IV. Fiscal Consolidation–Issues and Policy Options1
Nicaragua’s still-high debt, limited fiscal space, and large exposure to external financing argue for fiscal consolidation. This chapter estimates short- and medium-term fiscal multipliers for Nicaragua (controlling for feedback effects from public debt) and use them to assess the impact of different modalities of fiscal consolidation on economic growth. The results show that fiscal consolidation has only a small temporary negative effect on growth in Nicaragua, while it raises medium-term output. Shifting expenditure composition toward capital expenditure would further support long-run growth.
1. Nicaragua’s high public debt limits the space for countercyclical policies and measures to reduce poverty, but reducing debt could, in principle, hurt growth. Nicaragua’s public debt and spending ratios to GDP are the highest among Central American countries despite the debt relief initiated in 2006. Even though staff has assessed the risks of debt distress in the country as moderate (inter alia, because of its concessional nature), Nicaragua’s vulnerability to external capital inflows, contingent fiscal liabilities, and other shocks requires wider policy buffers. But, the process of creating such buffers could hurt growth and limit needed reduction in poverty.
2. This chapter finds a positive long-term effect of fiscal consolidation in Nicaragua on output, more so if this consolidation is based on cutting public spending. Advanced and emerging market economies are also shown to post better medium-term output effects when fiscal consolidation focuses on spending cuts—a well-known result from recent papers. However, in general, other Central American and low-income countries seem to benefit more from exogenous increases in tax revenues than from spending cuts—an interesting result that requires additional research. As far as staff knows, these are the first set of estimates for the growth-effect of fiscal consolidation in Central American countries using structural VAR techniques.
B. Fiscal Multipliers and Exogenous Fiscal Shocks
3. A fiscal multiplier is the ratio between output change and an exogenous variation in the fiscal deficit with respect to their respective baseline values. Past work has shown that the size of the fiscal multiplier depends on the country, time period, special circumstances, and the methodology used to estimate them. Taken as a whole, results suggest a wide range of fiscal multiplier estimates going from -1.5 to 1.5, including instantaneous impact and cumulative effects, suggesting that multipliers can be negative—a phenomenon named “contractionary fiscal expansion.” In general, these episodes are marked by a widening of interest rate spreads which affect economic activity negatively despite the initial positive impulse from larger net government demand for resources.
4. Estimating fiscal multipliers requires isolating fiscal policy shocks from the initial influence of economic conditions. This so-called “identification issue” arises from the bi-directional causality between government spending or tax revenue, and growth. It has been addressed more successfully recently by a class of models called structural VAR (SVAR). Papers in this tradition also use monthly and/or quarterly data, and institutional information on the timing of fiscal policy decisions to identify exogenous shocks. However, Central American countries do not have such high-frequency information as a group and this chapter develops a way to identify exogenous fiscal policy shock using annual data (see appendix for details).2
5. The proposed method incorporates feedback effects from public debt accumulation and is also applied to data from advanced and emerging market economies. The inclusion of debt as a ratio to GDP in the estimation (as suggested by Favero and Giavazzi, 2007) allows for attenuating effects from changes in the fiscal deficit. For instance, as public debt declines as a result of a smaller fiscal deficit, interest rates would also decline, thus undoing part of the initial negative impulse. The chapter also compares the results from applying the proposed procedure and data frequency to advanced and emerging market economies with estimates from other recent papers, which validates the new methodology proposed here.
6. Overall, in less developed countries, fiscal consolidation hurts output only in the short-term (Figure 1). The negative short-term effect is largest for advanced economies (AEs), significant for emerging markets (EMEs), and small for less developed economies—a result consistent with the evidence presented in Ilzetzki, Mendoza, and Végh (2010). The impact multipliers for spending cuts in Central America range from -0.01 (Nicaragua) to -0.44 (Panama). For comparator countries, the multipliers for spending cuts are found to be between -0.01 (HIPCs) and -0.42 (AEs). For the medium term, spending cut multipliers in Central America range from -0.54 (Panama) to 0.43 (Nicaragua) and are positive for poorer economies, although not in emerging markets and advanced economies. On the tax revenue side, the impact multipliers for increase in tax collection in Central America are statistically not significantly different from zero; a result that is shared by some other groups of countries. The cumulative effects of increases in tax revenue are positive for Central American countries (ranging from 0.20 in the Dominican Republic to 0.51 in Guatemala), HIPCs, low-income countries (LICs), and sub-Saharan Africa (SSA), but negative for the advanced and emerging market economies, and oil producers.
Source: Authors’ estimates.
1/ Response of output growth to a one standard deviation of expenditure and tax shocks, rescaled to output growth response to a 1-percentage-point increase in expenditure and in taxes.
2/ 95% confidence intervals include zero and (almost always) exclude 1.
4/ “Tax revenue” referrers to total tax collection and tax base (perhaps at given tax rates).
