Learning from Argentina's fiscal adjustment

4c ons Learning from Argentina's fiscal adjustment Argentina's success in reviving an economy strained by government spending shows the importance of building consensus among stakeholders, dispelling eco- nomic myths, and adjusting programs and policies to match economic realities. In recent years Argentina has made impressive cal adjustment was not, however, the only cuts in government spending. During the explanation for a stabilized economy and 1980s spending averaged 33.1 percent of renewed growth. Although fiscal adjustment Based on remarks GDP; in 1989 it reached 35.6 percent. In was important, Argentina would not have at the World Bank's 1990, however, it fell to 29.8 percent-and achieved stability-much less the uninter- Economists Week has continued to drop each year since. By rupted growth of the 1990s-unless it had conference made by 1996 government spending was 27 percent of also implemented many other reforms, Domingo Cavallo GDP. including monetary reform. We also would Spending has fallen even more than these not have achieved these results without numbers suggest because during the 1980s emphasizing the supply side of the economy. many expenses-mainly debts of public enter- Fiscal reform it is not just a matter of elimi- prises that had to be paid or transformed into nating the budget deficit or reducing govern- bonds-were not recorded. The budget deficit ment spending. Also important are how averaged 5.8 percent of GDP during the government spending is cut, tax revenue is 1980s; in 1989 it peaked at 7.6 percent. But increased, and the deficit is eliminated as infla- in 1990 the deficit fell to 2.3 percent and in tion is being lowered. 1991 the budget almost balanced. Small sur- Efforts to significantly cut government pluses were achieved in 1992 and 1993, the spending and to eliminate a chronic fiscal budget balanced in 1994, and there was a deficit must involve various levels of govern- small deficit in 1995. As part of the business ment-federal, provincial, municipal-in cycle the deficit rose to 2 percent of GDP in decisionmaking. The decision to cut spending 1996. For the 1990s as a whole, however, the and collect taxes should not be made solely by budget has nearly balanced. the president, by congress, or by the finance minister. Society as a whole-politicians, Not fiscal adjustment alone businesspeople, members of Congress, and public officials at every level-must work These impressive indicators of fiscal adjust- toward the same objectives. ment show how an economy that experienced The same is true for promoting competi- inflation of 750 percent a year in the 1980s tiveness: everyone must work together to managed to cut it to 1.6 percent in 1995. Fis- increase productivity. Getting social mecha- FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY OF THE WORLD BANK NO. 34 OCTOBER 1997  n nisis right in a society that has abused them provincial banks could collect money from requires removing unrealistic beliefs that prevent depositors and lend it to the provinces. Thus the the necessary adjustment. provinces continued to receive financing for huge deficits and excessive spending. Eventually, Forcing discipline however, the provincial banks that had borrowed from abroad ran into trouble. Depositors got Let me explain what I mean by removing illu- scared and tried to withdraw their deposits, but sions. Suppose that the mayor of a city, the pres- the provincial banks did not have sufficient liq- ident of a country, or the officials overseeing uidity to honor the depositors' claims. Some government agencies believe that the central provincial governments decided to pay the bank (or some other entity) can create credit. debts, but then they could not pay the wages of Thus everyone demands credit but no one tries public employees-creating another crisis. The to convince savers or investors to lend. Instead federal government was under enormous pres- they request credit from the central bank, believ- sure to bail out the provinces, but it could not ing that it can create it. But the central bank will do so because the central bank could not create only print a lot of money, causing high inflation money. Thus we visited Washington, D.C., seek- and redistributing resources in favor of the deficit ing assistance. agency or government. That, in turn, prompts We approached the World Bank, the Inter- defensive actions by those taxed through infla- American Development Bank, and the Interna- tion-spawning a vicious circle. tional Monetary Fund (IMF) for financing for be changed only But once people are convinced that the central the provincial banks-loans that were condi- through real bank cannot create credit, whoever runs a deficit tional on the banks' privatization and on elimi- decisions, not must seek a loan in the market. To get a loan, they nating the mechanism used to finance deficits in mmust inspire confidence in their ability to pay, in the provinces. Most provincial banks are now through monetary