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OCCAS IONAL PAPER SER IESNO. 38 / OCTOBER 2005

ECONOMIC REACTIONS TO PUBLIC FINANCE CONSOLIDATION:A SURVEY OF THE LITERATURE

by Maria Gabriella Briotti

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ECONOMIC REACTIONS TO PUBLIC FINANCE

CONSOLIDATION:A SURVEY OF THE

LITERATURE1

by Maria Gabriella Briotti

1 The author works as Principal Economist in the Fiscal Policies Division of the European Central Bank. The authorwould like to thank Philippe Moutot, José Marín Arcas, Franceso Paolo Mongelli, Ludger Schuknecht, J.-P. Vidal,

colleagues from the Fiscal Policies Division and an anonymous referee for their comments, as well as Anna Foden,Elisabeth Keable and Paul Williams for their editing suggestions. Any remaining errors are the sole responsibility

of the author. The views expressed do not necessarily reflect those of the European Central Bank.

© European Central Bank, 2005

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ISSN 1607-1484 (print)ISSN 1725-6534 (online)

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Occasional Paper No. 38October 2005

CONTENTSC O N T E N T SABSTRACT 4

EXECUTIVE SUMMARY 5

1 INTRODUCTION 8

2 THE THEORY OF THE INFLUENCE OF FISCALPOLICY ON ECONOMIC ACTIVITY 9

2.1 The traditional Keynesian modeland the New Classical elements 9

2.2 Rational expectations view 10

2.3 Ricardian Equivalence view 10

2.4 Non-linear effects: interest rate riskpremia and credibility 11

2.5 Non-linear effects: the new policyexpectation view 12

2.6 Supply-side effects 12

3 EMPIRICAL EVIDENCE FROM FISCALCONSOLIDATION: A SURVEY 14

3.1 Macroeconomic model simulations 14

3.2 Episodes of fiscal consolidation 15

3.3 Demand side: the consumptionchannel 15

3.4 Demand side: the investmentchannel 17

3.5 Supply-side effects: composition ofbudget adjustment 17

3.6 Spillover effects 19

4 EFFECTS ON SAVINGS: TEST OF RICARDIANEQUIVALENCE 21

5 CONCLUSION 22

REFERENCES 24

LIST OF OCCASIONAL PAPERS 27

4ECBOccasional Paper No. 38October 2005

ABSTRACT

The paper reviews the theoretical and empiricalliterature that has investigated the conditionsunder which a contractionary fiscal policy iseffective in reducing debt and deficit, but doesnot have a negative effect on growth. The issueis central to macroeconomics and policymaking, given that many countries arecurrently facing increasing fiscal imbalances,with additional pressure coming in the mediumterm from population ageing. The paperconcludes that the theoretical impact of fiscalpolicy on aggregate demand and economicactivity depends largely on the conceptualframework considered and its assumptionsabout the world. Empirical studies based onmacro-econometric model simulations findevidence that fiscal consolidations leadinitially to production losses, while they canresult in a higher output in the medium term.Empirical studies focusing on episodes ofchanges in fiscal policies provide in turnevidence that under certain circumstancesausterity measures may have an expansionaryimpact on the economy.

Key words: fiscal multiplier, fiscalconsolidation, non-Keynesian effects,government spending and taxing.

JEL Classification: E62, H30

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EXECUTIVESUMMARYEXECUTIVE SUMMARY

The impact of fiscal policy on aggregatedemand and economic activity has been thesubject of a long-standing debate. Thepossibility of “non-Keynesian effects”resulting from restrictive fiscal policies wasfirst raised by Barro (1974), who introduced theconcept of “Ricardian Equivalence”: a tax cutfinanced by issuing government debt may failto stimulate private consumption becauseconsumers discount the future tax burdenrequired to serve and repay the debt, in thebelief that this will cancel out the current taxalleviation. This issue attracted much renewedinterest in the light of the experiences of fiscalconsolidation in Denmark (1983-86) andIreland (1987-89). In spite of the severerestrictive policies pursued in the two countriesduring the periods concerned, their rates ofgrowth showed significant increases onprevious years. Since then, a number of studieshave tried to find evidence of the transmissionchannels of a potentially expansionary fiscalretrenchment.

Against this background, this Occasional Paperreviews the theoretical and empirical literaturethat has investigated the conditions andcircumstances under which a contractionaryfiscal policy is effective in reducing debt anddeficit, yet does not have a negative impact ongrowth. Indeed, there is not much consensus onthe interaction between fiscal policy andgrowth in the short term. Conceptually, theimpact of fiscal policy on aggregate demandand economic activity very much depends onthe theoretical model and its assumptions aboutthe “world” in which policy measures areimplemented. The traditional Keynesianapproach emphasises the demand implicationsof restrictive fiscal policies and points to theshort-run contractionary impact of fiscalconsolidation. The opposite view highlightsthe fact that, in the short run, expansionaryeffects may emerge if fiscal policies improvethe expectations of economic agentsconcerning their future income and wealth(demand-side effects) and/or help to enhance

labour market efficiency and thecompetitiveness of the economy (supply-sideeffects). Despite the complexity of thetheoretical arguments and the difficulty ofobtaining clear-cut empirical results, thereseems to be broad agreement about the basicfactors influencing the size and sign of fiscalmultipliers.

In the most simple static model with fixedprices, an exogenous increase in publicexpenditure (or an increase in disposableincome following a tax cut) will bring abouttraditional Keynesian effects on demand. In theshort-run horizon envisaged by the model, aloosening of fiscal policy has an expansionaryeffect on private consumption and economicactivity. In other words, the fiscal policymultiplier is positive. Even in such a simplifiedframework, the size of the multiplier isadversely affected by a number of factors.Productive capacity close to full use willseverely limit the use of expansionary policiesbased on aggregate demand. Possible increasesin market interest rates may crowd out privatedemand, particularly when investments show asignificant sensitivity to interest rate changes.In an open economy with flexible exchangerates and mobile capital, there can besignificant offsetting effects resulting from anexchange rate appreciation. Taking intoaccount such circumstances, the expansionaryeffects of fiscal loosening on demand can bevery limited, i.e. the effect is likely to be“weakly Keynesian” and the multiplier stillpositive but small.

Moving to a dynamic model that does notassume full market clearing, the range ofpotential transmission channels for fiscalpolicy to aggregate demand is broader on thelonger horizon. In this context, agents formexpectations regarding future developments inpublic finances and budget policies, and hencetheir future disposable income and wealth. Thisintertemporal optimisation implies complexand non-linear relationships in the traditionalconsumption and investment model, whichdepend, among other things, on how economic


agents form their expectations. In particular,the inclusion in the model of New Classicalelements, such as the formation of agents’expectations and the Ricardian Equivalenceproperty, implies that wealth and expectationaleffects might well outweigh the traditionalKeynesian multiplier effects on demand andactivity. In other words, multipliers maybecome negative and overall effects non-Keynesian.

In most theoretical models, potential non-Keynesian effects are explained by a change inthe expectations of economic agents and/or bybetter labour market performance leading toenhanced competitiveness in the economy.Fiscal retrenchment can have expansionaryeffects on private consumption whenconsumers feel that such consolidation willincrease their lifetime income. If consolidationis delayed, consumers will expect higher taxincreases in future, which, given the non-linearincrease in the distortionary effects of taxation,will have a more disruptive effect on futureoutput and income. By contrast, timelyconsolidation can improve expectations offuture income. Furthermore, in countries withhigh public debt ratios, restrictive fiscalpolicies can reduce the risk of default and, inturn, boost confidence in future policies. Thesubsequent interest rate decline would spuraggregate demand both directly, throughinvestment, and indirectly, through thepositive wealth effect in the private sector andtherefore consumption.

A number of modelling assumptions, however,are crucial to obtaining the expansionaryeffects of a contractionary policy. First, taxesmust be distortionary, with larger tax increasescausing larger distortionary effects. Under thisassumption, if consolidation is delayed,consumers will expect larger tax increases infuture, which will have larger disruptiveeffects on future output. Second, consumersshould be forward-looking and not liquidity-constrained, so that higher expected incomecan be translated into higher effective demand.Third, fiscal consolidation must be unexpected

in order to trigger expansionary effects. Onlyunder this condition is fiscal consolidationlikely to produce a change in people’sexpectations of future fiscal policies andtherefore expected future income.

Several empirical studies have been carried outin an attempt to find evidence of theexpansionary effects of fiscal consolidation.One approach is to estimate fiscal multipliersusing macroeconomic model simulations. Thegeneral conclusion is that fiscal consolidationinitially leads to output losses, albeit small,which are then followed by a recovery.In particular, expansionary non-Keynesianeffects from expenditure cuts can emergein the medium run owing to the anticipatedeffects of higher future disposable income orprofitability.

