Avoiding Fiscal Crises in a Deteriorating Global Economic Environment

The war in Ukraine and the aftershocks of the Covid-19 pandemic present emerging markets and developing economies (EMDEs) with an extremely challenging external environment, shaped by rising food, fertilizer and energy prices, rising inflation and interest rates and risks of stagflation in advanced economies.

Fifteen years ago, food price spikes, followed by the global financial crisis, then oil price hikes followed one another and governments dealt with each of these crises separately as they arose. were happening. Today, the crises all occur at the same time.

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Fiscal policy is the main instrument available to governments to mitigate the impact of these shocks on households and businesses, as monetary policy should focus on price stability. Unfortunately, many countries have exhausted fiscal space following the Covid-19 crisis.

Options for strengthening fiscal space include reallocating spending from lower priority programs to programs aimed at mitigating the economic and social impacts of war; improving spending efficiency; and increase revenue, including by broadening the tax base, making the tax system more progressive, and reducing tax evasion and evasion.

Even where there is fiscal space, strong inflationary pressures can limit the scope for expansionary fiscal policies. If pent-up demand is the main driver of inflation, expansionary fiscal policies could exacerbate inflationary pressures by widening the gap between aggregate supply and demand, and should therefore be avoided.

However, if inflation is mainly driven by rising commodity prices, it may be possible to implement remedial measures to mitigate the impacts on the most vulnerable, particularly if total production of goods and services of an economy is significantly below its potential.

A recent report from the World Bank’s Fiscal Policy and Sustainable Growth Unit sets out several key questions that can help countries design an appropriate response to these multiple negative shocks:

1. Economics of crisis mitigation measures

Levers for designing fiscally sustainable response measures include: (i) affordability the extent to which the instrument has an impact on fiscal stability; (ii) predictability and cost control the ability to set upper limits for the cost of a program and reasonably forecast costs; (iii) targeting benefits limited to specific enterprises, population groups or activities; (iv) resistance to abuse limiting leakage; and (v) reversibility the ease with which the response can be withdrawn if necessary, without causing economic and behavioral distortions.

2. Avoid a multiplicity of measures and prioritize

Where adequate social protection systems exist, it will generally be more effective to channel support to households by temporarily increasing existing benefits. Where such systems do not exist, focusing on a priority can help avoid administrative complexity and targeting difficulties. For many EMDEs, it may be food security.

3. Avoid general tax measures

Fiscal measures are ill-suited to alleviate the difficulties. Broad-based tax measures such as tax rate reductions or tax exemptions are generally difficult to target. While tax increases translate quickly into higher consumer prices, a tax cut 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 it, even if the rate reduction is announced as temporary.

4. Review grant programs

Sharp price increases can inflate the cost of existing subsidy programs for food, fertilizer and energy, which are often untargeted or poorly targeted. To ensure effective support for the most vulnerable, governments should consider reforms that improve targeting. This involves strengthening data on vulnerable households, individuals and businesses. While it is politically difficult to exclude beneficiaries from programs in an environment of rising prices, governments can at least consider differentiated levels of support based on need.

5. Energy sector interventions must not compromise climate objectives

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

Measures that temporarily relieve price spikes could shift to the introduction of carbon taxes to ensure that carbon prices remain at a level consistent with medium- and long-term climate change mitigation goals.

Targeted social protection measures to compensate vulnerable households facing energy price pressures are preferable to measures that reduce energy prices for consumers.

Taxing the windfall gains of carbon-based energy producers would reduce incentives for harmful investments in carbon-based energy sources.

Reducing dependence on fossil fuel imports from Russia by prioritizing investments in renewable energy instead of increasing domestic hydrocarbon production.

6. Developing countries may need support from the international community

Many developing countries, and especially low-income and fragile ones, may need the support of the international community to mitigate the negative effects on their economies, households and businesses. The World Bank Group’s response is outlined in the Global Crisis Response Framework document, which emphasizes a commitment to help countries meet these fiscal challenges through increased financing, technical assistance, and analytical and advisory activities to support green, resilient and inclusive development. This includes work on budget options for crisis response, monitoring impact on the poor, designing and advocating for debt solutions for the most vulnerable countries, building sector resilience financial.

Chiara Bronchi is Practice Manager, Tax Policy and Sustainable Growth, Macroeconomics, Trade and Investment at the World Bank. Eric Lacey is a Tax Policy Analyst, Tax Policy and Sustainable Growth, Macroeconomics, Trade and Investment. Robert Utz is Chief Economist, Fiscal Policy and Sustainable Growth, Macroeconomics, Trade and Global Investment Practice.