Address by Governor Carlos da Silva Costa at the opening session of the 8th Annual Conference of the Portuguese Economists’ Association
I would like to start by congratulating the Economists’ Association on this timely initiative.
The Portuguese public finance situation requires serious, informed, deep and comprehensive debate.
Public debt will reach €198 billion this year. This equals 119% of GDP, i.e. almost a year and three months of national production.
Public sector indebtedness represents an enormous burden on present and future generations, who are forced to allocate an important share of their wealth to servicing debt. The ratio of public debt to GDP greatly exceeds the threshold above which indebtedness is without doubt an obstacle to economic growth.
Notwithstanding the considerable fiscal adjustment undertaken in 2011 and 2012 and forecast for 2013, the public debt ratio remains on an upward path and is likely to stabilise only in 2014.
This unfavourable trend has been leading many people to advocate a slowdown of the fiscal consolidation pace, on the grounds that we are facing a negative spiral of fiscal adjustment and economic activity.
I have recently had the opportunity to speak in some detail about this kind of remedial action, and therefore today I will only reiterate the conclusion from that analysis. (2)
In the country’s current circumstances, a delay in fiscal adjustment would imply renewed financing needs and a worsening of the public debt sustainability problem, with a consequent additional loss of credibility.
Fast fiscal adjustment should therefore take priority. Adjustment should rely on structural expenditure cuts that pave the way to restoring confidence and allowing public finances to return to a sustainable path.
The increase in the weight of public debt in GDP was expected at an early stage of the adjustment process, although for many reasons developments were less favourable than initially forecast.We know that the trend of the debt ratio over time depends on three types of effect:
- The cumulative effect of economic growth (the so-called “denominator effect”)
- The cumulative effect of primary balance adjustment;
- The effect of fiscal consolidation on interest rates
In a first stage, the contraction of economic activity leads to a worsening of the public debt ratio. This is heightened by the fact that in the current circumstances fiscal multipliers are higher than usual.
As consolidation progresses, the cumulative effect of primary balance adjustment and the favourable impact of public finance consolidation on interest rates and the economy’s medium-term growth first lead to the stabilisation and subsequent decline of the indebtedness ratio. The process will be faster and more successful the more credible and growth-friendly the primary balance adjustment is.
This is the urgent debate that must take place. In order for it to be conclusive and pave the way to a real change in the fiscal regime, it should be based on a shared diagnosis of the Portuguese public finance situation.
I believe this diagnosis is now quite clear. Still, it is worth remembering the main features of the evolution of public finances from a longer-term perspective, before commenting on certain aspects that I see as critical for public finance sustainability.
II. Excessive public sector indebtedness is an outcome of decades of financial indiscipline
Excessive public sector indebtedness is not an outcome of the international financial crisis. Indeed, it reflects the structural saving gap that characterises the evolution of Portuguese public finances for the last 40 years and which was at the root of the two adjustment programmes agreed with the International Monetary Fund in 1978 and 1983.
The Portuguese public sector financial indiscipline has thus crossed different economic policy junctures and regimes, as well as various political configurations. This has not changed with the integration of the Portuguese economy into the euro area.
In the first 12 years of euro area participation the annual fiscal deficit was on average 5% of GDP, and the primary deficit was on average 2.2% of GDP. Based on current data, the fiscal deficit was never below 3% of GDP and the primary balance never posted a surplus. Fiscal policy was almost always pro-cyclical, therefore intensifying fluctuations in the economy.
The public debt ratio deteriorated successively, from close to 50% of GDP at the start of the millennium to over 70% of GDP in 2007 and over 90% of GDP in 2010. Throughout the whole period, indebtedness of state-owned enterprises also increased substantially, and so did the future liabilities associated with Public-Private Partnerships. The deterioration of the public sector net asset position was therefore much more marked than suggested by general government national accounts data.
If there were any doubts as to the unsustainability of such dynamics, they were surely eliminated by the Portuguese Treasury’s inability to obtain market financing as of early 2011, which inevitably led to recourse to international financial assistance.
