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IV Stance of Fiscal Policy and Non-Oil Economic Growth

Author(s):
Volker Treichel, and Ahsan Mansur
Published Date:
November 1999
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Author(s)
Volker Treichel

Stance of Fiscal Policy and Non-Oil Economic Growth

Oman’s economy is dominated by the oil sector and a large central government. Oil accounts for about 40 percent of GDP. about 92 percent of exports, and about 75 percent of budgetary revenues.1 Central government expenditure was equivalent to about 49 percent of GDP on average during 1981—95, one of the highest ratios in the world. Budget deficits have been high, averaging about 10 percent of GDP over 1991—95. Fiscal adjustment has become an increasingly important concern for Oman, since the assets of the State General Reserve Fund (SGRF)—established in 1980 to create a source of revenues after the exhaustion of oil reserves—have been substantially depleted to finance the large budget deficits. The government has been fully aware that the fiscal policy stance pursued through 1995 is unsustainable, and accordingly it adopted a medium-term fiscal consolidation plan beginning in 1996 as part of its Fifth Five-Year Plan. As a result of the government’s swift implementation of policies envisaged under the FFYP, the budget deficit declined to an average of 2.4 percent of GDP in 1996–97, and the ratio of expenditure to GDP fell to about 38 percent. The effect of fiscal contraction on non-oil real GDP growth has been moderate, which might be evidence for an increasing robustness and independence of private sector economic activity from the government’s impulses.

This section analyzes developments in fiscal policy in Oman since 1981 and examines the effect of fiscal policy in sustaining growth in Oman’s non-oil real GDP. Based on the findings from this analysis, the section offers a strategy for achieving fiscal consolidation while contributing to sustained economic growth in the medium term.

The empirical analysis presented in this section indicates that Oman’s stance of fiscal policy differed across four distinct subperiods covering 1981–97. Fiscal policy was expansionary and deficits grew during 1981–86 because, despite a falling oil price, expenditure was not restrained. Non-oil real GDP grew by about 12 percent a year on average during this period, largely because of the expansionary stance of fiscal policy. During 1987—91, in response to sharply lower oil prices, the stance of fiscal policy became contractionary, primarily driven by restrictive expenditure policies. The decelerating impetus to economic growth, partly resulting from declining fiscal outlays, contributed to a deceleration of the average growth rate of non-oil real GDP to about 4 percent. During 1992–95 fiscal policy was at first expansionary, in the aftermath of the Gulf war, and then turned moderately contractionary. During 1996–97 fiscal policy became increasingly contractionary, in line with the FFYP’s objective of achieving a balanced budget by 2000. During 1981–97 the composition of expenditure changed substantially, with the share of current expenditure increasing significantly at the expense of capital expenditure. The econometric analysis in this section shows that, as expected, the real growth rate of expenditure goes a long way toward explaining the growth of non-oil real GDP; furthermore, the two variables appear to be cointegrated, indicating long-run stability of the impact of fiscal policy on growth. Importantly, the behavior of recursive parameter estimates suggests that the importance of the fiscal impulse seems to have declined in recent years, as non-oil GDP has increasingly gained its own momentum.

Given that the stance of fiscal policy in recent years has been judged unsustainable, the section also discusses the authorities’ fiscal adjustment plan under the FFYP. Taking into account the Indonesian experience and the recent literature on fiscal policy and growth, the section argues that, although the pronounced retrenchment of current expenditure called for under the FFYP would be most desirable, it should be coupled with a more ambitious effort to increase non-oil revenue.

The section first briefly reviews some of the literature about the relationship between fiscal policy and short- and long-term economic growth. It analyzes certain aspects of Oman’s fiscal policy since 1981: first, trends in revenue and expenditure are identified; second, the stance of fiscal policy in Oman since 1981 is assessed using fiscal impulse analysis; and finally, the link between expenditure policy and the growth of non-oil real GDP is analyzed econometrically. The question of the sustain-ability of Oman’s recent fiscal policy stance is then addressed. Finally, a fiscal adjustment strategy is proposed that would limit short-term adjustment costs and he conducive to a sustained high growth rate of non-oil real GDP over the medium term.

Fiscal Policy and Growth: An Overview of the Literature

The economic literature generally distinguishes between short and long-term effects of fiscal policy on real economic growth. That fiscal policy can have effects on growth in the short run is a relatively non-contentious proposition. The idea was first set out theoretically by Keynes (1936) and later formalized by Hicks (1946) in his IS-LM framework. A sufficiently expansionary fiscal policy would be expected to drive up aggregate demand and push nominal GDP beyond its potential in the short run. However, the expansionary fiscal impulse would not be fully transmitted into a higher growth rate, for two reasons. First, under the assumption of a fixed money supply, the expansionary stance of fiscal policy could trigger an increase in interest rates, which would depress investment. Second, if the money supply were adjusted to accommodate the increase in money demand and allow for a constant level of interest rates, inflation might rise and depress growth. Both effects undermine the long-run sus-tainability of the fiscal impulse: interest rates or the inflation rate might rise to such levels that the expansionary effects of fiscal policy on output would be fully crowded out.

