1. Are all the principal fiscal variables diverging?

Despite the deepening of economic and financial integration, in recent years the fiscal performances of EU members have varied widely (Table 1). ^4/ Table 2 recapitulates the relative fiscal positions of EU members at the end of 1995. A set of statistical indicators now investigates some developments crucial for the paper. The data from 1970 to 1994 show that, as a share of GDP, government expenditure and the public debt have diverged the most. Conversely, in more recent years, tax revenue (and partly, total government revenue), and budget deficits have tended to converge. These developments are particularly evident with respect to the six founding EU members (the EU6): Belgium, France, Germany, Italy, Luxembourg, and the Netherlands, as they have integrated their economies earlier than the others. Figure 2.a shows that between 1970 and 1994, the standard deviation of tax revenue was consistently less than that of total government expenditure and total revenue. Since the late 1970s the standard deviation of tax revenue has been declining sharply in the EU6 (Figure 2.b). In the case of budget deficits, their standard deviation has followed a downward trend since the early 1980s in the EU6, and the late 1980s in the EU as a whole. However, this finding may be biased by the size of the deficits.

Table 1.

Selected Budgetary Indicators and Tax Rates for 1993–1995

Sources: National sources; IMF World Economic Outlook, OECD Economic Outlook; and Ernst and Young.

^1/IMF World Economic Outlook, May 1996. Balances are deficit if (-) and surplus if (+).

^2/The gross debt is not consistent with the definition agreed at Maastricht. It includes all financial liabilities as defined by the System of National Accounts.

^3/Total tax revenue comprise: (1) taxes on Income, profits and capital gains levied on individuals and corporations; (2) social security contributions; (3) taxes on property; (4) domestic taxes on goods and services; and (5) taxes on international trade and transactions.

^4/Social security contributions paid by employees and employers as a percent of GDP. For Denmark they are included in taxes on income and profits.

^5/General sales tax, value-added tax, excises, and other taxes as a percent of GDP in 1991.

^6/Includes taxes on capital gains and on property, and taxes on payroll.

^7/Represents only indicative tax rates in effect at the beginning of 1993. May include state and local corporate income tax (minus some deductions). Some reduced or increased rates, and certain exemptions are not reflected. Distributed profits may be taxed less in some countries. Other rates may apply to specified entities.

^8/1994 data for Columns (1) through (6).

^9/Weighted by relative GDP.

Table 1.

Selected Budgetary Indicators and Tax Rates for 1993–1995

		General Government, 1995 1/						Selected tax ratios and tax rates,1993
		Tatal Revenue	Tatal Expend	Overall Balance	Structural Balance	Primar Balance	Gross Debt 2/	Tatal Tax Revenue 3/	Taxes on Income and Prof	Social Sec. Contrib. 4/	Taxes on goods and Services 5/	Other Taxes 6/	Corpor. and Capital Gains Tax Rates 7/
		(In percent of GDP)								(In percent of Total Tax Revenue)			(Tax rates)
	Belgium	47.9	52.4	-4.5	-3.9	4.7	133.8	45.5	35.6	35.6	26.3	2.5	39.0
	Denmark	60.6	62.3	-1.7	-0.8	1.7	81.6	48.9	59.5	3.2	31.7	5.6	34.0
	France	49.6	54.6	-5.0	-3.1	-2.0	52.3	43.7	17.4	44.6	26.7	11.3	33.3
	Germany	47.0	50.6	-3.5	-2.1	-0.3	57.7	40.0	30.7	38.7	27.8	2.8	50.0
	Greece	45.0	54.0	-9.0	-7.4	2.9	113.2	38.3	18.2	33.8	43.9	4.1	35.0
	Ireland	43.0	45.1	-2.1	-2.1	2.3	85.3	38.0	40.2	15.4	38.3	6.1	40.0
	Italy	45.4	52.6	-7.2	-6.0	3.3	122.9	42.4	34.0	37.1	23.7	5.2	52.2
	Luxembourg 8/	37.6	37.2	0.4	…	…	6.3	43.1	36.8	28.6	26.9	7.7	42.1
	Netherlands	58.0	61.8	-3.8	-3.0	0.8	79.0	46.7	32.4	38.2	25.3	4.1	35.0
	Portugal	42.1	47.3	-5.2	-3.7	0.2	72.6	37.8	27.5	26.8	42.6	3.1	36.0
	Spain	41.0	47.0	-5.9	-4.3	-0.5	64.7	35.9	29.9	38.1	26.8	5.2	35.0
	United Kingdom	37.9	43.1	-5.1	-3.2	-2.5	48.8	35.8	35.0	17.8	35.3	11.9	33.0
EU aritnm. average		46.3	50.7	-4.4	-3.3	0.9	76.5	41.3	33.1	29.8	31.3	5.8	38.7
EU weighed average 9/		45.3	52.4	-5.1	-3.6	-0.0	73.2	40.9	29.9	35.0	28.2	6.8	41.1

Sources: National sources; IMF World Economic Outlook, OECD Economic Outlook; and Ernst and Young.

^1/IMF World Economic Outlook, May 1996. Balances are deficit if (-) and surplus if (+).

^2/The gross debt is not consistent with the definition agreed at Maastricht. It includes all financial liabilities as defined by the System of National Accounts.

^3/Total tax revenue comprise: (1) taxes on Income, profits and capital gains levied on individuals and corporations; (2) social security contributions; (3) taxes on property; (4) domestic taxes on goods and services; and (5) taxes on international trade and transactions.

^4/Social security contributions paid by employees and employers as a percent of GDP. For Denmark they are included in taxes on income and profits.

^5/General sales tax, value-added tax, excises, and other taxes as a percent of GDP in 1991.

^6/Includes taxes on capital gains and on property, and taxes on payroll.

^7/Represents only indicative tax rates in effect at the beginning of 1993. May include state and local corporate income tax (minus some deductions). Some reduced or increased rates, and certain exemptions are not reflected. Distributed profits may be taxed less in some countries. Other rates may apply to specified entities.

^8/1994 data for Columns (1) through (6).

^9/Weighted by relative GDP.

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Table 1.

