On the effectiveness and limits of fiscal stabilizers

Abstract

The smoothing impact of fiscal stabilizers (proxied by government expenditures) on business cycle volatility is studied for a panel of European Union (EU) countries in the period 1970–1999. Special emphasis is put on the investigation of possible nonlinearities in the relationship between Gross Domestic Product (GDP) growth volatility and fiscal stabilizers. The results show that the business cycle volatility smoothing effect of fiscal stabilizers may revert at high levels. The results hold when using government revenues as a proxy for fiscal stabilizers.

Acknowledgements

We would like to thank Mathias Sutter and Martin Kocher for providing us with data on political variables. Furthermore we would like to thank Edwin Deutsch, Helmut Hofer, Albert Jäger, Lawrence Klein, Walpurga Köhler-Töglhofer, Robert Kunst as well as the participants at the ‘East-West Conference 2002’ of the Oesterreichische Nationalbank in Vienna, at the Workshop of Public Finance at the University of Innsbruck, at the annual meeting of the Austrian Economic Association in Klagenfurt, of the 8th Spring Meeting of Young Economists in Leuven, of the Tinbergenweek 2003 in Rotterdam and at internal seminars at the European Central Bank, the IMF and the OECD, the Institute for Advanced Studies in Vienna, the Vienna Institute for International Economic Studies and the Oesterreichische Nationalbank the for many helpful comments and discussions.

Notes

¹ We use the broader term fiscal stabilizers instead of automatic stabilizers since we do not only use the classical categories representing automatic stabilizers, namely direct taxes and unemployment benefits, but test all subcategories of the revenue and expenditure side.

² See, e.g. Van den Noord (2000), using the OECD-INTERLINK model, or Barrell and Pina (2003), using the NiGEM model. Brunila et al. (2002), using the EC-QUEST model.

³ Our basic data set consists of yearly data on 14 EU countries covering the period 1970 to 1999. Our data set contains all current EU countries with the only exception of Luxembourg. For some countries the time range is shorter so that the sample is not balanced.

⁴ Several more variables were tested as a robustness check, e.g. openness, population, average inflation levels, average levels of core inflation and GDP growth. The coefficients never appeared significant and left the other coefficients basically unchanged.

⁵ Buti and Van den Noord (2003) provide a theoretical framework that explicitly predicts a nonlinear relationship between government size and GDP growth volatility.

⁶ This nonparametric approach fits for each data point in the sample a local linear regression line, weighting the other observations: data points that are relatively far from the point being evaluated get small weights in the sum of squared residuals, while closer data points get higher weights.

⁷ Figure 1 shows the residuals of Equation 2, estimated under the restriction β₁ = 0 (that is the part of GDP growth volatility that cannot be explained by the right hand side variables other than GOV EXP_it in Equation 2) against the fitted levels of government expenditures over GDP using the instruments and exogenous variables. This is the variable actually used instead of GOV EXP_it for the instrumental variables estimation.

⁸ All fiscal measures are used as logs of the share in GDP and those that are expected to contain a significant discretionary part (INVEST_it and GOVCONSw_it) are adjusted following the same approach applied to the government expenditure ratio. In all cases, the estimation is done using the same instruments selected for the case of the overall government expenditure measure.