Chapter

I. Introduction

Author(s):
International Monetary Fund
Published Date:
September 1986
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A major role of the Fund is to help economic adjustment by providing temporary finance to member countries which have a balance of payments deficit. Before the Fund provides finance it first works out with the authorities a set of policies to, inter alia, restore a sustainable balance of payments. While these policies are focused primarily on external financial flows, they also inevitably affect the domestic income distribution. Thus, although the Fund officially maintains that distributional issues are primarily an internal political concern, it, indirectly, has always been concerned with distribution and resource allocation issues and has recognized the relationship between external and domestic policies in its adjustment programs.

Indeed, the relationship is at the root of all discussions for the use of Fund resources, as the distributional effects of Fund-supported adjustment programs clearly have important implications for both the Fund and those countries considering the use of Fund resources. If Fund-supported adjustment programs imply that specific income classes (and in particular the poor) inevitably bear the brunt of the economic costs involved, then those programs would be both less acceptable and, in the long run, less effective than the available alternatives. To determine the effects of Fund-supported programs on domestic distribution, the programs of the last few years are examined, with particular concentration on the fiscal content and the effect of these policies on income distribution.

The very nature of these programs and the circumstances in which they are formulated make the assessment of their effect on income distribution difficult. Countries implementing a program typically do so because they otherwise face an even greater shortage of foreign exchange that will further retard growth and may well lead to severe economic disruption. Under such circumstances, the objective of these programs is to restore a country’s external balance and establish an environment for higher growth; this necessarily focuses on adjusting the levels of macroeconomic aggregates and usually emphasizes movements in aggregate demand in the context of measures to remove supply constraints (particularly for export supply).

Fiscal policies are also an important component of the adjustment process, often representing the major focus of new policy initiatives. However, it should be realized that the relationship between distributional concerns and fiscal policies is different than that for policies which act through private markets and the pricing system. Changes in the exchange rate, for example, have an immediate effect on resource allocation, but the most far-reaching structural changes in fiscal policies with which the Fund has been connected usually take several years to implement and are frequently not technically part of Fund-supported programs at all. Typically the best and most fundamental fiscal reforms are achieved through technical assistance undertaken with full collaboration and support of the authorities separate from discussion on a program with financial support, performance criteria, and policy reviews. This said, it is not uncommon for previous technical assistance recommendations to be implemented within the framework of a Fund program, and technical assistance requests often originate from and are given impetus by the requirements for an orderly adjustment program supported by the Fund.

In theory under certain conditions the desired change in the macroeconomic aggregates could be accomplished without affecting relative prices and hence distribution; in practice, the focus on supply-side considerations emphasizes changes in relative prices as a key element in the adjustment process. Through these changes appropriate incentives are transmitted throughout the economy. The issue is thus not whether various income classes, socioeconomic groups, or factors of production are affected by a Fund-supported program, for they must be if the economy is to adjust. Instead, the critical issue is whether income size and distribution would be enhanced or worsened in the medium term without a Fund-supported program. Is there an alternative set of policies which would promote the social and growth objectives more effectively than Fund-supported adjustment programs?

There are two primary obstacles to answering this question. The first is conceptual. Ideally, Fund-supported programs would have to be compared with the set of policies which the country would have pursued without a Fund-supported program—that is, compared with a “counterfactual” argument—and the time frame would have to be sufficiently long to allow the economy to achieve a new equilibrium. Clearly, economic analysis has not progressed to the point where this approach can be successfully undertaken. Not only are there no economic models sufficiently accurate to undertake this comparison with confidence, but most countries do not by themselves identify an adequate adjustment program before approaching the Fund. In these circumstances it is difficult to specify a set of alternative policies which would address the countries’ needs. Simple extrapolation of existing policies leads to the conclusion that income size would be seriously depressed, with uncertain but probably unfavorable consequences for distribution.

The second obstacle is one of application, relating to the nature of Fund-supported adjustment programs. These programs are not “Fund” programs, but “Fund-supported,” and the country plays an active role in their formulation. When negotiating a program, a country normally chooses policy mixes with little regard for outside concerns of equity and often emphasizes economic or political objectives other than those of income distribution. Moreover, subsequent changes in various policies, with their differing implications for income distribution, may still be consistent with the key macroeconomic objectives of the programs and observance of the performance criteria under the arrangement. Thus, the program finally implemented may have a very different distributional result than what the Fund would have advocated solely on the need for adjustment.

