The prospects of creating ‘fiscal space’ for the health sector

Never has there been a time when the visibility of the health problems of low-income countries (LICs) has been so prominent in the world's policy circles. Industrial governments have scaled up their aid for spending on HIV/AIDS treatment and prevention programmes; major foundations are providing major financing of immunization and vaccination programmes as well as research efforts to develop vaccines and cures for pervasive LIC diseases; non-governmental organizations (NGOs) have intensified their involvement in the delivery of health services; and government leaders now speak to the worry of a global flu pandemic. Overall spending in the health sector has increased dramatically in some cases, and countries are now grappling with how to staff clinics, hospitals and vaccination programmes. These efforts in the health sector are occurring in the context of the wider global concern about the financial costs of meeting the Millennium Development Goals (MDGs), since these will involve spending on education, water, sanitation and housing, as well as the physical infrastructure needed to foster rapid economic growth.

In this environment, concerns have emerged as to how to find the fiscal resources (or ‘fiscal space’) required to finance the required spending on health. Will macroeconomic constraints prove an independent limiting factor on what governments can spend? In what follows, I will try to clarify the issues that are involved in the fiscal space debate – describing how fiscal space can be created, indicating the macro and microeconomic factors that may limit a government's capacity to expand health sector spending, and underscoring the importance of budget sustainability as a factor that needs careful consideration as governments elaborate scaling-up plans. I will use the cases of Malawi, Zambia and Tanzania to illustrate some of the issues involved.

What are the sources of ‘fiscal space’?

In the broadest sense, ‘fiscal space’ can be defined as the capacity of government to provide additional budgetary resources for a desired purpose without any prejudice to the sustainability of its financial position. The desire is to make additional resources available for some form of meritorious government spending (or tax reduction). In principle, there are different ways in which a government can create fiscal space. Additional revenues can be raised through tax measures or by strengthening tax administration. Low priority expenditures can be cut in order to make room for more desirable ones. Resources can be borrowed, either from domestic or from external sources. Fiscal space may also be obtained if a government receives grants from outside sources. And, finally, governments can use their ability to print money to finance public programmes.

Raising the revenue share in Gross Domestic Product (GDP) is an obvious option for countries with low tax burdens. For LICs, raising the tax share to at least 15% of GDP should be seen as a minimum objective. Thus, in the case of Tanzania, with a tax ratio below 13%, some fiscal space from this source would appear possible. But for countries that have higher tax burdens (e.g. Zambia and Malawi at 17 and 21% of GDP, respectively), further increases may prove difficult. Often, raising the burden requires efforts to strengthen tax administration or reduce politically popular exemptions, since tax rates are already high (e.g. in Malawi and Zambia, the VAT rate is 17.5%, and in Tanzania, it is even higher at 20%). Even the most ambitious African countries have taken a number of years to raise their tax ratios to GDP by several percentage points. Mobilization of revenues for earmarked purposes (e.g. earmarking gasoline excises to road maintenance programmes) may be seen as an important vehicle for expanding fiscal space, but such earmarking also creates rigidities. It could result in resources being made available for purposes which may be less critical for growth or poverty reduction than other possible uses (e.g. primary education or health care). Earmarking may thus have the effect of crowding out other expenditures such that the fiscal space that is created may, in net terms, be significantly reduced.

Reprioritization of expenditure, by reducing unproductive expenditures, should be the first option for a government seeking to expand meritorious programmes. In principal, this would appear appropriate for countries that already have high spending ratios to GDP (e.g. Malawi's spending ratio exceeds 40% of GDP and Zambia's is above 25% of GDP). But finding such fiscal space in this way is also difficult, as governments have significant shares of the budget which are of a largely nondiscretionary character, e.g. high interest and wage bills. Reprioritizing expenditure may require a change in subsidy programmes, cutbacks in spending on defence and internal security, reduced foreign travel or embassy expenses, and actions to address overstaffing or to weed out ghost workers. International Monetary Fund (IMF) programmes often confront the dilemma that overall wages and salaries of a government have reached an unsustainable level and yet there is a high return to employing additional staff in certain key sectors, e.g. education and health. In principle, this can be reconciled through reduced spending on wages and salaries in non-key sectors at the same time as spending for critical policy programmes is increased. In practice, realizing such a strategy may prove politically difficult to implement quickly.

Fiscal space can also be created by an increase in the efficiency with which services are delivered or transfers targeted. Such strengthening would be appropriate even in favoured sectors (e.g. rationalizing the approach to delivering medical care). Policies that reduce corruption and improve governance also can create fiscal space. In a similar vein, the donor community increasingly recognizes the fiscal potential that can come from greater ‘alignment and harmonization’ of donor resources. If external resources can be used more efficiently (reducing donor conditionality, eliminating aid-tying, cutting administrative overheads, achieving greater consistency in the meshing of donor spending in a sector and reducing the administrative overload imposed on recipient country programme managers), the more fiscal space can be created.

