Fiscal policy, quality and quantity

By Clare Lombardelli, OECD Chief Economist[i] and Max Glanville

Fiscal policy faces a challenging outlook in most advanced economies. Using OECD long term analysis and cross country experience of fiscal consolidation I discuss the difficult choices lying ahead.

The starting point: A legacy of high public debt

After three major crises where fiscal support was used to support economies, public debt ratios stand at historically high levels in most advanced economies. In 2007, before the Global Financial Crisis, COVID-19 pandemic, and energy crises, debt levels were substantially lower than today, shown by the white diamonds in Figure 1. The average public debt to GDP ratio across G7 countries was 84%. Fast forward to 2025, and we’re looking at a spectrum ranging from Germany, with public debt relative to GDP at around 70%, to Japan, where it stands at around 240%.  We have also observed a shift in expectations around fiscal policy’s role in responding to economic shocks.

Figure 1: Public debt now and in the future

Future fiscal pressures and demographic challenges (Figure 1, green bars)

Assuming unchanged policies, by 2040, the fiscal outlook worsens significantly as additional pressures emerge, notably from demographic changes. Ageing populations will significantly impact economies, not just fiscally but also in terms of economic growth. For instance, if policy is unchanged, U.S. age-related pensions and health expenses, are set to add a whopping 25 percentage points to gross debt by 2040. This demographic shift, driven by increased longevity and declining fertility rates, poses a substantial challenge.

Interest Rate-Growth Differential (Figure 1, red bars)

Adding to the demographic pressures are the dynamics of interest rate-growth differentials (our earlier friend, r-g). r-g has direct implications for debt sustainability. If the interest rate on government debt is higher than the growth rate of the economy, the real burden of public debt increases over time. With the past favourable r-g dynamics unlikely to continue, there will be additional fiscal pressures. As they are very sensitive to assumptions, to give  a sense of size, in the U.S., for example, changing r-g dynamics could add an additional 30 percentage points to gross debt by 2040.

The impact of future expected deficits (Figure 1, orange bars)

Future expected deficits, based on the assumption of continued fiscal policies from 2025, indicate even more significant increases in debt levels. This should be interpreted with caution – the underlying primary balance can change year to year as governments borrow during downturns and rebuild fiscal buffers during recovery periods.  What is shown in the orange bars here is what the impact would be if current deficit levels were to continue into the future. 

Additional future fiscal costs

The fiscal costs of decarbonization (Figure 2), as outlined by the International Energy Agency, highlight the substantial investments required for advanced economies to reach net zero by 2050. How big these will be, depends on a whole range of factors, many driven by policy choices – including how costs will be shared across consumers, businesses and governments From 2017-2021, governments in advanced economies invested 0.16% of GDP on average in clean energy. By 2025 and 2030, that number needs to more than double.

Figure 2: Decarbonisation costs to 2030

Combined with current levels of defence spending and the increased cost of debt servicing at higher interest rates, this paints a challenging long-term picture for public finances.

Figure 3: Debt interest payments to 2025

So what should governments do?

Strategic Responses and Structural Reforms

In response to these challenges, governments have a toolkit which includes tax reform and spending choices, but also growth-enhancing structural reforms. Successful strategies from the past indicate that cuts in critical areas like education and healthcare come with economic and socials costs and should be avoided. And means-tested social protections need to be preserved. These matter hugely for well-being, inclusion and prosperity of economies. But the left hand panel in figure 3 shows just how small a proportion of social protection is targeted on the poorest people.

Figure 4: Quality of Spend and Structural reforms

Reforming taxes, broadening tax bases, and targeting transfers more effectively can offer sustainable solutions. Additionally, ambitious labour market reforms can significantly relieve fiscal pressures by boosting economic output and reducing public debt ratios, for example, by containing the cost of pensions. Ageing could reduce income per capita across the OECD by 8%. However, achieving higher old-age participation and employment rates can reduce this effect to 3%. Looking back at past episodes of successful debt reductions, as in figure 5, can show us how to bring public debt down.

Figure 5: Past episodes of successful debt reduction

Conclusion

The fiscal landscape for advanced economies is fraught with challenges, from high deficits and public debt to the pressures of ageing populations, decarbonisation, and the need for strategic defence spending. The path forward requires a nuanced approach that balances fiscal responsibility with growth-friendly policies and structural reforms. By learning from past successes and adapting to the unique challenges of the present, governments can navigate these difficult choices and set the course for a sustainable fiscal future.

References:

Guillemette, Y. and J. Château (2023), “Long-term scenarios: incorporating the energy transition”, OECD Economic Policy Papers, No. 33, OECD Publishing, Paris, https://doi.org/10.1787/153ab87c-en.

OECD (2023), OECD Economic Outlook, Volume 2023 Issue 2, OECD Publishing, Paris, https://doi.org/10.1787/7a5f73ce-en.

OECD Economic Outlook Digital Report : https://www.oecd.org/economic-outlook/november-2023/

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[i] Based on the intervention by OECD Chief Economist, Clare Lombardelli, at the 40^th Annual NABE Economic Policy Conference on 14-15 February 2024.