An alternative approach looks at specificepisodes of fiscal expansion and contraction inlarge samples of countries or in the form ofindividual case studies. A number of suchstudies provide some evidence that specificcharacteristics of a fiscal policy are relevant indetermining its persistence and potential non-Keynesian effects on economic activity. Thesize, composition, speed of implementationand initial state of public finances are all seenas relevant factors. However, studies differ asto the relative importance attributed to thevarious features of a budgetary adjustment indetermining possible expansionary effects.Most studies agree on the importance of thecomposition of a budget adjustment and, inparticular, that an expenditure-basedadjustment tends to be more growth-friendlyand lasting than a tax-based adjustment withoutexpenditure restraints. Views on the roleplayed by the size of the adjustment and theinitial state of public finances, on the otherhand, are more mixed, as there is no conclusiveevidence that larger initial fiscal imbalancesand sizeable adjustments are more likely toresult in expansionary effects from fiscaltightening. Moreover, the empirical evidencedoes not reveal whether expansionary effectsare driven by expectations concerning future

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EXECUTIVESUMMARY

disposable income (i.e. expectations of lowertaxes in future and better financing conditions)or by supply-side effects (through increasedincentives to work and invest).

Another way of analysing the impact of fiscalpolicies on aggregate demand is to look at howprivate saving responds to changes in the fiscalstance (or public saving). Although manyempirical studies strongly reject the idea that adecline in public saving brings about anequivalent increase in private saving, i.e. fullRicardian Equivalence, private consumptionmay still reflect a partial Ricardian effect. Inparticular, recent studies indicate that fiscaladjustments and expansions in many OECDcountries have been associated with inversemovements in private saving.

From a policy perspective, notwithstanding thecomplexity of the theoretical arguments andthe difficulty of obtaining clear-cut empiricalresults, there seems to be broad agreementabout the basic factors influencing the size andsign of fiscal multipliers. A key condition forfiscal expansion having a “standard” positivemultiplier effect on aggregate demand, andtherefore output, is that there be slack inproductive capacity. The composition of thefiscal expansion is also important, withincreases in government spending spurringdemand more than tax cuts, particularly in thecase of high-quality spending, such asspending that increases the productivity oflabour and/or capital. Tax cuts, however, canalso be expansionary, if labour supply and/orinvestment increase correspondingly inresponse.

The expansionary impact of the public budgetcould, however, be offset, in full or in part, byconsequent increases in market interest ratesand by exchange rate appreciation. In suchinstances, additional public spending wouldbe compensated by lower private spending,mitigating the effects on aggregate demand.Furthermore, fiscal expansions, whichgenerate uncertainty about the future course ofbudget policies and even jeopardise the

sustainability of public finances, may have anadverse impact on confidence and economicactivity. Consumers may form negativeexpectations about their future income and theconsequent precautionary saving behaviourwill adversely affect private consumption.Unsound fiscal policies may also result inhigher interest rates, reflecting higher riskpremia, and therefore have a negative impacton private activity. Such effects will be greater,the more investment decisions are driven byinterest rates and the more wealth affectsprivate consumption.


1 INTRODUCTION

The debate on the possible non-Keynesianeffects of restrictive fiscal policies started withBarro’s seminal paper (1974), whichintroduced the concept of “RicardianEquivalence”. Accordingly, in theoreticalmodels that embody this feature, a tax cutfinanced by issuing government debt fails tostimulate private consumption becauseconsumers discount the future tax burdenrequired to serve and repay the debt, in thebelief that this will cancel out the current taxalleviation. The issue attracted much renewedinterest in the light of the experiences of fiscalconsolidation in Denmark (1983-86) andIreland (1987-89). In spite of the severerestrictive policies pursued in the two countriesduring the periods concerned, their rates ofgrowth showed significant increases onprevious years. Since then, a larger numberof studies have been carried out in an attemptto identify the transmission channels ofpotentially expansionary fiscal retrenchment.

Indeed, there is not much consensus amongexperts on the interaction between fiscal policyand growth in the short term. The traditionalKeynesian approach emphasises the impact ofrestrictive fiscal policies on demand and pointsto the short-run contractionary effects of fiscalconsolidation. A key condition for fiscalexpansion having a “standard” positivemultiplier effect on aggregate demand, andthus output, is that there be slack in productivecapacity. The composition of the fiscalexpansion is also important, with increases ingovernment spending spurring demand morethan tax cuts, particularly in the case of high-quality spending, such as spending thatincreases the productivity of labour and/orcapital.

The opposite view emphasises that, in the shortrun, expansionary effects may arise if fiscalpolicies improve economic agents’expectations of their future income and wealth(demand-side effects) and/or contribute toenhancing labour market efficiency and the

competitiveness of the economy (supply-sideeffects). Fiscal retrenchment can haveexpansionary effects on private consumptionwhen consumers feel that such consolidationwill increase their lifetime income (sometimesalso referred to as the “wealth channel”). Ifconsolidation is delayed, consumers willexpect higher tax increases in future, which,given the non-linear increase in thedistortionary effects of taxation, will have amore disruptive effect on future output andincome. By contrast, timely consolidation canenhance expectations regarding future income.However, in order for the transmission of theseimpulses to be effective, consumers should beforward-looking and not liquidity-constrained,so that higher expected income can betranslated into higher effective demand.

In order to determine the size and sign of fiscaleffects, empirical literature either relies onmacroeconomic model simulations to estimatefiscal multipliers or draws lessons from theinvestigation of specific episodes of fiscalcontraction. The first approach shows thatshort-term multipliers are generally positive,although their estimated values have declinedover the last two decades. Such estimatesprovide only limited evidence of negativefiscal multipliers. In general, fiscal multipliersare smaller in the case of changes in taxationthan in the case of changes in spending.

In the alternative approach, empirical studiesfocus on specific episodes of fiscalconsolidation in order to identify transmissionchannels of potentially expansionary fiscalcontractions. A number of these empiricalstudies provide evidence suggesting that fiscalconsolidation policy may have an expansionaryeffect on economic activity in certaincircumstances. However, the studies availabledo not provide conclusive evidence as towhether expansionary effects are driven byexpectational effects or by supply-side effects.The studies also differ in terms of theimportance they attribute to the various featuresof a budgetary adjustment in determiningpotential expansionary effects. Most studies

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agree on the relevance of the persistency andcomposition of a budget adjustment. Inparticular, there is broad agreement that anexpenditure-based adjustment tends to be moregrowth-friendly and lasting than a tax-basedadjustment without expenditure restraints. Bycontrast, evidence on the size of the adjustmentand, in particular, on the initial state of publicfinances is more mixed. Furthermore, a numberof methodological considerations suggest thatempirical results are sensitive to the way inwhich fiscal consolidation is analysed andconclusions may therefore lack the desiredrobustness.

The impact of fiscal policy on aggregatedemand depends on the response of privatesaving to changes in fiscal stance. Althoughempirical evidence is quite mixed and no clear-cut conclusions can be drawn about fullRicardian Equivalence, the behaviour ofprivate consumption may still be consistentwith a partial Ricardian offset.

Against this background, this Occasional Paperreviews the theoretical and empirical literaturethat has analysed the conditions andcircumstances under which a contractionaryfiscal policy is effective in reducing debt anddeficit, but does not have a negative impact ongrowth. Section 2 examines some of thetheoretical literature that investigates potentialchannels for the non-Keynesian effects, orweak Keynesian effects, of a budgetcontraction. Table A and Table B summarisethe main issues of the theoretical debate. Basedon the studies available, Section 3 illustratesthe empirical evidence in support of non-Keynesian or weak Keynesian effects of abudget contraction. A synopsis of the mainempirical results is set out in Table C.Empirical studies on Ricardian Equivalenceare analysed in Section 4, and finally Section 5presents the main conclusions.

2 THE THEORY OF THE INFLUENCE OFFISCAL POLICY ON ECONOMIC ACTIVITY

2.1 THE TRADITIONAL KEYNESIAN MODELAND THE NEW CLASSICAL ELEMENTS

In the most simple static model with fixedprices, an exogenous reduction of publicexpenditure (or a contraction of disposableincome following a tax hike) will bring abouttraditional Keynesian effects through thedemand side by way of the well-knownmultiplier mechanism. In the short-run horizonenvisaged by the model, Keynesian effectsprevail and restrictive fiscal policies havecontractionary effects on private consumptionand economic activity. When assessing theeffects of a fiscal loosening, the size of themultiplier, however, is affected by a number offactors which may entail crowding-out effects,such as insufficient slack in productivecapacity, increases in market interest rates, thedegree of openness of the economy andappreciation of the exchange rate, and thepossibility of at least limited price flexibility.Depending on these conditions, theexpansionary effects of fiscal loosening ondemand can be very limited.