Selected Budgetary Indicators and Tax Rates for 1993–1995

		General Government, 1995 1/						Selected tax ratios and tax rates,1993
		Tatal Revenue	Tatal Expend	Overall Balance	Structural Balance	Primar Balance	Gross Debt 2/	Tatal Tax Revenue 3/	Taxes on Income and Prof	Social Sec. Contrib. 4/	Taxes on goods and Services 5/	Other Taxes 6/	Corpor. and Capital Gains Tax Rates 7/
		(In percent of GDP)								(In percent of Total Tax Revenue)			(Tax rates)
	Belgium	47.9	52.4	-4.5	-3.9	4.7	133.8	45.5	35.6	35.6	26.3	2.5	39.0
	Denmark	60.6	62.3	-1.7	-0.8	1.7	81.6	48.9	59.5	3.2	31.7	5.6	34.0
	France	49.6	54.6	-5.0	-3.1	-2.0	52.3	43.7	17.4	44.6	26.7	11.3	33.3
	Germany	47.0	50.6	-3.5	-2.1	-0.3	57.7	40.0	30.7	38.7	27.8	2.8	50.0
	Greece	45.0	54.0	-9.0	-7.4	2.9	113.2	38.3	18.2	33.8	43.9	4.1	35.0
	Ireland	43.0	45.1	-2.1	-2.1	2.3	85.3	38.0	40.2	15.4	38.3	6.1	40.0
	Italy	45.4	52.6	-7.2	-6.0	3.3	122.9	42.4	34.0	37.1	23.7	5.2	52.2
	Luxembourg 8/	37.6	37.2	0.4	…	…	6.3	43.1	36.8	28.6	26.9	7.7	42.1
	Netherlands	58.0	61.8	-3.8	-3.0	0.8	79.0	46.7	32.4	38.2	25.3	4.1	35.0
	Portugal	42.1	47.3	-5.2	-3.7	0.2	72.6	37.8	27.5	26.8	42.6	3.1	36.0
	Spain	41.0	47.0	-5.9	-4.3	-0.5	64.7	35.9	29.9	38.1	26.8	5.2	35.0
	United Kingdom	37.9	43.1	-5.1	-3.2	-2.5	48.8	35.8	35.0	17.8	35.3	11.9	33.0
EU aritnm. average		46.3	50.7	-4.4	-3.3	0.9	76.5	41.3	33.1	29.8	31.3	5.8	38.7
EU weighed average 9/		45.3	52.4	-5.1	-3.6	-0.0	73.2	40.9	29.9	35.0	28.2	6.8	41.1

Sources: National sources; IMF World Economic Outlook, OECD Economic Outlook; and Ernst and Young.

^1/IMF World Economic Outlook, May 1996. Balances are deficit if (-) and surplus if (+).

^2/The gross debt is not consistent with the definition agreed at Maastricht. It includes all financial liabilities as defined by the System of National Accounts.

^3/Total tax revenue comprise: (1) taxes on Income, profits and capital gains levied on individuals and corporations; (2) social security contributions; (3) taxes on property; (4) domestic taxes on goods and services; and (5) taxes on international trade and transactions.

^4/Social security contributions paid by employees and employers as a percent of GDP. For Denmark they are included in taxes on income and profits.

^5/General sales tax, value-added tax, excises, and other taxes as a percent of GDP in 1991.

^6/Includes taxes on capital gains and on property, and taxes on payroll.

^7/Represents only indicative tax rates in effect at the beginning of 1993. May include state and local corporate income tax (minus some deductions). Some reduced or increased rates, and certain exemptions are not reflected. Distributed profits may be taxed less in some countries. Other rates may apply to specified entities.

^8/1994 data for Columns (1) through (6).

^9/Weighted by relative GDP.

Table 2.

European Union: The Relative Fiscal Position of the EU Members in 1995

Sources: National Sources; IMF May 1996 World Economic Outlook

Table 2.

European Union: The Relative Fiscal Position of the EU Members in 1995

	Government Expenditure	Total Revenue	Budget Deficit	Public Debt
High	Belgium Denmark France Italy Netherlands	Belgium Denmark France Netherlands	Greece Italy Spain	Belgium Greece Ireland Italy Denmark
Medium	Germany Greece Portugal	Germany Italy Luxembourg Portugal	Belgium France Netherlands Portugal United Kingdom	Netherlands Portugal Spain
Low	Ireland Luxembourg Spain United Kingdom	Greece Ireland Spain United Kingdom	Denmark Germany Ireland Luxembourg	France Germany Luxembourg United Kingdom

Sources: National Sources; IMF May 1996 World Economic Outlook

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Table 2.

European Union: The Relative Fiscal Position of the EU Members in 1995

	Government Expenditure	Total Revenue	Budget Deficit	Public Debt
High	Belgium Denmark France Italy Netherlands	Belgium Denmark France Netherlands	Greece Italy Spain	Belgium Greece Ireland Italy Denmark
Medium	Germany Greece Portugal	Germany Italy Luxembourg Portugal	Belgium France Netherlands Portugal United Kingdom	Netherlands Portugal Spain
Low	Ireland Luxembourg Spain United Kingdom	Greece Ireland Spain United Kingdom	Denmark Germany Ireland Luxembourg	France Germany Luxembourg United Kingdom

Sources: National Sources; IMF May 1996 World Economic Outlook

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Standard Deviations of the Principal Fiscal Variables in the EU ^1/

Citation: IMF Working Papers 1996, 072; 10.5089/9781451849295.001.A001

Source: IMF World Economic Outlook (WEO).^1/ Each year, it includes only the current members.

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Standard Deviations of the Principal Fiscal Variables in the EU 6 ^1/

Citation: IMF Working Papers 1996, 072; 10.5089/9781451849295.001.A001

Source: IMF World Economic Outlook (WEO).^1/ Restricted to only the founding members of the European Union: Belgium, Germany, France, Italy, Luxembourg, and the Netherlands.

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To overcome the size problem, the coefficient of variations of the principal fiscal variables is calculated. It consists of the absolute value of the ratio between the standard deviation of each variable and its mean, and is illustrated in Figures 2.c and 2.d. In both figures, the coefficient of variations of tax revenue is consistently less than that of the other variables, while that of the budget deficits is initially high but drops in the mid 1970s, and remains almost constant. Therefore, the picture is somewhat mixed with respect to total government expenditure and revenue, and only the EU6 figure shows that the latter variable is slightly smaller. To obtain some additional information about the evolution of the main fiscal variables, the statistical correlation of each country’s time series is computed for the 1980–94 period. Only for tax revenue the sample ranges from 1970 to 1992 because more recent data were not yet available. These statistical indicators are reported in Appendix I, and show that: (1) correlations are consistently positive only in the case of tax revenue; (2) correlations between total government revenue are generally higher than those between government expenditure; and (3) correlations between budget deficits are generally positive. These findings suggest that debt-to-GDP ratios have diverged across countries due largely to different expenditure policies. Furthermore, some fiscal convergence is currently taking place across the EU on the revenue side, particularly concerning tax revenues.

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Coefficients of Variation of the Principal Fiscal Variables in the EU ^1/

Citation: IMF Working Papers 1996, 072; 10.5089/9781451849295.001.A001

Source: IMF World Economic Outlook (WEO).^1/ Coefficient of variation is the ratio between the standard deviation and the mean. Each year, it includes only the current members.

