Economic policy for achieving sustainable, inclusive growth

Fiscal policies must target inclusive growth
Empirical studies have shown that supportive fiscal policies, globalisation and free trade are key to achieving strong, sustained and inclusive growth.

Inclusive growth key to sustainability: Global growth has been extraordinary in the last 200 years. There have been advances in technology and productivity that helped humanity overcome the Malthusian prediction that the population would outgrow food supply. Income per capita has risen from $2,000 to more than $50,000 in the US and by a similar rate across the world. Economic growth has powered improvements in living standards. Over two centuries, growth has reduced extreme poverty from 19 out of 20 people in 1820 to two out of 20 people in 2015.

There has also been a dramatic rise in education attainment and literacy. This was accompanied by improvements in health and an increase in the share of people living in democracies. This shows that economic growth is key to improvement in living standards. However, growth and income have been distributed unevenly across countries. For example, a citizen of Malawi or Burundi earn less than $1,000 annually, while those in the US, Luxembourg and other rich countries earn 80 to 100 times that amount. These income differences are correlated with indicators such as child mortality, life expectancy and years of schooling.

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While economic development of a country is vital, that alone is not enough. There is also a need to address income inequality. Inequality has been rising since the late 1970s in most advanced countries and many emerging market economies. According to French economist Lucas Chancel, the share of within-country inequality has been rising since the 1980s and now accounts for three quarters of the global income inequality. There is a time lag for within-country inequality data as they are based on household surveys, making it impossible to have a systematic measurement across the globe. But we can see that Covid-19 has had a deep impact on lower-income countries.

The IMF’s World Economic Outlook shows that in emerging Asia and other developing countries, output and employment are significantly below their pre-pandemic levels whereas they have rebounded in the US and other advanced countries. The degree to which countries have rebounded from the Covid-19 crisis is partly related to the distribution of vaccines and access to healthcare. It is also linked to the scale of the macroeconomic response. Research shows that a strong policy response can reduce output losses caused by financial stress and other shocks in recessions.

Policies must target inclusive growth

My research with Shweta Saxena and Hugo Panetta showed that the speed of recovery from recessions is closely linked to the fiscal and monetary stimulus and flexible exchange rate regimes. Economic losses are also strongly correlated to an increase in inequality. The countries that experienced severe output losses are those which tend to have high inequality. Similarly, inequality rose in countries with greater employment losses. Rising inequality can exacerbate poverty traps and social immobility. Countries that have a high level of inequality also have situations where a person’s income is highly dependent on the position of their parents. This shows how inequality persists.

We are familiar with the Sustainable Development Goals which focus on commitments to improve outcomes on 17 dimensions by 2030. Now, given that inclusive and sustainable growth is multidimensional, we need a whole-of-the-government approach to policy design. Even more than that, we need a whole-of-the-economy approach to achieve inclusive and sustainable development. So, we developed an inclusive growth framework as a systematic way to analyse economic interlinkages and help design appropriate policy responses.

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Strong, sustained and broad-based growth requires inputs from both the private sector and the government. In most economies, private individuals and firms generate a substantial share of economic activity. They produce goods and services and earn income on inputs of labour, capital and technology. These inputs can be derived from domestic sources or from globalisation, which adds labour, capital and technology through migration, capital flows and technology transfers across borders. In addition, the marketplace must be fair and competitive, both domestically and internationally, and needs to ensure appropriate prices and opportunities for all who contribute to economic activity.

The government provides inputs to create the right conditions for inclusive growth. Its governance framework establishes the rules of the game to manage the economy and hold political leaders accountable for their decisions. The political system creates opportunities for citizens to voice their views on social goals and reforms that promote inclusive growth. The government uses macroeconomic tools like fiscal and monetary policies to cushion economic fluctuations and to avoid disruptive recessions and crises.

The government also contributes by providing an array of public services such as health, education and infrastructure. It then uses its tax and spending instruments to redistribute income so as to increase the welfare of the poorest and to reduce income disparities. Usually, market outcomes are more unequal than outcomes after government redistribution through taxes and transfers. The private sector and the government jointly generate economic activity and impact the distribution of income. This may result in disparities in how economic benefits are distributed across genders and races.

Govts must support the poorest sections

In some countries, the young and the very old tend to be more vulnerable to poverty. Different regions of a country may grow at different rates, with some regions racing forward and others lagging behind. Economic benefits including resource wealth need to be shared across current and future generations. Inclusive growth must be sustainable, and sustainability requires addressing the potential detrimental impact of climate change on future generations. And finally, there is a feedback loop since inclusive growth is dynamic. Also, inequality can lead to political action that could change government policies.

One question that begs an answer is whether policies that improve inclusion come at the expense of growth. Is there a trade-off between growth and inclusion? There are some mechanisms and policies that lead to a trade-off between growth and inclusion, but others have promoted higher growth and equality at the same time. For example, high growth can create more job opportunities and provide resources for redistribution, lowering poverty and inequality.

Conversely, depending on the source of growth, some sectors may grow faster than others, or the returns to capital and skilled labour may be higher than returns to unskilled labour, leading to inequality. If inequality is too high, it could produce poverty traps, crime and a social split, which impair growth. So, we need to be conscious of these various channels when we design policies. If a society has equality of opportunities, a person’s income tends to be determined mostly by their effort and ability. This provides incentives for hard work and investment in improving skills. If we promote equality of opportunities, equality and growth will improve at the same time and there will be no trade-off.

