September 13, 2012
Many OECD countries suffer from high sovereign debts. Sooner or later, this problem must be addressed. Many argue that this will require some form of fiscal retrenchment or institutional reform or a combination of the two. This column argues that the two are not complements as many suggest – they are instead substitutes.
Many OECD countries suffer from high sovereign debts. Sooner or later, this problem must be addressed. That will require some form of fiscal retrenchment.
Quite often the fiscal problems are due to market rigidities, barriers to entry, and distortive tax systems. A programme of reform must therefore include both fiscal consolidation and institutional reform to enhance future growth. Growth and the larger tax base that goes with it provides the best prospect for solving the fiscal problems.
The obvious question regards timing. What should have priority: fiscal consolidation or institutional reform? A hard-line reasoning would argue that both should go hand in hand.
- Immediate fiscal consolidation to convince financial markets that policymakers stand to get the budget under control, and
- Institutional reform to increase the future tax base.
The more consolidation is put in place, the smaller the scope for institutional reform. Policymakers therefore face a trade off. The argument does not rely on political fatigue, but on the distribution of wealth between generations:
- Both consolidation and reform reduce the current generation’s wealth and hence their consumption.
- Too sharp a fall in consumption will lead to costly adjustment of production capacity, from consumption goods and non-tradables (which can only be sold on the home market) to investment goods and tradables (which can be sold abroad).