The idea that there could be a causal relation between fiscal policy and long-term growth is relatively new.2 In neoclassical growth models, growth is entirely determined by exogenous factors (Solow, 1956). Only in the context of the endogenous growth literature (e.g., Romer, 1986), whose basic claim is that economic policies can directly influence the growth rate of a country, has the role of fiscal policy been reassessed as an important factor contributing to growth. The impact of fiscal policy on the long-run growth rate of a country can be analyzed by considering separately the influences of tax policy and of expenditure policy as well as that of overall fiscal policy on the economy.

Tax Policy

In general, taxes are thought to have a contractionary impact on growth. Taxes distort the allocative decisions of economic agents from what they would be in the absence of tax. For example, a tax on income from physical capital could lower the after-tax return to saving and therefore serve as a disincentive to accumulating physical capital. The overall effect on growth of this tax would depend on how the other factors of production, which cooperate with physical capital in the production process, are affected by the tax, as well as on the production function of the economy. Therefore, the impact of taxation on growth will depend crucially on the tax structure—that is, on the distribution between direct and indirect taxes, and in particular that between consumption and income taxes.

Expenditure Policy

Although public expenditure may displace private sector output (through the crowding-out effect), it may also improve private sector productivity (by means of an externality effect) through the accumulation of public infrastructure as well as of human capital. Therefore, the structure of expenditure has an important influence on the rate of economic growth. Traditionally, expenditure was divided into public consumption, which was generally considered to be unproductive, and public investment, which tends to foster growth. This distinction, however, is questionable, since expenditures on education and alleviating income inequality may have growth-enhancing effects yet are generally regarded as public consumption, whereas public investment may include some public projects whose impact on growth is doubtful. Therefore, the emerging consensus is that expenditure may be more usefully categorized as either productive or nonproductive. Recent research (Tanzi and Schuknecht, 1995) also shows that the relationship between expenditure and growth may not be monotonic: in fact, beyond a certain percentage of GDP public expenditure may become increasingly harmful.3

Budgetary Balance

The idea that the level of the budget deficit itself may affect growth is contentious. On the one hand, Barro’s Ricardian equivalence theorem suggests that budget deficits are neutral with respect to private saving and growth, as economic agents perceive the deficit as delayed taxes and therefore increase their saving to neutralize public dissaving (Barro, 1988). On the other hand, some evidence suggests that the correlation between deficits and growth is negative, in particular for middle-income countries.4 Moreover, the evidence buttressing Ricardian equivalence has been quite ambiguous. The response of private sector saving to public sector dissaving does not seem to completely neutralize the latter.5

Fiscal Policy in Oman, 1981–97

Developments in the Fiscal Sector and the Stance of Fiscal Policy

Based on trends in the overall fiscal balance (Figure 4.1), the composition of expenditure and revenue (Figures 4.2 and 4.3), and developments in the fiscal impulse (Table 4.1) and the structural fiscal balance, four subperiods can be distinguished, characterized by four different fiscal policy stances over the period 1981–97. The methodologies used to derive the output-adjusted fiscal stance and fiscal impulse, and the underlying structural fiscal balances for Oman, are described in Appendix I.

Figure 4.1Overall Fiscal Balance

(In percent of GDP)

Sources: Data provided by the Omani authorities; IMF staff estimates.

1 Excludes operations of the State General Reserve Fund.

Figure 4.2Composition of Expenditure

(In percent of total expenditure)

Sources: Data provided by the Omani authorities; IMF staff estimates.

Figure 4.3Composition of Revenue

(In percent of total revenue)

Sources: Data provided by the Omani authorities; IMF staff estimates.

Table 4.1Selected Fiscal Indicators

(In percent)1

Indicator1981–861987–911992–951996–97
Change from previous year in
Total revenue5.68.34.110.6
Total expenditure12.50.75.9−2.6
Current expenditure12.02.96.3−1.3
Capital expenditure144−3.54.5−5.6
Ratios to GDP 2
Official fiscal balance−8.86.2−10.4−2.3
Consolidated fiscal balance 3−1.00.2−5.64.4
Cyclically neutral budget balance−4.5−7.4−7.6−7.8
Fiscal stance4.3−1.22.8−5.5
Fiscal impulse3.4−2.20.1−4.4
Structural deficit−12.6−5.3−9.3−1.0
Sources: Data provided by the Omani authorities; IMF staff estimates.

Data are annual averages.

Negative numbers represent deficits.

Includes the operations of the SGRF, the Oil Fund, and the Contingency Fund.

Sources: Data provided by the Omani authorities; IMF staff estimates.

Data are annual averages.

Negative numbers represent deficits.

Includes the operations of the SGRF, the Oil Fund, and the Contingency Fund.

