Rule-Based Resource Revenue Stabilization Funds: A Welfare Comparison.

• Author: Landon, Stuart

1. INTRODUCTION

Non-renewable natural resources generate more than 25 percent of government revenue in 50 countries and provide an even higher share of revenue in petroleum-producing jurisdictions (IMF, 2007). (1) Resource prices are volatile and difficult to predict, so government revenue in resource-producing regions is also uncertain and volatile. Adjusting government expenditure in response to revenue movements involves economic, social and political costs. (2) For example, increased government expenditure volatility can increase private sector uncertainty and, thereby, reduce investment, growth and welfare. Volatility in government revenue that leads to volatile movements in government spending and stop-go pro-cyclical fiscal policies can accentuate economic cycles (Boothe, 1995; Sturm, Gurtner, and Alegre, 2009; Villafuerte and Lopez-Murphy, 2010; Erbil, 2011; The Energy Journal, Vol. 36, No. 2. Copyright [c] 2015 by the IAEE. All rights reserved.

Ploeg and Venables, 2012). (3) The rapid expansion of programs and capital spending during revenue booms can raise input prices and stretch the capacity of governments to provide services and monitor spending, leading to waste, inefficiency and the unproductive use of government funds (Barnett and Ossowski, 2002). Similarly, during a revenue collapse, it is often difficult to first cut spending on government programs with the lowest benefit. Further, a reduction in capital spending caused by a decline in resource revenue may mean abandoning viable projects that are crucial to a country's development. To the extent that it is easier politically to raise government spending in booms than to reduce spending in recessions, revenue volatility may also lead to the expansion of government and the implementation of an unsustainable fiscal plan. (4)

The optimal response to an uncertain revenue stream is an expenditure path that maximizes the expected present value of intertemporal welfare given the expected path of revenue (Bremer and Ploeg, 2013; Ploeg and Venables, 2011). The solution to this type of problem is complex to calculate and difficult to explain to the public and government decision makers, so "implementing solutions is cumbersome and the results are not as transparent as the political process requires" (Engel and Valdes, 2000,14). As a feasible alternative, numerous jurisdictions have created resource revenue stabilization funds. (5) Using some form of ad hoc rule, a revenue stabilization fund channels a portion of resource revenue into a fund when resource prices are high, and withdraws assets from the fund to maintain spending when prices are low. By weakening the link between current resource revenue and current budgetary revenue, a stabilization fund can smooth expenditure. (6)

Rule-based stabilization funds have several desirable features. Bacon and Tordo (2006) argue that formal rules for payments into and out of a fund facilitate public scrutiny and inform the debate on fiscal choices, while Kumar, Baldacci, and Schaechter (2009) note that rules that are transparent and backed by appropriate fiscal institutions promote better fiscal performance. Further, a fund can be designed so that policy makers do not require forecasts of future resource prices, which is beneficial since these prices are highly uncertain. In addition, stabilization funds can reduce revenue uncertainty since current and future budget revenues depend on known past contributions to the fund. For jurisdictions that rely heavily on resource revenue, a policy that stabilizes government spending would be expected to also stabilize the overall economy. Finally, by providing a smoother revenue stream to government, a stabilization fund may prevent cyclical tax rate changes. Barro (1979) argues that this may reduce the incentive to concentrate market activity in periods with temporarily low tax rates, thereby, improving economic efficiency.