7. Fiscal consolidation based on expenditure cuts tends to produce the highest medium-term output effects in advanced and emerging economies, but not necessarily in less developed countries. Results for advanced economies and emerging markets match the evidence in other papers.3 Surprisingly, the long-run tax multipliers tend to be higher than expenditure multipliers in HIPCs, LICs, SSA, and oil producers, suggesting that a well-accepted result that fiscal stabilization focused on spending cuts have better growth outcomes may not apply to poorer economies. Such an outcome may be caused by inefficient tax administration in those countries and observed increases in tax revenues may be the result of improved efficiency with little distortive impacts. Most Central American countries appear to have larger tax and spending multipliers in the medium term than other countries with a similar stage of development.
8. Unlike other Central American countries, in Nicaragua expenditure cuts produce slightly larger medium-term gains in output (Figure 2). Using current staff’s medium-term framework for Nicaragua as the baseline scenario, a 1-percentage-point cut in expenditure in 2012 would reduce output vis-à-vis its baseline value by 0.4 percent in 2012– 13 but boost output in 2014–15 by 0.9 percent. Assuming that any extra revenue generated in the medium-term is used to pay down debt, the debt-to-GDP ratio would be 1.9 percentage points below its baseline value in 2014–15. Similarly, a 1-percentage-point increase in tax revenue collection would lower real GDP relative to its baseline by 0.2 percent and boost it by 0.6 percent in 2014-15, bringing the debt-to-GDP ratio to a level 1.8 percent below its baseline value.
Figure 2.Nicaragua: Effects of Cut in Expenditure and Increase in Tax Revenue
Sources: Nicaragua authorities; and IMF staff estimates.
1/ In 2007, education worker wages was reclassified from capital spending to current spending, which shows that the spike in current spending is offset by the decline in capital spending.
9. Increases in government investment in Nicaragua raise output in the short and in the long run while increases in current spending always hurt output growth. The impact and long-run multipliers of public investment spending are 0.21 and 0.58, respectively, and that of current expenditure are -0.24 and -0.41, respectively, suggesting the composition of expenditure matters significantly for growth. Government size in Nicaragua has grown steadily during 2004–11 (Figure 2) but the composition of public spending has been skewed toward current expenditure.4 With Nicaragua’s vast infrastructure bottlenecks, continuation of such a trend could adversely impact medium-term growth potential, which hinges in part, on investments in infrastructure, including for roads and the energy sector.
D. Policy Implications
10. Nicaragua should continue on a fiscal consolidation path not only to create fiscal space for cyclical and structural policies, but also to raise medium-term output. The recent international experience has shown the importance of having fiscal space to counteract cyclical shocks. But, even more importantly, Nicaragua’s public sector faces many demands for investment and social programs. In this context, a steady path of fiscal consolidation can actually help, in particular if needed capital and social expenditures are preserved (or, even better, increased) in the effort. As the government moves away from excessive operational spending and the stock of debt declines, the results presented in this chapter suggest that output would grow faster. Tax reforms to increase fiscal revenues without burdening particular economic activities and increasing distortions may also be helpful. In addition, keeping current expenditure under control and steadily shifting expenditure composition toward capital expenditure would help support medium-term growth.
Figure 3.Fiscal Multiplier in Nicaragua
Source: IMF staff estimates.
Note: One standard deviation (70 percent) confidence intervals. Variables are in growth rates and the impulse responses are cumulated and presented for orthogonalized error.
Figure 4.Nicaragua: Fiscal Multipliers of Current and Capital Expenditures
Source: IMF staff estimates.
Note: One standard deviation (70 percent) confidence intervals. Variables are in growth rates and the impulse responses are cumulated and presented for orthogonalized error. “Tax revenue” referrers to total tax collection (perhaps at given tax rates).
We nest traditional short-run restrictions and use the long-run properties of the model to introduce cointegrating relationships so that we identify exogenous fiscal shocks (Pagan and Pesaran, 2008). Further, we follow Favero and Giavazzi (2007) which extends the Blanchard and Perotti (2002) and Perotti (2004) SVAR to account for government’s budget constraint.
We typically consider the following SVAR model in which the public debt ratio (dt) enters as exogenous:5
The debt ratio, in turn, is determined in the government budget constraint from :
Where, following Blanchard and Perroti (2002), the vector of endogenous variables Yt = [gt, tt, yt, reert, it] includes government spending (gt) defined as the sum of government consumption and investment (excluding interest payment), net revenue (excluding interest receipt on government debt) (tt), real output (yt), real effective exchange rate (reert), and the yield on government securities (it).