In a dynamic model, which does not assume fullmarket clearing, the longer temporal horizonbroadens the range of possible channels oftransmission of fiscal policy to aggregatedemand. In this context, agents formexpectations about future developments inpublic finances and budget policies, andtherefore of their future disposable income andwealth. The intertemporal optimisation impliescomplex, non-linear relationships in thetraditional consumption and investment model,which depend, among other things, on howeconomic agents form their expectations. Inparticular, the inclusion of the New Classicalelements (e.g. Ricardian Equivalenceproperty) in the model implies that wealth andexpectational effects might well outweigh thetraditional Keynesian multiplier effects ondemand and activity.


Intertemporal issues have been explored in aKeynesian context by Barry and Devereux(1995), who developed a theoretical model thatexplicitly takes into account agents’expectations and assumes perfect foresight,perfect capital markets and the RicardianEquivalence property. The model is, however,Keynesian, in the sense that wages and pricesare not perfectly flexible. It examines theimpact of temporary and permanent fiscalcontractions on consumption, investment,employment and the current account, in a two-period and two-sector framework (tradeablesand non-tradeables). According to Barry andDevereux’s analysis, permanent fiscalcontractions can have expansionary effects,although this largely depends on the specificconditions met by the parameters of the model.In particular, when wages are rigid and prices(in the non-tradeables sector) are flexible,under a strong consumption smoothinghypothesis, fiscal contraction typically raisesprivate sector consumption, following the NewClassical elements of the model. The effects oninvestments and the trade balance are insteadless clear cut, while the general impact of afiscal contraction is to reduce employment,following the Keynesian features of the model.

2.2 RATIONAL EXPECTATIONS VIEW

When agents form rational expectations,permanent changes in fiscal policy modifytheir expected permanent income, whiletransitory fiscal changes do not affect it at all.Since agents bring forward the long-termeffects of fiscal policy to the present, short-term effects become relevant. In particular, ifagents expect that an initial increase in interestrates and/or an appreciation of the exchangerate, following fiscal expansion, will continueor even become larger, crowding-out effectswill be augmented and the fiscal multiplier maybecome negative (Krugman and Obstfeld,1997). Under such circumstances, a weakKeynesian effect is dependent on the effects ofpolicy measures being permanent, with thetransmission to aggregate demand beingthrough the permanent income hypothesis.

2.3 RICARDIAN EQUIVALENCE VIEW

The Ricardian Equivalence implies theirrelevance of the government’s financingdecisions vis-à-vis taxes and debt (Barro,1974). The key issue is that the economy isinfluenced only by the quantity of governmentexpenditure (purchases in the basic model) andnot by whether such expenditure is financed by

Taxonomy Main underlying Definition Value of the Multiplierassumptions

Traditional Keynesian Slack in productive capacity; Increase in income following Positive and greater than 1.Multiplier fixed price; static model. exogenous increase in public

expenditure or tax cut.

Weak Keynesian Productive capacity close Partial or full crowding-out Between 1 and 0.to full use; market interest side-effects of budgetincrease; exchange rate changes limit the size of theappreciation. multiplier.

Ricardian equivalence Intertemporal optimisation; Precautionary behaviour of Multiplier equal to 0.forward looking agents; economic agents fully offsetno liquidity constraints. fiscal policy changes.

Non-Keynesian Intertemporal optimisation; Prompted by a credible fiscal Negative or close to zero.large fiscal imbalances; risk consolidation, agents’premium on interest rates; expectations about futurecredible fiscal consolidation. fiscal policy and future income

improve.

Table A Potential impact of budgetary adjustments on economic activ ity

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higher taxes or debt. The RicardianEquivalence view states that a fiscal expansionprompts expectations of future fiscalcontractions, in order to repay for the initialloosening. The reduction in government savingbrought about by an initial tax cut willtherefore be fully offset by higher privatesaving and bequests, adopted by householdsand firms as precautionary behaviour.Consequently, changes in aggregate privatedemand will reduce or even bring to zero themultiplier effects of the fiscal expansion on theeconomy.

The link between fiscal policy andconsumption is based on the permanent incomehypothesis. Since, under the assumptions thatgive rise to Ricardian Equivalence, permanentincome and aggregate demand are not affectedby intertemporal changes of fiscal policy, thefiscal multiplier is zero. However, it should beemphasised that for the Ricardian Equivalenceproperty to be met, a number of crucialassumptions must be satisfied, e.g. perfectcapital markets and the absence of liquidityconstraints, perfect foresight, altruistic andforward-looking agents, and lump-sum taxes.

The robustness of Ricardian Equivalence cantherefore be questioned on the basis of thereality of the underlying assumptions. Theintroduction, in turn, of alternativeassumptions, such as myopic agents, a finitelife, liquidity-constrained consumers,imperfect capital markets and distortionarytaxation, makes a positive multiplier onceagain likely. Departures from the crucialunderlying assumptions are worth mentioningin greater detail. If agents cannot offsetincreases in public savings because of liquidityconstraints and/or imperfect capital markets,fiscal expansion can still have Keynesianeffects, particularly when debt is low(Blanchard, 1985). Taking into accountliquidity-constrained consumers is justifiedparticularly when there is no evidence ofconsumption smoothing in the face of incomefluctuations, or when there is evidence that asignificant share of consumers have near-zero

net worth. By the same token, considering thecase of myopic agents, whose time horizon isshorter than that of the government, a decreasein taxes today will boost the consumption of thecurrent generation. This is because anothergeneration will pay the higher taxes required inthe future to finance the deficit. The mainimplication of the cases considered is that thetime pattern of consumption depends on thetime profile of taxes and public debt, andtherefore on intertemporal changes of fiscalpolicies (Modigliani and Brumberg, 1954;Ando and Modigliani, 1963).

Furthermore, dropping the hypothesis of lump-sum taxes, the case for distortionary taxes(proportional or progressive) makesintertemporal changes of fiscal policy matter tothe economic impact. More specifically, a taxcut increases the present value of future taxpayments expected by agents, as they wouldexpect future fiscal adjustments that, in thepresence of distortionary taxes, produce largeroutput losses. Hence, a permanent increase inpublic spending financed by higher future taxeswill lead to a reduction in permanent income,and therefore consumption, owing to thedistortionary effects of taxes. This will reducethe size of the multiplier and even imply anegative fiscal multiplier.

2.4 NON-LINEAR EFFECTS: INTEREST RATERISK PREMIA AND CREDIBILITY

Risk premia, which reflect the risk of default orinflation, particularly in the case of a largepublic debt stock, will reinforce potentialcrowding-out effects and even turn fiscalmultipliers into negative value. Restrictivefiscal policies, which can reduce the risk ofdefault in countries with high public debtratios, will possibly reduce or even eliminatesuch risk premia. The subsequent interest ratedecline would spur aggregate demand bothdirectly, through investments (McDermott andWescott, 1996), and indirectly, through thepositive wealth effect in the private sector andtherefore consumption (Giavazzi and Pagano,1990). Against this background, a large budget


consolidation and correction of fiscalimbalances will prompt confidence effects,boosting consumption and/or investment in anon-linear way. Changes in household wealthand interest rates are the main channels oftransmission to aggregate demand, mitigatingthe traditional Keynesian effects of fiscalcontraction or even prompting the non-Keynesian case of expansionary fiscalconsolidation.

2.5 NON-LINEAR EFFECTS: THE NEW POLICYEXPECTATION VIEW

A restrictive fiscal policy, through higher taxesand/or lower expenditure, could haveexpansionary effects on aggregate demand iffiscal policies prompt a change in agents’expectations of their future disposable income.More specifically, in a simplified framework,fiscal consolidation undertaken through highertaxes – in order to stabilise debt at a constantlevel – influences consumer behaviour in twoways (Blanchard, 1990). The intertemporalredistribution of taxes from the future to thepresent day has the conventional effect ofreducing taxpayers’ current income andconsumption. If the agents’ time horizon isshorter than that of the government, bringingforward taxation will be perceived as a netreduction of disposable income. However, byresorting to timely fiscal consolidation,governments will avoid the need for muchgreater fiscal consolidation in the future, whichwould have more disruptive effects on incomeand output. In this context, fiscal consolidationwould improve expectations of future incomeand wealth. Similarly, in the case of a sizeablereduction in public expenditure, perceived aspermanent, consumers would anticipate areduction in the future tax burden and apermanent increase in their expected incomeand wealth. Consequently, households willrevise upwards their expected futuredisposable income, and therefore wealth, thusincreasing their current consumption.

