Chapter

V. The Impact of Government Expenditure on Income Distribution

Author(s):
International Monetary Fund
Published Date:
September 1986
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Redistribution of income and wealth can occur not only through taxation but also through government expenditure, which can be categorized in economic or functional terms. The more traditional focus is on an economic classification of expenditures, because it depicts expenditure flows as the government typically determines and monitors expenditure policies. Thus, attention is focused on, for example, outlays for wages and salaries, or on debt-servicing charges, or on the capital budget.

A functional classification of government expenditure often provides useful insight into important social issues. From a practical standpoint, most budgetary accounts under the “vote accounting” systems are presented in this fashion and the authorities are familiar with it. Moreover, expenditures can be organized and monitored in an analytical framework that permits and encourages appraisal of government outlays to determine how successfully the government is addressing major social objectives, such as educating the population. Thus this accounting framework provides an answer to the question, what share of government expenditures is spent on education? When more sophisticated analysis is possible, an “achievement-by-objective” approach to government expenditure decisions can lead to benefit-cost comparisons that maximize the efficiency of government expenditures while achieving the stated policy objective. In the case of educational systems, for example, the choice may be one of choosing a delivery system (such as school consolidation, a system of radio or television programs, or more traditional programs) that will most efficiently spread literacy.31

This section examines the effect of measures relating to expenditure policies in Fund-supported adjustment programs on income distribution, starting first with a functional expenditure orientation, and then looking at expenditure by economic classification. Two major classes of “economic” expenditure, those for subsidies and nonfinancial public enterprises (NPEs), are of such importance that they are discussed separately in Section VI.

Functional Expenditure

In the context of determining the income redistribution effects of Fund-supported adjustment programs it is also appropriate to discuss the relationship between the functional expenditure pattern and income distribution within a country, and then to examine how a program affects the functional expenditure pattern and hence the income distribution. Several obstacles stand in the way, however.

The difficulties may be more immediately obvious if a particular type of functional expenditure is considered. Educational expenditures may be seen as an investment to enable society’s poor to compete on an equal basis with the rich.32 Will an increase in educational outlays thus foster income redistribution? Not necessarily, for if the poor are generally also elderly, educational outlays will have little effect on existing income patterns. Under these circumstances, increased old age benefits would be a more effective redistributional tool, no matter how large the return on educational outlays. Moreover, even if higher educational expenditure holds the potential to improve the income distribution (if the poor are young), the absolute level of educational expenditure may be less important than its distribution. Higher educational outlays will serve little redistributional purpose if they are targeted at urban children and most of the poor reside in rural areas or if they do not promote basic education for all.

Usually, it is difficult to determine who benefits from government programs or what benefits have been conferred. It has often been suggested, for example, that educational outlays provide “externalities” that everyone enjoys in the form of a better educated society, so that everyone gains from these programs. The allocational problem is even more acute in the case of pure public goods, such as defense, where the exclusion principle totally fails and there is no obvious means of imputing the benefits from public expenditure33 to individuals in the society. Another issue is the value of these benefits. Some goods and services provided by the government are sold through the marketplace and thus are explicitly valued by the market system, but many goods and services such as education are normally provided free of charge to the recipients. Without a market-determined price, what is the value of these programs to the recipient? Finally, as mentioned, public expenditures such as education frequently are imbued with a large element of investment, so that immediate imputation of the full amount of expenditure to the presumed target group may substantially overstate the benefits actually received during the year.

From just this brief review of some of the methodological issues in expenditure incidence studies, it should be apparent that even if the Fund could undertake more studies, they could only suggest tentative conclusions about the redistributive effects of government expenditure patterns under the best of conditions. For these and other reasons, studies of the income redistributional effects of government expenditure have reached contradictory results, with some concluding that government expenditure policies have had little or even negative redistributional effect and others suggesting that their effects have contributed to greater equality.34 Interestingly, most studies which report a favorable effect on income redistribution also suggest that the redistributional effect of specific benefit expenditure is somewhat less important, implying that the imputation formulas used to allocate general benefits were very supportive of the conclusions they reached. Several studies have indicated that the presence of any redistributive effects is related to the socioeconomic characteristics of the regime, further equivocating the significance of these results.35 The important ancillary issue of the redistributive effects of specific types of functional expenditure rather than overall expenditure programs has generally been restricted to those in developed countries.

