a. Wealth effects on consumption

A cut in government spending, if perceived as long lasting, implies a permanent reduction in the future tax burden of consumers, generating a positive wealth effect.

Even tax increases can have expansionary effects on consumption. Blanchard (1990) argues that a tax increase today can have expansionary effects if it generates the expectations of less dramatic and disruptive tax increases tomorrow. Also, by resolving uncertainty about the course of future fiscal policy it may reduce precautionary savings.

Blanchard’s argument is an example of what Bertola and Drazen (1993) characterize as the “expectation view of fiscal policy.” That is, in an intertemporal model of consumption behavior, the effects of current fiscal policy depend on what expectations it generates on the course of future fiscal policy. In their words “a policy innovation that would be contractionary in a static model may be expansionary if it induces sufficiently strong expectations of future policy changes in the opposite direction.”

Bertola and Drazen (1993) consider a model where government spending follows a random walk with a positive drift and national income is (for simplicity) constant. Bertola and Drazen argue, realistically, that stabilizations often have a discrete character. That is, even if public debt accumulates rapidly, political constraints often delay the adoption of the appropriate stabilization policies. ^3/ However, because of the feasibility constraint, sooner or later a stabilization will have to occur. Call g_c the ratio of government spending over GDP at which with probability p a stabilization occurs, where “stabilization” is a sharp drop in spending. If the stabilization does not occur at g_c, then it will occur with certainty later, when spending over GDP reaches a much higher level g. At that point, spending is set below g_c so that, again, with probability p a stabilization may again occur at g_c.

The model implies that at low levels of government spending, private consumption falls less than one-to-one with increases in government spending: this is because an increase in spending implies that a stabilization may come soon. Thus, higher government spending only partially crowds out private demand, a typical keynesian result, obtained in a fully neoclassical model. When the economy reaches g_c, if the stabilization occurs, private consumption jumps up reflecting the wealth effect or reduced expected future taxes. With probability 1-p, however, the stabilization does not occur. In this case consumption jumps down because the public realizes that political constraints will delay the stabilization. Thus, a failed stabilization has a contractionary effect because it signals the lack of political commitment to a “serious” attempt at reducing spending.

Bertola and Drazen’s point is consistent with arguments put forward by Giavazzi and Pagano (1996). They argue that large fiscal contractions can be expansionary precisely because they signal a permanent and decisive change in the stance of fiscal policy, while small adjustments may have the opposite effect for the opposite reason. The “small” adjustments in Giavazzi and Pagano’s words can be interpreted as an example of the failed stabilization at trigger point g_c, using the terminology of Bertola and Drazen.

Sutherland (1995) considers the effects of a stabilization in a model where consumers have finite lives, as in Blanchard (1985). Each consumer faces a constant probability of death in every period of his life, thus the model does not imply Ricardian properties even with nondistortionary taxes and transfers. As in Bertola and Drazen (1993) the government is on an unstable fiscal path and a stabilization sooner or later has to occur. At low level of debt the model displays keynesian features. This is because the stabilization is expected to occur in the distant future, when many of the current consumers will be dead. These consumers do not internalize fully the future increase in taxation. As debt increases, the model displays anti-keynesian features, namely an increase in the fiscal deficit is contractionary. This is because current consumers expect that a stabilization will occur relatively soon, when they are still alive.

One problem with the expectation view is that the critical variable driving the results is the effect of current policies on the public’s expectation about future policy changes, a variable which is intrinsically not observable. A devil’s advocate might argue that any behavior of private consumption following any type of fiscal policy can be rationalized by an appropriate assumption about what the current fiscal policy signals about the not observable future policies. For instance, a generally accepted assumption in this literature is that a large spending cut signals a permanent change in the stance of fiscal policy. However, one may argue just the opposite. Suppose that a large spending cut threatens the political survival of a government committed to fiscal austerity, than a spending cut which is too large may imply a future relaxation of fiscal policy following an electoral defeat of the current government. While we do not particularly subscribe to this argument, the point is that the expectation view suffer from an embarrassment of riches; namely, it is consistent with too many possible empirical observations.

A second channel for wealth effects arises from a fall in interest rates which may accompany a fiscal adjustment. Lower interest rates imply a higher market value of private wealth.

b. Credibility effects

A fiscal consolidation, particularly a strong one in a high debt country, may have important credibility effects on interest rates by reducing risk premia. The latter can be of two types: (i) inflation risk premia or (ii) default or consolidation risk premia. Default risk may be trivial for relatively low debt countries, but may become significant for high debt ones. ^4/

A decisive discrete change in the fiscal policy stance may have a significant credibility effect on interest rates which would crowd in private investment and consumption of durable foods. For instance Miller, Skidelsky, and Weller (1990) consider a model with a threshold above which the government is forced to impose a tax on bond holders. With random shocks on the level of debt, as the debt level approaches that threshold, the risk premium increases, leading to a fall in private demand. A decisive stabilization which reduces the debt level well below the threshold, eliminates the risk premium, crowding in the components of private demand particularly sensitive to interest rates.

Along similar lines, Alesina, Prati, and Tabellini (1990) show that at high level of debt, particularly if the debt has short maturity, self-fulfilling confidence crises may materialize. If a crisis occurs and the public is not willing to roll over the debt, the government is forced to tax bond holders or default. A reduction in the level of the debt, and a lengthening of its maturity, reduces the risk of confidence crises and thus the associates risk premia. This is a model which displays multiple equilibria for some levels of debt/GDP ratios. Thus, a fiscal adjustment which reduces the debt below the level where multiple equilibria are possible, may have large discrete effects on the risk premia.