The pre-condition for a non-linear functionalrelation of private consumption to fiscal

consolidation is given by a very high andunsustainable level of public expenditure(Bertola and Drazen, 1993) or public debt(Sutherland, 1997). In such a scenario, non-Keynesian effects are triggered by large andcredible budgetary adjustments which, in thepresence of pre-existing large fiscalimbalances, induce economic agents to changetheir expectations of future policies. In theexpectation view of fiscal policy, the channelof transmission between fiscal policy andprivate consumption is household wealth,driven by intertemporal effects of expectedchanges in fiscal policy. The expectation viewis also consistent with the argument set forth byGiavazzi and Pagano (1995), who argue thatlarge consolidation can be expansionary whenfiscal imbalances reach a critical level,precisely because they signal a permanent anddecisive change in the stance of fiscal policy.By contrast, small adjustments may have theopposite effect because they might beinterpreted as an example of failedstabilisation.

A number of assumptions are crucial in thespecification of the consumption functionwhen deriving the expansionary effects of acontractionary policy. First, taxes must bedistortionary, with larger distortionary effectsattached to larger tax increases. Under thisassumption, if consolidation is delayed,consumers expect larger tax increases in future,with larger disruptive effects on future output.By contrast, timely consolidation can improveagents’ expectations of future income. Second,consumers should be forward-looking and notliquidity-constrained, so that higher expectedincome can be translated into higher effectivedemand. Third, in order to be good news, fiscalconsolidation must be unexpected.

2.6 SUPPLY-SIDE EFFECTS

If it can be shown that tax increases or spendingcuts have different macroeconomic effects,then the composition of a budgetary adjustmentis instrumental in its success. In a standardneoclassical model, higher taxes would have

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opposite income and substitution effects onlabour supply, with income effects increasingthe labour supply and substitution effectsdecreasing it (if leisure is a normal good). Atthe individual level, tax effects on laboursupply depend on the consumption-leisureelasticity of substitution, which mostdisaggregated studies on labour supplybehaviour find rather small. By contrast, taxeffects on aggregate supply might be large inunionised labour markets, because an increasein labour taxation will induce unions to demandhigher pre-tax real wages. This would result infirms having higher unit labour costs and a lossof competitiveness. To what extent theeconomy will suffer from a loss ofcompetitiveness depends on the labour marketinstitutions. Effects on labour costs tend to besmaller when labour unions are weak orinternalise the effects of their policy.

The relevance of trade union moderation is alsoapparent on the expenditure side. Decliningpublic expenditure and, particularly, publicemployment would have a depressive effect on

the dynamics of public wages, which, throughspillovers in the labour market, would betransmitted to private sector wages. In turn,this would increase profits and investments,with some supply-side effects also present(Alesina and Perotti, 1995a, 1995b and 1996;Alesina and Ardagna, 1998; Alesina et al.,1999).

Furthermore, additional considerationssuggest that composition matters in terms of itsmacroeconomic consequences and howpermanent the fiscal adjustment is (Alesina andPerotti, 1997). Cuts in social welfare can beseen as more lasting than cuts in investment orinfrastructure maintenance, which cannot bepostponed forever. Furthermore, cutting thepolitically more delicate components of thebudget, such as public employment and socialtransfers, would signal that governments havethe necessary instruments and consensus totackle those issues. In both cases, expectationeffects and political credibility effects wouldinfluence expectations concerning the futurestance of fiscal policy.

Assumptions Conditions Channels Demand/Supply Effects

Rational expectations. Permanent change Interest rates/ Demand/consumption/ Weak Keynesianin fiscal policy. permanent income. investment. or non-Keynesian.

Ricardian consumers a) Lump-sum taxes. Permanent income. Demand/labour supply. a) Ricardian(no liquidity constraints, b) Distortionary taxes. a) equivalence.perfect capital market, b) Weak Keynesianaltruistic agents). a) or non-Keynesian.

Liquidity constraints/ a) Low debt. Income/wealth effect. Demand. a) Keynesian.myopic agents/finite b) High debt. b) Weak Keynesian.life.

Risk premia and High debt or discrete Interest rates/wealth Demand/investment/ Weak Keynesian orcredibility. change in fiscal policy. effect/permanent consumption. non-Keynesian.

income.

Expectation view a) Low initial Permanent income/ Demand/Consumption. a) Keynesian.of fiscal policy. a) expenditure/debt. wealth effect. b) Non-Keynesian.

b) High initiala) expenditure/debt.

Unionised labour Fiscal tightening Unit labour cost. Supply. Non-Keynesian.market. through expenditure

cuts or tax hikes.

Table B Non-Keynesian or weak Keynesian ef fects of f iscal consol idation in a dynamic model


3 EMPIRICAL EVIDENCE FROM FISCALCONSOLIDATION: A SURVEY

3.1 MACROECONOMIC MODEL SIMULATIONS

Empirical studies that rely on macroeconomicmodel simulations to estimate fiscalmultipliers show that short-term multipliersare generally positive, although they declineover time (IMF, 2000). Multipliers are broadlysimilar across large countries and there is onlylimited evidence of negative fiscal multipliersin the short term. Furthermore, fiscalmultipliers are smaller in the case of taxchanges than in that of spending changes. In themedium run, expansionary effects of fiscaltightening may materialise, driven by higherprofitability and/or higher future income.

Bartolini, Razin and Symansky (1995) evaluatethe macroeconomic effects of the fiscalrestructuring undertaken in the 1990s in the G7countries, using the IMF’s multi-countrymodel (MULTIMOD). The model reflects theneoclassical theory underlying privateconsumption and investments, while alsotaking into account various sources of marketimperfections and short-run rigidities. Hence,full Ricardian Equivalence does not occurbecause households are liquidity-constrainedin the short run and face a constant probabilityof death. The model examines the effects ofpermanent unanticipated increases in labour,capital and indirect taxes, as well as of a cut ingovernment expenditure of the same size.Shocks other than fiscal policy (e.g. Germanunification, ERM crisis, etc.) are not analysed.In addition, simulations assume monetarypolicy neutrality, defined as an unchangedmoney growth rate compared with the baselinescenario.

Their general conclusion is that fiscalconsolidation initially leads to output losses,which are then followed by a recovery. Thefiscal adjustments of the 1990s have onlyresulted in a temporary loss of output andemployment. Such demand effects resultingfrom fiscal consolidation are not offset by

higher private demand because of short-runliquidity constraints and the decline inhousehold net wealth. In the medium run, theprojected recovery mainly reflects the shift ofdemand from (public) consumption to (private)investment, with some of the additional taxrevenue rebated to firms. In the long run, thechoice of policy instruments makes asignificant difference. Countries that relyprimarily upon increases in indirect taxes andexpenditure cuts are expected to enjoy outputgains from their adjustment over the long run,while countries that mainly rely on labour andcapital taxes are expected to suffer outputlosses.

A more recent simulation conducted with theEuropean Commission’s QUEST modelsupports evidence for non-Keynesian effectsof fiscal adjustments in the medium run(European Commission, 2003). The model canbe described as a neoclassical-Keynesiansynthesis. Behavioural equations are based onintertemporal optimisation of households andfirms, with forward-looking expectations. Themodel has Keynesian features in the short run,although intertemporal budget constraintslimit the effectiveness of fiscal policy. Sinceplanning horizons are finite, there is nocomplete tax discounting and RicardianEquivalence does not hold. The model allowsfor non-Keynesian effects through thefunctioning of the consumption and investmentchannels. The policy experiments allow anassessment of the potential economic impact ofbudgetary adjustments, either tax-based orexpenditure-based, under the assumption ofunchanged monetary policy. The results showthat fiscal adjustments, in general, have anegative, albeit small, impact on economicactivity. However, expansionary non-Keynesian effects from expenditure cuts canemerge in the medium run as a result ofanticipated effects of higher future disposableincome or profitability. The consumptionchannel is a major force offsetting standardKeynesian effects (demand side), with theinvestment channel also playing a role whenconsolidation occurs through cuts in the

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government wage bill (supply side). Toevaluate the impact of monetary policy, anaccommodative monetary stance inconjunction with fiscal consolidation is alsoconsidered. Alternatively, the fall in interestrates can be interpreted as related to a reductionin risk premia, following credibleconsolidation, particularly in the case of highlyindebted countries. Falling real interest ratesreduce the negative impact of fiscalconsolidation and contribute to supportinggrowth rates. Under such circumstances,positive effects on output stemming from fiscalconsolidation may emerge in the short run.

