Fiscal consolidation and financial reforms

Abstract

We use a rare events logistic regression model as well as traditional probit and logit models to investigate the impact of fiscal consolidation on the likelihood of financial reforms for a panel of 17 countries over the period 1980–2005. We show that large austerity plans, mainly implemented through spending cuts rather than tax hikes, promote financial reforms. By considering reforms affecting specific areas of the financial sector, we find that the banking sector reforms and domestic finance reforms are more likely to occur when fiscal adjustments are put in place. Interestingly, while banking sector reforms are mainly prompted during periods of tax-driven consolidations, spending cuts driven consolidation packages seem to propel the implementation of domestic finance reforms. Finally, we show that higher inflation, lower degree of trade openness, a deterioration of financial conditions and, to some extent, a fall in the degree of competitiveness enhance the probability of financial reforms.

Keywords:

• fiscal consolidation
• financial reforms
• macroeconomic determinants
• rare events logit model

JEL Classification:

• P11
• P16
• P34
• N20
• G28

Acknowledgement

The authors gratefully acknowledge the constructive comments made by participants to the Third International Symposium in Computational Economics and Finance (ISCEF2014: www.iscef.com), 10–12 April 2014, Paris, France. The opinions expressed herein are those of the authors and do not necessarily reflect those of the OECD or its member countries. The usual disclaimer applies.

Notes

¹ Johannesson Lindén and Gayer (2012) also highlight the importance of real estate taxation for the purpose of contributing to fiscal consolidation. The authors emphasize its impact on macroeconomic stability and the fact that it impinges less strongly on growth than other sources of taxation, despite its unpopular nature. Jensen and Wöhlbier (2012) recall that the efforts to narrow the tax compliance gap and to improve the efficiency and the effectiveness of tax collection are especially relevant when countries face the need to implement fiscal consolidation measures.

² Agnello et al. (2012) find a negative relationship between financial reforms and the income gap.

³ Bouthevillain and Dufrénot (2011) show that the nature of the fiscal adjustments also depends on features, such as the occasional and sudden occurrence of financial crises, thereby, making it difficult for governments to implement fixed-regime rules (Bouthevillain and Dufrénot, 2011).

⁴ We use the software package ‘relogit’ provided by Tomz et al. (1999).

⁵ These are: banking supervision and regulation, credit controls, direct credit and reserve requirements, entry barriers, interest rate controls and banking privatization.

⁶ Note that Contraction and real effective exchange rate also have positive coefficients, suggesting the same conclusion. However, their coefficients estimates are not statistically significant at usual levels.

Additional information

Funding

Castro and Sousa also acknowledge that this work has been financed by the Operational Programme for Competitiveness Factors – COMPETE and by National Funds through the FCT – Portuguese Foundation for Science and Technology within the remit of the project ‘FCOMP-01-0124-FEDER-037268 (PEst-C/EGE/UI3182/2013)’.