Identification is achieved with assumptions about policy decision lags and estimated elasticity through cointegrating properties. As defined in Banchard and Perotti (2002) and in Perotti (2004), observed fiscal policy reactions (expenditure and tax):
is function of (i) automatic response of spending/tax to output, exchange rate, and financial shocks; (ii) systematic discretionary response of fiscal policy to macroeconomic system; and (iii) random discretionary fiscal policy shocks. The relation between the structural shocks and the innovation is thus given by:
Or in matrix format  is: A0et = Bεt
From , a just identification of  would require
1. We make the assumptions that:
on the ground that interest payments on government debt are excluded from the definition of expenditure and tax that enter the model. Furthermore, the contemporaneous impact of interest rate on tax is generally likely to be small or close to zero (in practice).6
2. Next, we consider that the interest rate on government depends on fiscal stance and exchange rate, but (contemporaneously less on output.; thus:
3. We now need (at least) 2 restrictions. Notice that most studies using high frequency data, have assumed that either (αg,y = 0) expenditure or (αt,y = 0) tax do not respond to the economic activity within a quarter. Such assumption may not hold for annual data. One can rule out this constraint by dwelling on the statistical properties of the cointegration analysis. Suppose that there is at least one cointegration relation (which is likely to be the case, given that, by construction, all system variables enter in level and generally follow I(1) processes), then one could either estimate the automatic response of tax to change in economic environment or exchange rate movement or the automatic response of government spending to economic or exchange rate shocks.
Assuming that there is evidence of (at least) one cointegrating vector7, then the structural VECM counterpart of the baseline model  is:
where a = A0α where α is the loading parameter.8
Now let’s assume that such cointegration is found between government spending, output growth, and exchange rate, then the remaining two coefficients can be obtained by:9
Hence, the corresponding SVECM representation of the baseline model is:
And its associated error correction terms with parameters to achieve, at least, a just-identified system is:
With this estimation, all fiscal shocks are identified and the matrix A0 can be fully estimated.
BlanchardOlivier and RobertoPerotti2002 “An Empirical Characterization Of The Dynamic Effects Of Changes In Government Spending And Taxes On Output,” The Quarterly Journal of Economics117(4) pages 1329-1368.
EstevãoMarcello and SamakeIssouf2012 “Fiscal Multipliers and Debt Feedback in Central America” IMF Working Paper (forthcoming) Washington D.C.
FaveroCarlo and FrancescoGiavazzi2007 “Debt and the Effects of Fiscal Policy” NBER Working Papers 12822.
FaveroCarlo and FrancescoGiavazzi2010 “Reconciling VAR-based and Narrative Measures of the Tax-Multiplier,” CEPR Discussion Papers 7769.
IlzetzkiEthanEnrique G.Mendoza and Carlos A.Végh2010 “How Big (Small?) are Fiscal Multipliers?” CEP Discussion Papers DP1016Centre for Economic Performance, LSE.
International Monetary Fund2010World Economic OutlookOctober.
KaminskyGraciellaCarmenReinhart and Carlos A.Végh2004 “When It Rains It Pours: Procyclical Capital Flows and Macroeconomic Policies” in NBER Macroeconomics Annualedited byMarkGertler and KennethRogoffCambridge, MA: MIT Press.
PerottiRoberto2004 “Estimating the effects of fiscal policy in OECD countries,” WorkingPapers 276IGIER Bocconi University.
PerottiRoberto2011 “The Effects of Tax Shocks on Output: Not So Large, But Not Small Either” in NBER Working Papers 16786.
RomerC. D. and D. H.Romer2007a “The Macroeconomic Effects of Tax Changes: Estimated Based on a New Measure of Fiscal Shocks,” NBER Working Paper No. 13264. 126.
Prepared by Issouf Samake.
Contrary to a number of studies on Latin American countries which focus on clusters, the proposed model is tailored for each country to account for their idiosyncratic factors (on monetary, exchange rate, trade, and fiscal policies) as well as vulnerabilities and structural breaks.
Recently, Ilzetzki (2011) found that government expenditure is more potent in expanding output in high-income countries than in developing countries. On tax, he found that tax multiplier is virtually zero in most countries. However, the exception was developing countries where the tax multipliers range from 0.3 on impact to close to 0.8 in the long-run. See also Ilzetzki, Mendoza, and Végh (2010), IMF (2010), and Perotti (2004 and 2011).
Note, however, that in 2007, the salaries of teachers and service staff from autonomous colleges were reclassified (mostly capital spending) from municipalities to the central government budget (as current spending).
A pitfall of using standard VAR (or VECM) is the lack of power to measure foreseen changes in fiscal policy (Ramey, 2007; Romer and Romer, 2007).
However, the assumption that tax is inelastic to interest rate change is controversial given that income tax-base includes interest income as well as dividends, which co-move negatively with interest rate.
The SVECM representation also hold with mix of I(0) and I(1) system variables. We assume shocks are either temporary or persistent.
The β’yt-1 is estimated e β’yg,t-1 = yg,t-1 - αg,yyGDP,t-1 - αg,reryrer,t-1 = ECMt-1
Typically, this would imply that