Academic journal article National Institute Economic Review

Decomposition of Fiscal Deterioration in the OECD

Academic journal article National Institute Economic Review

Decomposition of Fiscal Deterioration in the OECD

Article excerpt

Government fiscal positions in all the advanced economies suffered severe deteriorations during the financial crisis. Figure 1 illustrates the cumulative deterioration of the government budget ratio as a per cent of GDP between 2007 and 2009 in a selection of OECD economies. The sharpest declines materialised in Ireland, Spain and Finland, while public finances in Austria, Germany and Italy have held up better. Budget deficits have worsened in part because of the cyclical downturn, in part because of the policy response to the crisis, including both fiscal stimulus packages and certain fiscal costs related to government support of financial institutions, and in part because of a change in the relationship between revenue and production, which may prove longer-term.

We use the National Institute model NiGEM (3) to decompose the change in the fiscal position between 2007 and 2009 into a cyclical component, a policy component and a residual component, which may reflect longer-term structural change. Using a similar approach to that developed in Barrell and Holland (2010), we undertake a series of model simulation exercises in order to calibrate the decomposition. We make a similar decomposition of the rise in government debt stocks, into the component attributable to the rise in financing needs given the increase in the budget deficit, the part attributable to government support provided to financial institutions, and a residual component.

[FIGURE 1 OMITTED]

Impact of the cycle

A recession will necessarily lead to a deterioration of public finances, as automatic stabilisers respond to partially offset the impact of the decline on the economy. Job losses entail a decline in income tax revenue as well as higher payouts in benefits to the newly unemployed. Revenue from corporate taxation can also be expected to fall as profits are squeezed and firms suffer bankruptcy, while the slowdown in consumption leads to a decline in indirect tax revenue. Our baseline projects government spending in line with trend output in the long run, and if the downturn in activity contains a permanent component then spending will adjust. This adjustment process is politically painful, and it is essential to decompose the downturn into trend and temporary components. In our short-term decomposition analysis below this is not necessary, but it is important to bear the distinction in mind.

Links between output and the budget deficit are discussed, for instance, by Melitz (2000), Blanchard and Perotti (2002) and Wyplosz (2002). A common rule of thumb used by many studies (see Girourd and Andre, 2005) is that an output gap of 1 per cent of GDP raises the deficit by 0.5 per cent of GDP. However, the actual impact will depend on the causes of the cyclical movement. A slowdown in activity driven by falling export demand is likely to have noticeably less impact on revenues than one driven by weak consumer spending, which is more tax rich than are exports. In order to extract the cyclical component from the deterioration in public finances observed between 2007 and 2009, we use the approach developed in Brunila et al (2002) using the European Commission's model QUEST, and Barrell, Hurst and Mitchell (2009) using NIESR's model NiGEM. In general, output effects on the budget increase with the size of the government sector and the share of cyclically sensitive components of taxation and spending, and so vary across countries. Country-specific factors such as the degree of openness and the flexibility of the labour market will also matter.

In order to assess the cyclical impact on the deficit in each of the countries in our sample, we run a series of diagnostic simulations using NiGEM. We look at the impact of a 1 per cent exogenous shock to consumption, a ! per cent shock to investment and a 1 per cent shock to exports on the budget deficit as a per cent of GDP. In order to abstract from other factors, we hold interest rates, government discretionary spending, and tax rates fixed for one year, and then allow them to follow the default rules on NiGEM. …

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