Before providing a brief overview of what effect measures affecting functional expenditures in programs may have had on income distribution, it is important to recall from the discussion in Section III that these programs may contain some understandings about undertakings in specific sectors, but in the main their operative content concentrates on broad macroeconomic developments. In the case of functional expenditures, general reservations about the usefulness of specific expenditure criteria are reinforced by the lack of meaningful guidelines with which to evaluate expenditure levels. How much health expenditure is too much? At what point does educational expenditure become counterproductive? Defense expenditure is frequently cited as being excessive, but what level is adequate?36 These are clearly difficult questions to answer and ones which the Fund should be reluctant to embark on.

A detailed look at the adjustment programs supported by the Fund confirms the view that they only make limited reference to specific functional expenditures (Table 6). Of the 94 programs surveyed, only 4 contained restrictions on general public services, 7 limited defense outlays, 4 limited educational expenditures, 1 related to housing, and 1 related to the level of economic services. Thus, only about 1 in every 6 programs restricted any element of functional expenditure, and only one fourth of these were of a specific nature which can in any direct sense be related to distributional concerns. There were, however, a number of programs which did establish limits on general government expenditures such as caps on current expenditure (2 programs), public sector wages and employment levels (3), official travel (5), materials and supplies (5), vehicles (3), and other (1). Given the very tenuous relationship between expenditure patterns and income distributions, it is hard to argue that this element of Fund-supported adjustment programs has had an adverse effect on income distribution.

Table 6.Expenditure Policies Relating to Functional Expenditure in Fund-Supported Adjustment Programs
Number

of

Programs
Percent
Restrictions on central government outlays1516
General public service44
Defense outlays77
Education44
Housing outlays11
Level of economic service11
Restrictions on general government outlays1314
Current expenditure22
Public sector wages and employment33
Official travel55
Materials and supplies55
Purchase of vehicles33
Other11
Source: Appendix III.
Source: Appendix III.

Expenditure by Economic Purpose

The adjustment efforts incorporated in Fund-supported programs often have significant implications for certain types of expenditures which are most easily identified by their economic function. In terms of operational importance, the main economic categories are wages and salaries, other purchases of goods and services, interest payments, subsidies, transfers, capital outlays, and net lending.37 The emphasis on government current expenditure in the programs surveyed was split more or less equally between wages and salaries (59) and goods and services (51); policies to limit capital investment and net lending were also important (56) (Table 7). The most significant policy actions were restraint in the public sector wage bill and a curtailment of capital outlays (at least in real terms). Subsidies and transfers to public enterprises are discussed separately in Section VI.

Table 7.Expenditure Policies by Economic Type in Fund-Supported Adjustment Programs
Number

of

Programs
Percent
Restraint of central government current expenditure8691
Wages and salaries5963
Freezing or reduction of numbers of government employees3234
Freezing, reduction of wage increase13840
Change in the employment policy1314
Limit on salary indexation11819
Goods and services5154
Improvement in overall expenditure controls2426
Cumulative monthly/quarterly restrictions on expenditures1213
Reduction on appropriation for specific expenditures3234
Capital expenditure and net lending2, 35660
Curtailment of investment4346
In real terms2628
In nominal terms1516
Other22
Limit or delay new investment or new projects2324
Improvement of investment program2021
Reduction in domestically financed investment1112
Expenditure administration4043
Improve expenditure control3941
Others (shift in budgetary priorities)44
Source: Appendix III.

In one case, a policy in the opposite direction was suggested.

World Bank collaboration specifically mentioned in 21 cases.

In eight cases (not included here) the policy mentioned was in the opposite direction.

Source: Appendix III.

In one case, a policy in the opposite direction was suggested.

World Bank collaboration specifically mentioned in 21 cases.

In eight cases (not included here) the policy mentioned was in the opposite direction.

Wages and Salaries

Government wage and salary policies often have a major role in the determination of national wage and salary structures. The salaries the government can offer to existing or potential employees are commonly known, and unidentified nonwage incentives are seldom attached to new wage pacts. In some countries, the salaries of public employees are routinely published. More important, the public sector often dominates the determination of wages in the nonagricultural sector through its relative size. The government normally determines salaries for the public enterprises as well as for the military and the civil service. In developing countries, where the government at times guarantees employment for school graduates and may even act as an employer of last resort for its citizens, public sector employees comprise an average of 44 percent of nonagricultural employment. In some countries the ratio is over 70 percent.38 Clearly, public sector wage determinations in these countries could have a significant demonstration effect on average salary levels, as private sector employees strive to match the (publicized) increases government workers receive.

