Journal Issue

2. How to Measure the Degree of Fiscal Procyclicality

Tetsuya Konuki, and Mauricio Villafuerte
Published Date:
August 2016
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The focus of this paper is to analyze the link between the fiscal policy stance and economic activity in sub-Saharan Africa between 2000 and 2014, a period marked by relatively high rates of growth, a substantial reduction in inflation rates, and positive and negative terms-of-trade shocks in most countries. The specific objective of this analysis is to determine whether fiscal policy in the region has been expansionary or contractionary in good and bad times; that is, whether it has helped to dampen business cycle fluctuations (a countercyclical fiscal policy stance) or, on the contrary, has exacerbated them (a procyclical fiscal policy stance). Importantly, the previous statements are based on the assumption that output shocks drive fiscal policy, which is the standard precept of the literature on the cyclical behavior of fiscal policy.2

The standard indicator to assess the fiscal policy stance in terms of its impact on domestic demand is the ratio of dynamics of primary balance to GDP. However, that indicator is not well suited for some resource-rich countries for several reasons (see Villafuerte, Lopez-Murphy, and Ossowski 2010). First, fiscal resource-related revenues (mostly from oil and mineral sectors, because other sectors like agriculture typically do not generate large rents that can in turn be appropriated by the government) largely originate from abroad (via export proceeds) and are therefore akin to a “helicopter drop” in that they do not reallocate income from the private sector to the government. Thus, changes in the primary balance arising from fluctuations in these revenues (before they are spent) should be expected to have limited effects on domestic demand (through “wealth effects”). Second, resource prices can have major effects on the observed ratios of fiscal variables to GDP because the resource and nonresource GDP deflators can and often do deviate markedly, making nominal GDP quite volatile. Changes in resource prices can therefore drive large changes in conventional fiscal policy indicators, which make their interpretation difficult.3 In this context, the sample countries are divided into resource-rich (oil-exporting and mineral-exporting) countries and other countries. This classification is based on the fact that basically only the oil and mineral sectors generate large rents that can be appropriated by the government, in contrast to agriculture, for example, which tends to generate limited fiscal revenues.4

Following a methodology proposed elsewhere (Medas and Zakharova 2009; Villafuerte, Lopez-Murphy, and Ossowski 2010), this paper assesses the fiscal policy stance through (1) the cyclically adjusted nonresource primary balance measured in percent of nonresource GDP for resource-rich countries in sub-Saharan Africa; and (2) the ratio of cyclically adjusted standard primary balance to GDP for all other countries. The idea behind this adjustment is that part of the observed changes in the (nonresource) primary balances would be not the result of intentional policy actions but rather the result of exogenous changes in economic conditions. To remove that effect, the economic cycle can be estimated by quantifying the output gap. Ideally, the production function approach should be used to estimate potential output and the associated output gap. However, estimates of the cycle based on this method require the availability of reliable data on the use of labor and capital stocks, a daunting task for many sub-Saharan African countries. This is particularly more problematic for resource-rich countries, where the relevant output gap pertains to the nonresource GDP since the latter is a better proxy of the tax basis for nonresource fiscal revenue.5 Similarly, data limitations make it difficult to apply other sophisticated output gap estimation methods, such as the multivariate Kalman filter approach. Therefore, and as a second-best approach, this paper applies the Hodrick-Prescott (H-P) filter to the annual time series of (total or nonresource) GDP in real terms.6

Following the standard methodology to compute cyclically adjusted balances (Fedelino, Ivanova, and Horton 2009), the cyclically adjusted (nonresource) primary balance for each country during 2000–14 is estimated using the following formula:

where capb is the cyclically adjusted (nonresource) primary balance measured in percent of (nonresource) GDP, R is (nonresource) revenues excluding grants, Y is the (nonresource) GDP, YP/Y is the ratio of potential (nonresource) output to actual output, and G is the primary expenditure. It is assumed that the elasticity of (nonresource) revenues is equal to one and primary expenditure elasticity is equal to zero for all countries, following existing studies (see Villafuerte, Lopez-Murphy, and Ossowski 2010).

This paper defines fiscal policy as expansionary when changes in the cyclically adjusted (nonresource) primary balance are negative, and contractionary when changes in that variable are positive. The term “fiscal impulse” can be used in this analysis, defined as an expansionary fiscal policy (Δcapb < 0).

Finally, to assess whether fiscal policy is countercyclical or procyclical, the link between the stance of fiscal policy and the economic situation needs to be determined. To that effect, the next section links the changes in the (nonresource) output gap and the changes in the cyclically adjusted (nonresource) primary balance. If the change in the (nonresource) output gap is negative (positive), then expansionary (contractionary) fiscal policy entails a countercyclical fiscal stance. Expansionary (contractionary) fiscal policy in the face of a positive (negative) change in the (nonresource) output gap implies a procyclical fiscal policy.7

To check for robustness in the analysis, this paper also uses the unadjusted (nonresource) primary balance to measure the fiscal stance, linking the changes in the real (nonresource) GDP growth rate to the changes in the (nonresource) primary balance to determine whether fiscal policy was pro- or countercyclical.

As implied from the discussion above, the previous approach would be the preferred one as it uses a theoretically more sophisticated and appealing methodology. However, the measurement of the output gap and of the related cyclical adjustments is tricky in many sub-Saharan African countries given the large volatility of growth. Hence, the analysis is complemented with the second approach.

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