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European Union 6: Coefficients of Variation of the Principal Fiscal Variables in the EU 6 ^1/

Citation: IMF Working Papers 1996, 072; 10.5089/9781451849295.001.A001

Source: IMF World Economic Outlook (WEO).^1/ Coefficient of variation is the ratio between the standard deviation and the mean. This chart is restricted to only the founding members of the European Union: Belgium, France, Germany, Italy, Luxembourg, and the Netherlands.

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2. Endogenous fiscal discipline

The endogenous fiscal discipline is prompted by three main factors.

a. The harmonization of tax systems across the EU. This process of harmonization is bolstered by a spontaneous convergence of tax structures in response to competitive pressures, and by institutional factors. Concerning the first factor, the deepening of economic integration is rendering goods, some services, and factors of production increasingly mobile across the EU. Increased mobility, in turn, is blurring the separation between national tax jurisdictions and compelling most members of the EU to bring their tax rates closer to those of their partners. The tax harmonization is also prompted by the following institutional factors: (1) the acceptance of common EU external tariffs with respect to the rest of the world; (2) the elimination of internal tariffs, border controls, and restrictions across the EU; (3) the harmonization of several tax bases; and (4) the adoption of several EU directives concerning the operation of the members’ tax systems and the acceptance of common regulatory standards for conducting business. ^5/ The statistical findings of the previous subsection provide some grounds for the hypothesis that some harmonization is already taking place across tax systems. In the EMU the harmonization of the tax systems, whether spontaneous or mandated by institutional factors, will increasingly reduce the ability of each country to raise its effective tax rates relative to those of the trading partners.

b. The loss of control of monetary policy and money financing. The effects of losing control of current and prospective money financing are far reaching in the EMU. Each participating country will lose control of two sources of money financing: seigniorage and surprise inflation. The importance of seigniorage has varied widely among EU members, but has steadily declined since the inception of the European Monetary System (EMS). Mongelli (1996a) shows that average seignorage across the EU is now about 0.3 percent of GDP and falling. Hence, from the standpoint of seignorage the EMU should not significantly worsen fiscal sustainability. By joining the EMU, national governments will also lose control of surprise inflation, the second source of inflation financing. In some EU members surprise inflation has been a significant source of financing in the 1960s, 1970s, and early 1980s (Mongelli (1996a)). However, since the mid-1980s, the surprise inflation effect had largely faded. Furthermore, there is increasing empirical evidence that the EU members with a higher inflation rate have been increasingly penalized by means of significant devaluation risk premium. ^6/ Hence, by establishing a low and stable inflation, the EMU will reduce interest rates in the previously “high inflation” countries, and improve fiscal sustainability.

c. The strengthening of financial market-based discipline. The EMU will render information on each borrower, as well as alternative investment opportunities, more easily available and less costly to pursue. As a result, investors are more likely to shy away from a high debt-to-GDP government out of fear that it would resort to some partial repudiation such as adopting a retroactive tax on interest payments. Investors will then command a country-specific default risk premium by holding the liabilities of that government only until the risk-adjusted rates of return are equalized. To the extent that a country with a relatively high debt-to-GDP ratio responds to these “signals” and refrains from further borrowing, its country-specific default risk premium will fall, and interest rate differential across the EU will also fall. This constitutes the core of the financial market-based discipline which is strengthened by the EMU. Conversely, the EMU could increase the country-specific risk premium and worsen fiscal sustainability in any member country that did not pursue cautious fiscal policies.

1. Debt sustainability and fiscal adjustment

The original question posed by Blanchard (1984), “what does it mean to say that a given combination of debt and deficits is unsustainable?”, seems even more relevant today in the light of the divergence of the level of indebtedness across the EU. This fiscal divergence stands in sharp contrast to the commitment undertaken by each EU member in signing the Maastricht Treaty. This section presents a methodology to analyze the responsiveness of fiscal sustainability to the changes that may be entailed by the EMU. ^7/ Appendix II gives the list of notation.

The present section extends Blanchard’s (1984) analysis in three ways. First, it assumes that the interest rate is set endogenously and is a positive function of the stock of debt. This assumption allows an analysis of the link between fiscal sustainability and the endogenous fiscal discipline. In this sense this modified model of fiscal sustainability is a generalization of Blanchard (1984). Second, the implications of the endogenous fiscal discipline are extensively discussed. Specifically, this section illustrates how the endogenous fiscal discipline could alter the level of sustainable public debt. Third, the main findings are illustrated by means of the “fiscal sustainability frontiers” that are similar to the stable arm in Blanchard (1994). This modified model, while simple, is powerful in its ability to yield intuition-building treatments of issues linked to fiscal sustainability.

2. The model of fiscal sustainability

The basis of the model is the following temporal government budget constraint,

where G_t are nominal non-interest government expenditure on goods and services, T_t are nominal government revenue from taxes and other receipts (and net of government transfers). B_t are net nominal liabilities of the government in the form of perpetual bonds. Equation (1) states that a government finances its fiscal deficit by issuing new debt $({DB}_t-dt)\mathrm{.}$. The fiscal deficit is constituted by a primary deficit $(G_t-T_t)$ plus the interest payments on the outstanding public debt $\left(i(b_t,{\pi }_t)B_t\right)\mathrm{.}$ The nominal interest rate has a real and a nominal component, i.e.,$i(b_t,{\pi }_t)=r\left(b_t\right)+{\pi }_t,$ and b_t is the level of indebtedness normalized by output (i.e., $b_t=B_t/Y_t$). For simplicity, the revenue from seignorage are omitted (they are currently negligible across the EU and can be thought of as part of T_t), prices grow at a constant level of inflation (π_t), and real income grows at some nonzero rate μ. Revenue from money financing have been omitted for simplicity and because currently very modest (Section II.2, point b).

To allow comparisons across time and countries, all terms in (1) are normalized with respect to the nominal level of output,

ps_t is the real primary balance (i.e., a primary surplus if positive, and a primary deficit if negative). Taking the time derivative of the normalized stock of debt, and simplifying, cancels out the inflation component of the nominal interest rate and yields the growth adjusted real interest rate $(r\left(b\right)-\mu )\mathrm{.}$ To prevent the government from indefinitely borrowing to service the outstanding debt the condition $(r\left(b\right)>\mu )$ must be stipulated.