Many jurisdictions utilize revenue stabilization funds, but there is little empirical research on whether stabilization funds improve welfare or on how stabilization fund characteristics affect fund performance. (7) While Wagner and Elder (2005) and Sobel and Holcome (1996) find that a fund can increase fiscal stabilization, they do not address the question of whether alternative fund structures could yield greater stabilization, nor do they quantify the welfare impact of a fund. Arrau and Claessens (1992), Engel and Valdes (2000) and Bartsch (2006) employ Monte Carlo simulations to determine optimal government saving in the presence of commodity price shocks, but do not make welfare comparisons across rule-based funds. The study by Borensztein, Jeanne and Sandri (2009) uses a numerical approach to assess welfare gains in commodity exporting regions, but their focus is on optimal hedging strategies, not stabilization funds. Pieschacon (2012) shows that fiscal discipline can smooth consumption and increase welfare following oil price shocks, but does not evaluate or compare stabilization rules. Ploeg, Stefanski and Wills (2011) consider rules along a spectrum from a permanent income rule to a "spend-all" rule and find that, for Ghana, expenditure should be brought forward somewhat to stimulate development. Maliszewski (2009) employs numerical simulations to examine the impact on a petroleum-producer's welfare of employing various fiscal rules and concludes that ad hoc rules perform poorly. In contrast, using simulations and parameter values that match the Chilean economy, Engel, Neilson and Valdes (2011) find considerable benefit from the use of a simple rule.

We contribute to the literature by quantifying the impact on welfare of different types of rule-based resource revenue stabilization funds. This allows us to determine whether these funds improve welfare and whether some fund designs increase welfare more than others. Our results also help identify fund characteristics that may cause funds to be significantly altered or abandoned. (8) In previous work (Landon and Smith, 2013), we calculate the relative welfare performance of stabilization funds using historical data for the Canadian province of Alberta. In contrast to this earlier analysis, the current study explicitly incorporates revenue uncertainty. We use Monte Carlo techniques to specify a large number of different possible paths for future revenues and compare the expected welfare performance of different funds given these paths. This forward-looking approach contrasts with our previous paper which was a time-period and jurisdiction-specific counterfactual simulation.

Although we use the term "stabilization", the funds we examine are both stabilization and savings funds. Since resource revenue arises from the conversion of a physical asset into a financial asset, proponents of savings funds suggest that governments treat this revenue as wealth and, therefore, spend only the annuity value of resource wealth, leaving the balance in a savings fund to support the provision of services to future generations. (9) The welfare measure used in the current study takes a standard intertemporal form that includes an infinite horizon and volatility aversion. As a result, this welfare measure incorporates the objective of a stabilization fund--the reduction of expenditure volatility, but also gives weight to the goal of a savings fund--the accumulation of assets to support future spending. (10)

Our comparison of stabilization funds focuses on a petroleum-producing jurisdiction since, for many countries and subnational governments, petroleum products are a major revenue source. Petroleum prices are also one of the most volatile types of commodity prices, so stabilization is likely to be particularly important to petroleum-producing regions. However, our findings are likely to be applicable to jurisdictions that rely on revenue from other commodities that are characterized by price volatility, such as natural gas.

As the future path of resource-based revenue is uncertain, we use historical petroleum price data to simulate 1000 possible revenue paths and compare the expected intertemporal welfare of each stabilization fund given these paths. Since resource depletion is likely to have an important impact on welfare, we evaluate the stabilization funds under two radically different depletion scenarios. In one, petroleum production continues indefinitely, while in the other production falls rapidly to zero. The non-depletion scenario emphasizes the stabilization function of a fund, while the depletion case focuses the analysis on both the stabilization and savings roles of a fund. Welfare is evaluated over an infinite horizon and the welfare implications of the different funds are quantified relative to the welfare generated by a policy of spending all revenue as it is received. We also compare the welfare of rule-based funds to the welfare of the (unattainable) perfect foresight "permanent income" expenditure path. The benchmark analysis employs the fairly standard assumptions of a coefficient of relative risk aversion of 2 and a discount rate of 3 percent, but we also consider a value of 4 for the risk aversion parameter, and a 2 percent discount rate. The interest rate is treated as exogenous to the domestic country's saving and lending decisions, consistent with the characteristics of many resource-producing countries that are small open economies.

We find large potential gains from the use of a stabilization fund to smooth government expenditure. These gains can be, for example, much greater than the benefit of eliminating the US business cycle as measured by Lucas (2003). The main reason for this is the high volatility of petroleum-based revenue. This is consistent with the findings of Pallage and Robe (2003) that business cycle fluctuations are more costly in developing countries because developing economies are more volatile. Although large, the gains we measure do not include the cost...