Fiscal space most commonly refers to the ability of a government to expand discretionary spending for priority spending. The IMF defines it as “room in a government’s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy.” The core idea is that fiscal space is a limited resource, dependent on a government’s ability to raise domestic revenues and to borrow without jeopardizing future stability.

The essence of such arguments is that fiscal space depends on several factors. First, it depends on the financial and economic benefits from government spending. When such spending has an economic benefit, for example through investment in human or other capital, then the economy expands. The quality of budget allocation processes and implementation is therefore crucial. But unless the government can recoup its expenses, for example, through user fees, the spending will still take up fiscal space. How much depends on indirect receipts—the level and buoyancy of the tax system, for example. Those revenues can partially offset the extra interest payments governments will have to make if spending is financed through borrowing rather than grants. Hence, yet another variable is the marginal interest rate on public debt. The higher the interest rate, the larger the amount of fiscal space that is taken up when borrowing.

Viewed in this way, fiscal space is analogous to a depletable natural resource. Good investments can expand it, just as successful exploration expands a natural resource. And both fiscal space and depletable natural resources should be treated and managed as assets.

Over time, fiscal capacity is created by new revenue, in turn dependent on economic growth in an economy, and by the net returns on past investments. It is used up by expenditures that do not return equivalent net present value to the budget. Figure 1 depicts the three requirements for sustaining fiscal space:

  1. The speed of economic growth and the dynamism of the tax system in capturing some of those benefits for the treasury.
  2. The ability to identify and implement a pipeline of high-priority spending for which fiscal space is needed.
  3. An ability to access enough up-front financing to enable the priority spending to take place.

Read the full article about redefining fiscal space by Homi Kharas at Brookings.