3.2 EPISODES OF FISCAL CONSOLIDATION

As an alternative approach, lessons can bedrawn from the investigation of specificepisodes of fiscal contractions or even casestudies. However, some methodologicalpitfalls suggest that the results might lack thedesirable robustness, so that great cautionshould be used when drawing generalconclusions about the design of fiscal policy.More specifically, the definition andmeasurement of the fiscal stance are not fullyuncontroversial as there is not a universallyaccepted methodology to quantify the effect ofthe cycle on the budget. Consequently, anumber of alternative measures have beenadopted by the various studies, such as a full-employment budget balance (Blanchard,1993), a cyclically adjusted budget balancebased on detrending techniques (EuropeanCommission, 1995), and a structural budgetbalance based on the production functionapproach (OECD, 1993 and Giorno et al.,1995). As expected, different measures affectthe results of the analysis. A relevant elementof the analysis is the definition andidentification of the episodes of fiscaladjustments to be considered significant, basedon their size, duration, graduality and lastingeffects on public finances. Studies differ as tothe identification of what is to be considered asizeable and successful budgetary adjustment.Unavoidably, a margin of arbitrariness isimplied in the definition adopted, which also

affects the results (Zaghini, 1999).Furthermore, a number of additional factors,such as changes in interest rates, asset prices,exchange rates and world demand, can indeedaffect the statistical correlation observedbetween fiscal consolidation and growth.Hence, robustness of results also depends onhow these factors have been controlled duringestimation.

3.3 DEMAND SIDE: THE CONSUMPTIONCHANNEL

In a study on the experiences of fiscalconsolidation in Denmark and Ireland,Giavazzi and Pagano (1990) provided someevidence that large fiscal contractions canchange people’s expectations of future fiscalpolicies. They hypothesised that large fiscalcontractions could signal lower future taxburdens, which, in turn, would lead to anincrease in expected lifetime disposableincome. In a Blanchard-type model, whereconsumers have finite life and hence RicardianEquivalence does not hold, changes in people’sexpectations can boost consumption. Wealtheffects on consumption might thereforeoutweigh a Keynesian recessionary impulsetriggered by a reduction in public spending.

In a more recent work (Giavazzi and Pagano,1995), the same authors looked into whetherthe size and persistency of fiscalconsolidations are relevant to the specificationof the consumption function. They analysedcross-country data for 19 OECD countries,including most European countries, over theperiod 1970-92, using the OECD indicator forthe estimated cyclically adjusted primarybudget balance, based on the productionfunction approach. Compared to their previousstudy, the analysis indicates additionalcases of “expansionary budget cuts” (Greecein 1990-94 and Sweden in 1986-87) and of“contractionary budget expansions” (Finlandin 1977-90 and 1990-92 and Sweden in 1977-79and 1990-93). The authors identified 223 fiscalepisodes, where an episode is defined by aperiod in which the variable has recorded


changes of the same sign. Hence, the shortestepisode lasts one year and has only oneobservation. The regression analyses confirm anon-monotonic relationship between privateconsumption and fiscal variables. This meansthat non-Keynesian responses of privateconsumption are more likely when changes infiscal policy are large and persistent. Incontrast to their previous study, they alsodetected that not only cuts in governmentconsumption but also cuts in transfer paymentsand increases in taxes can have non-Keynesianeffects.

A further investigation (Giavazzi, Jappelli andPagano, 1999) aimed at testing the relevance ofthe initial debt level and its dynamics, as wellas the composition of a budgetary adjustment,to possible macroeconomic effects of fiscalconsolidation. Contrary to their previousstudies, they focused only on large andpersistent episodes of fiscal consolidation.Based on a sample of 18 OECD countries ofsimilar size, but covering a longer periodof time (1970-1996), they detected 38expansionary episodes and 65 contractions.They expanded upon their previous results withthe finding that changes of taxes and transfershave higher non-Keynesian effects than publicconsumption. Furthermore, the composition ofthe fiscal impulse is important and non-Keynesian effects are amplified when thisis carried out primarily by raising taxes.Macroeconomic effects, however, areasymmetric, meaning that they are stronger forfiscal contraction than for fiscal expansion.Yet, while the sign, size and persistence offiscal adjustments are relevant, the initialconditions and dynamics of the debt ratios arenot relevant. The effect of fiscal policytherefore becomes non-Keynesian when largeand persistent budgetary adjustments areimplemented.

Focusing on cases of fiscal crisis, the paperby Hogan (2004) found evidence that privateconsumption increases following a cut ingovernment consumption, based on a sampleof 18 OECD countries covering the period

1970-99. However, it appears that privateconsumption does not increase sufficiently tooffset the direct effect on output of a reductionin public consumption. Therefore, fiscalcontractions are not literally expansionary.

The paper by Perotti (1999) searches forconditions under which non-Keynesian effectsmight prevail, by applying the structural vectorautoregression (VAR) approach to the analysisof fiscal policy. His study also verifies whetherdifferent fiscal regimes (identified as normaland difficult times) influence the effects offiscal policies on consumption. He uses amodel based on relatively standardmacroeconomic assumptions, such asdistortionary taxes and the coexistence ofliquidity-constrained and unconstrainedconsumers, among others. In normal times, i.e.a relatively low debt ratio, Keynesian effectsrelated to changes in public consumption mightprevail. However, in the case of very high debtand therefore very large distortions from taxes,wealth effects can be very sizeable (difficulttimes). Hence, in a scenario of reducedgovernment spending, the increase inconsumption by unconstrained individualsmight well outweigh the fall in consumption byconstrained individuals, thus pushing upaggregate private consumption and showingnon-Keynesian effects. Perotti tested thisprediction on a sample of 19 OECD countriesfrom 1965 to 1994. He found that an increase ofone percentage point in government purchasesof goods and services generates, in the sameyear, an increase in private consumption of 0.7percentage point of GDP in low debt (normal)times, but a fall of about 0.4 percentage point ofGDP in high debt (difficult) times.

In a more recent paper (2002), Perotti studiesthe effects of fiscal policy on GDP, prices andinterest rates in five OECD countries(Australia, Canada, Germany, the UnitedKingdom, and the United States), again using astructural VAR approach. The study concludesthat the effects of fiscal policy on GDP and itscomponents tend to be small and have becomesubstantially weaker over time. Before 1980,

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positive government spending multipliers oflarger than 1 were an exception, and could onlybe estimated in the United States. In the post-1980 period, these effects have been mostlynegative, particularly in the case of privateinvestment, with tax multipliers being evensmaller than spending multipliers. The studyalso emphasises that the United States is anoutlier in many dimensions and that USresponses to fiscal policy are often notrepresentative of the average OECD countryincluded in the sample.

Focusing on the US economy in the post-warperiod, Blanchard and Perotti (1999) examinethe effects on economic activity of shocks togovernment spending and taxes, using a mixedVAR/event approach. The results show thatmultipliers for both spending and tax shocksare typically small, with larger spendinghaving positive effects on output and largertaxation having negative effects. Furthermore,increases in both taxes and governmentspending have strong negative effects onprivate investment. Consistent results havebeen obtained by Fatás and Milhov (2001), andby Galí, López-Salido and Vallés (2004), whenapplying a VAR approach to the United States.

3.4 DEMAND SIDE: THE INVESTMENTCHANNEL

The study by McDermott and Wescott (1996)looks into whether the composition of fiscalconsolidation is relevant to its success, asmeasured by the stabilisation of debt dynamics,and into whether a successful fiscalconsolidation might enhance growth. Datafrom 20 OECD countries (including most EUcountries) are analysed over the period 1970-95, using the OECD estimated indicators forthe cyclically adjusted primary budget balance,expenditures and revenues. The study focuseson significant and successful episodes of fiscalconsolidation, which are defined as animprovement in the corrected budget balanceof at least 1.5 percentage points of GDP overtwo years, provided it does not decline in eitherof the two years. An episode is considered to be

a success when a discretionary policy puts thedebt-to-GDP ratio on a stable downward trend.

The empirical results suggest a positiveresponse to their questions. Out of 62 episodesof fiscal adjustment between 1970 and 1995,the 14 successful ones are associated withhigher GDP growth and lower unemployment.Most of this economic growth stemmed frominvestment buoyancy rather than fromconsumption. More specifically, the credibilityeffects of fiscal adjustment, strengthened byinitial high debt conditions, caused a decline inthe nominal interest rate. Furthermore, thedimension and composition of budgetadjustment are of relevance. In particular,consolidation on the expenditure side,specifically on government wages andtransfers, is more likely to reduce the debt-to-GDP ratio than a tax-based consolidation.

