Building strong fiscal foundations: Essential strategies for pacific island countries to withstand and recover from economic shocks

The views expressed in the Let’s Talk Development blog are solely those of the author(s).
 

In January 2022, the underwater volcano Hunga Tonga-Hunga Ha'apai erupted, causing a tsunami that devastated infrastructure, and severely impacted livelihoods of approximately 80,000 Tongans, or 85 percent of Tonga’s population. The disaster caused damage and losses of at least $90.4 million—or 18.5 percent of Tonga’s GDP. This event underscores the vulnerability of Pacific Island Countries (PICs) to natural disasters, highlighting the need for resilience to ensure long-term prosperity.

The estimated average annual losses from natural disasters in these countries range from approximately 3 to 5 percent of their GDP. This figure is expected to rise as climate event-related risks continue to grow.
 

Understanding Fiscal Resilience in the Pacific Context

Fiscal resilience represents a country's capacity to withstand economic disruptions, adapt to changing economic conditions, and maintain core functions while preserving long-term fiscal sustainability. For PICs, this means developing the capacity to anticipate, absorb, and adapt to external shocks — from cyclones to pandemic-induced tourism collapses while continuing to provide essential services and pursuing development goals.

How can Pacific Island Countries build stronger fiscal foundations to withstand and recover from economic shocks related to natural hazards or global economic shifts?
 

The Pacific Vulnerability Challenge

PICs face significant challenges in achieving fiscal resilience due to a combination of factors:

• Economies are concentrated in only a few sectors: In over half the PICs, tourism and remittances make up about 41 percent of GDP. When COVID-19 halted global travel, it caused a 15 percent real GDP decline in 2020–22. This highlights the need for economic diversification to enhance economic, and in turn, fiscal resilience.
• High cost of public services: Dispersed islands lead to high per capita service costs, creating ongoing fiscal pressures. A water system or healthcare facility serving thousands on the mainland may only serve hundreds on islands.
• Human capital challenges: Human capital issues remain a serious concern for the Pacific. According to the Human Capital Index, a child born today in the PIC-9 countries is expected to reach only half of their potential productivity as an adult, largely due to gaps in health and education. The toll of Non-Communicable Diseases (NCDs) is also deeply felt across Pacific communities, with more than 37 years of healthy life lost for every 100 people. This is 16 percent higher than other comparable countries. Without stronger action, the growing NCD crisis could increase the economic burden on Pacific nations by 5 to 9 percent of GDP by 2040, placing even more pressure on families and health systems.
• Complex debt dynamics: Debt sustainability analyses show that five countries—the Republic of the Marshall Islands (RMI), Tonga, Vanuatu, Kiribati, and Tuvalu—are at high risk of debt distress. This includes sovereign rent-led countries such as RMI, Kiribati, and Tuvalu, which rely heavily on external grants and funding, making them particularly vulnerable to shifts in global policy.
   

A Fiscal Resilience Strategy

To strengthen their fiscal foundations and be better prepared for economic shocks, PICs need to adopt strategies that target several interconnected areas:

Building Meaningful Fiscal Buffers: Fiscal buffers are essential for PICs as they provide financial protection against natural disasters and economic shocks, enabling stability and continuity of essential services. Maintaining such buffers requires policy discipline. Institutionalizing them through legislation and transparent governance can overcome short-term political pressures.  The majority of PICs do well here, by using Sovereign Wealth Fund and accumulating cash reserves.

Raising Revenues for Fiscal Buffers: The public sector in Small Island Developing States (SIDS)—of which PICs are part of—is larger (35 percent of GDP) than in non-SIDS states (27 percent of GDP). This calls for revenue increases to build buffers for shocks. It is crucial to reduce revenue volatility to respond to external shocks.

To build buffers by closing the tax gap, Pacific Island Countries can consider:

• Broadening the tax base: Implementing (or reforming) Value Added Tax (VAT) structures, corporate profit tax, and property tax, and improving non-tax revenue collections, for example, on fisheries and extractives.
• Assessing tax expenditures: Tax expenditures in small island states can significantly impact fiscal health, at times exceeding 10 percent of GDP in terms of revenue forgone. Reforms require governments to cost and publish expenditures as part of the budget, verify compliance of tax expenditures beneficiaries, and evaluate the cost and benefits of phasing out unproductive tax expenditures.
• Digitizing core tax systems: Most SIDS have small, manual tax administrations with relatively low capacity. A compliant, open source iTAX system, preferably shared with neighboring countries, can reduce operating costs and enable data exchange.
   

Improving Expenditure Flexibility

Several PICs allocate roughly 35 percent of government spending to public sector wages, significantly higher than the global average of 20–25 percent. Budget rigidity with high pre-committed expenses limits resource reallocation during crises. Structural reforms are needed to increase discretionary elements in budgets, allowing for reprioritization when necessary.
 

Strengthening Institutional Frameworks

Fiscal rules and medium-term fiscal frameworks set clear parameters for sustainable government finances, balancing immediate needs with long-term goals. Transparent budgeting processes enhance government credibility and decision-making, ensuring resources reach intended beneficiaries.
 

Employing Risk-Transfer Mechanisms

Insurance products and financial instruments can transfer a portion of disaster risk to global markets and provide predictable funding after a disaster. By including risk-transferring mechanisms in budget planning processes, governments can create a layered approach to disaster financing, complemented by emergency funds, flexible budgeting, and diversified revenue sources.
 

The World Bank Fiscal Resilience Program

The journey toward fiscal resilience is challenging, particularly for small island countries with inherent structural challenges. However, with strategic planning, political commitment, and international support, PICs can build financial systems capable of weathering even the most serious economic storms.

The World Bank, with support from the Japanese Government, recently launched the Fiscal Resilience Program to support Small Island Developing States in building resilience to economic and natural hazard shocks. The Program aims to provide just-in-time technical support to Ministries of Finance to undertake fiscal reform, focusing on efficiency improvements, strengthening of fiscal buffers, and analytical capacity to assess, mitigate, and respond to shocks.