As for the case of the “expectation theory” on consumption behavior, however, this argument also relies on a variable; namely, “credibility of the adjustment” which is ex ante not observable. That is, it is not a priori obvious what makes an adjustment credible or not. However, Giavazzi and Pagano (1990) in their study of the Danish and Irish stabilization in the eighties report some suggestive evidence in favor of both the expectation view and the credibility effects. They show that standard wealth effects on consumption, and real interest rate effects on investment are not sufficient to explain the consumption and investment growth in these two countries during their fiscal adjustment.

c. Supply-side effects

(1) Labor supply: neoclassical effects

While wealth effects on consumption from permanent reductions in government spending are expansionary on the demand side, the same wealth effects may reduce labor supply (Barro (1991). If both consumption and leisure are normal goods, a wealthier individual will want to consume more of both, therefore he will work less. In addition, the induced higher real wages by reducing Tobin’ q may crowd out investment (Baxter and King (1993)).

The standard substitution effect suggests that tax increases should reduce work effort and labor supply. Higher labor income taxes reduce labor supply. Thus, a permanent spending cut financed by a tax cut has two opposite effects on labor supply. The wealth effect reduces it, the substitution effect increases it.

In the case of a temporary cut in government spending, the wealth effect should be small and the substitution effect relatively large. Thus for temporary spending cuts the substitution effect should predominate, for permanent spending cuts the wealth effect should dominate. However, Baxter and King (1993) argue that their simulation shows that the financing side of the government budget (i.e., how the spending cut is financed with or without distortionary taxes) is more important for its macroeconomic impact on supply than its duration. Empirically, however, both the wealth effect and the substitution effect on individual labor supply are likely to be small. ^5/

(2) Labor market structure

While the effect of taxes on individual labor supply may be small, their effects on aggregate labor supply in unionized labor markets may be much larger. With unionized labor markets a permanent increase in labor taxation shifts the union’s aggregate supply of labor because it decreases the after tax income of employed union members at any before tax wage. In other words, an increase in labor taxation leads the union to demand higher real wages to compensate for the decreased after tax income.

Building on work by Calmfors and Driffil (1988), Alesina and Perotti (1994) show that this effect depend on the structure of labor markets. The effect is weak in countries with decentralized labor markets (like the United States or Canada) and is also relatively weak in countries with highly centralized unions where highly union-government negotiations internalize the entire fiscal maneuver. That is, at the bargaining table centralized union will take into consideration the spending side of the government budget as well; thus, for instance, the union will internalize the effects of higher taxes on more public goods or higher transfers. On the contrary, the effect of labor taxation on unit labor cost is highest in countries were union are strong enough to pass on tax increases to wages but not encompassing enough to internalize the connection between taxes and benefits of the fiscal maneuver. For example, Alesina and Perotti (1994) calculate that in the countries in the intermediate group an increase of the income tax of 1 percent of GNP causes an increase in relative unit labor costs of about 2 percent.

In summary, according to this channel tax increase affects unit labor costs of firms, influencing their competitiveness.

d. Why composition matters ^6/

The previous discussion has highlighted that tax increases or spending cuts may have very different effects. Several additional reasons suggest that even the composition of spending cuts may have important consequences on how permanent the fiscal adjustment is and on its macroeconomic consequences. One can identify at least three reasons why the composition of cuts may matter.

(i) Expectation effect: Different types of spending cuts may be more or less permanent by their nature. Consider two types of spending cuts of the same magnitude. The first one relies only on a reduction in public investment, for instance in maintenance of public infrastructures. The second one includes cuts in welfare obtained by changes in eligibility criteria for transfer programs and by cuts in government employment. Even though the two types of spending cuts may have the same “impact” magnitude, clearly the second one has more lasting effects than the first. In fact maintenance of public infrastructure cannot be postponed forever; on the contrary, structural changes in the parameters which determine the extent of the coverage of the “welfare state” by influencing the dynamic of entitlement have long lasting effects. Thus, according to this argument, the composition, much more than the size per se, influences expectations about future the future stance of fiscal policy, a critical point of the expectation view.

(ii) Political credibility effect: Governments which are willing to tackle the politically more delicate components of the budgets, public employment, social security, welfare programs, may signal that they are really “serious” about the fiscal adjustment. Not every government has the necessary strength to tackle these politically difficult issues. Typically, coalition governments lack the necessary cohesion to implement this type of adjustment, as shown by Alesina and Perotti (1995a). ^7/ In fact, coalition governments succumb to intercoalition conflicts concerning the distributional consequences of the adjustment. ^8/ On the contrary, single party governments may have the necessary strength to cut transfers, social security programs, and the government wage bill. ^9/

(iii) Labor market effect: Cuts in the government wage bill may have different effects than cuts in non wage government consumption. Lane and Perotti (1996) show that a fall in government employment shifts the aggregate demand for labor facing the union, thus improving profitability through two channels: a fall in unit labor costs, and a depreciation of the exchange rate in a flexible exchange system. On the contrary, a cut in nonwage government consumption does not have these effects because, at least up to a first degree of approximation, the private and the public sectors have the same propensity to spend on the goods and services which enter in the definition of nonwage government consumption. They present empirical evidence on a sample of OECD countries which shows that the composition of spending cuts strongly influences labor market variables, in the direction described above.

The composition of tax increases may also influence the macroeconomic consequences of fiscal adjustment. For instance, Alesina and Perotti (1994 and 1995b) show that taxes on household and social security contributions have the largest impact on relative unit labor costs, via union behavior.

a. Size and composition of the adjustment

Table 13 summarizes several features of the Irish adjustment. Our measure of cyclically adjusted primary surplus (BFI) improves by about 8 percent of GDP from 1985-86 to 1990-90. The entire adjustment is on the spending side. The only moderate increase in household taxes during the adjustment is entirely due to a one off tax amnesty in 1988. Total revenues (including taxes on households) as a share of GDP were lower in 1989-90 than in 1986.

Table 13.