Expansionary Phase of the Early 1980s

The period 1981-86 was characterized by an increasing deficit, which averaged about 9 percent of GDP, primarily as a result of faster growth of expenditure than of revenue. Whereas expenditure growth averaged 12.5 percent a year, revenue growth averaged only 5.6 percent (Table 4.1). Among the various expenditure categories, recurrent expenditure of the civil ministries grew at an average annual rate of over 16 percent, while capital expenditure grew at a rate of over 14 percent. Accordingly, the share of civil expenditure in total expenditure rose from about 25 percent to over 30 percent (Figure 4.4). About 40 percent of civil expenditure was allocated to health, education, electric power generation, water production, and housing, partly reflecting the development needs of a country where a broad share of the population did not have access to some of these basic services. Defense outlays were by far the biggest expenditure, averaging 20 percent of GDP. The composition of revenue changed quite significantly over the period 1981–86, as the share of non-oil revenue in the total rose from about 10 percent to over 20 percent. This reflected in part the frequent adjustment of fees and charges as well as increases in profit transfers from the central bank and the General Office of Telecommunications. Furthermore, the share of tax revenue in total revenue grew from 2 percent in 1981 to over 6 percent in 1986, reflecting increases in customs duties and the training tax.

Figure 4.4Civil and Capital Expenditure

(In percent of total expenditure)

Sources: Data provided by the Omani authorities; IMF staff estimates.

Fiscal impulse analysis (Table 4.2) indicates that this period was also characterized by an increasingly expansionary stance of fiscal policy, as policymakers did not alter expenditure policy in response to falling oil prices. The fiscal impulse, which indicates by how much the stance of fiscal policy has deviated from a growth-neutral stance, peaked at over 9 percent of GDP in 1982 and averaged about 3.4 percent of GDP during 1981–86. The corresponding fiscal stance—measuring the cumulative change in fiscal impulses beginning in 1982 that would have materialized if the economy were growing at its trend rate—increased from less than 4 percent of GDP in 1982 to more than 10 percent in 1986. Also, the structural deficit was greater than the official deficit, indicating that economic growth over this period was above its trend level, perhaps reflecting the expansionary fiscal impulse during this period.

Table 4.2Fiscal Impulse Analysis
Indicator19811982198319841985198619871938193919901991199219931994199519961997
(millions of rials Omani except where noted otherwise)
Observed GDP (Y)2,666.32,797.62,932.73,232.13,590.63,143.43,317.73,224.53,603.64,493.14,360.84,787.94,803.84,967.25,307.15,890.16,019.5
Growth rate (in percent)21.94.94.810.211.1−1255.5−2.811.824.7−299.80.33.46.811.02.2
Potential output (TP)12,311.02,461.22,621.22,791.62,973.03,166.33,372.13,591.33,824.74,073.34,338.14,620.04,920.35,240.25,580.85,943.56,329.9
Output gap (Y–YP)355.3336.4311.5440.5617.6−22.9−54.4−366.8221.1419.822.7167.9116.5273.0−273.7−53.4−310.4
Official fiscal balance (OFB)238.4236.5293.0−4l9.6−355.4−699.8−179.3−361.7−295.7−11.1−283.0−578.6−516.5495.5−479.4−263.5−8.0
Consolidated balance 3341.633.14.6−98.1−73.5−469.337.7−217.36.3235.341.8−199.4389.3−379.3−116.5213.0320.0
Cyclically neutral budget

deficit (CNB)
−96.6−117.5−133.695.0−36.8329.6−243.5−369.7−331.9−116.6−176.0−241.3−362.2−438.1−466.1−402.1−522.8
Fiscal stance (CNB – OFB)−135.2119.0159.4324.6318.6370.2−64.2−8.0−36.2−105.57.0337.3156.357.413.3−138.6−514.8
Fiscal impulse254.240.4165.2−6.051.6−434.456.2−28.2−69.4112.5330.4−181.0−99.0−44.0−151.9−376.2
Omani crude oil export price

(in U.S. dollars per barrel)
36.934.429.228.427.013.517.313.516.321.417.518.015.515.216.319.418.6
(In percent of GDP)
Official fiscal balance (OFB) 23.4−6.0−3.3−10.7−8.0−20.8−5.0−10.7−3.0−0.7−6.5−12.2−10.7−9.8−8.94.5−0.1
Consolidated balance 313.01.2−0.2−3.0−2.0−14.91.1−6.70.25.21.0−4.2−6.1−7.8−2.23.65.3
Cyclically neutral

budget deficit (CNB)
−3.7−4.24.6−2.9−1.0−10.5−7.3−11.5−9.2−2.66.35.0−7.53.8−8.8−6.8−8.7
Fiscal stance (CNB – OFB)−7.03.83.77.87.210.3−2.4−0.7−1.2−1.90.17.23.11.00.0−2.4−8.6
Fiscal impulse9.11.45.1−0.21.6−13.11.7−0.8−1.52.66.9−3.3−2.0−0.6−2.6−6.2
Structural deficit1.3−12.1−12.0−16.1−15.5−13.64.1−5.85.3−4.66.6−13.7−9.67.5−6.5−4.12.1
Memoranda; Ratio of
oil revenue
To total expenditure95.977.574.566.669.448573.861.466.582.966.657.656.958.559.166.179.3
To capital expenditure354.7267.7294.0243.7245.0168.3347.9357.6419.8579.2333.5289.4286.3296.4313.5376.0477.9
To current expenditure131.4109.299.791.796.868.293.674.179.196.883.372074.172.972.879.495.2
Sources: Data provided by the Omani authorities; IMF staff estimates.

Assumes the annual growth rate of potential output is equal to the average observed growth rate over 1980–97.

Excludes SGRF operations and timing differences.