Government policies that foster significant improvements in the efficiency through which it allocates resources may also facilitate higher and more effective spending in both the public and private sectors. For example, if a government can improve the quality of its own health services, households, even if required to pay user fees, may be able to save resources by reducing spending on inefficient private sector health providers. Conversely, not spending enough in a sector such as health may weaken the sector to the extent that it would, in the future, be costly and time consuming to ‘rebuild’ it. Creating fiscal space by allowing cutbacks in a sector may ultimately be more costly in fiscal space over time.

External grants can clearly provide fiscal space, in contrast to borrowing (which implies the obligation for future debt service payments). But a sustained and predictable flow of grants is essential, since it reduces the uncertainty as to whether the grant is simply of a one-time character and creates the potential for a scaling up of expenditure to be maintained in the future. Regrettably, few donors now are willing to make external assistance commitments for more than 1 or 2 years. Moreover, the experience of many countries is that grants can prove highly volatile, as a consequence not only of donor decisions and bureaucratic processes but also due to policy slippages by recipient governments (see below). Thus, the fiscal space entailed by additional grants (or concessional loans) may be less than is apparent on the surface.

Expanding programmes that entail a ‘permanent’ employment of workers is subject to the risk that further assistance may not come or that the additional fiscal space from any growth-engendered increase in domestic revenues is insufficient. It is risky for government policy makers to assume there is scope for an easy downsizing of a programme or cutbacks elsewhere. Temporary employment contracts or the design of programmes that may facilitate flexible downsizing may be desirable, but are often precluded by labour legislation or political economy pressures. Note the difficulties encountered by Zambia in transferring contracts from the public service commission to hospital boards (a shift strongly opposed by the public service union). Perhaps more relevant, when programmes are implemented that have high costs of downsizing (e.g. antiretroviral treatment of AIDS patients), finance officials may be cautious about exploiting readily available, but only short-term assistance.

Some have argued that external grants and loans may also reduce the incentive of governments to improve their revenue mobilization efforts and may create dependency and rent-seeking effects within government bureaucracies (see Gupta et al. 2004 or Moss et al. 2006). Assessments of fiscal sustainability necessarily must gauge such disincentive effects, particularly given uncertainties on the long-term sustainability of external assistance inflows. In effect, the fiscal space created in the short term may have a negative impact on available fiscal space in the future if it reduces domestic resource mobilization efforts.

Borrowing represents another option for the financing of additional expenditure. But borrowing, whether domestic or external, implies the need to repay, thus raising the question of whether the return on the expenditure justifies the cost of borrowing, and perhaps even more relevant, whether the spending will enhance future government revenues that can be used to finance the repayment of the loan. Governments may borrow to finance an overall fiscal deficit, rather than with regard to a specific project or expenditure programme. But such borrowing must then be considered in the context of an assessment of the overall sustainability of a government's debt obligations, in terms of its capacity to service interest and principal repayments. Such assessments typically need to consider, inter alia, an economy's prospective growth rate, its potential for exports and remittances, the prospective interest rate environment, the elasticity of revenue to growth, the composition of existing debt (in terms of interest rate, maturity, currencies of borrowing), and the terms of any new debt being considered (see IMF 2004) (i.e. wheteher new borrowing is on concessional or at market terms). Certainly, borrowing to finance the recurrent cost of programmes, particularly in the health sector, is unlikely to be a reasonable strategy, since it would quickly build up the debt that would then need to be serviced, generating an increased interest burden on the budget.

Domestic borrowing must be managed with particular care, since it can quickly lead to government budgets being overburdened with debt service obligations. No possibility exists for such borrowing to be forgiven by external donors through debt cancellation initiatives. And, as can be illustrated in the cases of Malawi and Zambia, thin domestic capital markets can quickly result in high real interest rates that can prove a heavy burden on a government budget in terms of debt service. Thus, in Malawi and Zambia, domestic debt as a share of GDP has risen sharply in recent years to around 20–25%, which, in view of the limited degree of monetization, has resulted in high interest rates of around 20%. In contrast, in Tanzania, domestic debt has halved in recent years, with a concomitant drop in the Treasury bill rate, thus creating fiscal space by the reduction in the overall interest bill.

