Advanced economies face a herculean task to restore public debt to pre-crisis levels, and failure to do so will drive up borrowing costs and curb economic growth, the IMF warned on Friday.
If government debt is not reduced, potential growth in rich countries could decline by more than 0.5 percent annually, the International Monetary Fund said in its Fiscal Monitor report, which it launched last year.
In order to accomplish that, advanced economies will need to reverse current account deficits, which now average 4.9 percent, into an average surplus of 3.8 percent by 2020.
That will require a mix of spending cuts and tax increases, neither of which is popular, so mustering the political will to enact those changes may prove difficult.
But the IMF said Europe's debt troubles, which pushed Greece to the brink of default and forced officials to cobble together a $1 trillion rescue package, showed that if governments fail to act, financial markets can force them.
The IMF said it was sensitive to concerns that focusing on public finance repairs too soon would undermine the recovery, but thought more planning could be done now.
Most advanced economies are still feeling the effects of the deepest recession since World War Two. Unemployment remains high, and tax revenues have fallen.
I am convinced that there is much that countries can do now to strengthen confidence in long-term fiscal sustainability without weakening growth prospects, IMF Managing Director Dominique Strauss-Kahn said.
Total loss of investor confidence in public finances is an unlikely tail risk, the IMF said, although it added that Europe's recent experiences have clearly indicated that this risk cannot be ignored. Uncertainty about government debt has driven up borrowing costs not only in Greece but also in Portugal, Ireland and Spain.
Across the Group of Seven richest countries, government debt as a percentage of total output -- or debt-to-GDP -- is rising to levels exceeding those prevailing in the aftermath of World War Two, the IMF said.
Based on current likely policies, debt-to-GDP ratios in advanced economies will probably rise another 20 percentage points to 110 percent by 2015, the IMF estimated. Before the financial crisis struck in 2007, those levels were closer to 60 percent of GDP.
The IMF said countries may be inclined to simply stabilize debt where it is now rather than restoring it to pre-crisis levels, but that would likely slow economic growth.
For many advanced economies, including the United States and Japan, aging populations will put even greater strain on finances in the coming years.
The oldest of the U.S. Baby Boomer generation, born in the years after World War Two, turn 65 next year, making them eligible for full retirement and healthcare benefits. The IMF said raising the retirement age now would help shore up public finances without hurting economic growth.
It also suggested improving collection of value-added taxes in countries that already have such measures, and implementing them in places like the United States that do not.
For instance, introducing a VAT in the United States, and doubling the very low VAT rate in Japan, could raise 4.5 percent and 2.6 percent of GDP, respectively, in those countries, the Fund said.
Other useful options include increasing levies on alcohol, tobacco and fuel, adopting a tax on carbon emissions, and raising property taxes.
(Editing by Andrea Ricci)