Ireland: Fiscal Adjustment Size and Composition, 1987-89 ^1/

Source: OECD.

^1/“Before” is the two-year period before the adjustment, thus 1985-86; “during” is the period of the adjustment, 1987-89; “after” is the two-year period after the adjustment, thus 1990-91. All variables are in shares of GDP.

Table 13.

Ireland: Fiscal Adjustment Size and Composition, 1987-89 ^1/

	Before	During	After	Diff.	Diff.
	(1)	(2)	(3)	(2)-(1)	(3)-(1)
Fiscal impulse	−3.5	2.1	4.4	5.6	7.9
Primary expenditures	40.6	35.3	33.8	−5.3	−6.8
Transfers	17.4	16.0	14.8	−1.4	−2.6
Government wages	12.2	11.0	10.7	−1.2	−1.5
Nonwage public consumption	7.4	6.2	6.3	−1.1	−1.0
Public investment	3.6	2.1	2.1	−1.5	−1.5
Revenues	35.9	35.9	34.5	0.0	−1.4
Taxes on households	12.9	13.4	12.2	0.5	−0.7
Taxes on business	1.3	1.3	2.0	0.0	0.7
Indirect taxes	16.3	16.0	15.0	−0.3	−1.3
Social security contributions	5.4	5.2	5.3	−0.2	−0.1

Source: OECD.

^1/“Before” is the two-year period before the adjustment, thus 1985-86; “during” is the period of the adjustment, 1987-89; “after” is the two-year period after the adjustment, thus 1990-91. All variables are in shares of GDP.

View Table

Table 13.

Ireland: Fiscal Adjustment Size and Composition, 1987-89 ^1/

	Before	During	After	Diff.	Diff.
	(1)	(2)	(3)	(2)-(1)	(3)-(1)
Fiscal impulse	−3.5	2.1	4.4	5.6	7.9
Primary expenditures	40.6	35.3	33.8	−5.3	−6.8
Transfers	17.4	16.0	14.8	−1.4	−2.6
Government wages	12.2	11.0	10.7	−1.2	−1.5
Nonwage public consumption	7.4	6.2	6.3	−1.1	−1.0
Public investment	3.6	2.1	2.1	−1.5	−1.5
Revenues	35.9	35.9	34.5	0.0	−1.4
Taxes on households	12.9	13.4	12.2	0.5	−0.7
Taxes on business	1.3	1.3	2.0	0.0	0.7
Indirect taxes	16.3	16.0	15.0	−0.3	−1.3
Social security contributions	5.4	5.2	5.3	−0.2	−0.1

Source: OECD.

^1/“Before” is the two-year period before the adjustment, thus 1985-86; “during” is the period of the adjustment, 1987-89; “after” is the two-year period after the adjustment, thus 1990-91. All variables are in shares of GDP.

The spending cuts were broad ranging but the largest in terms of share of GDP were on transfers, which fell by more than 2.5 percent of GDP. The government wage bill and public investment received the second largest reduction. Reductions in government wages were obtained by an agreement in 1987 with the unions to limit pay increase to 2.5 percent, well below inflation. More important was the large reduction in public employment. Between 1986 and 1989 total public employment was cut by about 10 percent, from 300,000 to 270,000. This development was the result of an hiring freeze instituted in 1987, early retirement schemes, and voluntary redundancy schemes. ^16/ Social spending cuts were mostly in the health sector.

b. Tax reform and wage bargaining

In 1988 a broad tax reform was introduced and took effect in 1989. A cornerstone of it was a cut in marginal tax rates on the income of households. The top rate which was as high as 65 percent in 1984-85 was reduced to 56 percent, but also the standard rate was cut from 35 percent to 32 percent. These cuts were accompanied by an increase in standard allowances. The Irish tax system is quite progressive, therefore these tax cuts reached very low in the income ladder. The corporate income tax was also reduced from 47 to 43 percent.

Wage bargaining had a decentralized nature throughout the eighties. On the contrary, a centralized wage agreement was reached in 1987 in the context of the Program For National Recovery (PNR). The accord covering 1988-90 insured wage moderation both in the private and in the public sector. A very large majority of firm level wage agreements were in line with the guidelines established by the accord between the government and the national union. We claim that this tax reform and the wage bargaining agreements are not unrelated. As argued in the previous section, wage moderation was achieved probably because the unions internalized the increase in the after tax disposable income due to the tax cuts, in addition to the effects of a soft labor market with high unemployment. Also the more or less voluntary layoffs in the public sector probably contributed to increase union’ moderation at the bargaining table.

c. Macroeconomic consequences of the adjustment

The year 1987 marks a remarkably positive turnaround for the Irish economy. Unemployment started to decrease in 1988 after a rising trend which had lasted 25 years. Table 14 shows that growth which was almost 2 percent below G-7 average before the adjustment was well above G-7 average during and after the adjustment. GDP growth was sustained by both domestic and foreign factors. Domestic consumption grew at steady rates during and after the adjustment, mostly due to consumer durables, particularly automobiles. Private investment increased and picked up the slack left by the contracting public investment. The external sector was sustained by the devaluation of the Irish pound of 1987 and by the policy of wage moderation obtained in the same year.

Table 14.

Ireland: Macroeconomic Conditions and the Fiscal Adjustment, 1987-89

Source: OECD. For a definition of the variables see Table 10.

Table 14.

Ireland: Macroeconomic Conditions and the Fiscal Adjustment, 1987-89

	(1)	(2)	(3)
	Before	During	After	Diff (2)-(1)	Diff (3)-(l)
GR (G-7)	−1.72	1.89	3.86	3.61	5.58
U (G-7)	9.80	10.80	8.63	1.00	−1.17
Δ I	−7.71	8.31	1.31	16.02	9.02
Δ C	2.47	5.78	1.93	3.31	−0.54
i (G-7)	3.41	2.14	1.43	−1.27	−1.98
ULC	8.67	−2.73	2.16
EXCH RATE	3.30	−1.03	3.31
TB	1.51	2.27	−1.91
WSH	54.23	51.58	50.41	−2.65	−3.82
PSH	21.75	25.32	26.48	3.57	4.73

Source: OECD. For a definition of the variables see Table 10.

