II. Measuring fiscal space

Fiscal space is sometimes measured simply as discretionary fiscal spending—the amount of revenue and borrowing capacity that is left over when non-discretionary spending has been subtracted out. Non-discretionary spending, in turn, is usually defined in terms of items that are deemed to be mandatory, either by economic, political, or legislative necessity. Debt service and pensions are often core items of non-discretionary spending. In the United States, mandatory spending refers to entitlement programs, like social security, Medicare, and Medicaid, which are available to everyone who qualifies, while discretionary spending has to be appropriated by Congress. Wages of civil servants are a grey area—in the United States, they are counted as part of discretionary spending, but in many developing countries, they are included in non-discretionary or inflexible spending, as firing civil servants can be politically difficult.

The fact that fiscal space includes the option to borrow means that measuring fiscal space requires an estimation of the amount that a government could potentially borrow, something that is derived either from a debt sustainability assessment made by an independent technical group, or in accordance with fiscal rules that have been passed by a country’s legislature. Both the modelling and rules-based approaches are designed to restrict the inherent tendency of a democratically elected government with a short time horizon to overborrow and overspend.

Debt sustainability models

Debt sustainability assessments are used by the IMF and World Bank to measure fiscal space in client countries. These assessments combine judgments on the soundness of macroeconomic and structural policies, crucial to understanding whether high-return spending is feasible, along with judgments on the ability to service external debt. The latter determines whether future fiscal space is being compromised or not by current actions.

The key economic variables in a fiscal space calculation are the size of the fiscal deficit, the rate of interest on government borrowing, and the growth of the economy and of exports. But even when these variables are the same across countries, the amount of fiscal space can differ due to differences in the perceived quality of policies and institutions.

This last observation explains why debates over fiscal space can be so contentious. Most of the time, there is little major disagreement on the contours of economic policy. After all, current growth rates, deficits and interest rates are observable, and while there may be uncertainty about the future values of these variables in the medium term, the real discussion about fiscal space hinges on judgments about the quality of institutions and hence of government ability to implement high-return spending, which in turn affects borrowing capacity.

The IMF and World Bank have used historical episodes of debt distress to empirically estimate the maximum size of a sustainable fiscal deficit, given other exogenous economic variables like GDP, export growth rates, and institutional quality, proxied by the World Bank’s Country Policy and Institutional Assessment. From this modelling work, a maximum fiscal deficit is computed by imposing a requirement that debt and debt service levels remain below certain threshold values. The threshold values vary according to staff judgment on the quality of institutions and policies in each country. As a rough guide, developing countries assessed to have weak policies have threshold values that are half the value used for countries assessed to have strong policies.

The challenge of current models

The problem is that the modelling of debt distress episodes is inevitably imprecise. To arrive at a model, the World Bank and the IMF reviewed a sample of 1356 country-year observations. They selected thresholds to forecast debt default in the following year. The model indicated such thresholds were exceeded 523 times. However, only 40 cases—8% —were correctly called, meaning that the country actually experienced a default. The remaining 483 cases were false positives, episodes when the model signaled imminent debt default in the following year and hence called for radically reduced fiscal spending but where the ex-post outcome turned out to be benign. Conversely, the model showed a false negative in 19 of 833 cases (2%), wrongly suggesting that no additional fiscal action was needed in these cases to avoid debt default.

For policymaking purposes, there is a tension in calibrating fiscal space models between the number of false positive and false negative signals that the model calls. The presumption is that false negatives should be minimized—that the cost of falling into debt distress is so large that all effort should be made to avoid such an outcome. This is why the thresholds selected in the DSA are chosen to be conservative. And indeed, when debt treatments require a net present value write-down, there is a long-drawn-out negotiation between creditor and debtor that results in substantial losses for both parties. But net present value reductions themselves are only a small fraction, about one-seventh, of debt treatments—any change in debt obligations—in the event of a default. In most cases, the needed action is a reprofiling of debt service obligations due, mostly to manage cases where a bunching of maturities has led to temporarily high debt service obligations or where a sudden fall in commodity prices has led to a temporary fall in foreign exchange receipts.

