Fiscal rules for Guyana’s future oil exporting economy

Commodity exporters such as Guyana should adopt procyclical fiscal policies that exacerbate macroeconomic volatility. Increasingly, empirical evidence suggests that the mismanagement of the commodity revenues may be a primary culprit behind the volatility in commodity exporting countries (Snudden 2016).

Oil price changes affect the economic cycle of oil exporters primarily through their impact on fiscal policy (IMF 2012). However, stark differences exist across countries and it is evident that there must be a call for the adoption of formal fiscal frameworks to manage the commodity revenue volatility.

Although fiscal rules for an emerging oil-exporting economy (i.e. Guyana) must include explicit provisions to respond to cyclical conditions, there are currently no such measure examining the performance and design of alternative fiscal rules for oil-exporting countries. The short-run management of revenues via fiscal policy rules focus on the case of managing revenues in a generally calibrated format. Therefore, alternative forms of fiscal policy rules for both macroeconomic and welfare stabilization for the new Guyanese economy must be developed and implemented.

Thus, for Guyana’s emerging oil-economy; budget-balance rules with countercyclical responses to both the non-oil tax gaps (traditional sectors; agriculture, forestry and mining) and oil royalty gaps will be the preferable rules to the alternative forms of the fiscal policy rules to stabilize the macroeconomic volatility and welfare of this emerging oil-exporting country. These rules clearly outperform fiscal rules that only target the debt-gap and are slightly more advantageous to fiscal rules that only respond to the output gap.  Macroeconomic stabilization is found to require more aggressive fiscal reaction relative to welfare stabilization. The desirability of targeting of the oil-royalties gap is due to the high correlation of the oil-royalties gap with the pass-through of oil prices into headline inflation.

In addition, the optimal design of fiscal rules differs for externally driven demand and supply price movement due to each shock unique impact on the non-oil balance and the corresponding inflation-output trade-off. The decisions by the Guyanese government should be robust to alternative instruments satisfying the fiscal rule, but with reduced inefficiency from instruments that impact potential output such as government investment and capital taxes. Moreover, Guyana should note that budget-balance rules with countercyclical responses to both the non-oil tax gaps and oil royalty gaps are found to be robust across a diversified set of oil-exporters, including advanced countries such as Canada and Australia, and the Organization of the Petroleum Exporting Countries (OPEC) oil specialists such as Saudi Arabia (Snudden 2016).

Jointly optimal fiscal and monetary policy regimes must be considered for Guyana’s proposed Natural Resources Fund. The use of fiscal policy rules is especially desirable for supply driven price movements as they show success in being able to tackle the inflation-output trade-off rife in oil-exporting countries. Optimal headline inflation targeting outperforms optimal core inflation targeting regimes under a structural surplus rule. However, when both fiscal and monetary rules are jointly optimized, both headline and core inflation targeting can roughly achieve the same degree of macroeconomic stabilization. Even under optimal monetary policy, adopting a fiscal rule can produce large reductions in macroeconomic volatility (IMF 2008).

The Fiscal Rule

The fiscal authority employs a generalized budget-balance rule. The formalization encompasses a range of rules, including the standard targeting rules as well as the commodity and non-commodity tax revenue gaps. The rule has two main functions:

1. The first is to stabilize the government debt-to-GDP ratio to its long-run target which is achieved by centring on the overall government surplus-to-GDP ratio, which will ensure dynamic stability. By targeting the overall deficit, the long-run target is inclusive of the oil revenues and tax income.
2. The second main function of the fiscal rule is to respond to the business cycle.

Optimal Fiscal Rules

For both the external supply and demand-driven oil-price shocks, a countercyclical response to the non-oil revenues gaps constitutes the efficient fiscal policy response. An optimal budget-balance tax gaps rule with countercyclical positions on the tax gaps achieves the lowest degree of macroeconomic volatility relative to targeting the debt or output gap. Only when the quantities on the tax, debt, or output gaps are jointly optimized do the optimal rules imply a non-zero weighting on the debt or output gap. Weights on the debt gap can be combined with the tax-gap fiscal rules to reduce debt volatility, but provide very little additional improvement in output volatility.

Targeting the non-oil structural balance and optimally responding to cyclical non-oil tax revenues come very close to matching the optimal design of fiscal policy rules for most cases. However, modest gains in performance can be made by allowing for a countercyclical response to the oil royalties gap due to its close correlation with inflation, which helps stabilize inflation and real consumption. The desirability of targeting of the oil-royalties gap is due to the high correlation of the oil-royalties gap with the pass-through of oil prices into headline inflation.