View Table

Table 14.

Ireland: Macroeconomic Conditions and the Fiscal Adjustment, 1987-89

	(1)	(2)	(3)
	Before	During	After	Diff (2)-(1)	Diff (3)-(l)
GR (G-7)	−1.72	1.89	3.86	3.61	5.58
U (G-7)	9.80	10.80	8.63	1.00	−1.17
Δ I	−7.71	8.31	1.31	16.02	9.02
Δ C	2.47	5.78	1.93	3.31	−0.54
i (G-7)	3.41	2.14	1.43	−1.27	−1.98
ULC	8.67	−2.73	2.16
EXCH RATE	3.30	−1.03	3.31
TB	1.51	2.27	−1.91
WSH	54.23	51.58	50.41	−2.65	−3.82
PSH	21.75	25.32	26.48	3.57	4.73

Source: OECD. For a definition of the variables see Table 10.

Nominal and real rates fell dramatically between 1987 and 1989 both in absolute terms and relative to Germany. Short-term real rates (defined as nominal minus actual inflation) fell from about 11 percent at the end of 1986 to about 7 percent in 1989. Differential of these rates with Germany fell from about 7 in 1986 to about 3 in 1989. Similar developments occurred on long rates, with a differential of real rates respect to Germany falling from about 5 in 1986 to about 2 in 1989. These developments are an indication of credibility effects in asset markets, as pointed out by Dornbusch (1989).

The increase in market value of private wealth due to the fall in interest rates generated a positive wealth effect in consumption. As noted by Giavazzi and Pagano (1990) an effect on liquidity constrained individuals, who obtained an increase in disposable income due to the tax cuts, was a second source of the increase in private consumption. Interestingly, most of the increase in consumption came from durables, perhaps implying a strong interest rate effect.

All indicators of competitiveness show marked improvements between 1986 and 1989. For instance, IMF staff calculations of relative unit labor costs fell by a cumulative 15 percent in this period. Our measure of relative unit labor costs fell by about 10 percent in the same period. These developments are the result of the combined effect of wage moderation and the devaluation of the Irish pound. The trade balance improved during the adjustment despite the booming domestic demand (Table 14).

The effect of wage moderation is apparent in the evolution of distributional shares (see Table 14). The wage share fell from about 54 percent before the adjustment to about 50 afterward, while the profit share gained about five points in the same period. IMF Staff calculation of profitability also show a sharp improvement in ten same period. For instance the ratio of wholesale prices over unit labor costs increased by more than 20 percent between 1986 and 1989. The ratio of export unit value over unit labor costs displays a similar pattern.

a. Composition of the adjustment

Table 15 shows that the turnaround of Danish fiscal position was remarkable: the largest in the recent history of any OECD economy. By 1987/88 our cyclically adjusted measure of budget deficit improved by more than 11 percent of GDP relative to 1981/82. The adjustment was about equally divided between expenditure cuts and tax increases.

Table 15.

Denmark: Adjustment Size and Composition, 1983-86 ^1/

Source: OECD.

^1/“Before” is the two-year period before the adjustment, thus 1981-82; “during” is the period of the adjustment, 1983-86; “after” is the two-year period after the adjustment, thus 1987-89. All variables are in shares of GDP.

Table 15.

Denmark: Adjustment Size and Composition, 1983-86 ^1/

	Before	During	After	Diff.	Diff.
	(1)	(2)	(3)	(2)-(1)	(3)-(1)
Fiscal impulse	−5.7	2.7	5.7	8.4	11.4
Primary expenditures	50.4	46.4	46.6	−4.0	−3.8
Transfers	19.7	18.6	19.0	−1.1	−0.7
Government wages	19.9	18.3	18.2	−1.6	−1.7
Nonwage public consumption	8.0	7.3	7.2	−0.7	−0.8
Public investment	2.8	2.2	2.2	−0.6	−0.6
Revenues	45.7	49.3	50.4	3.6	4.7
Taxes on households	24.4	25.6	28.1	1.2	3.7
Taxes on business	1.1	2.4	2.3	1.3	1.2
Indirect taxes	18.0	18.5	19.2	0.5	1.2
Social security contributions	2.2	2.8	2.8	0.6	0.6

Source: OECD.

^1/“Before” is the two-year period before the adjustment, thus 1981-82; “during” is the period of the adjustment, 1983-86; “after” is the two-year period after the adjustment, thus 1987-89. All variables are in shares of GDP.

View Table

Table 15.

Denmark: Adjustment Size and Composition, 1983-86 ^1/

	Before	During	After	Diff.	Diff.
	(1)	(2)	(3)	(2)-(1)	(3)-(1)
Fiscal impulse	−5.7	2.7	5.7	8.4	11.4
Primary expenditures	50.4	46.4	46.6	−4.0	−3.8
Transfers	19.7	18.6	19.0	−1.1	−0.7
Government wages	19.9	18.3	18.2	−1.6	−1.7
Nonwage public consumption	8.0	7.3	7.2	−0.7	−0.8
Public investment	2.8	2.2	2.2	−0.6	−0.6
Revenues	45.7	49.3	50.4	3.6	4.7
Taxes on households	24.4	25.6	28.1	1.2	3.7
Taxes on business	1.1	2.4	2.3	1.3	1.2
Indirect taxes	18.0	18.5	19.2	0.5	1.2
Social security contributions	2.2	2.8	2.8	0.6	0.6

Source: OECD.