Includes transfers to the SGRF, the Oil Fund, and the Contingency Fund.

Sources: Data provided by the Omani authorities; IMF staff estimates.

Assumes the annual growth rate of potential output is equal to the average observed growth rate over 1980–97.

Excludes SGRF operations and timing differences.

Includes transfers to the SGRF, the Oil Fund, and the Contingency Fund.

First Phase of Fiscal Consolidation, 1987–91

Following the collapse of oil prices in 1986, the government attempted to restore a sustainable Fiscal position through strict containment of expenditure growth, which was limited to an annual average of only 0.7 percent. The composition of government outlays was, however, adversely affected, with civil expenditure rising on average by over 6 percent and capital expenditure falling on average by 3.5 percent. Consequently, the share of civil expenditure in total expenditure rose from about 30 percent to about 40 percent. Defense expenditures were reduced by one-third, to about 15 percent of GDP in 1991. The growth of civil expenditure, in spite of the contractionary stance of fiscal policy, was indicative of the pressures experienced by the Omani government to provide basic services such as education, health, and energy. The increase in revenue averaged 6 percent and exhibited high volatility due to large fluctuations in oil prices. The composition of revenue did not change markedly over the period. Fiscal impulse analysis indicates that the tightened fiscal stance exerted a strong contractionary impulse during the entire period: the cumulative withdrawal of fiscal stimuli accounted for about 10 percent of GDP. The strongest contractionary impulse was recorded in 1987. Consistent with this impulse, the structural deficit over this period declined significantly, to an average of 5 percent of GDP, compared with about 13 percent of GDP during 1981–86.

Mixed Performance, 1992–95

Except for 1992, when in the aftermath of the Gulf war defense expenditure and the wage bill grew significantly, the period 1992–95 was characterized by falling official budget deficits. Nevertheless, the planned budget deficits and expenditure authorizations were exceeded by relatively wide margins, averaging over 4 percent of GDP. The reduction of the deficit was brought about mainly by containing capital expenditure, which grew by only 1 percent on average, while civil expenditure increased by almost 4 percent. Defense expenditure remained roughly unchanged at around 15 percent of GDP, although if one excludes the Gulf war-induced pressures on the defense budget, the average is around 12 percent of GDP (Box 4.1). As in the two previous periods, the share of civil expenditure continued to expand, from about41 percent in 1991 to over 44 percent in 1995, while the share of capital expenditure declined slightly, from 20 percent to 19 percent. Fiscal impulse analysis indicates that whereas in the aftermath of the Gulf war in 1992 fiscal policy was sharply expansionary, it then turned less expansionary and became neutral in 1995. The analysis of the structural deficit over this period mirrors the results from fiscal impulse analysis, as the structural deficit declined from the sharply higher level of 1992 but remained quite high, in the range of 7 percent of GDP, during 1994–95.

Successful Fiscal Adjustment under the FFYP,1996–97

Since 1996 the Omani government has implemented a rigorous fiscal adjustment program in line with the FFYP. During 1996–97, expenditure declined by an average of 2.6 percent a year, while revenue increased by over 10 percent a year. For the first time since 1981, current expenditure declined, by 1 percent on average, supported by cuts in defense expenditure. Also, the share of civil expenditure declined from 46 percent of the total in 1996 to 44.4 percent in 1997. As a result of these measures, the fiscal deficit declined to 4.5 percent of GDP in 1996 and further narrowed to 0.1 percent of GDP in 1997. Fiscal impulse analysis indicates a sharply contractionary fiscal impulse in 1996–97, averaging more than 4 percent of GDP. Analogously, the structural deficit averaged only 1 percent of GDP, less than half the official deficit.

Role of Oil Revenues in Determining Expenditure Policy

In many oil-exporting countries, oil revenue has been identified as an important determinant of the stance of expenditure policy.6 To assess the role of oil revenues in setting the level of expenditure in Oman, the ratios of oil revenue to total expenditure and to capital and current expenditure were calculated (Table 4.2). A falling ratio would be consistent with an expansionary stance of policy, and a rising ratio with a contractionary stance. This analysis is different from fiscal impulse analysis: whereas fiscal impulse analysis compares the stance in the current year with a hypothetical stance derived from the fiscal stance in a base year, this analysis compares the stance of expenditure policy in relation to oil revenue, which in Oman is the dominant component of government receipts. The results are, however, broadly in line with those of fiscal impulse analysis.

The ratio of oil revenue to total expenditure declined during 1981–86 from 96 percent to less than 50 percent. This indicates a period of expansionary fiscal policy, because the growth rate of government outlays substantially exceeded the growth rate of oil resources. Between 1987 and 1990 fiscal policy became steadily more contractionary: the ratio of oil revenue to total expenditure moved upward to about 83 percent by 1990. In 1991 that ratio fell from 83 percent to 67 percent, mainly on account of higher capital expenditure. During 1991–95 the ratio of oil revenue to total expenditure remained broadly stable, at less than 60 percent. This indicates a broadly unchanged fiscal stance, albeit at an unsustainably position, since such a low ratio in an environment of a limited non-oil revenue base entailed unstistainably high fiscal deficits. In 1996–97 the contractionary stance of fiscal policy was reflected in a sharp rise in the ratio of oil revenue to total expenditure, to almost 80 percent, indicating that the significant rise in oil revenue in those years did not lead to a corresponding increase in expenditure. The behavior of the ratios of oil revenue to current and capital expenditure was also broadly in line with that of oil revenue to total expenditure.