the quality of their investments, and in the qual- being privatized. And we are better off than tricks ity of their operations (if it is a business or a before because the new convertibility law and bank). When a society faces that reality, an monetary system has forced discipline-people important change occurs in favor of fiscal adjust- have learned that if they run a deficit, they must ment and discipline. borrow and someone must lend to them volun- That is what happened in Argentina. In the tarily. early 1990s we introduced a new monetary sys- A similar lesson holds for competitiveness. If rem that makes it absolutely clear that the only producers believe that competitiveness comes way the central bank can create money is by pur- from currency devaluation, they will not work to chasing foreign exchange. It cannot create money increase productivity and lower the costs of pro- by generating domestic credit. We did this duction. Similarly, policymakers will not elimi- because at the time of hyperinflation Argentines nate taxes that hinder competitiveness and were using the dollar, not the peso, as their cur- productivity. But if the illusion that competitive- rency. To induce Argentines to hold a local cur- ness can be raised through devaluation is rency, we had to create one that was not removed, everyone-inside and outside the gov- obligatory (because people still wanted to use the ernment-will work to lower the costs of pro- dollar) but that competed with the dollar. The duction. As a result competitiveness is new system established a stable currency and had permanently increased. The two lessons are an important fiscal effect because everyone real- related because when every economic actor is ized that anyone who ran a deficit had to go to held to a budget constraint, everyone accepts the the market to borrow. idea that monetary shocks or monetary decisions Provinces were exempted from the new sys- cannot affect relative prices. Real prices can be tem, however-and that was a problem. Under changed only through real decisions, not through Argentina's constitution the central bank cannot monetary tricks, particularly in economies that impose constraints on the credit that provincial in the past used such tricks to try to produce real banks give to the provinces. So for a while the effects.  the dramatic escalation of benefits that had been In addition, it is crucial to build the mechanisms occurring. and institutions through which members of soci- Today something interesting is going on in ety discover that fiscal discipline and budget con- Argentina. Almost daily, a new case of corruption straints are important. in the social security system is reported in the Some analysts carefully examine quarterly fig- press. Because now everyone cares. People realize ures and try to measure the overvaluation or that if someone receives benefits that they do not undervaluation of this and the excessive expan- deserve, someone else is getting less. Now people sion of that. It is much more important to pay are anxious to ensure, for example, that people attention to the rules of the game, to the organi- receiving disability benefits are actually disabled. zation and mechanisms that a society needs for Thus we have developed a mechanism by which transparency, and to prevent imbalances and people are trying to remove corruption and injus- deficits. If the problem is lack of competitiveness, tice from the social security system. and to address it a variable is adjusted by 5 or 10 For the future we are developing a new pen- percent, that does not solve the problem. Before sion system, based on Chile's, that will allocate discretionary decisions are made, their potential employee contributions to pension funds they effect on each segment of society must be con- choose. Some observers fear that such a system sidered. For example, the behavior of local agents will create fiscal problems because pension con- may not have been taken into account in Decem- It is essential to tributions will no longer be used to finance the ber 1994, when the Mexican authorities decided It is essential to old social security system. So, because we have that the peso had to be devalued 14 percent. introduce fiscal reduced spending in public enterprises, we plan Maybe they devoted a lot of time to identifying adjustment in a to earmark tax revenue to finance the old system. whether to devalue by 13, 14, or 15 percent. But country suffering they should have realized that the exact number fromunigh inflation Stressing organization was not the problem. Instead, it was that the gov- from high inflation ernment was changing the rules after having con- and stagnation Thus it is possible-indeed, essential-to intro- vinced investors that there would be continuity. duce fiscal adjustment in a country suffering And when the rules of the game are changed from high inflation and stagnation. But it is not unexpectedly, the outcome may be very different just a matter of saying that spending must be cut from what