Averting fiscal crises in a deteriorating global economic environment

Fiscal policy is the key instrument for government to mitigate the shocks from COVID-19 and the war in Ukraine. But the space for expansive fiscal policies could be limited.

The war in Ukraine and aftershocks from the COVID-19 pandemic present Emerging Market and Developing Economies (EMDEs) with an extremely challenging external environment shaped by higher food, fertilizer, and energy prices, rising inflation and interest rates, and stagflation risks in advanced economies. Fifteen years ago, spikes in food prices, followed by the global financial crisis, and then by increases in oil prices were sequential and governments addressed each of these crisis separately as and when they occurred. Today the crises are happening all at once.

Fiscal policy is the key instruments for governments to mitigate the impact of these shocks on households and businesses, as monetary policy must focus on price stability.  Unfortunately, many countries have a depleted fiscal space following the COVID-19 crisis. Options to strengthen fiscal space include reallocating expenditures from lower priority programs toward programs aimed at mitigating the economic and social impacts of the war; improving the efficiency of spending; and raising revenue, including by broadening the tax base, making the tax system more progressive, and reducing tax avoidance and evasion.

Even where fiscal space exists, strong inflationary pressures may limit the scope for expansionary fiscal policies. If pent-up demand is the primary driver of inflation, expansionary fiscal policies could exacerbate inflationary pressures by widening the gap between aggregate supply and demand, and so should be avoided. However, if inflation is primarily driven by increases in commodity prices, there may be scope to implement measures that address this to mitigate the impacts on the most vulnerable, especially if an economy’s total output of goods and services is significantly below potential.

A recent report by the World Bank’s Fiscal Policy and Sustainable Growth unit sets out several key issues that can help countries design an appropriate response to these multiple adverse shocks:

1. Economy of crisis mitigation measures

Levers to design fiscally sustainable response measures include: (i) affordability the extent to which the instrument impacts fiscal stability; (ii) predictability and control of cost the ability to set upper limits for the cost of a program and reasonably predict costs; (iii) targeting limiting benefits to specific businesses, population groups, or activities; (iv) abuse resistance limiting leakages; and (v) reversibility  the ease with which the response can be withdrawn when appropriate, without causing economic and behavioral distortions.

2. Avoid a multiplicity of measures and prioritize

Where adequate social protection systems exist, it will typically be most efficient to channel support to households by temporarily scaling up existing benefits. Where such systems do not exist, focusing on a priority can help avoid administrative complexity and difficulties in targeting. For many EMDEs, this may be food security.

3. Avoid broad tax measures

Tax measures are ill suited to mitigate hardship. Broad-based tax measures such as reductions in tax rates or tax exemptions are typically difficult to target. While increases in taxes are quickly reflected in higher consumer prices, a reduction in taxes does not lower prices (unless administrative capacity is very high). Moreover, once a tax rate is reduced, political economy constraints make it difficult to reverse, even if the rate reduction is announced as temporary.

4. Review subsidy programs

Sharp price increases can swell the cost of existing subsidy programs for food, fertilizer and energy, which are often not or only poorly targeted. To ensure efficient support for the most vulnerable, governments should consider reforms that enhance targeting. This involves strengthening data on vulnerable households, individuals, and businesses. While excluding beneficiaries from programs is politically difficult in an environment of rising prices, governments may at least consider differentiated levels of support based on needs.

5. Energy sector interventions should not undermine climate objectives

When considering relief measures for high energy prices, it is important to consider the impact on climate objectives:

• Measures that give temporary relief from peak prices could transition to the introduction of carbon taxes to ensure carbon prices remain at level that is consistent with climate mitigation objectives in the medium- to long-term
• Targeted social protection measures to compensate vulnerable households facing energy price pressures are preferable to measures that reduce energy prices for consumers.
• Taxation of windfall gains of producers of carbon-based energy would reduce incentives for harmful investment in carbon-based energy sources.
• Reduced dependence on fossil fuel imports from Russia by prioritizing investments in renewable energies instead of scaling up domestic hydrocarbon production.

6. Developing countries may need support from the international community

Many developing countries, and most importantly low-income and fragile countries, may need support from the international community to mitigate adverse impacts on their economies, households, and businesses.  The World Bank Group’s response is set out in the Global Crisis Response Framework paper, highlighting engagement in supporting countries to address these fiscal challenges through scaled-up finance, technical assistance, and analytic and advisory activities to support green, resilient, and inclusive development. This includes work on the fiscal options for crises response, monitoring the impact on the poor, design and advocacy for debt solutions for the most vulnerable countries, enhancing the resilience of financial sectors.