Committee for a Responsible Federal Budget

The IMF on Fiscal Adjustments

Apr 20, 2011 | Budgets & Projections

As we have been looking at a number of fiscal plans for the US recently, the IMF has a useful appendix in its most recent Fiscal Monitor on what has worked and what has failed in past fiscal consolidation attempts (a topic we have delved into in the past).

Of course, there is considerable uncertainty as to how much various fiscal plans will actually reduce the deficit due to varying baselines. To see what has worked in the past and what hasn't, the IMF looked at medium-term deficit reduction attempts since 1976 from across the G-7 countries. On average, the plans studied intended to reduce their three-year fiscal deficits by 1.7 percent of GDP, but only succeeded in reducing deficits by 0.9 percent of GDP. Overall, spending cuts ended up much smaller than expected, while revenues proved higher than expected.

In doing this comparison, the IMF learned many lessons about what makes a successful fiscal plan.

  • Initial ambition matters: Not surprisingly, going big makes it more likely for a plan to succeed in making the adjustments necessary. While this does not guarantee that a plan will meet those expectations, a plan that fails to meet its ambitious goals may still achieve large enough deficit reduction to successfully alter a country's fiscal path.
  • Growth matters: As  expected, economic growth -- or lack thereof -- makes a substantial difference in the fiscal outlook. Many plans were derailed by sudden financial crises that forced governments to reverse course (Japan in 1997, Britain in the late 2000s). On the flip side, higher than expected growth helped many plans exceed expectations, such as deficit reduction efforts in the US and Canada in the mid-to-late 1990s. To minimize risk for fiscal plans, the IMF suggests making longer term fiscal targets that allow for responses to negative growth shocks while still keeping an eye on the prize. Also, it would help to coordinate government so that, for example, monetary policy is kept looser in order to minimize the short-term economic harm of the cutbacks.
  • Structural reforms: The IMF found that plans which included structural reforms seemed more likely to reach their goals than those without. This point underscores the fact that fiscal debates need to be grounded in ideas about how our government should work. This should be encouraging for the US, since any legitimate fiscal plan will likely have to contain some structural reforms, whether it be in entitlements, in the tax code, or elsewhere.
  • Balance, balance, balance: There is no universal optimal spending and revenue balance in a fiscal plan, according to the IMF: "The revenue-expenditure mix of fiscal consolidation plans needs to reflect country-specific societal preferences and structural fiscal characteristics." Thus, the definition of balance may be open to interpretation based on the problems a country faces and the societal-preferences for size and scope of government.
  • Get the public on board: As was hinted at in the quotation in the last paragraph, the IMF believes that public support for a plan is important. Specifically, the IMF says that governments must educate the public about their country's fiscal issues and explain how those issues could be confronted in a credible matter. 

Clearly, the various lessons offered by the IMF have inherent tradeoffs. Certain structural reforms may very well be unpopular with the public. Striving to be ambitious or inclusion of certain pro-growth policies may sidetrack policymakers from getting the right balance. These are just a few examples of the challenges that lawmakers face in constructing a fiscal plan.

The IMF provides yet another useful reminder that it's not just about whether you cut and how much you cut, it's also about how you cut.