The supplementary budget—will it relieve or stoke inflation?

The forthcoming supplementary budget for 2008 plays a crucial role in the present circumstances of disconcertingly high inflation, a deteriorating external environment...

The forthcoming supplementary budget for 2008 plays a crucial role in the present circumstances of disconcertingly high inflation, a deteriorating external environment, and the diminished room for maneuver for monetary policy owing to the exchange rate peg. To steer the economy to a path of lower inflation and sustained growth in living standards, the supplementary budget needs to be realistic, sound, and must avoid intensifying inflationary pressures by lowering, not raising the deficit target. 

1.      It is critical to base the supplementary budget on realistic economic assumptions. It should not assume an implausibly low inflation rate or high nominal GDP level. Neither should it set unrealistically ambitious targets for revenue increases, notably by assuming sharp and sudden gains in the performance of collection agencies.

2.      Containing the budget deficit is key to lowering inflation pressures. A lower deficit would alleviate domestic demand pressures, a key contributing factor to the current inflation surge. It would also enlarge the elbow room for future fiscal policy action, should the need arise. Fiscal prudence at the current juncture is particularly important to avoid the risk that higher inflation will be built into expectations and wages. Once such expectations are entrenched, reducing inflation would involve very high costs. In contrast, output gains from boosting demand further at this point when capacities are tight would be small and transitory.

3.      The supplementary budget should strengthen the revenue base. In this regard, we welcome that the revised draft government program no longer calls for replacing the VAT by a sales tax, which would have narrowed the tax base and risked increasing avoidance. To further develop financial markets, the supplementary budget should eliminate the highly distortionary financial transactions tax. Revenues could be bolstered by reducing exemptions and tax privileges (notably in agriculture) that have eroded the tax base.

4.      Restraining expenditures is the cornerstone of a prudent fiscal strategy. New discretionary spending initiatives include up-front budgetary cash repayment of lost savings, and may extend to raising subsidies, notably for government-backed mortgages. These initiatives can only be accommodated through offsetting cuts in other expenditure. Increases in social spending, which the 2008 budget expanded by more than 40 percent above the 2007 budget target, and in wages should also be contained. They are outpacing the rise in total expenditures, as well as the state’s underlying ability to pay. Finally, government programs requiring budgetary support should be reviewed, with a view to canceling inefficient ones.

5.      Budget financing is not a binding constraint, but important. A greater part of financing should be domestic, since this would help to develop financial markets and foreign financing carries risks that need to be factored in to appropriately assess its cost. Privatization should be driven by criteria of long-term economic efficiency, not cash-flow considerations. Privatization receipts are one-time revenues that should not be earmarked to ongoing social spending, as this would increase inflationary pressures in the short term and be unsustainable in the longer term.

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