Given the constant rate of growth of real GDP (μ), the evolution of public indebtedness (b_t) hinges on the fear of some default by the financial markets and the evolution of the real primary balance (ps_t). The term r(b_t) captures a government-specific risk premium which is commanded by bondholders because government bonds bear a perceived probability of complete default ø, where $0\le \mathrm{ø}<1.$ The higher the perceived probability of a default, the higher is ø. This implies that the supply curve of funds to the national government is upward sloping, and that its steepness increases with the level of indebtedness. It is this new specification of the interest rate that will provide the new insight with respect to Blanchard (1984), who assumed a constant real interest rate. These bonds are issued at a rate r(b_t), which must equalize the interest rate with similar assets that bear a risk free rate r^f (Figure 3(a)). ^8/ It is assumed that the risk of default is a function of the debt-to-GDP ratio $\mathrm{ø}=\mathrm{ø}\left(b_t\right),$ that it is zero when there is no debt and that the first derivative is always positive when there is some debt outstanding $\mathrm{ø}\left(0\right)=0,{\mathrm{ø}}_b\left(b_t\right)>0,$ and ${\mathrm{ø}}_b\left(b_t\right)>0$ when $b_t>0.$ Furthermore, $\underset{b\to \infty }{\lim }\mathrm{ø}\left(b_t\right)=1$ but $\mathrm{ø}\ne 1,$ must be stipulated as well.

Consequently, $(1+r\left(b_t\right))(1-\mathrm{ø})=1+r^f,$, must hold which in turn yields $r\left(b_t\right)=\frac{r^f+\mathrm{ø}\left(b_t\right)}{1-\mathrm{ø}\left(b_t\right)}\mathrm{.}$ Totally differentiating this expression of the real interest rate yields,

For example, if the reputation of the government is low or the uncertainty associated with a complete repayment of the outstanding public debt is high, the financial market may immediately demand a higher risk premium. ^9/ In this case, ø_b is high and r(b_t) becomes steep at lower levels of the debt as in curve I in Figure 3(a).

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The Risk Premium Function

Citation: IMF Working Papers 1996, 072; 10.5089/9781451849295.001.A001

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Figure 3(b) illustrates the points that satisfy the $\frac{{db}_t}{dt}=0$ schedule. Given a rate of growth of output μ, a lower reputation of the government, entails higher risk premiums, increases the growth adjusted real interest rate and renders the $\frac{{db}_t}{db}=0$ schedule steeper. If instead the confidence in the country’s fiscal and monetary management is high, the response of the financial markets to high debt-to-GDP ratios may be almost negligible. In this second case, ø_b would be lower, $r\left(b_t\right)-\mu$ less steep, and, consequently, the risk premium function may be flatter as in curve II in Figures 3(a) and 3(b). Instead, the lack of a feedback between the debt-to-GDP ratio and the interest rate, as in Blanchard (1984), is illustrated by curve III in Figures 3(a) and 3(b).

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The Maximum Deficit and Debt Pairs: The Effect of Endogenous Fiscal Discipline

Citation: IMF Working Papers 1996, 072; 10.5089/9781451849295.001.A001

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The discussion now turns to the freedom of the primary balance ps_t in the EMU. It is now assumed that there are upper and lower bounds for government revenue net of transfers, respectively, $\overline{\tau }and\underset{-}{\tau }\mathrm{.}$ There are also upper and lower bounds for non-interest government expenditure on goods and services, $\overline{g}and\underset{-}{g}$ respectively. Two of these variables will play an important role in the ensuing analysis.

The first variable is $\overline{\tau }$ the maximum amount of government revenues net of transfers that can be collected. This variable is determined, inter alia, by the state of the tax system and several other characteristics of the economy, such as its degree of openness and the exposure to international competition. A deepening of integration and the endogenous fiscal discipline, which increases tax competition, is likely to lower $\overline{\tau }$ in high tax countries. Conversely, $\overline{\tau }$ may still be able to raise in low tax countries but this case is not discussed in the rest of the paper.

The second important variable is g, the minimum amount of socially acceptable government outlays. It could be interpreted as that level of provision of public goods below which there could be a decline in output. For example, the reduced provision of some indispensable public services may hinder production and/or lead to an emigration of the tax base. The deepening of economic integration, which will be expedited by the EMU, works toward increasing g in those countries with a relatively low provision of some public services (e.g., the high speed railway currently under construction across Europe, or some waste treatment plants built to improve environmental standards). On the other hand, the deepening of economic integration could decrease g in those countries with a relatively high provision of some public services, but this latter case is not discussed here.

Correspondingly, $\overline{ps}=\overline{\tau }-\underset{-}{g}$ is postulated to be the maximum primary surplus the country can manage without great difficulty. At the inception of the EMU, the deepening of integration and the endogenous fiscal discipline are likely to reduce the maximum primary surplus $\left(\overline{ps}\right)$ that is attainable in a country with a relatively high level of taxation. In Figure 3(b) this is illustrated by a decline from $\overline{ps}to\overline{ps\prime }$, which would in turn shift the points A, B, and C to A′, B′, and C′ along the new horizontal schedule $\overline{ps}\prime \overline{ps\prime }$. A steepening of the growth adjusted real interest $r\left(b_t\right)-\mu$ that could be the result of a loss of confidence, would also reduce the fiscal autonomy of a national government. The combined effect of the decline in $\overline{ps}$ and the loss of confidence is illustrated by the contraction of the feasible fiscal area from the rectangle (0 1 B 2) to the smaller one (0 1′ A′ 2′).

Another important feature of fiscal policy considered in this model, is that budgetary policy changes cannot take place all at once. Both the increases in the tax burden (toward $\overline{\tau }$) and the decrease in public expenditure (toward g) can occur only gradually. In fact, these measures may require extensive reforms of the tax administration—for example, to improve taxpayers compliance—or the central and local expenditure centers. These reforms can be slow to implement, and may be politically unpopular or even unfeasible in some economic sectors or regions. Hence, the adjustment of the gap between the current primary surplus ps_t towar ${\overline{ps}}_t$ will require time. It is assumed here that the gap between the current primary balance and the maximum primary surplus follows an adaptive process limited by an inequality as in (2). The model of fiscal sustainability is represented by,

where γ is the speed of adjustment and may be interpreted as an indicator of the maximum fiscal effort which a national government is willing to undertake during a particular period to improve its primary balance. Two difficulties arise at this point, due to the specification of the model. The first difficulty is that the system presents an inequality in (2). However, this inequality represents a restriction of an economic nature. Therefore, the system can be studied by imposing an equality, keeping in mind that there are more solutions if (2) is an inequality than if it is an equality. The inequality will be reintroduced later. This will expand the admissible space of the solutions. The second difficulty pertains to the non-linearity of the system. This difficulty can be overcome by studying the properties of the linearized system near its saddle point equilibrium $(b^{*},{ps}^{*})$ that is found by setting $\frac{{db}_t}{dt}=\frac{{dps}_t}{dt}=0.$ Specifically, ${ps}^{*}=\overline{ps}$ and $b^{*}=\frac{1}{r\left(b^{*}\right)-\mu }\overline{ps}=\frac{1-\mathrm{ø}\left(b^{*}\right)}{r^f+(1+\mu )\mathrm{ø}\left(b^{*}\right)-\mu }\overline{ps}\mathrm{.}$