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Fiscal policy also reduces poverty by 2.25% on an average in developing countries. Here, nearly all the impact comes from transfers rather than taxes. In addition, the right composition of public expenditure is important for reducing inequality. However, it is important to keep in mind that the impact of fiscal policy on inclusive growth needs to jointly account for the revenue and expenditure side. For example, even if taxes alone result in little direct reduction in inequality, they do provide resources for transfers and social spending that can improve the lives of the poor. So, efforts to mobilise domestic revenue can be impactful for inclusive growth.

The state has a broader role than its direct instruments and policy measures. Legal and political structures set the rules of the game and determine property rights. So, institutions of governance shape how successful the country is in spurring inclusive and equitable growth. There are many dimensions to a country’s governance. Avoiding corruption is an important component of it. Corruption can have a sizable macroeconomic impact. Some studies find that bribes account for as much as 2% of the global GDP. In all regions, there is a significant share of firms that report corruption as a top concern for the business environment.

Corruption, poor governance undermine trust

Corruption and poor governance can breed lack of trust in the government and undermine support for reform. This is especially critical when the government wants to introduce a reform that has potentially large benefits over a larger horizon, but may entail short-run costs. If citizens are suspicious of public officials, they may not tolerate reforms with short-run costs because they do not trust that the reforms will deliver them long-term benefits.

The government also has a crucial role in maintaining macroeconomic stability using its stabilisation tools. This topic is fundamental to the work at the IMF. We find that economic volatility and outward scarring lead to income inequality across countries and within countries. Countries that have highly volatile GDP per capita also have highly volatile of unemployment and poverty. Therefore, it is critical to avoid scarring. In an article published in the American Economic Review in March 2008,

Shweta Saxena and I presented evidence from a large cross-country panel showing that the balance of payments and banking crises lead to a persistent loss in the level of output. On an average, the magnitude of output losses was 5% for currency crises, 10% for banking crises and 15% for twin crises. In another study, we showed that recessions more broadly lead to persistent output losses. This phenomenon is not limited to financial crises. As I already mentioned, we also found that this output scoring or hysteresis can be reduced by fiscal and monetary expansions during recessions. So, countercyclical macro policy can not only reduce volatility, but also can affect growth.

We found that output scarring also affects development. According to the neoclassical growth theory, poor countries are expected to grow faster than rich countries due to diminishing returns on capital. In other words, in theory, each dollar of investment should be more valuable in poor countries. However, the empirical evidence has not shown much support for convergence, and we argue that output scarring provides an explanation.

Let me turn to some of our findings about the links between globalisation and inclusive growth. Here we find a distinction between the impact of trade versus financial integration. There have been a lot of concerns on whether trade, especially the rise of China, is adversely impacting the US. Some politicians argue that trade was bad and we needed protection against it. However, our findings disagree. Empirical evidence shows a strong correlation between trade, openness and growth.

It is evident that trade helps growth, but what about equality? The study finds that countries that were liberalised had less inequality than countries that remained closed. Trade also helps poverty reduction, although this also depends on institutions and complementary policies. It could be that this poverty-reducing effect of trade could arise indirectly because of the fact that trade boosts growth and higher growth is associated with a decline in poverty. Trade has a lot of benefits such as increases in productivity and innovation. It reduces prices, which benefits the poor.

Within a country, there are different impacts across individuals, locations and firms, depending on which sectors expand and which ones contract. The impact depends on the pattern of tariffs and other barriers. In India, people with lower levels of income tend to be employed in sectors that face higher barriers to exports. Women face barriers such as higher tariffs for goods that women produce and consume. For India, the gap between what women pay and what men pay, the so-called pink tariff, is 6 percentage points.

Inward foreign direct investment’s tendency to contribute to the inequality is less in countries with higher levels of educational attainment. A higher level of human capital in an FDI recipient country will tend to limit the impact on the scale premium. For example, between 1995 and 2015, more than 6% of the population completed tertiary education in emerging and developing countries that observed a decline in inequality, whereas only 2.5% of the population completed tertiary education in countries that experienced an increase in inequality.

Climate change is linked to the three major pillars of inclusive growth – economic development, sustainability of growth, and physical environment and inclusion – which ensure decent living standards for all. Governments will need to employ a broad policy package to enable this green transition.

All this is complemented with enabling policies like financial inclusion and the promotion of active labour market policies and entrepreneurship. It will require regional investment strategies to help facilitate this transformation and transition to a green economy, especially for workers and regions that are most affected. But if done right, this transition to a low carbon economy can also create new jobs and opportunities. For example, even though solar and wind energy are a small share of energy production in the US compared with coal, they employ almost three times as many workers.

Mitigation and adaptation policies like land restoration and sustainable agriculture can also help subsistence farmers. Mitigation can provide important co-benefits. For example, switching to cleaner sources of energy and transport can help reduce air pollution, which is a major source of health problems and deaths, especially in developing countries.

In a 2017 study, some of my colleagues in the fiscal affairs department estimated that increasing the tax per ton of coal by a hundred and fifty rupees annually from 2017 to 2030 could help avoid over 237,000 air pollution deaths, raise revenue of one percent of GDP in 2030, reduce carbon dioxide emissions by 12 percent and generate net economic benefits of approximately 1% of GDP.

Green public financial management reforms constitute the government undertaking with the minister of finance as the custodian of public resources. Countries can look for smart sequencing of green PFM reforms. This mean actual impact of the policies must be measured from the budget formulation process itself. Rolling out reforms can also be helpful. It is also important to communicate green PFM reforms to ensure buy-in from stakeholders and manage expectations.

(Valerie Cerra is Assistant Director and Division Chief of the Inclusive Growth and Structural Policies Division in the International Monetary Fund’s Institute for Capacity Development. This article is the reproduction of a presentation at EGROW Foundation. A Noida-based think tank.)

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