The temptation to finance all spending through debt must be resisted

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The writer is the first deputy managing director of the IMF

There has been much focus on monetary policy in the aftermath of the pandemic and Russia’s war in Ukraine, and justifiably so. But if recent turbulence in bond markets is any signal, the winds are shifting. This calls for a renewed focus on fiscal policy, and with it, a reset in fiscal policy thinking.

In response to Covid and to the war, governments were called upon to act as “insurers of first resort” for their citizens. This added a heavy fiscal burden to already-high levels of debt. Looking ahead, there are large ageing-related spending needs in advanced economies, while emerging and developing economies (EMDEs) require sizeable public investment to achieve sustainable development goals. Next, pile on rising defence spending amid escalating geopolitical tensions; and then overlay this picture with the resurgence of industrial policies with expensive price tags. We also cannot ignore the massive public resources required for the climate transition.

Add all that up, and we estimate that, annually, additional spending over current levels could surpass 7 per cent of gross domestic product ($6tn) by 2030 in advanced economies and exceed 8 per cent of GDP ($5.3tn) in EMDEs. By any scale, these numbers are enormous.

In the halcyon days of lower-for-longer rates, governments could finance their spending through low-cost borrowing. In today’s environment — where it is politically difficult to cut spending or raise taxes — debt-financed spending may still seem tempting. However, that would be a grave mistake, setting debt on an unsustainable trajectory as borrowing costs rise sharply.

With record-high debt levels, higher for longer interest rates, and growth prospects at their weakest in two decades, restraint is required — even for reserve currency issuers. Indeed, the US has some of the largest deficits, at 8 per cent this year and expected to average 7 per cent over the next few years. At these rates, general government net interest payments in the US would grow from 8 per cent of revenues ($486bn) in 2019 to 12 per cent ($1.27tn) in 2028. Given the centrality of the US to global financing conditions, putting its fiscal house in order is paramount — for itself and others, who are getting hit by rising rates and weaker currencies.

But the US is not the only country that should heed this advice. While specifics vary, several principles of a reset in fiscal policy thinking are common to all.

First, we need to rethink what governments can do. They cannot be the insurer of first resort for all shocks. Pandemic support measures averaged 23 per cent of GDP in advanced economies and 10 per cent of GDP in emerging markets. European economies spent on average 2 per cent of GDP to shield households and businesses from last year’s energy crisis.

Few countries have capacity to repeat these efforts. Given a more shock-prone world, depleted fiscal buffers need to be rebuilt and enlarged. Any future responses to shocks should be better targeted to the most vulnerable and made temporary by design. For several advanced economies with ageing populations, entitlement reforms are inescapable. Many EMDEs need to reduce the footprint of state-owned enterprises, which strain the public purse and often fail to deliver effectively. As for industrial policies, think time-bound, well-targeted to address market failures, and well-governed to prevent rent-seeking and loss of competition. We need to be candid: for many industrial policies, these conditions are simply not met.

Second, revenues need to keep up with spending. One element is to put a floor under tax competition mitigating a race to the bottom. The minimum corporate tax under pillar two of the OECD inclusive framework agreement could boost global corporate tax revenues by more than 6 per cent. Wealth also needs to be taxed effectively by closing loopholes in capital gains and property taxes, and through enforcement. EMDEs urgently need to grow their tax base. We estimate that they can feasibly increase their tax-to-GDP ratios by between 5-8 percentage points, and low-income economies by 7-9 percentage points.

Carbon pricing must be on the table. It can both catalyse and pay for the climate transition while supporting the vulnerable. Importantly, countries need to invest in measures that boost growth and help pay for themselves, such as early years education, critical infrastructure investment, and improved governance.

Third, fiscal frameworks need strengthening. More than 100 countries have fiscal rules but deviations are frequent. Few have contained debt since the global financial crisis. This requires credible plans, better integrated with annual budgets and anchored on spending targets. They must be able to respond to shocks but with clear mechanisms to correct for non-compliance. Independent fiscal councils can also enhance checks and balances.

These are demanding times for policymakers. Amid ongoing shocks, the pressure to deliver social support and structural transformation is immense. Doing so means setting spending priorities that raise growth alongside a serious dialogue around revenue-raising to ensure sustainable debt paths. Putting fiscal houses in order is essential to ensure governments can deliver for their people.