Question

Discuss the following statements: The prudent fiscal policy rule (PFPR) allows temporary negative output gaps to widen the deficit and increase debt, but requires permanent increases in expenditures to be financed by higher permanent taxes.

Answer 1

Following several years of implementing a proactive fiscal policy, China’s economy gradually emerged out of the shadow of deflation and stepped into the upswing phase of a new economic cycle. All the macroeconomic indicators looked good. The three major types of demand—investment, consumption, and export—recovered simultaneously. The robust demand in investment and export spurred economic growth and kept the general price level stable. Foreign trade grew steadily and rapidly, keeping the balance of payments in surplus. Pressure was eased on employment.

The regulatory role of market mechanisms was greatly enhanced, bringing about a mechanism of self-sustained economic growth. However, in the second half of 2003, despite the rapid development of the national economy, problems began to appear in some areas, such as over-investment and increasing inflation pressure. In short, China’s economy was confronted with a different situation from that in 1998, when the government decided to carry out a proactive fiscal policy. In 2003, the internal and external environment was conducive to economic development. Deflation was basically curbed and demand increased, bringing about a general equilibrium. However, structural and institutional issues became prominent

The Decision-making on Prudent Fiscal Policy

Prudent fiscal policy is also known as neutral fiscal policy in economics. In the face of the new economic situation, MOF initiated the study on fiscal policy adjustment in early 2004. For this purpose, it held a series of seminars to solicit opinions and suggestions from domestic and international experts and to examine the lessons and experience of other countries in implementing the neutral fiscal policy. Based on these preparatory activities, MOF proposed a shift in fiscal policy to the central government, which, after careful assessment, approved it and made a resolute decision to implement a prudent fiscal policy in 2005. Clearly the prudent fiscal policy was born out of a scientific and democratic decision-making process.

Acknowledging International Experience

International understanding of neutral fiscal policy

Discussion of neutral fiscal policy abounds in Western economic literature, involving important concepts such as neutral fiscal policy, neutral fiscal stand, fiscal neutrality, and neutral budget. All these concepts mean almost the same thing, that is, a relatively steady state where the central government does not expand or contract aggregate demand.

A neutral budget refers to a budget prepared by the government that neither contracts nor expands. In terms of public finance, fiscal neutrality occurs when tax revenue and government expenditure do not stimulate or contain demand and the net effect is neutral. In general, by implementing a neutral fiscal policy in the context of a general equilibrium, relatively stable prices, and steady economic performance, the government’s direct intervention will be curbed, making it possible to bring into full play the role of market mechanisms. Of course, neutrality does not require a complete balance between fiscal revenue and expenditure. Fiscal neutrality can be achieved in the case of a general equilibrium between fiscal revenue and expenditure, an incremental balance, or growth of fiscal revenue and expenditure based on certain rules. Many international experts and scholars have defined neutral fiscal policy from different perspectives. These definitions are based on six situations where:

• A government breaks even, with little or no influence on economic activities.
• Fiscal expenditure (exclusive of interest) rises in tandem with potential GDP growth and expected inflation, while tax revenue is the function of real GDP.
• A basic balance is maintained in public finance, together with managed government debts, despite a certain potential output gap.
• The average tax ratio (the proportion of fiscal revenue in GDP) and the proportion of fiscal expenditure (exclusive of interest) in potential GDP remain constant.
• The proportion of non-cyclical fiscal expenditure in potential GDP is kept constant.
• A balance is kept between the structural parts of fiscal revenue and expenditure, after excluding the influence of a business cycle.