The $\frac{{db}_t}{dt}=0$ schedule, drawn in Figure 4, crosses the origin and is upward sloping. Assuming that (2) holds with equality, the $\frac{{dbs}_t}{dt}=0$ schedule is horizontal at the value ${ps}_t=\overline{ps}\mathrm{.}$ Both ps^* and b^* are positive because the interest rate function is monotonically nondecreasing in b_t, and crosses the $\frac{{dps}_t}{dt}=0$ schedule only.once. It can be shown that given some plausible values of the parameters and the variables this system has a saddle point equilibrium (b^*, ps^*), to which it might converge along the stable arm AA in Figure 4.

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Sustainable Deficit and Debt Pairs

Citation: IMF Working Papers 1996, 072; 10.5089/9781451849295.001.A001

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To obtain an indication of the dynamic of the points in the (ps_t, b_t) space, the following two partial differentials are obtained from (1”) and (2) when it is an equality,

The sign of (a), indicates that on the left of the $\frac{{db}_t}{dt}=0$ schedule, b_t is decreasing, while to the right, it is increasing. The sign of (b), indicates that above the $\frac{{dbs}_t}{dt}=0$ schedule, ps_t will decrease, while below it will increase. ^10/ However, when (2) is taken with the inequality sign, below the $\frac{{dbs}_t}{dt}=0$ schedule, ps_t can increase or decrease as shown in Figure 4. The following condition is the stable arm AA of the system (1”) (2), that needs to be satisfied by each initial pair (ps₀, b₀) to secure fiscal sustainability,

If the economy finds itself at the initial point C in Figure 4, which lies below the stable arm AA, the deficit will be so high that it will not be reduced fast enough to prevent the public debt from growing along one of the unsustainable paths. If instead the economy starts at the initial point E, which lies above the stable arm AA, it might reach the $\frac{{db}_t}{dt}=0$ schedule by moving along the path EE’, and crossing it. Alternatively, it can move toward the path EE” and reach the stable arm AA.

Therefore, just as in Blanchard (1984), it is the area below the stable arm AA that may lead to debt repudiation, and not the area to the right of the steady state level of the public debt (b^*). An increase in the fiscal effort to increase the primary surplus improves fiscal sustainability. This improvement is reflected in an increase in the speed of adjustment γ, which increases the slope of the stable arm, tilting it from AA to A’A’ in Figure 5 and lowers its intercept with the vertical axis of the primary balance in Figure 5. This will reduce the area in which the debt is unsustainable. In the same figure, this will now render point C sustainable. If the adjustment could be realized instantaneously (i.e., $\gamma \Rightarrow \infty$ in the absence of any constraint in the adjustment of ps_t to the maximum primary surplus), the key condition for sustainability would be that the debt never exceeds the critical threshold (i.e., $b_t<b^{*}$). If instead $\gamma \Rightarrow 0$, no debt is sustainable.

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Sustainable Deficit and Debt Pairs: the Effect of an Increase in the Speed of Adjustment

Citation: IMF Working Papers 1996, 072; 10.5089/9781451849295.001.A001

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The “fiscal sustainability frontiers” can assist in illustrating the main findings of the model. They define the regions where combinations of deficit and debt are fiscally sustainable. These frontiers—which are obtained from (3)—are samples of the stable arms AA and A’A’ in Figure 4. Each EU member will have its own fiscal sustainability frontier given its country-specific maximum amount of net government revenue ($\left(\overline{\tau }\right)$) which can be collected, the minimum amount of socially acceptable non-interest government expenditure (g), the fiscal effort γ that a national government is willing to undertake to improve the primary surplus, the risk free real interest rate (r^f), its specific borrowing conditions, and its real income growth μ. Therefore, each EMU member’s fiscal sustainability frontier has a different slope and positions because each country’s constraints are different (this point will be investigated further in the next section). These frontiers will also continuously move over time as the economic and budgetary conditions of the country evolve.

Three conclusions can now be advanced. The first conclusion is that b^* is positively related to ps^*, and inversely related to the growth adjusted real interest rate which increases when the confidence in the government by the financial markets declines. Specifically, the higher ø_b and the steeper $\left(r\left(b_{*}\right)-\mu \right)$ the lower b^* (i.e., $b^{*}=\overline{ps}/\left[r\left(b^{*}\right)-\mu \right]$) will be. In Blanchard (1984), instead, this critical threshold of the debt-to-GDP ratio (that is equal to $b^{*}=\overline{ps}/(r-\mu )$,) is constant given $\overline{ps}$, and a constant r and μ. ^11/

The second conclusion is that as in Blanchard (1984), the sustainability condition cannot be approximated by any critical threshold, but is rather more complex. The principal difference between the solutions in Blanchard (1984) and the solutions in this paper is represented by the grey shaded area in Figure 5. In Blanchard (1984), the debt could become unsustainable on the right of the straight line (i.e., the fiscal sustainability frontier is straight). Instead, when the government faces an upward sloping supply of funds, as in this paper, the fiscally sustainable region is reduced. Furthermore, the lower the reputation of the government—and the higher the risk premium commanded by the financial market for each increment of the debt—the smaller the fiscally sustainable region becomes. Only if the uncertainty associated with a complete repayment of the outstanding public debt vanishes, will the two solutions converge.

The third conclusion concerns an aspect not discussed in Blanchard (1984). A high budget deficit can also imply a loss of fiscal sustainability even at low levels of debt. Lines 1 and 2 which cross Figure 5, show that relatively high debt-to-GDP ratios could be fiscally sustainable if associated with primary surpluses high enough to produce a fall in debt over time. Conversely, relatively low debt-to-GDP ratios, could be fiscally unsustainable if associated with relatively high budget deficits. This problem could worsen if the improvements in the primary balances are delayed because efforts to improve the primary balance (i.e., γ) are minimal. Furthermore, the upward sloping supply of funds schedule could provide a significant impediment to redress a significant budget deficit. Specifically, when the reputation of the government is low, each increment of the debt (that occurs while the government increases its primary balances) will bring about a higher risk premium. This higher risk premium will in turn increase the sizes of the primary surpluses necessary to secure fiscal sustainability.

