, Japan, United Kingdom, Singapore, Thailand, and the United States. 

  • Hien Nguyen
    Analyst, Statistics of New Zealand

    Hien has a PhD in Economics from Victoria University of Wellington and 7-year lecturing experience in Viet Nam. She has joined several Asian Development Bank-funded projects on fiscal capacity, sustainable development goals, and global commodity price shocks. Her research expertise focuses on fiscal and monetary policies and development issues.

  • Donghyun Park
    Economic Advisor (Strategic Knowledge Initiatives), Economic Research and Regional Cooperation Department, Asian Development Bank

    Prior to joining ADB in 2007, Donghyun was a tenured associate professor of Economics at Nanyang Technological University in Singapore. He has a PhD in Economics from UCLA in the United States. His main research fields are international finance, international trade, and development economics. His research work revolves around policy-oriented topics relevant for Asia’s long-term development, including innovation, entrepreneurship, and green finance.

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  • Joshua Aizenman
    Dockson Chair in Economics and International Relations and Professor of International Relations and Economics, University of Southern California

  • Yothin Jinjarak
    Senior Economist, Economic Research and Regional Cooperation Department, Asian Development Bank

  • Hien Nguyen
    Analyst, Statistics of New Zealand

  • Donghyun Park
    Economic Advisor (Strategic Knowledge Initiatives), Economic Research and Regional Cooperation Department, Asian Development Bank