3.5 SUPPLY-SIDE EFFECTS: COMPOSITION OFBUDGET ADJUSTMENT

In a series of studies, Alesina and Perotti (1995a and b and 1996) investigate whether thecomposition of a fiscal adjustment is relevantto its success, which is defined as a lasting andsizeable reduction of the debt ratio. Thereafter,they examine the impact of fiscal consolidationon economic activity, while also taking intoaccount its composition. To measure the fiscalstance, they use the Blanchard fiscal impulse,i.e. the estimated change in government budgetwith respect to the previous year that wouldhave materialised had the unemployment ratestayed the same as in the previous year. Theyanalyse a sample of 20 OECD countries(including most EU countries) over the period1960-94. A significant episode of fiscalconsolidation is defined as a tightening of thefiscal stance by 1.5% of GDP in one year (orby a slightly lower percentage over twoconsecutive years). The authors identify 62episodes of tight fiscal policy and report thatthere is no strong link between the size of anepisode of fiscal consolidation and its success.However, the composition is relevant, withcuts in spending transfers and government


wages being the main engine of the deficitreduction. By contrast, increases in taxes andinvestment cuts are not effective inguaranteeing the success of the adjustments asthey heighten the effects of fiscal policy onunit labour costs and competitiveness.Furthermore, they provide some evidence thatinvestment is, at least partly, crowded in duringfiscal consolidation and that internationalcompetitiveness measured against unit labourcosts could improve. For a suitablecomposition of budget adjustment, devaluationappears to enhance expansionary effectsthrough the trade balance. Results show thatnominal interest rates and relative unit labourcosts fall significantly during successfulepisodes, while they remain roughly constantduring unsuccessful ones. Furthermore, therate of GDP growth is significantly higherduring, and immediately after, successfulfiscal consolidation than during unsuccessfulepisodes. One interpretation is that successfultypes of adjustments induce moderation effectson wages. Hence, it is suggested that the unitlabour cost channel might even be empiricallymore relevant to consumption than the wealtheffects and credibility channels.

A study by Alesina and Ardagna (1998) bringsfurther support to the evidence presentedabove. Their sample includes almost all OECDcountries over the period 1960-94. Successfuladjustments are defined as those characterisedby an investment boom during and immediatelyafter the adjustment, with private consumptiongrowth also on the increase. Both successfuland unsuccessful episodes are accompanied bya nominal devaluation of a similar magnitude.Unit labour costs fall immediately before andafter successful adjustments, with allindicators pointing to an increase in profitsduring successful adjustments. In terms of size,expansionary adjustments appear to be largerthan the contractionary ones, but the differenceis not statistically significant. The compositionof budgetary adjustments is important, withtransfers and public wage cuts positivelyheightening the likelihood of successfuladjustments. By contrast, the authors did not

observe any cases of fiscal adjustments thatwere based on a large tax increase and hadexpansionary effects. Initial conditions, suchas debt and its dynamics, do not appear toinfluence the probability of a successfuladjustment. The study therefore provides someevidence to support the wealth and expectationeffects (demand side), as well as the labourmarket argument (supply side). The policyprescription is that a successful and long-lasting fiscal adjustment, with expansionaryeffects, must combine spending cuts(particularly transfers, welfare programmesand government wage bills), some form ofwage agreement with the union to ensure wagemoderation, and a devaluation before fiscaltightening. Although devaluations areimportant elements of a policy package, theyalone are not sufficient to have expansionaryeffects on economic activity.

Alesina et al. (1999) carry out an empiricalinvestigation in order to assess the effects oftaxation and expenditure on investments. Theyfocus on the role of profits as a determinant ofinvestment in a model where workers belong toa union that is a monopolist. Based on an annualpanel of 20 OECD countries over the period1960-95, they use a structural-VAR procedureto identify fiscal policy shocks and estimate theeffects of these shocks on profits, wages andinvestment. They find that governmentspending shocks have a negative effect onprofits and also show that the composition offiscal policy is relevant to profit determination.In particular, higher government spending willprompt higher labour demand, and the unionwill increase the price (real wage) of labour. Ina standard Q model of investment, thesubsequent decline in profits will also lowerinvestment. Lower profits and investment willalso result from increased labour taxes,although the effects are weaker than in the caseof spending changes. Combining all thoseeffects, when government purchases of goodsand services increase by 1 percentage point ofGDP, investment falls by 0.4 percentage pointof GDP on impact and by 0.5 percentage pointin the long run.

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A more recent analysis conducted by Ardagna(2004) on a panel of 17 OECD countries,including most euro area countries, coveringthe period 1975-2002, brings new evidence onthe determinants and channels through whichfiscal consolidation influences the dynamics ofthe debt-to-GDP ratio and economic activity.The paper shows that, in order to successfullyreduce the debt-to-GDP ratio, the size of afiscal adjustment is more relevant than itsbudget composition. Conversely, thecomposition of budget measures is crucial toobserve expansionary effects of fiscaladjustment, with spending cuts supportinghigher GDP growth rates than tax increases.Concerning the channels of transmission ofexpansionary effects on growth, there isevidence that the labour market is moreimportant than agents’ expectations of futurefiscal policy. According to the study, theresults are not affected by the monetary policystance and the exchange rate regime.

3.6 SPILLOVER EFFECTS

The study by Caselli and Rinaldi (1998) aims toinvestigate whether the composition of thefiscal consolidation is relevant because of itsimpact on consumer expectations or on thecompetitiveness of the economy. To answerthis question, the study empirically tests themain prescriptions of the Obstfeld and Rogoffmodel (1996), i.e. whether the growthdifferential of private consumption betweentwo countries depends, in both the short andlong run, negatively on the increase of thepublic consumption ratio-to-GDP in onecountry and positively on the increase of thesame ratio in the other one. As a measurementof the fiscal stance, the study uses the indicatorcalculated by the European Commission and anHP filter to determine the trend from therevenues and primary expenditures, the latterbeing limited to transfers to households.Hence, the identification of the relevantepisodes differs significantly from otherstudies, emphasising the relevance of theselection of the fiscal stance indicator.

The model is applied to the EU15 using annualdata from the period 1980-97. The study findsthat budget composition affects privatedemand through expectational effects ratherthan supply-side effects. In terms of thecomposition of fiscal adjustments, largerexpansionary effects on private consumptionare higher for public consumption cuts than forother components of primary expenditure.Furthermore, improvement of the primarybalance brought about by higher revenuesoffsets these expansionary effects. However,simultaneity of fiscal consolidation in thesecond half of the 1990s might havecontributed to the weakness of the economiccycle in Europe.

The study by von Hagen, Hughes-Hallet andStrauch (2001) illustrates that, when takinginto account fiscal spillovers across EUcountries, results are consistent with the non-Keynesian view but are not strong enough toimply expansionary fiscal contraction. Theirmodel analyses the interaction between fiscalpolicy, output and monetary policy and, whenestimated for the period 1973-98, it producesKeynesian results. However, when estimatedfor the period 1990-98, the output cost of fiscalcontraction is irrelevant.

Using panel regression, Hemming, Mahfouzand Schimmelpfenning (2002) evaluate theeffects of fiscal policy during economicdownturns. Their results illustrate that fiscalexpansion is likely to have a standardKeynesian impact in a relatively closedeconomy. Such an impact, however, is weakerfor open economy, with flexible exchange ratesand no excess capacity.

A study conducted by Giudice, Turrini andin’t Veld (2003) on a panel data analysis,covering 14 EU countries during the period1970-2002, shows that about half of theepisodes of fiscal consolidation that havebeen undertaken by EU countries in the pastthree decades have been followed by animmediate acceleration in growth. Moreover,roughly half of these episodes of expansionary


Study Sample Indicator Number Empirical Channels Underlying Characteristicof fiscal of fiscal evidence theory of expansionarystance episodes contraction

Giavazzi 19 OECD OECD primary 223 episodes. Consolidation Private Credibility Size/persistencyand Pagano countries, structural has non- consumption effects and are relevant.(1995). 1970-92. budget balance. Keynesian based on non-linearity

effects. wealth effects of consumption.through a declinein interest rates.

McDermott 20 OECD OECD primary 62 fiscal Consolidation Investment Credibility Size,and Wescott countries, structural budget contractions, has weak through a decline effects composition,(1996). 1970-95. balance (only large of which Keynesian or in interest rates. reinforced by persistency and

and successful 14 successful. non-Keynesian initial debt initial conditionsepisodes). effects. conditions. are relevant.

Alesina and 20 OECD Blanchard 62 episodes Consolidation has Supply side Unionised labour Size not relevant,Perotti countries, fiscal impulse. of tight fiscal non-Keynesian effects through markets/budget composition(1995a, 1995b 1960-94. policy. effects. enhanced composition. relevantand 1996). competitiveness. (expenditure

cuts).