^1/“Before” is the two-year period before the adjustment, thus 1981-82; “during” is the period of the adjustment, 1983-86; “after” is the two-year period after the adjustment, thus 1987-89. All variables are in shares of GDP.

On the expenditure side most of the cuts were on transfer programs and government wages (see Table 15). Cuts in transfer programs were broad ranging and focused on unemployment insurance (freezing of maximum rate and reduction of abuses), changes in the parameter of pensions schemes, particularly on public employees, cuts in sickness insurance funds. Transfer to local governments were also reduced in 1983-85. As shown in Table 15 transfers fell by more than 1 percent of GDP during the adjustment. Public employment which had been growing rapidly before 1982, was frozen. In the context of the income policies introduced in 1982, government sector wages grew less than inflation. Wage indexation was suspended until 1987, and the automatic link of public sector wages to wage increases in the private sector was eliminated. The result of all these measures was a substantial reduction in the government wage bill.

On the revenues side, most of the increase in revenues was due to direct taxes on household and business, with more modest increases in indirect taxes (Table 15). In the context of the policy of cuts in net transfers, several social security contribution were increased, including contribution from employees to the unemployment fund and tax subsidies to private pension schemes. The result was a substantial increase in the tax burden for families in the period 1982-87.

b. Macroeconomic consequences of the fiscal adjustment

The average growth rate during the adjustment in 1983-86 was about 3.3 percent per year, well above the G-7 average (Table 16). Both consumption and especially private investment boomed. The latter grew by more than 10 percent per year and the former by more than 3 percent. The share of private investment grew by almost 2.5 points of GDP relative to 1981/82. Export increased steadily as a result of improvements of competitiveness (reduction of relative unit labor costs), due in part to the depreciation of the exchange rate in the early 1980s and to the wage moderation accord of 1982, coupled with a suspension of indexation clauses. The effect of this wage policy is reflected in Table 16 in a sharp drop of the wage share and an even larger increase in the profit share in the period 1983-86 relative to the previous two years.

Table 16.

Denmark: Macroeconomic Conditions and the Fiscal Adjustment, 1983-86

Source: OECD. For a definition of the variables see Table 10.

Table 16.

Denmark: Macroeconomic Conditions and the Fiscal Adjustment, 1983-86

	Before	During	After	Diff	Diff
	(1)	(2)	(3)	(2)-(1)	(3)-(1)
GR (G-7)	0.40	0.38	−3.38	−0.2	−3.46
U (G-7)	2.21	1.55	1.36	−0.66	−0.85
ΔI	1.69	13.42	−6.36	11.73	−8.05
ΔC	−0.44	4.17	−1.26	4.61	−0.82
i (G-7)	8.55	3.36	2.43	−5.19	−6.12
r (G-7)	4.94	1.99	1.46	−2.95	−3.48
ULC	−13.85	0.29	8.25
EXCH RATE	−4.53	1.16	0.92
TB	0.80	0.03	1.50	−0.77	1.47
WSH	56.20	54.17	55.56	−2.03	−0.64
PSH	31.57	35.14	33.09	3.57	1.52

Source: OECD. For a definition of the variables see Table 10.

View Table

Table 16.

Denmark: Macroeconomic Conditions and the Fiscal Adjustment, 1983-86

	Before	During	After	Diff	Diff
	(1)	(2)	(3)	(2)-(1)	(3)-(1)
GR (G-7)	0.40	0.38	−3.38	−0.2	−3.46
U (G-7)	2.21	1.55	1.36	−0.66	−0.85
ΔI	1.69	13.42	−6.36	11.73	−8.05
ΔC	−0.44	4.17	−1.26	4.61	−0.82
i (G-7)	8.55	3.36	2.43	−5.19	−6.12
r (G-7)	4.94	1.99	1.46	−2.95	−3.48
ULC	−13.85	0.29	8.25
EXCH RATE	−4.53	1.16	0.92
TB	0.80	0.03	1.50	−0.77	1.47
WSH	56.20	54.17	55.56	−2.03	−0.64
PSH	31.57	35.14	33.09	3.57	1.52

Source: OECD. For a definition of the variables see Table 10.

Giavazzi and Pagano (1990) emphasize the expansionary consequences of the “credibility effect” and of the “wealth effect” in these four years. Interest rates dramatically fell immediately after the fiscal adjustment was announced and the implementation started. Giavazzi and Pagano (1990) calculate that their measure of an ex ante real rate fell from 6.7 in the 1979-82 period to 3.3 for the 1983-86 period of fiscal adjustment. Differential with real German rates were at least halved, dropping from about 8 percent to less than 4 percent. Table 16 also shows a sharp drop of ex post real rates relative to G-7, from almost 5 before the adjustment to less than 2 during, to less than 1.5 after. Another indicator of the credibility of the adjustment was a jump upward of indicators of consumer confidence.

The sharp drop in real interest rates, accompanied by the wage moderation achieved in 1982, the increase in the profit share and the reduction in unit labor costs all contributed to the boom in private investment.

c. Immediate aftermath

Giavazzi and Pagano (1990) interpret the Irish and the Danish adjustments as two cases of expansionary fiscal consolidations, and emphasize their similarities. However, the immediate aftermath of the two adjustments show that they were quite different. While the Irish economy continued booming after the adjustment, the Danish economy turned into a recession in 1987 and 1988 with growth rates of -.6 and -.2, respectively: average growth in Denmark was more than 3 percent lower than in the G-7 in both 1987 and 1988 (Table 16). In 1989 growth was only 1.1 percent. Unemployment increased in 1988 from 7.9 to 8.7 an continued to climb in the following two years. The Irish and Danish adjustments look quite different.