Box 4.1Selected Fiscal Indicators in Regional Perspective

Over the 1992–97 period, Oman’s central government budget deficit was the highest in relation to GDP among all the GCC countries except Kuwait, which was affected by the reconstruction needs following the Gulf war and is therefore not directly comparable (see Table).

Current expenditure in relation to GDP in Oman was at about the same level as in Saudi Arabia, lower than in Qatar, bin higher than in the United Arab Emirates and Bahrain. Only Kuwait had significantly higher current expenditure than Oman. Oman’s ratio of capital expenditure to GDP was the highest among all GCC countries, followed by the United Arab Emirates.

Oman’s ratio of total revenue to GDP was at about the same level as those of Saudi Arabia, Qatar, and the United Arab Emirates, but much lower than that of Kuwait and much higher than that of Bahrain, primarily reflecting differences in oil revenue. The ratio of Oman’s non-oil revenue (excluding investment income) to GDP was the second-highest of all GCC countries, below only that of Bahrain. Oman together with Saudi Arabia had one of the lowest ratios of investment income to GDP in the GCC, far below the levels of Kuwait, Qatar, and the United Arab Emirates, but higher than that of Bahrain.

The share of Oman’s oil revenue in total revenue was the highest of all GCC countries. It was also substantially higher than in other oil-exporting countries such as Indonesia, the Syrian Arab Republic, and Venezuela, demonstrating Oman’s high dependence on oil revenue.

Overall, the main characteristics of Oman’s fiscal indicators in comparison with other GCC and oil-exporting countries can be summarized as follows:

  • a high deficit-GDP ratio, primarily the result of high current and capital expenditure;
  • low investment income, but comparatively high revenue from fees and charges; and
  • a very high dependence on oil revenue.
Fiscal Indicators in Selected Oil-Exporting Countries, 1992–97

(In percent of GDP except where noted otherwise)1

ItemBahrain2KuwaitOman3QatarSaudi

Arabia
U.A.E.4IndonesiaSyrian Arab

Rep.
Venezuela
Total expenditure33.858.042.745.140.639.116.130.021.0
Current expenditure27.751.334.638,734.631.38.718.716.2
of which: wages and salaries17.315.09.414.818.13.210.23.8
Capital expenditure6.16.78.16.46.07.87.411.34.8
Total revenue529.449.535.237.733.737.015.925.718,3
Oil and gas revenue17.636.226.723.925.423.74.010.8610.4
Non-oil revenue11.113.38.513.88.313.21 1.914.97.8
Investment income10,30,910,51.45.8
Other non-oil revenue1 I.I3,07.63.36.97.41 1.914.9
Fiscal balance−3.4−8,6−7.7−74−6.9−2.1−0.2−4.3−2.7
Memorandum: Oil revenue
in percent of total revenue57.973,175.964875.263.427.342.055.0
Sources: Data provided by the Omani authorities; IMF staff estimates.

Data are annual averages. Numbers may not sum to totals because of rounding.

Excludes social security funds.

Figures refer to the budget balance excluding SGRF operations.

Through 1996 only.

Excluding grants.

Oil-related proceeds.

Sources: Data provided by the Omani authorities; IMF staff estimates.

Data are annual averages. Numbers may not sum to totals because of rounding.

Excludes social security funds.

Figures refer to the budget balance excluding SGRF operations.

Through 1996 only.

Excluding grants.

Oil-related proceeds.

Notwithstanding some movements in the ratio of oil revenue to expenditure between subperiods, the analysis just presented suggests that, over 1981–95, Oman did not succeed in cutting or containing expenditure to a level consistent with the level of oil revenue. The fact that the ratio of oil revenue to total expenditure remained below 60 percent, and the fact that the non-oil revenue base remained narrow, essentially indicated that the fiscal policy stance pursued through 1995 was structurally unsustainable. In this light the change in the fiscal stance in 1996 and 1997 is noteworthy and demonstrates the government’s ability to cut expenditure to restore fiscal discipline.

Impact of Fiscal Policy on Non-Oil GDP Growth

One of the critical questions about the role of fiscal policy in Oman, whose economy, as already noted, has traditionally been dominated by the government, is to what extent the growth of non-oil real GDP depends on fiscal policy. In addition to helping assess the contribution of the stance of fiscal policy to economic growth, the answer to this question is particularly relevant in assessing the potential output cost of fiscal retrenchment and its most appropriate phasing.

To assess the link between fiscal policy and non-oil real GDP growth, regressions of non-oil real GDP growth on expenditure were run for the period 1981–97 in two specifications. In the first, the growth rate of real total expenditure was the independent variable, and in the second the growth rates of real current expenditure and real capital expenditure were the independent variables. The dynamic nature of the relationship between budgetary expenditure and growth was analyzed through recursive parameter estimates. The recursive parameter estimate for a particular coefficient at a certain point in time is derived by estimating the regression parameters based on data up to that point. The moving values of the parameter estimates allow one to determine changes in the nature of the correlation between the variables in question over time.