Countries implementing neutral fiscal policy

Neutral fiscal policy is nothing new. Indeed, many countries have already implemented it. The European Commission (EC) considers it important to keep a neutral fiscal status in the European Union (EU). For the EC, it is necessary to reduce fiscal deficit and keep fiscal neutrality, if the Euro-zone seeks to maintain economic growth under lower inflation. According to Juergen von Hagen, the EU’s fiscal policy was expansionary in 1998 and 2000, and neutral in 1999 and 2001. In particular, Germany, France, Spain, Italy, and Portugal shifted their fiscal policies from expansionary in 2000 to neutral in 2001. Most European countries have turned to neutral fiscal policy since 2001. France and Spain’s policies in 2003 were basically neutral.

In a report on the Euro-zone monetary and exchange rate policies released after the fourth round of consultation with Euro-zone member countries, the International Monetary Fund (IMF) pointed out that most Euro countries were implementing neutral fiscal policies. According to the economic policy analysis report issued after the fourth round of consultation between IMF and Austria in 2001, Austria was also believed to be adopting a neutral fiscal policy from 1999. Analysis also reveals that Denmark’s fiscal policy was neutral in 2001 and 2005; Norway’s was mainly neutral in 1998, 2000, 2001, 2003, and 2004; Finland’s was expansionary from 1990 to 1991, contractionary from 1992 through 1995, and neutral from 1996 through 1999; the United Kingdom’s was neutral from 1974 through 1979, and neutral in 2004; Thailand’s was neutral from 1992 through 1997; Korea’s was neutral from 1994 through 1997. In its research on Japan’s economy in 2002, the OECD suggested that Japan should adopt a neutral fiscal policy instead of short-term incentive measures.

Decision Making

In view of China’s new economic environment in 2003 and the international and domestic experience of using fiscal policy to regulate macro economy, the country was in great need of an important transformation of its fiscal policy. On May 27, 2004, at the closing of the Global Conference on Scaling Up Poverty Reduction in Shanghai, it was revealed for the first time in a press release that China would shift from expansionary to relatively neutral fiscal policy, in order to ensure sound economic growth. Moderate regulation would be implemented to support underdeveloped sectors, and to curb overheating industries. This message soon became the focus of attention: the policy shift became a hot topic in the media, triggering heated discussions in various quarters of society, especially in the financial academia. MOF also conducted further research in due time.

In late July 2004, the ministry held a symposium, consulting with economists on the orientation of China’s fiscal policy. Participants included economists from the People’s Bank of China, the State Administration of Taxation, the National Bureau of Statistics, the Development Research Center under the State Council, the Chinese Academy of Social Sciences, the Research Institute for Fiscal Science of the Ministry of Finance, universities and colleges, and nongovernmental research institutes. It was generally agreed that China’s macroeconomic environment had changed and that a new growth cycle had started. The six-year-old proactive fiscal policy was no longer effective and valid. It was time to adopt a neutral one, in view of the changes in policy targets and the prevailing environment. However, opinions were divided on the naming of such a pro-neutral policy. Different names were proposed, such as “neutral fiscal policy,” “prudent fiscal policy,” “coordinated fiscal policy,” and “structural fiscal policy.” In early August 2004, MOF held another symposium on the orientation of fiscal policy in the next stage. Present at the symposium were experts from the Policy Research Office of the CCCPC, the Chinese Academy of Social Sciences, Renmin University, and the Research Institute for Fiscal Science of the Ministry of Finance. It was agreed that the proactive fiscal policy, which had fulfilled its historical mission, had to be phased out to accommodate the new economic environment. A neutral fiscal policy would take its place to focus on aggregate control and economic restructuring. The name of “neutral fiscal policy” was also widely accepted by the majority of the participants.

Measures of Prudent Fiscal Policy

Prudent fiscal policy is not only a name change, but also a shift of fiscal policy’s nature and orientation. It can play a better role in balancing social and economic development. In brief, the prudent (neutral) fiscal policy can be recapitulated in four aspects: controlling deficits, adjusting structure, advancing reforms, and increasing revenue while curbing expenditure.

1. Controlling Deficits

2. Adjusting Structure

3. Advancing Reforms

4. Increasing Revenue and Curbing Expenditure