Fine-tuning a debt sustainability model to derive an estimate of fiscal space requires both understanding the risks of the model producing false positives and false negatives and understanding the consequences of taking action based on the model predictions. When there are too many false positives, fiscal space can be unduly constrained, and high-priority spending may be deferred, at significant economic and social cost. Conversely, if there are too many false negatives, needed fiscal action may be postponed until it is too late, and a high-cost debt resolution negotiation becomes inevitable.

Fiscal rules

According to the IMF, around 75 emerging market and developing economies have some type of fiscal rule. The most common rule relates to fiscal deficits, often called balanced budget rules. Such rules are typically combined with a debt rule that limits either the stock of debt, new borrowing, or debt service obligations. In addition, some countries have expenditure rules to limit the growth in spending, and others have revenue rules to encourage tax mobilization.

One issue with fiscal rules is that they can be suspended in responding to crises. Use of such escape clauses was extensive during the Great Recession of 2008/9 and again during COVID-19. The spending associated with these crises used up considerable fiscal space, leaving open the question of whether to recapture space for future contingencies by temporarily running fiscal surpluses, or whether to amend thresholds and deficits to reflect the new reality.

Such questions are increasingly being addressed by fiscal councils, technical agencies with an official mandate to advise, interpret, and monitor government compliance with fiscal rules. Fiscal councils have been more widely used in advanced economies, especially in Europe, but a number of emerging markets have also introduced them, encouraging governments to comply with fiscal rules or explain any divergence. At their best, fiscal councils permit a reasoned discussion of the trade-offs involved in determining fiscal space based on a deep understanding of the social preferences of each country, rather than on generally applicable rules.

III. How spending links to fiscal space

Each dollar of spending does not necessarily translate into a dollar’s use of fiscal space. When spending is one-off, without direct returns to the fiscal accounts, there is an equivalence between spending levels and the use of fiscal space. An example is public provision of relief to people affected by a natural disaster: People are no better off than before if the government only partially compensates them for their losses, while the government bears a higher level of debt in the aftermath of the disaster and relief operation.

Other kinds of spending may have lower impact on fiscal space. For example, public spending on health and education, even if free, contributes to long-term economic growth. Economic growth, in turn, adds to government revenues. The net effect on fiscal space depends on the economic rate of return of the spending and on how much of this return is captured by the government. For example, the government may charge user fees and may also benefit from higher taxes, almost certainly in the long run as the economy expands and potentially even in the short run, depending on the size of fiscal multipliers. In developing countries, the buoyancy of tax revenues—the amount of tax revenue generated by each additional dollar of GDP—averages 1.1, so economically sound investments add to fiscal space in the long run.

In still other cases, fiscal spending can generate a surplus. When governments invest in productive infrastructure assets like toll roads, ports, or energy generation, for example, they may generate a positive net revenue stream. If these investments are successful, fiscal space actually expands, even in the medium term.

IV. Instruments to expand fiscal space

Tax revenues, strong fiscal management, and access to affordable finance are key instruments to expand fiscal space.

Tax revenues

One core variable in determining tax revenues is the quality of macroeconomic and sectoral policy. This manifests in a number of ways. Countries with better policies grow faster. They therefore generate more tax revenue and add fiscal space more rapidly over time. They are also able to borrow at lower interest rates and hence directly gain fiscal space by having lower levels of debt service. They can more sustainably access capital markets, so they can afford higher levels of debt. Countries with strong tax buoyancy find that fiscal spending can yield considerable indirect revenues for the treasury that limits the extent of fiscal space being used by each dollar of spending.

Fiscal management

Public financial management is a key ingredient in the broader concept of strong institutions and policies. Using the Public Expenditure and Financial Accountability (PEFA) toolkit, 607 assessments have been done at country and sub-national levels of public financial management issues and trends between 2005 and 2021. The main issues that tend to arise are: budget execution, transparency of fiscal reporting, and public investment management. Large subsidies for food and energy also eat up considerable fiscal space that could otherwise be used for higher-return spending. Countries can relax fiscal space constraints by shifting spending toward areas that create direct and indirect revenue streams for the treasury.

