ABSTRACT
In recent years, we have witnessed a worldwide swing towards fiscal profligacy. In the European Union, this has come somewhat as a surprise as the Maastricht Treaty and afterwards the Stability and Growth Pact seemed to have put in place a set of fiscal rules that guarantee the sustainability of public finances. The difficulty in applying the Pact, first to Portugal and later on to France and Germany, has been followed by a more widespread breach of the 3 per cent deficit limit in several EU countries. A revised version of the Pact was adopted in March 2005; it takes a more flexible approach in terms of curbing excessive deficits over a longer period of time, and pays more attention to sustainability of public finances. As part of the Lisbon Strategy, considerably more attention is given to the composition of budget adjustments with a view to promoting economic growth. A variety of political and economic factors probably underlie the observed rise in public
deficit and debt ratios. We try to uncover any underlying past trends behind the development of public finances that may contribute to explaining the recent budgetary outlook in France, Germany, Portugal and Spain. While the first three countries were subject to several steps of the Excessive Deficit Procedure, Spain on the other hand could be seen as an example of more vigorous fiscal management. We are particularly interested in the underlying causes of the breach of the Pact’s rules by looking into adjustments in various budget components. At the same time, we look into how these adjustments contribute to the long-term growth prospects and outlook for the sustainability of public finances. To that end, we construct a model-based indicator of structural balance by combining
insights from the growing empirical literature on the effects of fiscal policy – modelled with structural VARs – with statistical methods for cyclically adjusting fiscal balances. Our approach innovates on existing evidence in using a mixture of short-and long-term restrictions to identify economic and fiscal shocks in a small-scale empirical model in economic growth and fiscal variables. This allows for permanent shocks to determine trending behaviour of output and fiscal variables à la Blanchard and Quah (1989). Discretionary fiscal adjustments are captured by filtering out the fiscal balance for cyclical reactions of budget items, following Blanchard and Perotti (2002). The quantitative indicator that we obtain is best seen in the light of the growing theoretical
literature on the qualitative effects of fiscal policy. Dynamic stochastic general equilibrium models with nominal rigidities search for a rationale for fiscal stabilization policies. At the same time, these New Keynesian models attribute quite some importance to both supplyand demand-side effects of fiscal policy adjustments. Our indicator is consistent with such a distinction. We take a first step by restricting attention to overall expenditure and revenues,
but more elaborate models might incorporate refinements in the compositional adjustments of budget balance. In contrast to statistical models for adjusting fiscal balance, our economic indicator of structural balance has some attractive practical properties. Uncertainty is explicitly quantified, and theoretical assumptions can be explicitly tested. Also, the end-of-sample problem is reduced. The model is not necessarily more demanding in terms of data availability. The main result of our study is that both pre-EMU consolidations and expansions in
recent years are mainly based on revenue changes. The derailing of public finances comes from tax reductions being implemented in good economic times. As total revenues apparently remain constant, spending cuts are not implemented. As a consequence, deficits show up again when economic boom turns into bust. The easy way out of deficits is to reverse previous tax cuts, leading to a ‘ratcheting up’ of spending over the next economic cycle. This pro-cyclical bias in fiscal policies has not been eliminated with the Stability and Growth Pact. Governments still implement bad policies in good times. These policy reversals have negative economic effects. We find fiscal policy to have minor supply but large demand effects. Pro-cyclical policies unnecessarily induce macroeconomic fluctuations. The remainder of the chapter is organized as follows. In Section 5.2, we briefly review
some recent fiscal developments in the EU, notably for the cases of France, Germany, Portugal and Spain. Our structural VAR approach towards disentangling these developments, and the derivation of the fiscal indicator, is discussed in Section 5.3. Section 5.4 reports our empirical results, and Section 5.5 concludes the chapter.
