Academic journal article Economic Inquiry

Threshold Effects in the U.S. Budget Deficit

Academic journal article Economic Inquiry

Threshold Effects in the U.S. Budget Deficit

Article excerpt


There has been an ongoing debate on whether the U.S. fiscal policy is sustainable in the long run. In addressing this issue, a number of studies have examined whether the U.S. public finances are compatible with the government's intertemporal solvency constraint (Hamilton and Flavin 1986; Trehan and Walsh 1988; Hakkio and Rush 1991; among others). The requirement of budget processes to be sustainable implies effectively that Ponzi games are ruled out as a viable option of government finance. In other words, further new borrowing cannot be used indefinitely as a method of financing interest payments on existing debt. Therefore, the solvency constraint requires that any changes in taxes and government spending are followed by adjustment in future taxation and/or spending that equals to the original change in present value. This solvency constraint imposes testable restrictions on the time-series properties of key fiscal aggregates.

In this article we present new evidence on this ongoing solvency debate utilizing an empirical framework that allows us to test whether there have been threshold effects in the U.S. deficit. Unlike existing empirical studies that focus only on the identification of regime shifts in U.S. fiscal policy, we also offer an explanation and provide evidence as to why these regime shifts might occur. Specifically, we argue that for fiscal authorities to be able to meet the solvency constraint, they would intervene through deficit cuts only when the government budget deficit becomes very large. Therefore, we expect a mean reverting dynamic behavior for deficits only when they are above some threshold value. We test for this hypothesis using the threshold unit root empirical methodology recently developed by Caner and Hansen (2001).

The article is organized as follows. Section II reviews the empirical evidence. Section III describes the empirical methodology, and section IV presents the empirical results, which are analyzed and interpreted. Section V summarizes and concludes.


One strand of the empirical literature focuses on the stationarity of the stock of public debt. Uctum and Wickens (1997) deal with stochastic interest rates and primary surpluses that are allowed to be either exogenous or endogenous to the stock of public debt. They show that a necessary and sufficient condition for the intertemporal solvency condition to hold is a stationary discounted stock of public debt. Another strand of the empirical literature has concentrated on the dynamics of the undiscounted inclusive-of-interest deficit, or alternatively on the long-run relationship between government spending and tax revenues. Trehan and Walsh (1988) show that government spending, inclusive of interest payments, and government revenues should be cointegrated with a cointegrating vector equal to [-1, 1]'. They present evidence that supports this restriction. Hakkio and Rush (1991) point out that a necessary condition for intertemporal solvency is the existence of cointegration between government expenditure, inclusive of interest payments, and government revenues, with a cointegrating vector equal to [1, -[beta]]', and 0<[beta]< 1.

Quintos (1995) expands on Hakkio and Rush (1991) and shows that cointegration is not necessary for the intertemporal balance condition to hold. Specifically, she distinguishes between a weak and a strong sustainability condition. The former implies that the government solvency holds, but the undiscounted debt process is exploding at a rate that is less than the growth rate of the economy. Although this case is consistent with deficit sustainability, it is inconsistent with the ability of the government to market its debt in the long run, especially if the focus is on the debt to gross national product (GNP), or on the debt per capita (see also Hakkio and Rush 1991).

In contrast, strong sustainability implies that the undiscounted public debt is finite in the long run. …

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