# **1. INTRODUCTION**

As detailed in World Bank (2007), a renewed focus on fiscal policy and growth has spawned a lively debate over demands for greater “fiscal space” to support growth.<sup>1</sup> However, there is considerable controversy on what a suitable fiscal policy package should look like. Is there a trade-off between the objective of short-term stabilization and long-run growth? Currently, the debate over fiscal policy is cast in terms of “fiscal space” (i.e. availability of budgetary room to spend more on infrastructure and education for example) and sometimes “macroeconomic space” (the government’s ability to increase expenditure without impairing macroeconomic stability); see Perotti (2007).

As proposed in the recent report to the Development Committee, a growth and development oriented fiscal policy must take into account the composition and efficiency of public expenditures in a framework that includes country’s conditions (level of indebtedness, and other idiosyncratic characteristics like its access to international financial markets or, in the case of poor countries, to aid). Under this definition, the term “fiscal space” thus refers to a government’s ability to undertake spending to enhance economic growth without impairing its present and future ability to service its debt.<sup>2</sup> So far the exploration of fiscal space and performance has proceeded along three different paths: (i) case studies such as those in the Development Committee report where the performance of 12 countries with different fiscal/development profiles are contrasted and the complementary high-growth case studies for six countries presented to the Development Committee Meeting of March 2007 (see World Bank, 2007, and Biletska and Rajaram, 2007); (ii) studies of the efficiency of specific public sector expenditures - e.g. the several studies on infrastructure (Calderon and Serven, 2003, 2004, 2005) or on other components of social infrastructure (Estache, Gonzales, and Trujillo, 2007), and (iii) cross-country growth regressions (see the exhaustive summary proposed in Annex 2 of the report for the Development Committee, World Bank, 2007, or

> 1 As defined in the World Bank interim report (2006, p. 1), “ _the term_ [fiscal space] _initially applied to the view that fiscal deficit targets limited the ability of government to borrow to finance productive, growth-enhancing infrastructure projects. The term has now gained wider currency, however, and can be seen to refer to constraints to public expenditure which have the potential to raise productivity and yield returns in the future_ [...]”.

2 Depending on individual circumstances, creating fiscal space can occur by increasing borrowing and/or raising revenue mobilization, improving the efficiency of public expenditure, and mobilizing more grant aid. The “fiscal space diamonds” used in the interim Report (see World Bank, 2006) is a way to visualize differences across countries. The “diamond” presents the four main options (raise revenue effort; increase borrowing; increase grant aid; improve expenditure efficiency) along four axes departing from coordinates that summarize the country’s current fiscal stance. While a pedagogical and informative way to indicate how fiscal space may be created, this heuristic is not made easily operational.

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