WB: Good Governance Helps Fiscal Policy Spur Economic Growth

GOOD GOVERNANCE HELPS FISCAL POLICY SPUR ECONOMIC GROWTH

World Bank Group, DC
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July 2 2007

New World Bank Report Recommends Spending and Tax Reforms to Enhance
the Impact of Public Finance on Growth in Eastern Europe and Central
Asia

BRUSSELS, July 2, 2007-Well-run governments get better results out of
their budget resources, according to Fiscal Policy and Economic Growth:
Lessons for Eastern Europe and Central Asia, released today by the
World Bank. The study draws on quantitative analysis and case studies
to confirm that more productive public spending, lower fiscal deficits,
and greater reliance on non-distorting taxes can spur economic growth.

The report reviews trends in public spending and taxation in Eastern
Europe, Turkey, and Central Asia (ECA) since the 1990s and how they
compare to trends in high-growth countries elsewhere in the world.

Middle-income countries in Eastern Europe typically have bigger
governments than comparator countries in Asia or Latin America because
of large social transfers. Primary public spending in Croatia is more
than double the size of that in Thailand, and the 8 Eastern European
countries that joined the EU in 2004 spend on average three times
as much on social transfers as Korea. The lower-income countries
in ECA have smaller governments, closer in size to the high-growth
comparators.

Once public spending exceeds about one-third of GDP, higher spending
is associated with lower growth in countries with weak governance,
but no such relationship exists in well-governed countries. "High
levels of public spending are risky when public institutions are
weak," says World Bank Country Manager and report co-editor Aristomene
Varoudakis. "Money is less likely to be well-spent, fiscal deficits
are more likely to emerge, and higher taxes needed to finance such
spending are more likely to distort business and worker decisions."

"The biggest challenge in most countries in ECA is to increase the
efficiency of public spending," emphasizes World Bank Sector Director
and co-editor Cheryl Gray. "This is particularly important to enhance
growth prospects and ensure that populations benefit from expenditures
in health, education, pensions, and infrastructure."

The study offers policy recommendations to enhance the efficiency
and effectiveness of public spending in these four sectors, drawing
on experience in high-growth countries such as Chile, Korea,
and Ireland. In education and health, for example, Eastern Europe
achieves good results but at a high cost. Reorienting spending away
from expensive vocational programs and high-cost hospital care,
moving to per capita financing, and realigning cost-sharing between
governments and students or patients can both help make public spending
more effective and yield better results.

Investing in infrastructure can help boost economic growth if project
selection is appropriate and operations and maintenance costs are
adequately funded. Removing implicit subsidies, especially in power
and water, can make resources available for maintenance while also
making infrastructure more attractive for private investment.

Armenia, for example, has taken important steps to reduce pricing
subsidies and improve collections in the power sector to ensure
financial viability, while ensuring an adequate safety net for needy
households.

Given aging populations, low employment ratios, and a legacy of
generous social protection, pension spending in Eastern Europe tends
to be much higher than in fast-growing countries elsewhere. Reforms
of pension systems need to create fiscal space for growth-enhancing
public spending while continuing to protect the most vulnerable. In
middle-income countries, public pensions need to be further streamlined
and complemented by privately-funded pillars and means-tested social
assistance. In low-income countries, a universal or means-tested
low-rate pension financed out of general revenues-as has recently
been adopted in Georgia-may be the best option.

On the revenue side of the budget, the study focuses on two questions
that are central in today’s debate: (1) What are the economic
impacts of the flat-rate income tax reforms sweeping through Eastern
Europe? (2) How can labor taxes be reduced to stimulate employment?

"Flat-rate income tax reforms have generally had positive effects in
Eastern Europe, but need to be complemented with additional steps to
modernize tax administration and reduce labor taxation," says World
Bank Senior Economist and co-editor Tracey Lane. The flat-rate income
tax reform in Slovakia closed tax loopholes and improved compliance,
and well-designed exemptions and changes in social benefits maintained
the progressiveness of the overall fiscal system.

Despite income tax reforms, labor taxes are still much higher in
Eastern Europe than in comparator countries and are associated with
lower formal employment and growth. The key to reducing labor taxation
and stimulating employment is to reform social benefits and move some
financing to general revenues rather than relying on wage taxes.

http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0

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