The stability of the relationship was assessed using cointegration analysis. Under the premise that the independent and the dependent variable exhibit the same degree of integration in a given regression, the question of the cointegration of variables can be addressed through tests for the stationarity of the residuals of an estimated regression. If a time series is stationary, it will tend to return to its original value after a random shock, and the mean and the variance of such a series will not change with the passage of time. If the relationship between the growth of non-oil real GDP and expenditure is found to be stable over the long run in Oman, based on the residuals of the estimated regression, this would further corroborate the presumption of a dominant role of fiscal policy in determining non-oil output in Oman.

The results of the regression analysis are summarized in Table 4.3. Both regressions indicate that growth is indeed strongly correlated with fiscal expenditure and that developments in non-oil growth can be explained to a large extent by developments in government expenditure policy. (Figure 4.5 illustrates the regression result by showing the similar movements in expenditure growth and growth of real non-oil GDP.) In both regressions the R2 is fairly high (over 80 percent), and the Durbin-Watson statistics do not indicate the presence of first-order residual autocorrelation. Cointegration analysis based on an augmented Dickey-Fuller test, which was performed on the residuals of the estimated regressions, suggests a stable relationship between fiscal expenditure and non-oil real GDP growth.7

Table 4.3Determinants of Non-Oil Real GDP Growth, 1981–971
RegressionConstantDREXPDRCUREXPDRCAPEXPR 2Durbin-Watson

Statistic
ADR 2
14.66

(5.14)
0.70

(8.67)
0.832.144.36**
24.34

(4.34)
0.57

(5.33)
0.19

(3.91)
0.862.024.23**
Sources: IMF staff estimates based on data provided by the Omani authorities

Estimates are in logarithms. Numbers in parentheses are t-statistics. The dependent variable is the real growth rate of non-oil GDP; the independent variables are defined as follows:

variables are defined as follows:

DREXP = real growth rate of total expenditure

DRCUREXP = real growth rate of current expenditure

DRCAPEXP = real growth rate of capital expenditure.

Augmented Dickey-Fuller test for stationarity of residuals. All ADF tests include a constant. The appropriate lag length was determined based on an F-test. Asterisks indicate cointegration at a 99 percent degree of confidence.

Sources: IMF staff estimates based on data provided by the Omani authorities

Estimates are in logarithms. Numbers in parentheses are t-statistics. The dependent variable is the real growth rate of non-oil GDP; the independent variables are defined as follows:

variables are defined as follows:

DREXP = real growth rate of total expenditure

DRCUREXP = real growth rate of current expenditure

DRCAPEXP = real growth rate of capital expenditure.

Augmented Dickey-Fuller test for stationarity of residuals. All ADF tests include a constant. The appropriate lag length was determined based on an F-test. Asterisks indicate cointegration at a 99 percent degree of confidence.

Figure 4.5Real Growth of Expenditure and of Non-Oil GDP

(In percent)

Sources: Data provided by the Omani authorities; IMF staff estimates.

Interestingly, recursive parameter estimates in both regressions indicate that the coefficient of current expenditure has declined significantly since the mid-1980s, demonstrating a weakening of the structural dependence of non-oil GDP growth on government expenditure policy. This weakening role of government outlays is more visible in the case of current expenditure; the importance of capital expenditure seems to have increased marginally since 1981 and to have remained approximately constant over the past three years. These regression results, although broadly confirming the crucial role of fiscal policy for economic growth in Oman, also suggest that this relationship has become somewhat less important in recent years, with the private sector increasingly developing its own momentum. This trend was particularly visible in 1997, when, in spite of the sharply contractionary stance of fiscal policy, non-oil real GDP grew by over 5 percent.

Sustatnability of Fiscal Policy in Oman

The fundamental question in assessing fiscal sustailiability in Oman is whether the government can continue to pursue indefinitely the stance of budgetary policy that it pursued during the period up to 1995. The sustainability of fiscal policy in a country can be assessed in a variety of ways,8 Most criteria of fiscal sustainability are based on developments in the debt position. On the basis of one such criterion, for fiscal policy to be sustainable, the discounted present value of future primary surpluses in relation to GDP must be equal to the initial stock of government debt in relation to GDP. For Oman this criterion appears to be less relevant, since the total public debt is fairly low (less than 30 percent of GDP), and the financing of the budget deficit in recent years has primarily relied on the drawdown of foreign investments. Another criterion is the level of the primary balance, that is, the difference between total revenue and total primary (noninterest) expenditure. On this criterion Oman’s fiscal policy appears to be unsustainable, because the primary balance was negative in almost all years. Yet another criterion is whether the real interest rate paid on public debt is higher or lower than the rate of real economic growth. For a fiscal situation to be sustainable and the debt burden to assume a declining path, the real interest rate should be lower than the real growth rate. In this respect, Oman’s markedly slower economic growth rate of recent years and the developments in the real interest rate could lead to the emergence of an unsustainable debt dynamic.