The underlying cause of the Danish recession lies in the fall in competitiveness. The real effective exchange rate (relative unit labor costs) as measured by the IMF fell by 8 percent in 1986 and almost 11 percent in 1987. The current account deficit increased to almost 6 percent of GDP in 1986. The trade balance worsened during the adjustment, as shown in Table 16, particularly in 1985-86. The improvement of the trade balance after the adjustment is largely driven by the recession.

The decrease in competitiveness can only be partially explained by the appreciation of the real exchange rate due to the rapidly falling inflation with a fixed nominal rate. An important additional factor was the wage agreement of early 1987, which introduced sizeable wage increases for 1987 and 1988. Their effects, after the restraint during the period 1982-86, is shown in Table 16 by a rebound of the wage share which increased by more than 1 point of GDP relative to the average of 1983-86. The profit share, on the contrary fell of about 2 percentage points.

Our interpretation is that the wage accord of 1987 incorporated union demands for compensations for the increase in income taxes of the previous four years, which reduced workers’ after tax income. Thus, the tax increases might have been the originating cause of the recession, via wage negotiations, as implied by Alesina and Perotti (1994).

a. Size and composition of the adjustment

Table 17 considers the general government, the definition which is the most compatible with the one used for the other countries in this study. ^18/ First of all, the overall size of the adjustment, from 1994-95 relative to 1989 is much smaller than the one of Denmark and Ireland, despite being stretched over a longer period. In terms of share of GDP the adjustment in the primary surplus is about half of the Irish adjustment and not more than one third of the Danish adjustment, despite the fact that Italy had a much higher debt to GDP ratio of Denmark and a much higher interest burden. Until 1993 the adjustment was totally on the revenue side, with revenues increasing of 6.3 per cent of GDP and reaching 48.3 percent. Primary expenditures rose of 3.7 percent of GDP. Total expenditures reached 57.8 percent in 1993. After the spending and tax cuts of 1994 and 1995, primary expenditures returned to their 1989 level as a share of GDP, and revenues are still 3.5 percent of GDP above the 1989 level. The reduction in revenues in the last two years is largely due to the fact that many of the tax increases in 1992-93 had a “one off” nature.

Table 17.

Italy: Fiscal Adjustment General Government, 1989-95

Source: IMF.

Table 17.

Italy: Fiscal Adjustment General Government, 1989-95

				Diff.	Diff.	Diff.
	1989	1993	1994-95	1993/89	1994-95/89	1994-95/93
Revenues	42.0	48.3	45.5	6.3	3.5	−2.8
Expenditures	51.9	57.8	53.5	5.9	1.6	−4.3
Interest payments	8.9	12.1	10.8	3.2	1.9	−1.3
Primary expenditures	43.0	45.7	42.7	3.7	−0.3	−0.3
Wages	11.9	12.5	11.7	0.6	−0.2	−0.8
Social security	17.6	19.5	19.1	1.9	1.5	−0.4
Subsidies	2.5	2.3	2.1	−0.2	−0.4	−0.2
Other current expenditures	1.3	1.4	1.1	0.1	−0.2	−0.3
Fixed investment	3.3	2.7	2.2	−0.6	−1.1	−0.5
Other capital expenditures	1.5	2.1	1.5	0.6	0.0	−0.6
Overall balance	−9.9	−9.6	−8.1	0.3	1.8	1.5
Primary balance	−1.0	−2.6	2.8	3.6	3.8	0.2

Source: IMF.

View Table

Table 17.

Italy: Fiscal Adjustment General Government, 1989-95

				Diff.	Diff.	Diff.
	1989	1993	1994-95	1993/89	1994-95/89	1994-95/93
Revenues	42.0	48.3	45.5	6.3	3.5	−2.8
Expenditures	51.9	57.8	53.5	5.9	1.6	−4.3
Interest payments	8.9	12.1	10.8	3.2	1.9	−1.3
Primary expenditures	43.0	45.7	42.7	3.7	−0.3	−0.3
Wages	11.9	12.5	11.7	0.6	−0.2	−0.8
Social security	17.6	19.5	19.1	1.9	1.5	−0.4
Subsidies	2.5	2.3	2.1	−0.2	−0.4	−0.2
Other current expenditures	1.3	1.4	1.1	0.1	−0.2	−0.3
Fixed investment	3.3	2.7	2.2	−0.6	−1.1	−0.5
Other capital expenditures	1.5	2.1	1.5	0.6	0.0	−0.6
Overall balance	−9.9	−9.6	−8.1	0.3	1.8	1.5
Primary balance	−1.0	−2.6	2.8	3.6	3.8	0.2

Source: IMF.

The composition of the spending cuts in 1994-95 is quite revealing. The largest share of the cut comes from capital expenditures (1.1 percent of GDP). The remaining cuts between 1993 and 1994-95 are mostly from government wages (almost 1 percent of GDP) and other modest cuts on all the other items. However, despite these recent cuts, in 1995 government wages have about the same share of GDP, as in 1989, and social security increased by 1.5 percent of GDP, relative to that same year.

The fall in public investment is partly (or largely) due to the effects of criminal investigations known as “mani pulite” (clean hands) and it is unlikely that these cuts will be sustainable. Certainly a good portion of this reduction has a “one shot” nature. A sizable part (0.6 percent of GDP) of the total cuts on the capital spending account falls in the category of “other capital spending.” This entry includes refunds of tax credits of the public. In 1993 this entry was unusually high (2.1 of GDP). In 1995 although almost 1 percent of GDP of tax refunds were planned (Lit 16,000 billion) only Lit 700 billion was disbursed. On average about Lit 5,000 billion is disbursed every year. Thus, the postponement of tax refund in 1995 is largely responsible for a large part of the so-called cut in capital spending.