The analysis conducted so far has two main caveats. First, what would happen if it was not absolutely clear and credible that national public debts are the exclusive obligation of each national government? So far it has been assumed that monetary discipline will be clearly established, and that the no bailout principle stated in the Maastricht Treaty will be fully implemented. What if monetary discipline is lax and the financial market expects a bailout? Paradoxically, if a country was admitted in the EMU and started running continuous and excessive budget deficits the country’s specific interest rate may not rise as fast. Financial solidarity, which could take the form of an implicit or explicit bailout, would reduce the incentive of the financial market to raise the risk premium and/or restrict lending to “high debt” governments. That is, the fiscal sustainability frontier of such a high debt country would shift to the right, easing this country’s debt servicing.

The reverse side of the financial solidarity is that the burden of the fiscal undiscipline by one, or more, countries falls on all other EMU members. One of the channels—the previously “risk-free” real interest rate r^f of the EMU would not be risk free any longer but would include a premium (due to the possibility of a bailout of an “undisciplined” member). Correspondingly, the fiscal sustainability frontiers of these partner countries would shift to the left, worsening their fiscal sustainability.

The second caveat is that this chapter has only briefly addressed the political or institutional factors behind fiscal unsustainability. ^12/ These factors significantly affect the “true” commitment, or the ability, to improve tax compliance, stem public expenditure, and pursue a fiscal restraint when it is needed. To the extent that significant political or institutional biases toward budget deficits are present, the issue of fiscal sustainability will have to be examined on grounds not considered here. However, in terms of the framework developed in this chapter such political biases correspond to: (1) lower $\overline{\tau }$, the maximum government revenue that is sought by the government; (2) higher g, the minimum amount of socially acceptable non-interest expenditure that the government can afford from a political standpoint; and (3) lower γ the speed of adjustment of the budget that the government is willing to pursue. All these factors shift the fiscal sustainability frontier to the left and lower the maximum primary surplus that can be sought by the government (i.e., the $\frac{{dps}_t}{dt}=0$ schedule shifts downward). In summary, the fiscally sustainable region would be greatly reduced.

3. How likely is it that the public debt will become irreversibly unsustainable, leading to a sovereign default?

For illustrative purposes the discussion thus far has allowed the debt to grow along some outward bound trajectories (such as T, T’, and T” in Figure 5), if the initial pair (b₀, ps₀) is on the right of AA. Clearly, this condition is not realistic; although some sovereign defaults have occurred across Europe in the past, they are not very common among these countries. Therefore, an additional requirement, which has not yet been discussed, will reduce the likelihood of a sovereign default by a national government. ^13/ This requirement is the solvency condition that preclude any national government from indefinitely borrowing to service the outstanding debt. Hence, the question that is now asked is: what would happen if the solvency condition needed to be satisfied at each point in time? Adding the solvency condition to the elements discussed thus far could give rise to a contradiction if a country finds itself on the right of the fiscal sustainability frontier: specifically, it is impossible for a national government to contemporaneously satisfy the following four conditions:

Table 3.

Estimates of the Proximity to the Fiscal Sustainability Frontier, 1995 ^1/

Source: National Sources, IMF’s IFS and WEO.

^1/Col. (1) based upon recent values of the primary surpluses of each country. Col. (2) real interest rate is the average of the short-term and the long-term rates weighed by their share in 1995. Col. (3), (5), and (6) 1995 IMF WEO estimates. Col. (4) estimates of gamma are described in Append. III. Col. (7) debt values are computed on the basis of Eq. (4’) in the text. Some data for Luxembourg are unavailable. Col. (8) is the difference between the values in Col. (7) and Col. (6). In Col. (9) + + means satisfactory, + means adequate, - means inadequate, and—means unsatisfactory.

^2/May not be consistent with the definition agreed at Maastricht. It includes all financial liabilities as defined by the System of National Accounts.

^3/Outcome based upon the latest primary balance in Col. (5), the level of public indebtedness in Col. (6), and the fiscal gap in Col. (8)

^4/In 1995 economic growth was exceptionally high. Therefore 1991–1995 averages have been used in Columns (2), (3), (5), and (6). despite the very low fiscal gap in Col. (8) and the poor outcome in Col. (9), the fiscal situation has rapidly improved in recent years due to a decline in budget deficit and debt.

^5/Despite the worsening of the budget deficit in recent years, the debt-to-GDP ratio is still among the lowest in the EU. Therefore, the U.K. doesn’t face an immediate fiscal sustainability problem.

Table 3.

Estimates of the Proximity to the Fiscal Sustainability Frontier, 1995 ^1/

	Maximum Primary Balance (1)	Real Interest Rate (2)	Rate of Growth of GDP (3)	Estimates. of Gamma (4)	Latest Primary Balance (5)	Current Public Debt 2/ (6)	Sustainable Public Debt (7)	Fiscal Gap (7)-(6) (8)	Outcome 3/ (9)
Belgium	0.060	0.050	0.019	0.093	0.047	1.34	1.87	0.53	—
Denmark	0.040	0.054	0.029	0.303	0.017	0.82	1.53	0.72	+/-
France	0.040	0.047	0.024	0.533	-0.020	0.52	1.70	1.18	+ +
Germany	0.040	0.039	0.019	0.498	-0.003	0.58	1.92	1.34	+ +
Greece	0.045	0.051	0.020	0.369	0.029	1.13	1.45	0.31	—
Ireland 4/	0.040	0.062	0.042	0.145	0.015	0.85	1.74	0.88	+/-
Italy	0.040	0.055	0.032	0.163	0.033	1.23	1.74	0.51	—
Netherlands	0.040	0.048	0.024	0.429	0.008	0.79	1.69	0.91	+
Portugal	0.040	0.058	0.024	0.235	0.020	0.73	1.15	0.43	-
Spain	0.040	0.054	0.030	0.309	0.020	0.65	1.54	0.89	+
United Kingdom 5/	0.040	0.051	0.024	0.390	-0.025	0.49	1.40	0.92	+ +

Source: National Sources, IMF’s IFS and WEO.

^1/Col. (1) based upon recent values of the primary surpluses of each country. Col. (2) real interest rate is the average of the short-term and the long-term rates weighed by their share in 1995. Col. (3), (5), and (6) 1995 IMF WEO estimates. Col. (4) estimates of gamma are described in Append. III. Col. (7) debt values are computed on the basis of Eq. (4’) in the text. Some data for Luxembourg are unavailable. Col. (8) is the difference between the values in Col. (7) and Col. (6). In Col. (9) + + means satisfactory, + means adequate, - means inadequate, and—means unsatisfactory.

^2/May not be consistent with the definition agreed at Maastricht. It includes all financial liabilities as defined by the System of National Accounts.