To assess Oman’s fiscal sustainability in a more meaningful manner, the particular characteristics and long-term development objectives of the Omani economy should be taken into consideration in an appropriate, forward-looking manner. Oman’s horizon of proven oil reserves is about 16 years. Even though new exploration projects may continue to extend this horizon, Oman clearly faces a shorter life span of proven oil reserves than do most other GCC countries. This situation requires that the government pursue three important objectives: First, it must accumulate financial reserves for the time after the oil reserves are depleted. Second, it must develop a strategy to reduce dependence on oil revenue by broadening the non-oil revenue base to finance an increasing proportion of government operations on a sustained basis, particularly in the period beyond the oil reserve horizon. And third, it must take steps to diversify the economy.

Recognizing the importance of the first objective, in 1980 the government of Oman established the SGRF, to create a source of revenue that could replace oil revenue, at least in part, after the depletion of the oil reserves. Assuming a return of about 6 percent a year on invested capital, and average budgetary oil revenues of about RO 1.5 billion, this would imply that, when the oil reserves are exhausted, the SGRF would have to amount to about RO 25 billion (in constant 1996 prices) to compensate fully for the potential loss of oil revenue. The level of the SGRF is currently well below this implicit target amount and has been declining in recent years to finance the budget deficits. The government has recognized that this stance of fiscal policy is unsustainable and runs counter to its longer-term fiscal and other economic objectives. Building up SGRF investments at a fast pace will require eliminating the central government budget deficit and ensuring that oil revenue in excess of a certain specified level is fully transferred to the SGRF and the Oil Fund, as intended in the FFYP.

Even if the SGRF could generate sufficient revenue to fully replace oil revenue after the oil reserves have been depleted, this may be insufficient to achieve fiscal sustainability in the long run. Given a constant nominal return from the SGRF. a constant ratio of expenditure to GDP in an environment of growing nominal GDP would lead to growing fiscal deficits, unless a strategy to develop non-oil revenue is effectively in place to compensate for the difference. This issue appears even more important given that the accumulation of the SGRF to the target level by the time of the depletion of oil reserves would require substantial fiscal adjustment efforts, which might be difficult to achieve through expenditure cuts alone.

Given the strong dependence of the economy on expansionary fiscal impulses in the past, the attainment of a fiscal surplus through fiscal retrenchment appears to conflict with the objective of sustaining economic growth. At the same time, however, the diversification of the economy and the strengthening of the private sector would benefit from a partial withdrawal of the government from the economy. These objectives would also benefit from the increased confidence emanating from the execution of a comprehensive fiscal adjustment program. Thus, fiscal adjustment and increased economic growth in the longer term and diversification of the economy are mutually reinforcing objectives. Moreover, since the degree of dependence of the Omani economy on the fiscal impulse has fallen somewhat in recent years—as the regression analysis presented above suggests—the short-term costs of fiscal adjustment are expected to decline over time.

In contrast, the cost of failing to put fiscal policy on a sustainable path could be considerable. If current policies were kept in place, in addition to further depletion of the SGRF assets, Oman would have to start borrowing far beyond the present level to finance its deficit. A progressively higher debt level would require much larger fiscal retrenchments later to achieve sustainability.

The Government’s Fiscal Consolidation Plan

As already noted, the Omani government is fully aware of the unsustainability of the stance of fiscal policy pursued in recent years and its implications for the future. Accordingly, the FFYP has at its center a fiscal adjustment plan that foresees the achievement of a balanced central government budget (excluding SGRF operations) by 2000 (Figure 4.6). The plan’s fiscal adjustment is front-loaded, aimed at reducing the fiscal deficit by more than 2 percent of GDP. from 4.9 percent in 1996 to 2.4 percent by 1998, largely through reduction of expenditure by about 4 percent of GDP. This would be followed by a further reduction of the deficit by over 1 percent of GDP during 1999–2000. The thrust of the adjustment is rightly on the reduction of current expenditure, which compared with the 1995 outturn is envisaged to be reduced by about 9 percent of GDP from its 1995 level, with the reductions equally distributed among civil expenditure, defense expenditure, and the operations of Petroleum Development Oman (PDO), the national oil company. Key components of the expenditure measures announced by the government include the following: an early retirement program affecting about 20 percent of civil servants over 1996–98: the introduction of a new expenditure authorization process, replacing the previous system of continuous authorizations with a single annual authorization of additional expenditure under a special royal decree, which should lead to a much more intensive scrutiny of each additional expenditure authorization request; and cuts in capital expenditure by about 3 percent of GDP. A modest effort to increase non-oil revenue is planned as well, which (net of the expected revenues from the sale of natural gas) is foreseen to amount to 0.5 percent of GDP. In addition, the plan foresees the replacement of government-provided services by specific allowances and the privatization of a number of government-owned enterprises. Acknowledging the special significance of education and development of technical skills for Omani nationals, expenditure on vocational training has been substantially increased in the FFYP Oman’s fiscal adjustment plan, if implemented successfully, not only would enhance the sustainability of fiscal policy by building up the reserve fund, but could also help to invigorate the private sector by enhancing private sector confidence in the economy and increasing its self-generated momentum.

Figure 4.6Planned Fiscal Adjustment Under the Fifth Five-Year Plan

(In percent of GDP)

Sources: Data provided by the Omani authorities; IMF staff estimates.