Printing money to finance additional government spending, i.e. seignorage, offers only limited room for the creation of fiscal space and should be subordinated to the broader objectives of monetary policy, viz. the creation of sufficient liquidity to support an economy's real growth, preferably on a relatively non-inflationary basis. In the normal course of growth, seignorage consistent with a modest single digit rate of inflation, perhaps in the order of 0.5–1.0% of GDP, is created annually, with the associated resources flowing to the government, usually in the form of the profit remittances from the central bank (see IMF 2005b). Some NGOs have advocated that higher rates of monetary creation, even at the cost of higher inflation, should be explored as a mechanism for financing increased health outlays. But there are dangers to this approach. Not only does an inflation rate above 10–12% of GDP disproportionately hurt the poor (because they are least able to adjust for the loss in their real income), but high inflation is also a deterrent to efficient investment policies.¹ Except in situations where inflation is being gradually brought down from hyperinflationary levels, it would be unusual for the IMF to endorse a programme that explicitly targets an inflation rate above 10–12%. Thus, in the cases of Malawi and Zambia, the task remains to bring inflation rates down to single digits.

Issues that arise in the creation of fiscal space

The foregoing discussion merely lays out the possibilities for how fiscal space can be created. But there are a number of issues that bear on the usability of the resources thereby created.

The role of macroeconomic constraints

Are there limits to the amount of grants and loans that a country can or should absorb? The finance ministry and central bank must contend operationally with judging the macroeconomic impact of higher grant flows on the exchange rate (the so-called ‘Dutch Disease’ concern that higher foreign exchange inflows lead to an appreciation of the currency). The government's financial authorities may be wary about such an appreciation because of its adverse effect on the competitiveness and profitability of export industries. Such an appraisal is not easy, since the extent of the impact is affected by how the grants are used – whether for imports or what economists call ‘non-traded’ goods and services. In this regard, these financial sector officials may have a different perspective than a minister of education or health on the relative benefits of higher grant flows. While the empirical evidence is mixed as to whether higher grants would lead to an appreciation of the currency, two points are worth noting. First, many countries act as if the Dutch Disease issue is a potential problem, as witnessed by their efforts to use monetary policy tools to prevent a currency appreciation (with adverse consequences in terms of domestic interest rates) (see IMF 2005a). Secondly, the likelihood of Dutch Disease problems can be minimized if grants are used to finance the purchase of imports or for investments that relax key bottlenecks, particularly in sectors where absorptive capacity constraints cannot be easily overcome simply by imports. So it would be a mistake to assume that higher external grants necessarily must create difficulties for a country's export industry. Coherent and well thought-out policies can address many potential obstacles.

Moreover even if, with all best efforts, the Dutch Disease issue remains a relevant concern, its consequences must be weighed against the long-term benefits of the spending that can be financed by higher foreign aid inflows, viz. investments that address key deficiencies in human capital or physical infrastructural bottlenecks that limit the capacity of a country's economy to escape from a low-level poverty trap. The short-to-medium cost of some erosion of competitiveness may be thus worth accepting if the long-run benefits are large enough.

Fiscal sustainability

Explicit in the definition of fiscal space is the link to the concept of fiscal sustainability. This relates to the capacity of a government, at least in the future, to finance its desired expenditure programmes as well as service any debt obligations (including those that may arise if the created fiscal space arises from government borrowing).² This has a number of implications. First, it suggests that exploitation of fiscal space requires a judgment that higher expenditure in the short term, and any associated future expenditures, can be financed from current and future revenues. If an expenditure project is debt financed, it should be assessed in terms of its impact on the underlying growth rate or by its effect on a country's capacity to generate the revenue needed to service that debt.

Secondly, the definition forces attention on the medium-term implications of the spending programmes for which fiscal space is created in a given year. Are the expenditures for which fiscal space is created likely to be concentrated in the immediate term? Or are the desired expenditures likely to require future expenditures, in which case some fiscal space will be needed in the future as well? To illustrate, budgetary room could be made available in a given budget year to finance a meritorious objective – say, a one-time training programme for government civil servants. Yet there are many types of government expenditures – particularly in the health sector, where the initial spending will have implications for subsequent spending on operations and maintenance that would require the availability of future budgetary resources. In particular, for many of the programmes for which fiscal space is now being advocated in the health sector, the desire is for higher expenditures that can be sustained over a long period of time, e.g. antiretroviral treatment programmes for AIDS patients. In either case, it would be insufficient to create fiscal space in the first year without ensuring the creation of similar fiscal space in future years to cover these requirements.

Thirdly, this last point underscores that any consideration of fiscal space must be made in the context of at least a medium-term expenditure framework that has a comprehensive perspective on the government's expenditure priorities. If there is a possibility that the fiscal space that allows for today's additional expenditure will not be replicated in the future, governments may find that they are forced to either underfund the new initiative or cut back on other expenditure programmes in the future. Thus, fiscal space should not be seen strictly as an issue associated with a specific sector. It is necessary to assess the scope for higher spending within the context of a comprehensive and forward-looking fiscal and budgetary framework (Foster 2005; World Bank-WHO 2005). Governments have an obligation to weigh the relative merits of spending across different sectors, since initiatives in one sphere may ultimately have crowding-out effects on others.