was hope for or expected. this way and revenue must be increased that way. -Domingo Cavallo This DECnote is based on remarks made by Domingo Cavallo at the World Bank's Economists Week conference, held October 30-November 1, 1996. DECnotes do not necessarily represent the views of the World Bank or its member countries-and therefore should not be attributed to the World Bank or its affiliates. DECnotes are produced by the Research Advisory Staff. We welcome your questions and comments; please e-mail them to the authors or to Evelyn Alfaro, DECRA. Prepared for World Bank staff  Adjusting taxes be spending more on health insurance and other social programs that are riddled with corruption. As noted, fiscal adjustment is not just about cut- In addition, lowering payroll taxes eased unem- ting government spending or increasing rev- ployment, which is a problem in Argentina enue-the means of adjustment is also because of stringent labor regulations and high important. In March 1991 IMF representatives taxes on wages. Of course, if a deficit emerges visited Argentina, and we had a terrible discus- because spending exceeds a predetermined level, sion. They did not believe that we could make a that is a problem. fiscal adjustment and, even if we could, they believed that we would adopt it too late. First, Revamping social security they said, we had to demonstrate that we could make the necessary fiscal arrangements. They Fiscal adjustment is not just about fighting tax were taken aback when I offered to eliminate evasion, not creating new taxes, not creating dis- export and other taxes-at the time taxes on torted taxes, or not increasing tax rates. It is about exports accounted for 30 percent of government implementing neutral taxes-such as corporate revenue. But in fact, Argentina had already com- or personal income taxes. Taxes that increase the mitted to eliminating export taxes-because they costs of investment, labor, or production should were taxing agricultural exports-as part of an be avoided. It is also crucial to find mechanisms agricultural loan from the World Bank that make spending more rational. Balancing the It was not that I supported the World Bank's Consider Argentina's social security system. prescription over the IMF's. It was simply my Until 1995 the law said that upon retirement (60 budget requires conviction that balancing the budget requires for men, 55 for women) people received benefits collecting taxes- collecting taxes-but taxes that are neutral, not based on the salary of someone who continued to but taxes that are distorted. Thus we removed twenty distortionary work in the same job. These benefits were com- taxes. Yet we generated much more revenue than pletely unrelated to the contributions made by neutral, not before. How? employers and employees and to the total distorted Once.prices stabilize, it is much easier to col- amount that the government had to distribute. lect taxes. Then, with a good invoicing procedure Such a system invariably generated deficits, injus- for determining a value-added tax, reorganized tice, and corruption. internal revenue and customs services, and sim- Because benefits were fixed by law, beneficia- plified tax laws, it is possible to collect much ries could go to court if they did not get their full more revenue from taxes. Taxes should not be too entitlements. Because the amount of money the high, however. It is easy to raise taxes or to create government collected was not linked to the new ones in order to produce a fiscal adjust- amount it paid out, the system generated a ment-but it is not the best approach. New taxes deficit. Moreover, those who benefited most may generate additional revenue, but they will from the system did not want to alter the not necessarily lower the deficit because govern- system-until a crisis occurred. Then, everyone ment and its agencies are prone to spending. For became frightened by the deficit and the risk to example, in Argentina 50 percent of new taxes go the country. to the provinces, which have a 100 percent In reforming the system, we told Congress propensity to spend. Thus it is better to collect that it had to be converted into a pay as you go only the revenue needed to support current system or a distribution system-that is, the gov- spending. ernment can only distribute what it collects. Moreover, a small deficit is not always a bad Thus, if revenue does not fully cover the obliga- thing-particularly if it is the result of a cut in tions laid out in the law, benefits have to be cut. distortionary taxes. Argentina's deficit in 1996, 2 And if the system runs a surplus, benefits have to percent of GDP, occurred because payroll taxes be increased. The new plan became effective on were cut drastically. Some analysts have criticized 1 January 1995. For the first time the govern- this move, but I think it was an excellent deci- ment was able to control social security spending, sion. If payroll taxes had not been cut, we would remove many overly generous benefits, and halt