Concessional finance and debt write-offs to reduce the cost of capital

External grants and concessional credits are significant sources of expanding fiscal space in low-income countries. They have permitted a scale-up of health and education spending, amongst other areas. But concessional flows are rarely fully reliable and predictable over time. For example, recent aid cuts have thrown health and nutrition programs in many countries into disarray. When concessional funds are used for non-tradable activities like health and education, they can also have an impact on real exchange rates that can reduce prospects for economic growth.

Large volumes of debt owed by low-income countries were written off as part of the Heavily Indebted Poor Countries initiative, first launched in 1996, and the Multilateral Debt Reduction Initiative, launched in 2005. Both served to temporarily raise fiscal space. Over time, however, fiscal space has been eroded, particularly due to the heavy fiscal expenditures associated with the pandemic response. One potential interpretation is that debt write-offs only lead to a temporary expansion in fiscal space, not to a permanent expansion.

More recently, several large debt-for-nature swaps have been concluded, wherein debt service reductions are accompanied by spending increases in specified areas. Barbados (2024), the Bahamas (2024), Gabon (2023), Ecuador (2023) and Belize (2021) have each committed to expand specific types of nature conservation—coral reefs, tropical forests, mangroves—with savings derived from refinancing of existing debt at lower interest rates and reduced face values.

Similar temporary relief is available from other forms of debt treatment. Debt reprofiling, such as through the debt service suspension initiative of the G20, offered countries an option to defer debt service on bilateral official debt in 2020 and 2021. This provided liquidity to governments, but unfortunately did little to halt the slide in public investment in many beneficiary countries.

In sum, the debate over fiscal space has clarified the different impact of types of fiscal spending on public finance in the long term. Entitlements and transfers to households can provide social protection but may be expensive in terms of fiscal space unless they have a direct impact on GDP growth, which can be the case in poorer countries and regions where aggregate demand is low. Fiscal spending that adds to growth uses much less fiscal space—how much depends on the social returns and on the ability of tax systems to capture a portion of the gains for the treasury. Certain types of public investment can actually create additional fiscal space for other expenditures if they generate more revenue than the net interest cost of the associated financing.

A sound understanding of fiscal space can help developing country governments prioritize the size and composition of their spending better.

References

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Cardoso, Dante, Laura Carvalho, Gilberto Tadeu Lima, Luiza Nassif-Pires, Fernando Rugitsky and Marina Sanches. “The Multiplier Effect of Government Expenditures on Social Protection: A Multi-Country Analysis.” Department of Economics – FEA/USP. Working Paper Series 2023-11. 2023. https://socialprotection-pfm.org/wp-content/uploads/2023/11/wp18_multiplier-multi-country.pdf

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Heller, Peter. “Back to Basics – Fiscal Space: What It Is and How to Get It.” International Monetary Fund. June 2005. https://www.imf.org/external/pubs/ft/fandd/2005/06/basics.htm

International Monetary Fund. “Debt Sustainability Analysis Low-Income Countries.” https://www.imf.org/en/Publications/DSA

Luckner, Clemens Graf von, Sebastian Horn, Aart Kraay, and Rita Ramalho. “Predicting Debt Distress in Low-Income Countries.” Presented at the 25th Jacques Polak Annual Research Conference. International Monetary Fund. November 14, 2024. https://www.imf.org/en/News/Seminars/Conferences/2024/11/14/-/media/98ED2828BDC148FDA5BBE508AE9540A9.ashx

PEFA. “2022 Global Report on Public Financial Management.” Public Expenditure and Financial Accountability. 2022. https://www.pefa.org/global-report-2022/en/

Seguino, Stephanie. 2025. Engendering Fiscal Space: The Role of Macro-Level Economic Policies. New York: UN Women. https://www.unwomen.org/sites/default/files/2025-04/engendering-fiscal-space-the-role-of-macro-level-economic-policies-en.pdf