Competition for fiscal space

A critical fact of life with regard to fiscal space is that there are multiple competitors for it. And while there are many who advocate the exceptionality of the health sector, there are others who would also attach a higher priority to investments that will facilitate rapid economic growth. Even those who are motivated by health concerns recognize the importance of investments in water, sanitation, agriculture and other income-creating sectors. Also, in assessing the overall fiscal framework, a government must take account of the possibility that a higher level of spending in a sector, even if financed from external grant flows, may have ripple effects on spending in other sectors. Thus, an effort to improve the financial compensation of health workers can create irresistible pressures for wage increases in other parts of the public sector for which external grant flows are not available. Finding the financial resources to fund these other programmes may bump against overall fiscal resource ceilings.

Absorptive capacity, governance and other factors limiting the exploitation of fiscal space

The issue is often raised of whether a government can ‘absorb’ a higher level of external resource inflows for spending in a sector. The term ‘absorptive capacity’ can be interpreted in many ways, extending to separate concerns ranging from the availability of the required skilled manpower to deliver services, to the availability of managerial staff to organize the scaling up of programmes, to the existence of critical physical infrastructure, to the governance capacity of a government to use resources well, to the strength of public expenditure management systems. Ultimately, these are less issues of fiscal space, and more ones of the potential inefficiencies associated with a rapid scaling up of expenditure, and the implied reduced cost-effectiveness of such spending. But these various factors may preclude the effective utilization of fiscal space, and may need to be dealt with either before, or at least pari passu with, the efforts to scale up the delivery of services.

The impact of sound macroeconomic policy management

Fiscal space can also be created by the pursuit of consistent and effective macroeconomic policies. Some of the volatility in external assistance experienced by many countries has arisen from the failure to implement agreed macroeconomic policy programmes. This has resulted in a cessation of donor assistance, with the effective cutbacks in fiscal space dramatically weakening a government's ability to maintain the financing of its level of services. Malawi and Zambia illustrate this problem, where there was high volatility of grants during the period 1990–2003 as a result of macroeconomic policy slippages.

The effects of the recent debt-cancellation initiative

A number of LICs will benefit from the effects of the recent G8 initiative in Gleneagles, Scotland, to cancel all debt obligations to the multilateral financial institutions. In the cases of Zambia, Malawi and Tanzania, the nominal debt to GDP ratios will fall sharply (from 65, 82 and 57%, respectively, to 10, 20 and 22%, respectively). Obviously, there will be some additional fiscal space afforded and this is important, particularly because it is a permanent, predictable stream of resources. But because much of the debt was already on concessional terms, and because much of the debt service was ‘effectively’ financed by new loans from the multilateral agencies, the annual additional resources available on a flow basis to these countries as a consequence of the debt cancellation initiative will not dramatically enhance the capacity of countries for new spending programmes.³

This initiative will also significantly reduce the net present value of existing debt relative to such economic aggregates as GDP, exports or government revenues.

Governments will now also have the opportunity to use the fiscal space for creating fiscal infrastructure that can enhance growth prospects, achieve the MDGs and break out of poverty traps. But past experience with borrowing for unproductive projects highlights the need for any new projects to be financed by borrowing to be carefully appraised in order to ensure they realize high rates of return. Otherwise, these LICs may quickly find their future borrowing capacity to be once again compromised.

Concluding remarks

Judgments on fiscal space are inherently country specific, requiring detailed assessments of a government's initial fiscal position, its revenue and expenditure structure, the characteristics of its outstanding debt obligations, the underlying structure of its economy, the prospects for enhanced external resource inflows and a perspective on the underlying external conditions facing an economy. The basic message of this paper is that for most LICs, much of the fiscal space for increased health spending, particularly in the short-to-medium term, is likely to require external financing, with a strong preference for grants. This underscores the importance of greater predictability and longer-term financing by donors if countries are to be enabled to expand employment comfortably in the health sector. Competition for such fiscal space can be anticipated, as countries confront many urgent needs across sectors. While macroeconomic policy constraints are unlikely to be encountered by expanded health sector programmes alone, such issues as inflation or the prospect of a real exchange rate appreciation may become relevant if higher aid levels enable a country to scale up spending programmes across a wide range of sectors.

Biography

Peter S Heller, PhD, is Deputy Director of the Fiscal Affairs Department of the International Monetary Fund. He has worked on fiscal policy issues in countries as diverse as Japan, China, India, Somalia, Thailand, Korea, Indonesia, Bosnia, Slovenia and Russia. He participated in the Commission on Macroeconomics and Health, World Health Organization and the Millennium Task Force of the United Nations. He has published extensively in a number of areas, relating principally to fiscal policy, economic development, poverty reduction, aging populations, public expenditure policy and globalization. He is the author of Who will pay? Aging societies, climate change, and other long-term fiscal challenges.

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