Alesina and Most OECD Blanchard fiscal 28 fiscal Consolidation Supply side and Unionised labour Size not relevant,Ardagna countries, impulse. contractions and has demand effects markets/budget composition(1998). 1960-94. 23 expansions. non-Keynesian (consumption and composition/ relevant

effects. investment). wealth effects. (expenditurecuts); devaluationeffects.

Alesina et al. 20 OECD _ _ Consolidation Supply Unionised Composition(1999). countries, has side/investment. labour markets/ is relevant

1960-95. non-Keynesian budget (expenditureeffects. composition/ cuts).

wealth effects.

Caselli and EU cyclically Under specific Demand Wealth effects. Composition andRinaldi (1999). adjusted primary circumstances, side/consumption. spillover effects

budget balance/large consolidation has are relevant.and successful non-Keynesianconsolidation. effects.

Perotti (1999). 19 OECD _ _ Consolidation has Consumption Distortionary Composition andcountries, non-Keynesian through wealth taxes and initial conditions1965-94. effects. effects. expectation view. are relevant.

Giavazzi, 18 OECD OECD primary 65 fiscal Consolidation Private Credibility effects Size, compositionJappelli and countries, structural budget contractions and has non- consumption and non-linearity (tax hikes) andPagano (1999) 1970-96. balance (only large 38 expansions. Keynesian effects. based on wealth of consumption. persistency are

and persistent Consolidation effects. relevant. Initialepisodes). has stronger public finance

effects than conditions notexpansion relevant.

von Hagen, 20 OECD Cyclical adjustment Until 1998: Size not relevant;Hughes-Hallet, countries, based on a linear- Keynesian results; composition isStrauch (2001) 1960-90. quadratic trend in 1990-1998 neutral relevant.

each country.

Hemming et al. 29 advanced IMF data. Fiscal response Keynesian impact,(2002) economies, to economic small or very

1970-99. downturns. small multiplier(open economy)

Giudice, 14 EU Ameco databases 49/74 fiscal About half of the Consumption/ Labour market CompositionTurrini, countries (European contractions consolidation investment channel/ is relevantin’t Veld (1970-2002) Commission) (based on size/ episodes are(2003) persistence); expansionary

Ardagna 17 OECD As in Alesina and Years when Expansionary Supply side. Labour market Composition is(2004) countries, Perotti, 1995 fiscal austerity effects of fiscal channels; less relevant;

1975-2002. (a and b). is needed. adjustment from agents’ devaluationexpectations. plays no role.

Table C Empir ical evidence of weak Keynesian or non-Keynesian ef fects from episodes of f iscalchanges

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4 EFFECTSON SAVINGS:

TEST OFR ICARDIAN

EQUIVALENCE

consolidation were not matched by a reductionin interest rates (meaning that expansionaryeffects on output are barely attributable toconcomitant expansionary monetary policiesor exchange rate devaluation). This suggeststhat monetary easing and devaluations arefactors that may favour the emergence ofexpansionary fiscal consolidations, but are notnecessary conditions for consolidation toexhibit non-Keynesian effects. Furthermore,expansionary fiscal adjustments are morelikely to be based on expenditure cuts than ontax increases and they also appear to beassociated with an initially high level of debt.

4 EFFECTS ON SAVINGS: TEST OFRICARDIAN EQUIVALENCE

The impact of fiscal policies on aggregatedemand depends on the responses of privatesaving to changes in fiscal stance. Althoughmany empirical studies strongly reject the fullRicardian Equivalence, the behaviour ofprivate consumption may still be consistentwith a partial Ricardian effect. However,empirical evidence is somewhat mixed and noclear conclusions can be reached about theexistence and size of the Ricardian offset. Amajor difficulty stems from measurementproblems and methodological issues thatgreatly affect the estimation of the parameters.

A study on the behaviour of private sectorconsumption explores the hypothesis that thepropensity to consume out of income is notconstant but varies, in a non-linear fashion,with fiscal variables (Bhattacharya, 1999). Inparticular, it examines whether or not there isany empirical evidence to support the viewthat households move from non-Ricardianto Ricardian behaviour as government debtreaches high levels and uncertainty aboutfuture taxes increases. The sample included12 OECD countries (nine of which wereEU countries) that were analysed over theperiod from the mid-1960s to the mid-1990s.The individual country time series evidencepresented in this paper provides some

empirical support for the hypothesis examined.In countries where government net debt isrelatively low, the propensity to consumeis barely linked to government net debt.However, in countries with a high debt ratio,there is evidence of a clear negativerelationship once the debt ratio reaches thecritical threshold of 30-35%, after which thepropensity to consume falls steadily.

A further investigation (Giavazzi, Jappelli andPagano, 2000) was aimed at testing whichfactors (e.g. initial public finances conditions,size, persistence and composition of budgetaryadjustments) are more likely to be associatedwith non-monotonic effects of fiscal policy. Inorder to discriminate between competinghypotheses concerning the effects of fiscalpolicy on private sector behaviour, the authorsfocus on national savings, so as to comparetheir results with the Ricardian Equivalenceproposition. They concentrate on large andpersistent episodes of fiscal consolidation andbase their analysis on a sample of 18 OECDcountries over the period 1970-96 and on aWorld Bank sample of 150 developingcountries over the last thirty years. In the caseof the OECD countries, the results, on thewhole, strongly support models in whichincreases in net taxes boost national saving,while increases in government saving reduce it(a non-Ricardian result). However, the effectsof changes in taxes and spending aresignificantly dampened during large fiscalcontractions. The dampening is particularlypronounced when the fiscal impulse is tax-based. However, there is no conclusiveevidence that the non-linear effects of fiscalpolicy depend on the level of debt and itsdynamics, nor on the composition of theadjustment. In the case of the developingcountries, and notwithstanding seriouslimitations in terms of the data, non-linearresponses of national saving appear to be morefrequent, not only in the case of fiscalcontractions but also fiscal expansions.

A recent study by the OECD (de Mello et al.,2004) confirms that private saving responses


offset budget shifts, which, in turn, affect fiscalpolicy outcomes. In particular, fiscaladjustments in many OECD countries are oftenassociated with inverse movements in privatesaving. The empirical analysis conducted onpooled cross-country and time-series datacovering 16 OECD countries over the period1970-2002 reveals that co-movements in privateand public saving are confirmed by an averagecorrelation coefficient across countries ofroughly -0.5. However, the magnitude of co-movements differs greatly across countries.Furthermore, such co-movements are notnecessarily causally related, as developmentshave coincided with a number of secularinfluences. A test for the existence of privatesaving offsets provides strong evidence ofpartial, yet substantial, direct offsettingmovements in private saving, amounting toabout 50% in the short run and some 70% in thelong run. In the short run, the saving offset isgreater for revenue than for expenditurechanges, but it is broadly similar in the long run.In general, measurement problems necessitatecaution in the interpretation of results.

5 CONCLUSION

The impact of fiscal policy on aggregatedemand and economic activity has been thesubject of a long-standing debate about thetheoretical validity of alternative models andthe practical relevance of the implied policyprescriptions. This survey has reviewed thetheoretical and empirical literature dealingwith the hypothesis that contractionary fiscalpolicy could have expansionary effects.

From the theoretical works, it emerges thatintertemporal optimisation in a dynamic modelimplies complex and non-linear relationshipsin the traditional consumption and investmentmodel. Intertemporal effects depend, amongother things, on how economic agents formtheir expectations. In particular, the inclusionin the model of New Classical elements, suchas the Ricardian Equivalence property, impliesthat wealth and expectational effects might

well outweigh the traditional Keynesianmultiplier effects on demand and activity.

In most of the models examined, potential non-Keynesian effects are explained by a change inthe expectations of economic agents and/or bylabour market reactions that improve thecompetitiveness of the economy. Weak ornegative multipliers stem from theexpansionary effects of fiscal consolidation onprivate consumption, through the permanentincome hypothesis or the wealth channel, andon investment, through a reduction in interestrate risk premia and supply-side effects.

A number of assumptions, however, are crucialto the specification of the consumptionfunction in order to derive the expansionaryeffects of a contractionary policy. First, taxesmust be distortionary, with larger distortionaryeffects attached to larger tax increases. Underthis assumption, if consolidation is delayed,consumers will expect larger tax increases infuture, with larger disruptive effects on futureoutput. By contrast, timely consolidation canimprove agents’ expectations of future income.Second, consumers should be forward-lookingand not liquidity-constrained, so that higherexpected income can be translated into highereffective demand. Third, in order to triggerexpansionary effects, fiscal consolidation mustbe unexpected. Only under this condition isfiscal consolidation likely to produce a changein peoples’ expectations of future fiscalpolicies and therefore future expected income.