Given the impossibility of satisfactory empirical analysis, the study proceeds by reviewing the measures undertaken in the context of 94 Fund-supported adjustment programs during the period 1980–84 and assesses their effects on the various socioeconomic groups in the economy to determine their implications for domestic income distributions. In this way a link is maintained between macroeconomic theory and actual program experience without confronting intractable problems of quantification. As a presentational aid, the discussion is supplemented by tables summarizing each type of measure undertaken; a detailed look at the characteristics of specific programs is provided in Appendix III.

The tables indicate that a variety of measures were undertaken in the adjustment process. All programs limited monetary or credit expansion, a primary means of monitoring Fund-supported adjustment programs. Among other principal policy actions, 55 percent included measures to liberalize and reform external trade and 91 percent included measures to restrain government expenditure. Also, measures to improve revenue performance included personal income taxes in 46 percent of the programs, corporate taxes in 34 percent, and taxes on domestic goods and services in 73 percent. And finally, expenditure restraints included limits on the growth of wages and salaries in 63 percent of the programs, on purchases of goods and services in 54 percent, and on different types of transfers and subsidies in 61 percent.

The study begins by identifying in greater detail the difficulties in undertaking an empirical analysis (Section II), then proceeds to consider the problems likely to face a typical country about to implement a Fund-supported program. To set the context for the extended discussion of economic policies contained in the rest of the paper, the remainder of the section emphasizes the need for adjustment by developing a counterfactual argument depicting what outturn may develop if the authorities do not act decisively to cope with economic realities.

The main arguments are contained in Sections III through VII and begin (Section III) with a brief discussion of the effects of monetary policies and exchange rate movements on the distribution of income. Exchange rate action is often regarded as the single most important policy instrument of structural adjustment employed in Fund-supported financial programs, but its full effect on income distribution is obscured by the relatively long adjustment process it initiates. Broadly, labor and capital employed in sectors favored by the devaluation will enjoy relatively higher incomes than those in other sectors. This could enhance the position of, say, traditional agriculture at the expense of urban dwellers in many developing countries, but it does not necessarily follow that the income distribution will become more unequal or even that the poor will incur a decline in their standard of living, for both sectors may include large proportions of poor people. It is likely, however, that the immediate impact will favor those with capital held abroad (often a small, wealthy, urban class) compared with those with domestically invested capital (typically farmers and smaller businessmen). In the longer run, the exchange rate actions should lead to increased growth and employment, raising the level of income. These opportunities should lead to an increase in the absolute standard of living in the longer run, even for the poorest quartile.

Keeping in view the effects of these macroeconomic policy changes, the rest of the paper examines how fiscal policies affect the adjustment process, with frequent references to the linkage between fiscal policies and monetary developments. The next main focus is the revenue system, including both direct and indirect taxes (Section IV). The thrust of the examination of corporate and personal income taxation is that changes in these taxes in the context of Fund-supported programs are likely to have little effect on the distribution of income. Taxes on goods and services have been important fiscal instruments in Fund-supported adjustment programs. Evidence shows that these taxes affect the distribution between sectors (rural versus urban) and between different consumption patterns of individuals (e.g., smokers and drinkers versus those who do not smoke or drink) more than they redistribute between income groups. Short-run revenue needs often lead to increases in indirect taxes which may be regressive, but this phenomenon is not restricted to developing countries or countries undertaking Fund-supported adjustment programs.

Fund views have had little influence on specific functional expenditures (Section V); usually the authorities decide where to cut expenditures. Of the 94 programs studied only 3 have an explicit reference to a government functional expenditure and less than one third of the programs refers to government functional expenditure policies at all. In this area the Fund’s impact has been relatively minor, although staff views are frequently placed before the authorities for consideration.