The rise in indebtedness observed as of the outset of monetary union took place despite the worsening of the tax burden, from 32.1% of GDP in 1998 to 34.4% of GDP in 2010. The increase in the tax burden fell far short of public expenditure growth. Primary current expenditure – i.e. total expenditure excluding interest and investment spending – rose on average by 6.2% per year, much higher than the increase in nominal GDP, which was 3.8% on average.
In 2009-2010 public expenditure reached about 50% of GDP, i.e. close to the European average and clearly above expenditure levels that are typically observed in countries with similar per capita income. In 2010 Portugal ranked 17th among European Union (EU) countries in terms of per capita income, with an income corresponding to around two-thirds of the EU average. In the same year the weight of public expenditure in output was the eighth highest. The Czech Republic, with a per capita income only slightly below Portugal’s, recorded a public expenditure of 44% of GDP in 2010.
An analysis of the composition of expenditure shows that the most important items are social benefits and staff costs, which as a whole account for more than two-thirds of total public expenditure and around 70% of primary expenditure. Expenditure on social protection, particularly pensions, recorded the highest increase, accounting for around 19% of GDP in 2010. Spending on health, education and public security also increased considerably in terms of their weight in GDP.
This brief overview of the main public finance variables leads us to three inevitable findings:
- First, the level of public expenditure in Portugal is not compatible with the current tax burden;
- Second, the path of public expenditure observed in the past cannot be reconciled with the evolution of the economy’s productive capacity;
- Third, the trend of the Portuguese public accounts reveals the failure of the public sector financial regime.
These three findings result in three implications for the debate on a lasting sustainability of public finances.
First, it is urgent to reach wide consensus on the socially acceptable tax burden.
Second, expenditure programmes will have to be adjusted to ensure that they are compatible with the tax burden, the economy’s productive capacity and demographic trends.
Third, lasting sustainability of public finances also depends on deep reform of the fiscal framework and, more generally, of the public sector’s organisational and management rules.
Allow me to comment briefly on these three points.
III. Relevant aspects for the lasting sustainability of public accounts
The level of public expenditure must be compatible with a socially acceptable tax burden
It is up to political agents and society to determine the scope of intervention of the public sector and adapt the tax burden in order to guarantee fiscal sustainability. This is a complex choice which varies across countries, reflecting preferences that are influenced by historical, cultural and social factors.
A structural fiscal imbalance reflects a mismatch between the State’s role and the funding deemed necessary for the pursuit of its activities. Although there may still be persisting inefficiencies in public expenditure – that if eliminated would result in the provision of the same services with a lower expenditure level – the maintenance of chronic fiscal deficits reflects a need to redefine the State’s role.
There are many possible solutions, translating into different combinations of public services and taxation levels. It is possible to define two extremes: high-taxation countries with high levels of public services provision; and low-taxation countries with low levels of public services provision.
The level of public services provision is a social choice that should be well-informed. It concerns a series of essential goods and services subject to market failure and whose stable provision is an invaluable asset. It is therefore important that the choice reflects a high degree of social consensus and is not systematically put into question.
In other words, and to conclude this point, there is no optimal level of State’s intervention in the economy. However, one must guarantee that the social choice is conscious and consistent, insofar as – I repeat – it should translate into expenditure levels that are compatible with the tax burden.
The path of public expenditure must be compatible with the trend of the economy’s productive capacity
Public policies will have to be assessed and fiscal programmes resized, to ensure on the one hand a level of public expenditure that is aligned with a socially acceptable tax burden and on the other, expenditure growth that is compatible with the evolution of the economy’s productive capacity and demographic trends.
These factors are not independent. In particular, the composition of fiscal adjustment significantly influences the effects of such adjustment on economic growth in the short and medium term.
Vast empirical literature (3), studying public finance consolidation processes in different economies and moments in time leads to the conclusion that fiscal adjustments predominantly relying on expenditure cuts have a less negative effect on economic activity in the short term and benefit economic growth in the medium term.
The composition of expenditure cuts is also relevant, with the most successful experiences favouring reductions of current expenditure, including staff costs and social transfers. This is not a surprising outcome, insofar as these expenditures have the highest weight in total expenditure and also show the highest degree of rigidity.