^3/Outcome based upon the latest primary balance in Col. (5), the level of public indebtedness in Col. (6), and the fiscal gap in Col. (8)

^4/In 1995 economic growth was exceptionally high. Therefore 1991–1995 averages have been used in Columns (2), (3), (5), and (6). despite the very low fiscal gap in Col. (8) and the poor outcome in Col. (9), the fiscal situation has rapidly improved in recent years due to a decline in budget deficit and debt.

^5/Despite the worsening of the budget deficit in recent years, the debt-to-GDP ratio is still among the lowest in the EU. Therefore, the U.K. doesn’t face an immediate fiscal sustainability problem.

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Table 3.

Estimates of the Proximity to the Fiscal Sustainability Frontier, 1995 ^1/

	Maximum Primary Balance (1)	Real Interest Rate (2)	Rate of Growth of GDP (3)	Estimates. of Gamma (4)	Latest Primary Balance (5)	Current Public Debt 2/ (6)	Sustainable Public Debt (7)	Fiscal Gap (7)-(6) (8)	Outcome 3/ (9)
Belgium	0.060	0.050	0.019	0.093	0.047	1.34	1.87	0.53	—
Denmark	0.040	0.054	0.029	0.303	0.017	0.82	1.53	0.72	+/-
France	0.040	0.047	0.024	0.533	-0.020	0.52	1.70	1.18	+ +
Germany	0.040	0.039	0.019	0.498	-0.003	0.58	1.92	1.34	+ +
Greece	0.045	0.051	0.020	0.369	0.029	1.13	1.45	0.31	—
Ireland 4/	0.040	0.062	0.042	0.145	0.015	0.85	1.74	0.88	+/-
Italy	0.040	0.055	0.032	0.163	0.033	1.23	1.74	0.51	—
Netherlands	0.040	0.048	0.024	0.429	0.008	0.79	1.69	0.91	+
Portugal	0.040	0.058	0.024	0.235	0.020	0.73	1.15	0.43	-
Spain	0.040	0.054	0.030	0.309	0.020	0.65	1.54	0.89	+
United Kingdom 5/	0.040	0.051	0.024	0.390	-0.025	0.49	1.40	0.92	+ +

Source: National Sources, IMF’s IFS and WEO.

^1/Col. (1) based upon recent values of the primary surpluses of each country. Col. (2) real interest rate is the average of the short-term and the long-term rates weighed by their share in 1995. Col. (3), (5), and (6) 1995 IMF WEO estimates. Col. (4) estimates of gamma are described in Append. III. Col. (7) debt values are computed on the basis of Eq. (4’) in the text. Some data for Luxembourg are unavailable. Col. (8) is the difference between the values in Col. (7) and Col. (6). In Col. (9) + + means satisfactory, + means adequate, - means inadequate, and—means unsatisfactory.

^2/May not be consistent with the definition agreed at Maastricht. It includes all financial liabilities as defined by the System of National Accounts.

^3/Outcome based upon the latest primary balance in Col. (5), the level of public indebtedness in Col. (6), and the fiscal gap in Col. (8)

^4/In 1995 economic growth was exceptionally high. Therefore 1991–1995 averages have been used in Columns (2), (3), (5), and (6). despite the very low fiscal gap in Col. (8) and the poor outcome in Col. (9), the fiscal situation has rapidly improved in recent years due to a decline in budget deficit and debt.

^5/Despite the worsening of the budget deficit in recent years, the debt-to-GDP ratio is still among the lowest in the EU. Therefore, the U.K. doesn’t face an immediate fiscal sustainability problem.

Proof of the contradiction. First, (1’”) is forward integrated between time 0 (that is the initial time period of this exercise) and infinity, and is discounted by $e^{-(r-\mu )t}\mathrm{.}$ Second, the outcome is integrated by parts and solved. Third, one of the remaining terms is eliminated by applying the solvency condition. After some further simplifications the following intertemporal budget constraint is obtained, ^15/

Fourth, solving (2) with the equality sign yields $p{s}_t^i=(p{s}_0^i-{\overline{ps}}^i)e^{-\gamma t}+{\overline{ps}}^i,$ where $p{s}_0^i$ is an initial value of the primary surplus (or deficit if negative) and ${\overline{ps}}^i$ is the maximum primary surplus that a country can achieve. Fifth, substituting this solution into the intertemporal budget constraint, yields the following discounted stream of future primary surpluses:

Sixth, given some initial assumptions concerning the values of ${\overline{ps}}^i,p{s}_0^i,\gamma ,$ and $r^i-{\mu }^i,$ (4) can be further simplified as follows:

This new expression describes Blanchard’s (1984) stable arm in Figure 5, given the four conditions above. It divides the (ps_t, b_t) space into two regions. If (2) is now taken with the inequality sign, the region to the right of (4’) is the fiscally unsustainable region.

Therefore, to secure fiscal sustainability, any country should always be on the Blanchard’s stable arm (4’) or to its left. Hence, given ${\overline{ps}}^i,{ps}_0^i,\gamma ,$ and $r^i-{\mu }^i$ the current level of indebtedness $b_0^i$ must not exceed ${\tilde{b}}_0^i,$, and the following inequality should be satisfied for the debt to remain sustainable:

However, when a national government finds itself at a point such as point F on Figure 5, the level $b_0^i$ of the debt will be greater than the level ${\overline{b}}_0^i$ which satisfies (4’’). But, $b_0^i$ cannot at the same time exceed ${\overline{b}}_0^i$ (from the fourth condition listed above) and be smaller than ${\overline{b}}_0^i$ in order to satisfy (4’’). Similarly, (4’’) cannot be satisfied by all the combinations of deficit and debt in the area to the right of the Blanchard’s (1984) stable arm in Figure 5. Therefore, one of the four conditions above has been violated and the most likely culprit is the solvency condition.

Therefore, if the economy is at a point such as point F in Figure 5 or any other point to the right of the Blanchard’s stable arm, at some point in time the economy will need to undertake a shift in fiscal policy, toward the Blanchard’s stable arm and prevent the public debt from growing without bound. For example, it could adjust along the dotted path starting at point F, which would entail a decline in both the deficit and the debt.

1. Some empirical findings and the index of fiscal sustainability

When the time path of primary surpluses and the debt-to-GDP ratios are plotted together from 1970 to 1994 (as shown in Figure 6) it is apparent that most EU members have increased their primary surpluses over time. ^16/ For simplicity and ease of comparison, the data are grouped for the periods 1970–79, 1980–89, and 1990–94 whenever available. In the upper chart, the fiscal efforts to raise primary surpluses by Ireland, Belgium, Denmark, and Italy are clearly discernible. Also, Greece, Spain, Portugal, and the Netherlands, shown in the lower chart, display a marked improvement of their primary surpluses. In all these countries these fiscal efforts succeeded in slowing down the growth of debt.

