Fiscal rules, inertia and discretionary fiscal policy

Abstract

In current practice, changes in the cyclically-adjusted budget balance (CAB) are interpreted as reflecting the effort of discretionary fiscal policy. This paper shows that such an interpretation is not a sufficiently accurate description of the behaviour of fiscal policy, as, in some cases, it may conceal an important deficit bias. Specifically, as growth projections are an important building block of budgetary plans, systematic optimism in forecasting growth, coupled with pervasive lags and inertia in the implementation phase of the budget, will result in a fiscal expansion compared to plans, even in the absence of discretionary measures. In order to track down this kind of passive behaviour in the light of growth surprises or sanguine growth assumptions the traditional reading of the CAB needs to be adjusted. This is achieved by relaxing the benchmark assumption according to which, under unchanged fiscal policy, the deficit-to-GDP ratio is invariant to growth. An empirical application to public finance data of four large EU countries shows that passive behaviour is an important element in practice, as forecast errors are significant in explaining changes in the CAB. Moreover, in some cases official growth forecasts appear to have a clear upward bias.

Acknowledgements

We thank Marco Buti, Antonio Cabral, Lucio Pench, Werner Röger, Peter Weiss and Ralph Wilkinson for helpful discussions and comments on earlier versions of this paper. All remaining shortcomings are our own. Research assistance by Vito Ernesto Reitano is very much appreciated.

Please note: The views and opinions expressed here are the authors’ only and should not be attributed to the European Commission.

Notes

From a theoretical point of view Equation 3 involves two important simplifications. It disregards any direct effect fiscal measures fp_t may have on both actual and potential output. In the context of the prevailing macroeconomic paradigm, contractionary fiscal policy measures are generally assumed to have a negative effect, if not on the underlying rate of growth, then at least on the cyclical position of an economy. Hence Equation 1 may be rewritten as

The likely response of actual output to fiscal policy measures will generally dampen the efficacy of any consolidation effort in the sense that a larger discretionary correction is required to achieve a specific nominal target. Nevertheless, Equation 3 is justified by the problem at hand, i.e. decomposing observed changes in the budget. The aim of this work is not to determine ex ante the impact on output or the required size of a specific fiscal policy measure, but to identify different components in the observed changes of the budget balance given cyclical variations and underlying growth.

Giorno et al. (1995) and Van den Noord (2000), both published as OECD working paper, are the main references regarding tax elasticities for OECD countries.

While the assumption of neutrality may be justified in the planning phase of the budget, i.e. fiscal policy makers may plan to spend expected additional non-cyclical revenues, it will generally not hold in the implementation phase due to inertia. Expanding Equation 4 to allow for the difference between ex ante and ex post we get

where the last term on the left side can be taken to be zero.

Assuming no adjustment on non-cyclical primary expenditure in the implementation of the budget means that the level of expenditure is taken to be fixed at the planned level

. If in addition the tax system is taken to be proportional we have:

The risk of insolvency is highlighted by Corsetti and Roubini (1993) who perform statistical tests providing strong evidence against sustainability of fiscal policy at the time in Italy.