The reduction of the wage bill results form a hiring freeze, but especially from a less than full adjustment of public wages to inflation. An agreement with the unions in 1992 linked wages to planned rather than actual inflation. Since in the following three years actual inflation has been above planned, real wages have fallen. Currently the unions ar asking for an adjustment to wages to compensate for this difference. Whether this adjustment will occur in full in the next few years is unclear. The point is that the real wage reduction is the result of a rather convoluted and (perhaps) strategic use of projected and actual inflation rather than a clear and permanent agreement with the unions for a wage restraint. ^19/

Social security received some cuts in 1995 relative to 1994. As pointed out by the Bank of Italy (1996) these savings have a temporary nature and are due mostly to two “one off” measures: (i) some temporary suspensions of “liquidazioni” (severance pay) of public employees and some other postponement of payments of certain pensions, (ii) postponement from November of 1995 to January of 1996 of indexation payments.

While the concept of general government is the most relevant for international comparisons (and for the EMU criteria) the budget documents in Italy, the authorities’ goals and most of the parliamentary discussion refer to the State Sector (central government). Table 18 summarizes some statistic on the fiscal adjustment in the State Sector. While the trends of general revenues and expenditures are similar to those of the general government, an important observation concerns the composition of the spending cuts in 1994-95. The entire cuts are on two items: capital spending and transfers to regional and municipal governments. We discussed above the likely “one off” nature of the capital spending cuts. The drastic cuts to local governments are likely to generate either some local tax increases or more creative accounting at the local level to hide liabilities. The tax autonomy of local government is currently quite limited but it is increasing. The second problem is more serious. The local health units (“unita’ sanitarie locali”) are a source of large hidden liabilities. Thus, these cuts in transfers to local authorities may reappear sooner or later as liabilities of the general government. ^20/

Table 18.

Italy: Fiscal Adjustment Central Government, 1989-95

Source: IMP.

Table 18.

Italy: Fiscal Adjustment Central Government, 1989-95

				Diff.	Diff.
	1989	1993	1994-95	1994-95/93	1994-95/89
Revenues	30.8	34.8	31.7	−3.1	0.9
Expenditures	41.5	44.5	40.1	−4.4	−1.4
Interest payment	8.7	11.7	10.6	−1.1	1.9
Primary expenditures	32.8	32.8	29.4	−3.4	−3.4
Wages	5.6	5.7	5.7	0.0	0.1
Pensions	1.6	1.9	2.1	0.2	0.5
Goods and services	1.7	1.7	1.4	−0.3	−0.3
Transfers to public entities	15.0	14.1	13.1	−1.0	−1.9
Other transfers	4.0	4.7	4.0	−0.7	0.0
Capital expenditures	3.1	3.0	1.8	−1.2	−1.3
Overall balance	−10.7	−10.0	−8.4	−1.6	−2.3
Primary balance	−2.0	1.8	2.3	0.5	4.3

Source: IMP.

View Table

Table 18.

Italy: Fiscal Adjustment Central Government, 1989-95

				Diff.	Diff.
	1989	1993	1994-95	1994-95/93	1994-95/89
Revenues	30.8	34.8	31.7	−3.1	0.9
Expenditures	41.5	44.5	40.1	−4.4	−1.4
Interest payment	8.7	11.7	10.6	−1.1	1.9
Primary expenditures	32.8	32.8	29.4	−3.4	−3.4
Wages	5.6	5.7	5.7	0.0	0.1
Pensions	1.6	1.9	2.1	0.2	0.5
Goods and services	1.7	1.7	1.4	−0.3	−0.3
Transfers to public entities	15.0	14.1	13.1	−1.0	−1.9
Other transfers	4.0	4.7	4.0	−0.7	0.0
Capital expenditures	3.1	3.0	1.8	−1.2	−1.3
Overall balance	−10.7	−10.0	−8.4	−1.6	−2.3
Primary balance	−2.0	1.8	2.3	0.5	4.3

Source: IMP.

b. Pension reform

In 1995 the Italian government adopted a comprehensive reform of the pension system, one of the least solvent of the OECD. This reform, which follows a previous adjustment of 1992, replaces an income-based system with one that links benefits to contributions, although the system retains a “pay-as-you-go” nature. The reform also eliminated seniority pensions, which essentially permitted early retirement without penalties. In this paper we are only interested in the effects of this reform on the current fiscal adjustment and on its effect on long run cuts in spending.

The estimates for the budget impact of the reform in the short medium and long run are very difficult because they are based on uncertain predictions of macroeconomic and demographic variables. However even the most optimistic ones (from the Italian Treasury) suggest that the savings both in the short run and in the long run are not very large. According to the Italian Treasury, in the medium run (1995 to 2005) the reform would save about 0.4 to 0.5 percent of GDP per year, equally split between reduced spending and increased contributions. Peracchi and Rossi (1995) argue that these estimates are over optimistic because they rely on not credible forecasts. The most pessimistic estimates, form the Bank of Italy suggest that the reform may even have a negative impact on the government budget, even after the transition phase.

A recent ruling of the Constitutional Court concerning large pension arrears implies a further negative fiscal shock on the pension system. These payments will be financed with debt issues and should be about equal to the amount of savings of the pension reform as calculated by the Italian Treasury for the next five years. In summary, the effects of the reform on the budget are highly uncertain and even in the most optimistic scenarios not very large. ^21/

c. Cyclical versus discretionary adjustments and one-off measures

After the negative growth in 1993, GNP growth in Italy was higher than forecasted both in 1994 and 1995, 2.2 against a forecast of 1.4 and 3.2 against a forecast of 2.5 percent. An interesting question is how much of the adjustment of 1994-95 was purely a cyclical phenomenon or was a result of discretionary measures. Furthermore, it is obviously important to disentangle which of the discretionary measures have a one off character and which ones are more permanent. Quite apart from the difficulties in calculating cyclical adjustments, discussed in Section III, in the case of Italy an important consideration is the baseline against which the adjustment is measured.