By reducing uncertainty and creating expectations of lower future taxation levels, fiscal consolidation essentially based on permanent expenditure cuts stimulates private consumption and especially corporate investment.
Successful fiscal adjustment experiences also show that impacts on the level of economic activity crucially depend on other policies. In particular, structural policies aimed at increasing competition and removing barriers to the reallocation of resources, coupled with wide social consensus around the objectives and the measures of the reform programme signal a change of economic regime, also with a favourable impact on investment.
The reform of the public sector’s fiscal framework and management model is a necessary condition for the lasting sustainability of public finances
The institutional framework of public finances will have to be profoundly changed to ensure that primary balance adjustment is not reversed. Rules and procedures are needed that (i) generate fiscal objectives compatible with the medium and long-term sustainability of public finances in a context of stable taxes and (ii) ensure that budget execution occurs without slippages.
One must acknowledge the important improvements in the fiscal governance model. I am referring, for example, to changes in the Budgetary Framework Law of May 2011, the setting-up of the Portuguese Public Finance Council in October, or the approval this year, for the first time, of a multiannual budgetary framework containing indicative limits for the major expenditure areas up to 2016 (4).
However, we still have a long way to go to align the Portuguese fiscal management model with international best practice. The diagnosis on the Portuguese fiscal process is complete and the options are clear. This is shown in the strategic plan to create the institutional bases for public finance sustainability, included in the report accompanying the draft State Budget for 2013 (5).
This strategy must now be decisively implemented with the political priority and resources it needs, and promoting the involvement of the main stakeholders, namely the executive and wider government, the Parliament and the Court of Auditors.
In addition to fiscal reform, there must be a deep parallel reflection on the public sector organisational and management model and a strategy allowing for the future development of highly qualified and respected public servants. A model relying on the principles of delegation and accountability and the correct alignment of incentives will lead to efficiency gains in the production of public goods and services. Hence, the impact on society from the inevitable cut in resources allocated to the main expenditure areas will be minimised.
In 2011 for the third time in less than four decades, the Portuguese State was forced to resort to international financial assistance.
The lasting sustainability of public finances is one of the key concerns of the adjustment programme agreed with the European Union and the IMF.
The same concern was present in the programmes agreed with the IMF in the late 1970s and early 1980s, albeit less visibly. In that period, restoring the sustainability of public debt relied on the monetary financing of fiscal deficits, which in turn led to an increase in inflation and currency devaluation. In practice, inflation promoted the transfer of wealth from the holders of net financial assets and recipients of fixed nominal benefits, including pensioners and workers, to present and future debtors, in particular the State.
The existence of money illusion led to a misunderstanding of the phenomenon. However, this does not mean that the adjustment costs were lower. Actually, the real value of wages, pensions and savings fell and currency devaluation perpetuated a production specialisation model based on low wages.
In the current context, in which euro area participation guarantees nominal stability, the taxation needed to ensure public finance sustainability becomes transparent, as does the burden-sharing associated with different policy options. We no longer benefit from the numbing effect of money illusion – and we should appreciate this: the door is thus opened to guarantee that public expenditure is subordinated to a socially acceptable tax burden and to establish a range of priorities legitimised by social and political choices.
Thank you very much.
Lisbon, 13 November 2012
(1)As prepared for delivery.
(2) The Portuguese Economy: Structural saving gap and policy options - Address by Governor Carlos da Silva Costa at the Inauguration of the Academic Year of the University of Porto School of Economics and Business, 31 October 2012.
(3) See for example Mauro, P. (ed), Chipping away at public debt – Sources of failure and keys to success in fiscal adjustment, Wiley, 2011 and Alesina, A., Carlos Favero and Francesco Giavazzi (2012), “The output effect of fiscal consolidations”, NBER, WP 18336, August 2012.
(4)Law No 22/2011 of 20 May amending for the fifth time Law No 91/2001 of 20 August (Budgetary Framework Law); Law No 54/2011 of 19 October approving the Statute of Public Finance Council and Law No 28-2012 of 31 July approving the multiannual budgetary framework for the 2013-2016 period.
(5) Creation of the institutional bases for public finance sustainability: 2013-2015 strategic plan, Annex A1. of the 2013 State Budget report .