There are a number of reasons why wage levels could rise to levels which exceed the value of the typical worker’s marginal product, but the most important is probably the government’s sincere intent to improve the well-being of its citizens through higher general wage levels. Whatever its origins, an excessively high wage structure normally sets the stage for a demand-management problem: high wages fuel aggregate consumption, just as an artificially high wage rate encourages an inappropriate substitution of capital for labor in an economy in which labor is relatively abundant. Thus, the aggregate demand problem may be due to a government wage structure that is high or overemployment in the public sector, or both; either inflates the overall public sector wage bill beyond the economy’s ability to sustain the resultant demand.39 Under some circumstances, government outlays for wages and salaries have exceeded 50 percent of total expenditures, and are thus a major contributor to the supply-demand imbalance.

In general, some combination of the above factors has been evident in many countries seeking Fund-supported adjustment programs, and restraint on wages and salaries was a policy in 63 percent of the programs surveyed in the sample. These efforts to lower the wage bill took a number of different approaches, including wage-specific policies (38 programs) that limited the increase in nominal wages or lowered real wages, or both, and less often (32 programs) froze employment levels. In some cases where wage increases were contained, the impact of the low average rate of increase was moderated for low-income employees by skewing the wage increases to the lower paid, while the limits on new employment frequently allowed only the replacement of retiring workers or the recruitment of new employees with special skills (e.g., computer experts).

The implication of these measures for income distribution patterns is clearcut. Government workers in developing countries are often relatively well-off, so that a decline in their incomes from whatever cause may improve income equality, although at some sacrifice to those who experience wage cuts. The comparison here with all individuals may well be unfair, however, as government workers generally reside in urban areas where the cost of living is significantly higher than for those at a comparable level in rural areas, and possess skills which may be much better compensated in the private sector. There are many countries in which government workers are substantially underpaid compared with their urban counterparts, and lowering their salaries worsens the income distribution in urban areas. The practice of skewing wage increases toward those in the lower salary scales (by not imposing the income cut or the de-indexation on the lowest paid) also plays a small role in equalizing incomes but it is questionable in terms of allocative efficiency. Indeed, a principal problem many governments now encounter is that of a scarcity of competent civil servants, as their policies of using the civil service to absorb surplus labor has led to a compression in public sector salaries, making it difficult to attract skilled employees and aggravating the practice of corruption.

In conclusion, freezing both the number employed in the public sector and their remuneration has been a frequent policy in Fund-supported programs; this, combined with limiting wage indexation, has often caused a decline in government workers’ pay relative to others. Although this causes vocal urban opposition, it frequently improves income distribution. The improvement is more evident in those countries where the lowest paid have not been subject to the same cuts as the higher paid public employee. Whether these policies are desirable in terms of government efficiency is debatable.

Other Purchases of Goods and Services

Outlays for other purchases of goods and services comprise such expenditures as those for office supplies, rent, fuel and light, repairs and maintenance, travel, communications, nondurable goods, and all nonwage military purchases. As an eclectic grouping of numerous small noncapital expenditure items they are hard to characterize, but collectively they provide the physical support which allows government employees to perform their duties. Despite their self-evident importance, purchases of other goods and services often bear the brunt of any adjustment effort as they have no obvious constituency and the impact of these cuts on the provision of government goods and services is often delayed.40 To provide but one example of how costly these “savings” can be, the immediate effect of not patching road potholes is so small as to be inconsequential, but continuation of this neglect will result in the whole road needing replacement sooner than it would have otherwise.

The many and diverse elements of this expenditure category make it virtually impossible to assess, in a generic sense, how reductions in these outlays will affect the income distribution. The linkages following from these outlays further complicate any meaningful analysis of their income effects. Most direct purchases of goods for government use originate in the urban sector, but many in turn create a ripple effect in the rural sector which transmits government demand throughout the economy. The distributional effects of expenditure restrictions on “other purchases” will thus clearly depend on their original composition and specific targeting of expenditure cuts, if any. In this regard, it is of interest that 12 of the programs surveyed attempted to improve on overall expenditure control by seeking to restrict budgetary disbursements for these outlays, while 32 provided for reductions in the appropriations for specific outlays. Overall expenditure control was mentioned in 24 programs; the distributional impact of this is impossible to assess, but clearly it is desirable in itself since to the extent that the public sector spends more efficiently everyone gains.

