Effects of fiscal policy on private consumption: evidence from structural-balance fiscal rule deviations

Abstract

We use a new narrative measure of fiscal shocks to study how private consumption reacts to government spending increases. Our fiscal shocks arise from three announcements of expansionary fiscal rule deviations in a small and open economy where fiscal policy follows a structural-balance fiscal rule. All those deviations were announced to be mainly on the spending side. We find a negative response of private consumption in the face of those announcements. Our findings are consistent with the existence of consumers expecting some irreversibility in government spending increases and, as a consequence, a rise in future taxes to make the newly announced fiscal spending path consistent with the intertemporal government budget constraint.

Keywords:

• fiscal policy
• fiscal rule
• government spending
• unexpected shock

JEL Classification:

• E20
• E62
• H50

Acknowledgements

We would like to thank Michael Boskin, Juan Bravo, Rodrigo Cerda, José De Gregorio, Barry Eichengreen, Robert Engle, Stanley Fischer, Laurence Kotlikoff, Nouriel Roubini, Jeffrey Sachs, Salvador Valdés and all participants at the Central Bank of Chile Workshop, Chilean Ministry of Finance Workshop and the Fourth International Conference ‘Chile toward the Development’ for their useful suggestions and comments. We would also like to thank Raúl Morales for his excellent research assistance.

Notes

¹ Strictly speaking, the Ricardian equivalence refers to agents that expect higher future taxes after a deficit-financed cut in current taxes, given a path of government spending. In this context, we define Ricardian agents as consumers who expect higher future taxes in the face of a permanent increase in government spending beyond the intertemporal government budget constraint.

² Some presidential candidates proposed, in the fourth quarter of 2013, a new tax increase, in part to reduce the structural deficit of −1%.

³ Marcel et al. (2001) provide a complete description of Chile’s fiscal rule.

⁴ For instance, Marcel et al. (2001, p. 7) explain that ‘the structural surplus target of 1% of GDP ensures a dynamic asset accumulation that makes it possible to meet future financial commitments of the public sector, which grow at a higher rate than revenues and expenses, in addition to expenditures derived from contingent liabilities. Within this latter category, the most relevant are the guarantees of minimum income for concessions, those arising from lawsuits against the Treasury, the guarantees to ensure minimum pensions in the pension system and potential financial losses by the Central Bank’.

⁵ Since 2005, the molybdenum price has been considered in the calculation of the fiscal structural revenues.

⁶ Since the Chilean economy had been performing well, there was political pressure to increase government spending in certain areas, such as pensions and education.

⁷ From then on, the structural balance would be calculated using the methodology proposed by the Committee, which recommended treating as permanent any transitory fiscal policy considered difficult to revert in the future.

⁸ In the fourth quarter of 2010, the Budget Office announced that, to achieve this goal, the structural-balance target for 2011 would be −1.8% of GDP and would gradually converge to −1% until the end of 2013.

⁹ This shock is considered an expansionary deviation from the rule from two points of view. First, the information revealed by the Committee could have changed the expectations of agents about the levels of future taxes needed to rebalance the government budget. Specifically, agents realized that fiscal policy during Velasco’s administration was more expansionary than the one officially announced in 2009. Therefore, a rise in taxes could be required to equilibrate public finances again given the difficulties of cutting several fiscal programmes. Second, even though the information revealed by the Committee would not have been new for agents, Minister Larraín’s announcement of the change in the fiscal target, from 0% to −1%, can also be considered a more expansionary path of fiscal policy than the one expected by agents.