Stylized Facts of Government Finance in the G-7
Author: Mr. Riccardo Fiorito1
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Contributor Notes

Author’s E-Mail Address: rfiorito@iol.it
Publication Date:
01 Oct 1997
eISBN:
9781451927573
ISBN:
9781451927573
Language:
English
Keywords:
WP; business cycle; indirect tax; General government variable; government balance; period government consumption; Italy's result; expenditure trend; Germany's pattern; UK government consumption
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The stylized facts of government finance in the Group of Seven (G-7) industrial countries show that revenues lag real GDP procyclically, while government spending in most cases fails to lead the economy procyclically. This finding is not confined to transfers but also applies to the wage component of government consumption as well as, in most cases, to government fixed investment. Government deficits are always countercyclical but there is little evidence that stabilization is equally successful in stimulating the economy before shocks materialize.

Abstract

The stylized facts of government finance in the Group of Seven (G-7) industrial countries show that revenues lag real GDP procyclically, while government spending in most cases fails to lead the economy procyclically. This finding is not confined to transfers but also applies to the wage component of government consumption as well as, in most cases, to government fixed investment. Government deficits are always countercyclical but there is little evidence that stabilization is equally successful in stimulating the economy before shocks materialize.

I. Introduction

Since the 1970s government expenditure and tax to GDP ratios have steadily risen in the G-7 instead of fluctuating around some constant value as implied either by fine tuning or tax smoothing. Expenditure components shifted in most cases from purchases to transfers and interest payments as a result of the extension of the welfare state in the 1970s and of the debt financing of budgetary deficits afterwards. Comparative data for unemployment are not better in those countries or areas where government size increased most (Table 2).

The corrections introduced in the last decade to manage government debt or to satisfy in Europe the common currency requirements reflected an attitude of fiscal and monetary discipline but generally ignored the composition of the government balance and its impact on the business cycle and growth. This paper abstains from growth considerations (Barro-Sala-I-Martin, 1992; Easterly-Rebelo, 1993) and focuses on the business cycle only by raising, in particular, two questions:

- how do fiscal variables respond to business cycles?

- how do discretionary fiscal variables affect business cycles?

Given the possibility that fiscal policies and budgetary institutions differ from country to country (von Hagen-Harden, 1994), only a comparative analysis can separate facts that are common to all countries from facts mainly reflecting local environments or shocks. Here, I shall try to analyze in a systematic and uniform way the cyclical properties of public finance data in the G-7. To do so I shall use quarterly and detrended OECD General Government data that are consistent with NIPA definitions. Further, I shall utilize data that are disaggregated as much as possible to evaluate whether differences in expenditure or tax composition matter for macroeconomic performance (Alesina-Perotti, 1995,1996).

Fiscal policies can admittedly affect or reflect business cycles. A possible way of addressing this issue is trying to separate discretionary from cyclically induced fiscal policies by choosing among existing measures of fiscal stance or by devising new ones (Blanchard, 1993). Alesina and Perotti (1995) suggest using cyclically adjusted primary balances to pick similar episodes from all countries rather than evaluating the whole fiscal history in each country. Yet, episodes are difficult to select and - unless they denote regimes lasting for long time - are by definition too few to provide a sufficient number of data points. Hence, in a regression context this inevitably leads to using unbalanced panel data samples and highly subjective criteria for inclusion.

The episode literature (Alesina-Perotti, 1995,1996; IMF, 1995; OECD, 1996d; McDermott-Wescott, 1996) led to important insights on the changing role of fiscal policy depending on the size of the debt or the persistence of the stabilization program (Giavazzi-Pagano, 1990, 1996). Yet, I believe that a systematic knowledge of normal government finance at business cycle frequencies is a necessary preliminary unless one is looking for exceptions before recognizing what the standards are. The assumption is that the stylized facts methodology (Kydland and Prescott, 1990) can provide the benchmark information that is still missing for a systematic analysis of fiscal policies at cyclical frequencies.