Interest

The prolonged exposure to high fiscal deficits, which most countries have experienced during the past decade, has profoundly affected the composition of government expenditure patterns for two equally important reasons. First, the need to finance persistently high budget deficits year after year has greatly increased the stock of government debt. Second, the increase in interest rates which has been linked to the growing public sector demands on international capital markets by the developed countries has sharply increased the costs of servicing outstanding external debt. The cumulative effect has made interest payments by far the fastest growing component of public expenditure in most countries.41 On average, the growth in debt-servicing charges was a little higher in industrial countries than in developing countries; an occurrence perhaps related to the share of external debt the developing countries received on concessional terms and their willingness to maintain low interest rates on the domestic component of government debt.

Obviously, the existence of high and rapidly rising debt-servicing charges can be at once both a symptom and a cause of poor demand-management policies. At first, large government deficits have little impact on budgetary outlays, but after an accretion of a large pool of outstanding debt, the high interest payments absorb a large share of the resources diverted to the public sector. Fund-supported adjustment programs typically do not address the issues of debt-servicing costs directly but do focus on a number of policies that will act over time to reduce these costs in relation to other expenditures. The programs normally stress improvements in demand-management policies, typically by limiting the size of the government deficit. Of the programs surveyed, 76 (81 percent) proposed a reduction in the government deficit as a share of GDP (Appendix III). Fifty (or slightly more than half) imposed limits on bank credit to the central government, and 80 (85 percent) limited the size or composition of external debt. Programs are also frequently linked to debt-rescheduling exercises, which reduce the immediate burden of debt servicing. In many circumstances, however, they stress the establishment of interest rates that are positive in real terms and that can actually increase these charges, both in absolute terms and as a share of GDP. Policies to improve resource allocation through such measures as higher interest rates and depreciation of the currency were factors in increasing service charges for domestic borrowings and the local currency cost of foreign debt.

The distinction between foreign-held and domestic debt is important when considering distributional effects. In the case of foreign-held debt, the recipients of debt-servicing payments are outside the country and the redistributional issue hinges solely on the payments side, in the sense that current and future generations must reduce their consumption to free the resources to service the external debt. Of course, a depreciation only increases the local currency value and not the level of real resources which must be transferred abroad, so that the issue very much depends on the source of the public savings which must be realigned. In the case of domestic debt, both the payments and receipts sides are relevant and the issue of direct income transfers is germane.42

Under these circumstances, it is difficult to even speculate about the effects of this aspect of Fund-supported adjustment programs on the income distribution even in the near term. If the overall revenue system is regressive, then it follows that any increase in external debt-servicing charges (related to a devaluation of the currency) will bear harder on the lower-income classes, worsening the income distribution. A higher debt-servicing burden will also reduce the amount of government income which is available for redistribution and make it difficult to reduce the budget deficit by lowering other outlays. Normally, domestic non-bank government debt bears a fixed interest rate, so that any increase in domestic interest rates does not translate into any immediate rise in transfers to the debt-holding public, but as this debt is rolled over it requires higher servicing costs and the income distribution is likely to be skewed toward greater inequality. In the medium-to-long term, the constraints on debt under a Fund-supported program are likely to reduce government interest payments, but the more important issue then becomes who will contribute the resources to narrow the fiscal gap.

Capital Outlays

While the concept of a capital budget to guide and support construction projects that will provide lasting benefits has been accepted in nearly all countries, many developing countries have expanded this conceptual framework into a national program for “development.” An especially aggressive development program can impose a substantial resource burden on the budget of the economy.

A difficult budgetary position may be further exacerbated by the recurrent cost requirements necessary to make development projects fully operational.43 The conflict between an overall budgetary constraint and the government’s desire to pursue its development objectives may degenerate to the point where potential benefits of completed capital projects are dissipated by funding insufficient to run and maintain previously constructed development projects.44 This outcome could thus be characterized as a “paradox” of development funding in which the government’s efforts to increase development outlays actually result in dysfunctional investment and lower the level of useful capital investment, much as the “paradox of savings” characterizes a situation in which individual efforts to generate more savings actually lead to smaller aggregate savings.

To cope with these concerns, Fund-supported adjustment programs have undertaken general lines of action in conjunction with the World Bank. Public investment has been curtailed in 43 programs (46 percent of the survey), 26 of which entailed reductions in real terms. The domestic contribution to the capital budget was reduced in 11 programs (12 percent), and investment was otherwise streamlined in 20. Excluding the double counting of various types of constraints, 46 programs in all (49 percent) contained some restrictions on capital expenditure. The distributional effects of the employment opportunities created during the building phase and the mixed results achieved by these projects make it difficult to determine how restrictions of this nature have affected the income distribution.

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