In contrast, efforts to limit excessively expansionary fiscal policies through changes in expenditure policies relating to the economic categories of expenditure, especially on wages and salaries, food and petroleum subsidies, and transfers to cover the losses of public enterprises, are perhaps the most important and controversial aspects of Fund-supported adjustment programs (Sections VI and VII). Wage and salary policies in programs have tended to redistribute income in favor of the agricultural poor and pricing policies have been directed at reducing the incomes of firms and individuals who profit from government-created monopolies in the importation and distribution of goods. The reassessment of food subsidies under Fund-supported adjustment programs often redistributes the benefits away from the urban to the rural population. There also have been some successes in targeting subsidies more accurately to those who most need subsidized food. Moreover, the removal of petroleum subsidies redistributes income away from factors employed in the existing inefficient technological base toward a more broadly based employment-generating technology and, by removing subsidies on the use of private vehicles, promotes the development of mass transport systems which are typically used by lower-income groups. Thus, in these respects the most controversial aspects of Fund-supported adjustment programs ironically may well have been those which have had the most obvious success in improving income distribution.

Although government participation in the market economy is often justified by its effects on the existing income distributions, in practice nonfinancial public enterprises frequently become a major financial burden on the economy and have incalculable allocative consequences, with distributional implications that favor only labor and capital employed in the (usually large urban) loss-making enterprises. Although Fund-supported programs often encourage the government to raise public enterprises’ prices, these measures may have little distributive impact. The higher official prices frequently only acknowledge prices already charged in parallel markets and thus merely act to validate the hitherto hidden transfer of resources. At the same time, they also transfer incomes from the unofficial, untaxed sectors to individuals and companies liable to taxation (both direct and indirect) and thus, probably, improve equity.

Public debt fiscal policy is concerned with the ownership and maturity structure of the debt. The distributional consequences are diffuse and difficult to assess but it is argued (Section VII) that typical program recommendations to limit public sector borrowing, to broaden the ownership of public debt, and to finance domestic borrowings at positive real interest rates are likely to improve the allocation of capital, increase the long-term productive potential of the economy, secure a better funding for social security provident funds, retirement plans, life insurance schemes, and other programs which form a captive financing source, and thus reduce future needs for taxation. This environment is likely to be more favorable for distributional concerns than a system which is constrained by low levels of capital investment, an unvested social security program, and the need to increase taxation to finance domestic and foreign interest payments.

Finally, Section VIII draws together some of the lessons of this review. It observes that the types of policies undertaken in Fund-supported programs have important implications for the distribution of income and could improve the equality of income distributions. It notes that it is impossible to accurately quantify the effect of the programs on income distribution because of the absence of adequate figures but concludes that, in general, Fund-supported programs have improved rather than worsened income distribution.

Still, Fund-supported adjustment programs have been controversial, and the effects of their policies on the poor have been a source of criticism. Clearly, the overall compression in domestic consumption that is required in some circumstances may be so great that it does lower the incomes of the poor; however, the income distribution has not necessarily been made more regressive as higher income groups may be affected more. Indeed, in the absence of Fund-supported adjustment programs and the financial support they provide, both directly and indirectly, the required compression in incomes might well have been even more drastic.

A second but perhaps no less important factor is the source of domestic economic imbalances. Demand management problems are often characterized by the establishment of inappropriate economic policies which benefit relatively small population groups. When the costs of these policies are transferred to the population as a whole, the costs are spread so thinly that they do not excite public interest until they are well established as “acquired rights” in the minds of those who benefit from the programs. The reversal of these policies in even a phased manner thus adversely affects a limited group more than it benefits the general population. Moreover, often the beneficiaries of preferential treatment are urban workers, civil servants (including the military), and owners or controllers of protected industries, all of whom are more likely to speak out and threaten retaliation than rural agricultural workers. These characteristics of the affected group are usually the reason why the programs were begun, and they remain reasons why it is difficult to terminate them. The really poor are normally too unorganized to make an effective protest when specific programs are modified and often never qualified for the benefits in the first place. Any furor over Fund-supported adjustment programs may thus be more directly related to who is being affected than to the burden of adjustment which is imposed.

In the final analysis, the official Fund position on distributional issues remains that distributional policies are entirely a sovereign issue.1 If the Fund were to move away from this position, which has served it well in the past, it could be difficult to establish precise limits for policy advice on distributional concerns in the future. It should be noted, however, that while the Fund has in the past omitted explicit recognition of distributional issues in the programs it has supported, those concerns are clearly an important consideration in determining the political feasibility of programs and how much of the adjustment can be maintained beyond the program period, and are thus an inherent if unspecified element of all Fund-supported adjustment programs. Moreover, if the authorities ask the Fund to evaluate alternative approaches to meeting their distributional concerns the Fund is (and has been) prepared to do so.

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