Typically, the Italian authorities make a comparison between the actual budget of the state sector with the “bilancio tendenziale” that is, with the budget at “unchanged legislation.” Using this procedure, in 1995 an impressive 2.4 percent of GDP is the improvement of the primary balance, which arises from discretionary fiscal measures. One problem with these calculations is that the criteria for the computation of the “bilancio tendenziale” are obscure and depend on possibly questionable assumptions. A more useful comparison is between the primary budget surplus of the State Sector in 1995 relative to the surplus in 1994. According to the IMF staff calculations, of the 2.4 increase in the primary surplus between these two years, only 8 percent of GNP can be attributed to permanent discretionary measures. The remaining 1.6 percent is about equally split between the effect of higher than forecasted growth and inflation and one off measures.

Unfortunately, similar calculations are not available for previous years and for the general government. However as far as 1995 is concerned, the effect of the cycle and of one off measures should have the same order of magnitude as for the state sector. Thus, when closely examined only a small fraction of the 1995 improvement in the fiscal balance has a permanent nature. ^22/

d. Contractionary or expansionary adjustment?

Table 19 clearly shows that the Italian fiscal adjustment is associated with strong contractionary consequences on domestic demand, while the external sectors contained the negative effect of domestic demand on growth. The Italian growth rate shows a declining trend from 4.1 per in 1988 to -.7 in 1993. In the period 1989-94 the Italian growth rate is on average, 0.7 percent below the G-7 average. As shown in Table 19, private investment literally collapsed in this period: in 1993 it fell by about 18 percent! This development is in sharp contrast with the case of Ireland and Denmark, where private investment boomed during the adjustment. Growth in private consumption was very sluggish and turned negative in 1993. At least until 1993 there is no sign that interest rates incorporated a “credibility gain bonus.” The only “good news” for the economy in the period 1989-93 is the reduction in unit labor costs, as shown in Table 19. In summary, until 1993 the Italian adjustment has all the features of a contractionary adjustment, all driven by tax increases, without spending cuts.

Table 19.

Italy: Macroeconomic Conditions and the Fiscal Adjustment, 1989-94

Source: OECD. For a definition of the variables see Table 10.

Table 19.

Italy: Macroeconomic Conditions and the Fiscal Adjustment, 1989-94

	Before	During	Diff
	(1)	(2)	(2)-(1)
GR (G-7)	0.21	−0.70	−0.91
U (G-7)	6.60	5.63	−0.97
ΔI	10.6	−1.50	−12.10
ΔC	4.1	1.49	−2.61
i (G-7)	3.03	5.13	2.10
r (G-7)	0.57	2.66	2.09
ULC	5.16	−2.25
EXCH RATE	−1.76	−3.13
TB	−0.44	0.60	1.04
WSH	44.40	44.47	0.07
PSH	38.60	37.61	−0.99

Source: OECD. For a definition of the variables see Table 10.

View Table

Table 19.

Italy: Macroeconomic Conditions and the Fiscal Adjustment, 1989-94

	Before	During	Diff
	(1)	(2)	(2)-(1)
GR (G-7)	0.21	−0.70	−0.91
U (G-7)	6.60	5.63	−0.97
ΔI	10.6	−1.50	−12.10
ΔC	4.1	1.49	−2.61
i (G-7)	3.03	5.13	2.10
r (G-7)	0.57	2.66	2.09
ULC	5.16	−2.25
EXCH RATE	−1.76	−3.13
TB	−0.44	0.60	1.04
WSH	44.40	44.47	0.07
PSH	38.60	37.61	−0.99

Source: OECD. For a definition of the variables see Table 10.

The recent developments of 1994-95 are also quite instructive. The recession of 1993 was contained by a growth of almost 9 percent in export volume. The rate of growth in 1994-95 was also almost exclusively driven by the export sector. In 1994 and 1995 export volume grew at 10.7 and 13.6, respectively, with a trade surplus of about 4 percent of GNP. These external developments were driven mostly by the large real devaluation of the exchange rate, equal to about 25 percent from September 1992 when the lira abandoned the EMS. A second factor influencing competitiveness was the relative wage moderation achieved after 1993. Note that this wage moderation coincided with the end of major tax increases. All the measure of competitiveness indicate substantial gains for Italy in the last three years, of the order of 20 percent, the largest amount in the OECD together with Sweden.

The pattern of consumer confidence (Chart 1) closely follows the cycle. Consumer confidence was very low during the recession of 1993 and bounced back with the recovery of 1994. Despite the higher than expected growth of 1995, consumer confidence is slightly lower at the end of 1995 than in 1994. It is difficult to see any significant effect of the fiscal adjustment on consumer confidence.

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Household Confidence Index ⁽¹⁾

(1980=100)

Citation: IMF Working Papers 1996, 070; 10.5089/9781451960433.001.A001

Sources: Based on lsco data.⁽¹⁾ Data for August computed as average of July and September figures until 1994.

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Interest rate differential relative to Germany fell in 1993 from more than 6 percent on 10-year government bonds to less than 3 percent at the end of the year. By the beginning of 1995 this differential was back at almost 5 percent. The differential on 3-month treasury bills is about 4 percent, the same level as at the beginning of 1993. This pattern indicates that the market has doubts about the credibility and persistence of the fiscal adjustment even after the 1994-95 spending cuts. This behavior of interest rate differential is in sharp contrast with the Danish and Irish experience.

This evidence clearly points toward a clear conclusion: not only the 1989-93 fiscal adjustment negatively affected private demand, but the 1994-95 adjustment had the same effect and would have had negative growth consequences if it had not been accompanied by a massive depreciation of the real exchange rate. In summary, until 1993 the Italian adjustment is certainly of “Type 2”. Some of the spending cuts in 1995 seem to appear as a “Type 1” adjustment, but are too plagued by “one off” measures and are of uncertain duration.