1 Excludes SGRF operations.

Oman’s fiscal performance in 1996 and 1997, which exceeded the objectives set under the FFYP, is clearly encouraging and augurs well for the government’s ability to achieve the ambitious objectives of the plan. Since 1995, total expenditure has fallen by 7 percent of GDP, mainly through containment of current outlays, which were cut by 5 percent of GDP. The government’s retrenchment policy, aimed at reducing the number of Omani civil servants by 13,500 over 1996–98, was on track, with 11,000 persons already removed from the payroll by 1997. Defense expenditure declined by about 2 percent of GDP over the two-year period, and capital expenditure was reduced by 2.2 percent of GDP. As a result, the official budget deficit was reduced to 0.1 percent of GDP in 1997, well below the 3.4 percent of GDP targeted under the FFYP.

To assess the appropriateness of the government’s fiscal consolidation plan under the FFYP, we compare the plan with the fiscal adjustment experience of Indonesia, another oil-exporting country, which successfully implemented a fiscal consolidation plan in the late 1980s (Figure 4.7), Recognizing the volatility of its oil revenue, Indonesia undertook a fiscal adjustment consisting of two main elements: an increase in domestic tax revenue, in particular through a value-added tax; and a reduction in current expenditure. Tax revenue was increased by more than 5 percentage points of GDP, to about 11 percent of GDP, during the period from fiscal 1980 to fiscal 1993. Current expenditure (excluding interest payments on the external debt) was reduced over the same period by about 4 percentage points, to 7,7 percent of GDP, primarily through freezing of wages and reductions in subsidies. Expenditure on education and health was not reduced, and capital expenditure was increased by 3 percentage points, to 10 percent of GDP.

Figure 4.7Indonesia: Selected Fiscal Indicators

(In present of GDP)

Source: IMF, International Financial Statistics, various issues.

Oman’s fiscal adjustment plan—like that of Indonesia—concentrates on a sizable reduction of current expenditure as a percentage of GDP. The main difference between the Indonesian and the Omani adjustment strategies is that Indonesia undertook the development of non-oil revenue through the introduction of a broad-based consumption tax. In both countries, efforts to protect capital outlays and current expenditure in health and education seem particularly conducive to promoting growth. The Indonesian experience also highlights how Oman’s fiscal adjustment strategy may benefit from a proper mix of expenditure cuts and non-oil revenue mobilization. Although the need for non-oil revenue mobilization is not as pressing for Oman as it was for Indonesia, establishing a broad-based tax system (initially at relatively low rates) would prepare Oman for the post-oil period and permit the country to increase and sustain capital expenditure at a desirable level. A reduction of current expenditure beyond the level planned by the Omani government under the FFYP also seems advisable and has been incorporated in the medium-term vision prepared by Oman’s Ministry of Development. That document foresees a ratio of total expenditure to GDP of only 14 percent by 2020. This planned further reduction in outlays would seem appropriate because, at 37.8 percent of GDP (in 1997), Oman’s total government expenditure is still among the highest in the world. The reduction could be achieved through a further reduction of transfers and subsidies, and in the level and range of services provided by the public sector, as well as in other unproductive outlays.

Conclusions

The empirical analysis in this section demonstrates that Oman’s recent fiscal policy history can be divided, based on fiscal impulse analysis, into an expansionary period covering 1981–86, a contractionary period covering 1987–91, a period of mixed policies during 1992–95. and a sharply contractionary period in 1996–97. Econometric analysis also provides evidence for a close link between the fiscal policy impulse and the growth of non-oil real GDP, but also shows that the importance of this impulse seems to have declined in recent years. The sustainability of fiscal policy is assessed using a number of indicators, including the primary deficit, the level of debt, real interest rates, and the long-term development objectives of the Omani economy, which necessitate the accumulation of a respectable level of SGRF assets. Having determined that the current stance of fiscal policy was not sustainable through 1995. the section assesses the fiscal adjustment program under the FFYP and concludes that the objectives of this plan would be in line with the achievement of a sustainable fiscal position. Based on the adjustment experience in other countries (Indonesia in particular), however, it appears that the sustainability of both the government’s fiscal adjustment plan and Oman’s growth prospects could be enhanced by ensuring a proper balance between non-oil revenue and expenditure cuts. Such a balance would entail more pronounced efforts to increase non-oil revenue and sharper cuts in current expenditure, so as to allow for an increase in capital expenditure. The section finds that Oman’s successful fiscal adjustment in 1996 and 1997, which exceeded the adjustment targeted under the FFYP, augurs well for the government’s ability to adhere to the ambitious FFYP targets.

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1Unless otherwise indicated, the figures given for Oman’s central government fiscal operations refer to the fiscal position excluding SGRF operations.
2See Tanzi and Zee (1996) for a survey of different approaches to the link between fiscal policy and long-run growth.
3Tanzi and Schuknecht (1995) found that, beyond a share of 30 percent of GDP, expenditures tend to have a harmful effect on growth.
5A review of empirical evidence is found in Bernheim (1987); see also Leiderman and Blejer (1988).
7Unit-root tests showed that all variables in question were integrated of the first order. The optimal number of lagged differenced residuals in the ADF test was determined through an Ftest.

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