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European Union: The Time Path of Primary Surplus and Debt ^1/

Citation: IMF Working Papers 1996, 072; 10.5089/9781451849295.001.A001

^1/ Observations indicate average values for 1970–79, 1980–89 and 1990–94 respectively, whenever data is available.2/ The schedules Al, A2, and A3 are illustrative samples of “fiscal sustainability frontiers”. A more accurate measurement of the relative fiscal sustainability across the E.U. is in Table 3.

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How close to its “indicative” country specific fiscal sustainability frontier is each EU member at present time? Equation (4’) yields an estimate of the indicative stock of public debt ${\tilde{b}}_0^i$. The gap between ${\tilde{b}}_0^i$ and the current public debt $b_0^i$, provides a measure of the proximity of each EU member to its country specific fiscal sustainability frontier. This indicator of fiscal sustainability is based on two main elements. The first element is the effort of each national government to increase the primary surplus. This effort represents the speed of adjustment of the current primary balance, and is measured by the coefficient γ in column (4) in Table 3. The method of estimation of the EU members’ γ coefficients between 1970 and 1994 are detailed in Appendix III. The second element is the magnitude of the maximum primary surpluses $\overline{ps}$ in column (1). These values of $\overline{ps}$ are based upon the recent trends of EU primary surpluses. ^17/

The rest of the assumptions in Table 3 are as follows. Column (2) contains the 1995 real interest rates. ^18/ Column (3) contains the latest IMF World Economic Outlook estimates of the 1995 real rate of growth of the economy. The current primary balance ps_t is in Column (5). Column (6) contains the latest IMF World Economic Outlook estimates of the gross public debt stock at end 1995 (OECD estimates of net indebtedness are used in Table IV.1 in the appendix). The debt values in Column (7) are the “sustainable public debts.” These debt values are computed on the basis of Equation (4’). Column (8) calculates the gap between the sustainable debt in Column (7) and the current debt in Column (6). It is this gap which provides the estimate of the proximity to the fiscal sustainability frontier. A sustainability problem, and the consequent need for a “policy shift,” would be revealed by a negative or a small value in this column.

Given the relative fiscal positions in Tables 1 and 2, the recent fiscal performance and the efforts to improve the primary balance in Figures 1 and 6, and the estimates of the proximity to the fiscal sustainability frontier in Table 3, the EU members can be classified in three groups. Table 4 summarizes these preliminary findings, while Figure 7 illustrates them. ^19/

Table 4.

The Main Findings of the Paper ^1/

^1/++ means very adequate, + means adequate, - means slightly inadequate,—means very inadequate. This ranking of the EU members reflects: (1) the data on budget deficit and public debt in Table 1; (2) the relative fiscal position of the EU members in 1995 in Table 2; (3) the ranking of EU members according to the findings summarized in Table 3; and (4) the evolution of primary balances shown in Figure 6.

^2/Indicates whether an effort is under way to reduce the budget deficit and improve the primary balance in order to stem the growth of the debt-to-GDP ratio.

^3/A lower “rating” indicates that a “policy shift” is more urgent to continue to secure fiscal sustainability.

^4/Ireland is in this group due to its recent progress in reducing its budget deficit and the level of indebtedness. Portugal is in this group due to its reatively low level of indebtedness and its significant effort to reduce the budget deficit.

Table 4.

The Main Findings of the Paper ^1/

	Deficit/GDP	Debt/GDP	Effort to Improve primary balance in recent years 2/	Proximity to Fiscal Sustain. Frontier 3/
Group 1: Countries that do not have a fiscal sustainability problem
France	-	+ +	-	+ +
Germany	++	+	+/-	+ +
Luxembourg	+ +	+ +	+ +	+ +
United Kingdom	-	+ +	+/-	+ +
Group 2: Countries that do not have an immediate fiscal sustainability problem, 4/
Denmark	+ +	-	+/-	-
Ireland	+ +	-	+ +	+/-
Netherlands	+/-	-	+ +	+
Portugal	-	+/-	+ +	-
Spain	—	+/-	+/-	+
Group 3: Countries that need a fiscal adjustment
Belgium	-	—	+ +	—
Greece	—	—	+/-	—
Italy	—	—	+	—

^1/++ means very adequate, + means adequate, - means slightly inadequate,—means very inadequate. This ranking of the EU members reflects: (1) the data on budget deficit and public debt in Table 1; (2) the relative fiscal position of the EU members in 1995 in Table 2; (3) the ranking of EU members according to the findings summarized in Table 3; and (4) the evolution of primary balances shown in Figure 6.

^2/Indicates whether an effort is under way to reduce the budget deficit and improve the primary balance in order to stem the growth of the debt-to-GDP ratio.

^3/A lower “rating” indicates that a “policy shift” is more urgent to continue to secure fiscal sustainability.

^4/Ireland is in this group due to its recent progress in reducing its budget deficit and the level of indebtedness. Portugal is in this group due to its reatively low level of indebtedness and its significant effort to reduce the budget deficit.

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Table 4.

The Main Findings of the Paper ^1/

	Deficit/GDP	Debt/GDP	Effort to Improve primary balance in recent years 2/	Proximity to Fiscal Sustain. Frontier 3/
Group 1: Countries that do not have a fiscal sustainability problem
France	-	+ +	-	+ +
Germany	++	+	+/-	+ +
Luxembourg	+ +	+ +	+ +	+ +
United Kingdom	-	+ +	+/-	+ +
Group 2: Countries that do not have an immediate fiscal sustainability problem, 4/
Denmark	+ +	-	+/-	-
Ireland	+ +	-	+ +	+/-
Netherlands	+/-	-	+ +	+
Portugal	-	+/-	+ +	-
Spain	—	+/-	+/-	+
Group 3: Countries that need a fiscal adjustment
Belgium	-	—	+ +	—
Greece	—	—	+/-	—
Italy	—	—	+	—

^1/++ means very adequate, + means adequate, - means slightly inadequate,—means very inadequate. This ranking of the EU members reflects: (1) the data on budget deficit and public debt in Table 1; (2) the relative fiscal position of the EU members in 1995 in Table 2; (3) the ranking of EU members according to the findings summarized in Table 3; and (4) the evolution of primary balances shown in Figure 6.

^2/Indicates whether an effort is under way to reduce the budget deficit and improve the primary balance in order to stem the growth of the debt-to-GDP ratio.

^3/A lower “rating” indicates that a “policy shift” is more urgent to continue to secure fiscal sustainability.

^4/Ireland is in this group due to its recent progress in reducing its budget deficit and the level of indebtedness. Portugal is in this group due to its reatively low level of indebtedness and its significant effort to reduce the budget deficit.