Welfare Balance

The objective of welfare stabilization is consistent with that of macroeconomic stabilization, except for a few key differences. Optimally responding to the tax-revenues gaps can achieve welfare gains with less fiscal instrument volatility than debt gap rules. Targeting the Gross Domestic Product (GDP) gap fares similarly well in the face of a supply driven increase in the price of oil. In contrast, for demand driven changes in the price of oil, targeting the GDP gap can achieve the same welfare gains and reduce instrument volatility. The main difference is that the tax gap evokes more movement in the fiscal instrument, over the short-run.

For both the optimal tax-gap rules and GDP gap rule, welfare stabilization requires less volatility of the fiscal instruments than that required for optimal macroeconomic stabilization. This suggests that focusing solely on macroeconomic stabilization relative to welfare stabilization requires more aggressive policy action.

Policy Implications

1. The optimal policy implies it is ideal for the fiscal instrument to be volatile.
2. A budget-balance tax-gap rule that responds to both the oil-royalties and non-oil tax revenues gap is found to be more desirable than other fiscal rules that target the non-oil structural balance, debt-gap and output gap. For a small open economy (SOE) such as Guyana, oil price fluctuations mainly affect the economy through changes in the terms of trade. Hence, the desired degree of countercyclicality is increasing in the importance placed on output volatility relative to consumption volatility.
3. A larger countercyclical fiscal response is found desirable for external demand-driven relative to external supply-driven oil price movements due to their effect on the non-oil economy. In particular, oil exporters face the additional challenge of headline inflation volatility relative to non-oil commodity exporters due to oil’s importance in the consumption basket.
4. The optimal fiscal rule closely resembles targeting the non-oil structural balance and allowing for automatic countercyclical stabilizers. Budget-balance tax-gap rule is desirable for all types of oil-exporters from specialist such as OPEC economies to diversified advanced economies such as Norway, Canada, or Australia. This result is robust to several instruments satisfying the rule, excluding those that impact potential output such as government investment and capital taxes.
5. Joint coordination of countercyclical monetary and fiscal policy creates more flexibility for the authorities to reduce inflation and output variability. Even in the presence of an optimal monetary policy, adopting an optimal fiscal rule can produce large reductions in macroeconomic volatility. Large gains are particularly observed for supply driven oil price movements since monetary policy is quick to face an output-inflation trade-off. When jointly optimized with fiscal policy rules, both headline and core inflation targeting can achieve the same degree of macroeconomic stabilization.
6. The gains from moving to an optimal fiscal rule are largest under fixed exchanges rate policy. An optimal fiscal rule with a fixed exchange rate policy can achieve the same degree of macroeconomic volatility as an optimal inflation targeting regime for supply driven oil price movements. In contrast, for demand driven oil price movements, macroeconomic volatility is three times higher under the optimal fiscal rule and fixed-exchange rate policy compared to an optimized fiscal and inflation targeting regime.

In general, oil exporters have been moving in the right direction. Some are already operating effectively under a structural fiscal rule or are in the process of formalizing fiscal institutions. The experience of similar countries suggests that large gains to welfare and macroeconomic stabilization are possible when the fiscal authority makes even partial effort towards the optimal fiscal policy. A new oil-exporting country such as Guyana will achieve further and large gains from a formalized fiscal policy framework (Husain 2008).

Guyana’s Macroeconomic performance in an oil-exporting era will depend largely on developments in world oil prices. Economic growth, even the growth of non-oil output, will be tended to pick up during periods of high oil prices and slow down when prices have fallen. Hence, an interesting question, therefore, is whether world oil price changes will exert an independent influence on the economic activities in this new oil-exporting country, possibly through confidence effects and/or their effect on the monetary/financial situation, or if their impact on the economic cycle will only come through their effect on fiscal policy. The answer is important in determining if the underlying economic cycle – the output cycle that would have to be obtained in the absence of changes in the fiscal policy stance – is related to oil price swings and, if so, whether the economic cycle has been amplified by fiscal policy reactions to the oil price shocks.

Further, a caution for Guyana is that fiscal policy reactions to oil price shocks will amplify the underlying business cycle in its future oil-exporting economy, especially since the size of the non-oil sector is relatively small. There may be a few good reasons why Guyana should be careful in ramping up future spending in response to any predicted increase in oil prices, but concern that it might add to cyclical pressures is not one of them. In a country such as Guyana, where public spending occupies a large share of the economy, spending increases will almost by definition increase the cyclical component of output. Whether or not such spending variations coincide with oil price changes will not affect the degree of cyclical pressure. Indeed, timing spending increases to coincide with oil price downturns (rather than upswings) may well produce financing pressures in addition to cyclical pressures. This is not to say, however, that fiscal expansion is an optimal response to positive oil price shocks in new oil-exporting economies. Such a determination would require an assessment of the costs associated with increased cyclical pressure against the benefits of greater spending, both of which likely would depend on the magnitude and expected persistence of the expect price shock and the overall effect on Guyana’s small open economy.