A large body of empirical studies has attemptedto find evidence for expansionary effects offiscal consolidation. One approach involvesestimating fiscal multipliers usingmacroeconomic model simulations. Thegeneral conclusion is that fiscal consolidationinitially leads to output losses, albeit small,which are then followed by a recovery.In particular, expansionary non-Keynesianeffects from expenditure cuts can emerge in themedium run as a result of the anticipated effectsof higher future disposable income orprofitability. Furthermore, fiscal multipliers

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5 CONCLUSION

are smaller in the case of tax changes than inthat of spending changes.

Adopting an alternative approach, based on thestudy of specific episodes of fiscal expansionand contraction, empirical studies providesome evidence that specific characteristics of afiscal policy are linked to its effectiveness andpossible expansionary effects on economicactivity. To this end, crucial aspects of a budgetadjustment include its size, composition,graduality of implementation and initialconditions of public finances. However,studies differ as to the relevance given to thevarious features of a budgetary adjustment indetermining possible expansionary effects.Although most studies agree on the importanceof composition of a budget adjustment, theevidence relating to its size and the initialconditions of public finances, in particular,is more mixed. In addition, the empiricalevidence does not satisfactorily substantiatewhether expansionary effects are driven byexpectational effects about future disposableincome or by supply-side effects.

From a policy perspective, notwithstanding thecomplexity of the theoretical arguments andthe difficulty of obtaining clear-cut empiricalresults, there seems to be broad agreementabout the basic factors influencing the size andsign of fiscal multipliers. These factors can besummarised in the following way: a crucialcondition for a fiscal expansion havingmultiplier effects on aggregate demand, andthus output, is that there be slack in productivecapacity. The composition of the fiscalexpansion is also important, with highergovernment spending giving a strongerimpulse to demand than tax cuts, particularly inthe case of high-quality spending, such asspending that increases the productivity oflabour and/or capital. Tax cuts, however, canalso be expansionary, should labour supplyand/or investment increase in response to them.In general, the larger the responsiveness ofconsumption and investment to current income,the larger the multiplier.

The initial expansionary impact of the publicbudget could, however, be crowded out, in fullor in part, by induced changes in marketinterest rates and exchange rates. In suchinstances, additional public spending would becompensated by lower private spending,mitigating the effects on, or not affecting,aggregate demand. A number of conditionsmake crowding-out more likely. In particular,fiscal expansions that generate uncertaintyabout the future course of budget policies,and even jeopardise the sustainability ofpublic finances, may generate negativeexpectations among consumers about theirfuture income, therefore adversely affectingprivate consumption. Unsound fiscal policiesmay also have a negative impact on privateactivity through higher interest rates, which, inturn, reflect higher risk premia. Those effectswill be larger, the more investment decisionsare driven by interest rates and the more wealthaffects private consumption. In combiningthese elements, it can be concluded that thereseems to be evidence of positive, but small, oreven negative, fiscal multipliers in Europe.


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PAPERSEUROPEAN CENTRAL BANKOCCASIONAL PAPER SERIES

1 “The impact of the euro on money and bond markets” by J. Santillán, M. Bayle andC. Thygesen, July 2000.

2 “The effective exchange rates of the euro” by L. Buldorini, S. Makrydakis and C. Thimann,February 2002.

3 “Estimating the trend of M3 income velocity underlying the reference value for monetarygrowth” by C. Brand, D. Gerdesmeier and B. Roffia, May 2002.

4 “Labour force developments in the euro area since the 1980s” by V. Genre andR. Gómez-Salvador, July 2002.

5 “The evolution of clearing and central counterparty services for exchange-tradedderivatives in the United States and Europe: a comparison” by D. Russo,T. L. Hart and A. Schönenberger, September 2002.

6 “Banking integration in the euro area” by I. Cabral, F. Dierick and J. Vesala,December 2002.

7 “Economic relations with regions neighbouring the euro area in the ‘Euro Time Zone’” byF. Mazzaferro, A. Mehl, M. Sturm, C. Thimann and A. Winkler, December 2002.

8 “An introduction to the ECB’s survey of professional forecasters” by J. A. Garcia,September 2003.

9 “Fiscal adjustment in 1991-2002: stylised facts and policy implications” by M. G. Briotti,February 2004.

10 “The acceding countries’ strategies towards ERM II and the adoption of the euro:an analytical review” by a staff team led by P. Backé and C. Thimann and includingO. Arratibel, O. Calvo-Gonzalez, A. Mehl and C. Nerlich, February 2004.

11 “Official dollarisation/euroisation: motives, features and policy implications of currentcases” by A. Winkler, F. Mazzaferro, C. Nerlich and C. Thimann, February 2004.

12 “Understanding the impact of the external dimension on the euro area: trade, capital flows andother international macroeconomic linkages“ by R. Anderton, F. di Mauro and F. Moneta,March 2004.

13 “Fair value accounting and financial stability” by a staff team led by A. Enria and includingL. Cappiello, F. Dierick, S. Grittini, A. Maddaloni, P. Molitor, F. Pires and P. Poloni,April 2004.

14 “Measuring Financial Integration in the Euro Area” by L. Baele, A. Ferrando, P. Hördahl,E. Krylova, C. Monnet, April 2004.


15 “Quality adjustment of European price statistics and the role for hedonics” by H. Ahnert andG. Kenny, May 2004.

16 “Market dynamics associated with credit ratings: a literature review” by F. Gonzalez, F. Haas,R. Johannes, M. Persson, L. Toledo, R. Violi, M. Wieland and C. Zins, June 2004.

17 “Corporate ‘Excesses’ and financial market dynamics” by A. Maddaloni and D. Pain, July 2004.

18 “The international role of the euro: evidence from bonds issued by non-euro area residents” byA. Geis, A. Mehl and S. Wredenborg, July 2004.

19 “Sectoral specialisation in the EU a macroeconomic perspective” by MPC task force of theESCB, July 2004.

20 “The supervision of mixed financial services groups in Europe” by F. Dierick, August 2004.

21 “Governance of securities clearing and settlement systems” by D. Russo, T. Hart,M. C. Malaguti and C. Papathanassiou, October 2004.

22 “Assessing potential output growth in the euro area: a growth accounting perspective”by A. Musso and T. Westermann, January 2005.

23 “The bank lending survey for the euro area” by J. Berg, A. van Rixtel, A. Ferrando,G. de Bondt and S. Scopel, February 2005.

24 “Wage diversity in the euro area: an overview of labour cost differentials acrossindustries” by V. Genre, D. Momferatou and G. Mourre, February 2005.

25 “Government debt management in the euro area: recent theoretical developments and changesin practices” by G. Wolswijk and J. de Haan, March 2005.

26 “The analysis of banking sector health using macro-prudential indicators” by L. Mörttinen,P. Poloni, P. Sandars and J. Vesala, March 2005.

27 “The EU budget – how much scope for institutional reform?” by H. Enderlein, J. Lindner,O. Calvo-Gonzalez, R. Ritter, April 2005.

28 “Reforms in selected EU network industries” by R. Martin, M. Roma, I. Vansteenkiste,April 2005.

29 “Wealth and asset price effects on economic activity”, by F. Altissimo, E. Georgiou,T. Sastre, M. T. Valderrama, G. Sterne, M. Stocker, M. Weth, K. Whelan, A. Willman,June 2005.

30 “Competitiveness and the export performance of the euro area”, by a Task Force of theMonetary Policy Committee of the European System of Central Banks, June 2005.

31 “Regional monetary integration in the member states of the Gulf Cooperation Council(GCC)” by M. Sturm and N. Siegfried, June 2005.

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PAPERS32 “Managing Financial Crises in Emerging Market Economies: Experience with theInvolvement of Private Sector Creditors” by an International Relations Committee task force,July 2005.

33 “Integration of securities market infrastructures in the euro area” by H. Schmiedel,A. Schönenberger, July 2005.

34 “Hedge funds and their implications for financial stability” by T. Garbaravicius andF. Dierick, August 2005.

35 “The institutional framework for financial market policy in the USA seen from an EUperspective” by R. Petschnigg, September 2005.

36 “Economic and monetary integration of the new Member States: helping to chart the route”by J. Angeloni, M. Flad and F. P. Mongelli, September 2005.

37 “Financing conditions in the euro area” by L. Bê Duc, G. de Bondt, A. Calza, D. MarquésIbáñez, A. van Rixtel and S. Scopel, September 2005.

38 “Economic reactions to public finance consolidation: A survey of the literature” by M. G.Briotti, October 2005.

economic reactions to public finance: a survey of the literature · 2005-10-20 · economic...

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