In the stylized facts approach cyclical components are defined as deviations from a stochastic trend corresponding to the steady-state growth component. Contrary to Koopmans’ criticism of the NBER approach, Kydland and Prescott assume that business cycle facts can be established without specifying a structural model. Theory is important in selecting the facts and in producing models that are consistent with them. Empirically, the stylized fact approach combines Lucas’ (1977) theoretical definition of the business cycle with the Hodrick-Prescott (1980) filter that is used for extracting an unobserved growth component: hence, the amplitude and comovements of cycles are investigated by comparing volatility measures and the size of cross correlations between relevant macroeconomic variables and aggregate output at different leads and lags.2

The stylized facts approach can help in discriminating between automatic and discretionary fiscal policies: by analyzing the past, present and future comovements between any fiscal variable and real GDP, it is possible to assess which variables follow (built-in stabilizers) and which variables lead real GDP as discretionary interventions should.

An oversimplified scheme to interpret government behavior over the business cycle is represented in the following Table 1 where rows define procyclical (+) or countercyclical (−) comovements while columns define the leading or lagging phase with respect to real GDP.

Table 1.

Government Comovements with Real GDP

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Table 2.

Government Expenditures, Receipts and Balances (in percent of GDP) 1/

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Notes:

“Prim.” = Primary; “Dir” = Direct; “Ind.” = Indirect; “URATE” = Unemployment Rate; “RRATE” = Real Interest Rate, measured as the long-run yield on government bonds minus realized inflation (GDP deflator) one-year ahead.

A second advantage of the stylized facts methodology is that it can make operational the theoretical distinction between temporary and non-temporary effects of fiscal policy (Barro, 1981, 1989) without using the classical war/peace distinction that cannot be utilized for the postwar data of most G-7 countries.

The data sources utilized here are seasonally adjusted quarterly OECD data for the G-7 countries from 1970 to 1995. The chosen variables pertain to General Government level that consists of central and local government units together with social security funds (United Nations et al., 1993). The relevant variables are disaggregated receipts and disbursements such as direct taxes (business and household), indirect taxes, social security revenues on one side and government consumption (wage, nonwage), subsidies, transfers, interest spending and gross fixed investment on the other. All variables are cyclical deviations from a growth component obtained by applying the HP filter to quarterly General Government variables expressed in real terms. Details are available in the Data Appendix.

The plan of this paper is the following: in Section 2 I shall briefly describe major revenue and expenditure trends calculated as ratios to GDP. In Section 3 I shall explain the stylized fact methodology used in this paper. In Section 4 I shall report the univariate properties of each variable to assess differences in persistence and volatility. Comovements between government variables and real GDP are investigated in Section 5. Section 6 considers comovements between real GDP cycles and major General Government receipts as shares of GDP. These comovements approximate correlations between tax rates and the level of activity. In Section 7 I evaluate whether some revenues are mostly related to some specific outlay and whether some expenditures are a substitute or a complement for others. Section 8 concludes.

II. Recent Trends

Analyzing the business cycle stylized facts by construction leaves out of consideration the pertinent growth component. In our case this could imply a presumption that the size of government in each country is unimportant for evaluating the impact of fiscal policies. To avoid this interpretation and also to show how rapidly government size increased in the G-7, I shall briefly review the recent trends in public expenditure and taxation. For convenience, I shall divide the full sample into the following subperiods:

1970-75: labor and oil shocks

1976-80: responses to the oil shocks

1981-85: high interest rates

1986-90: high debt

1991-95: fiscal consolidation.

It is obvious that different labels can be used. What is important is to note that the same subperiod often includes both phases of recession and expansion so that average data are relatively independent of business cycles.

In the early 1970s the size of government, measured as the sum of total receipts and government outlays, ranged from about 40% (Japan) to about 80% of nominal GDP (Germany, France, UK). The oil shock was increasing government size (Roubini-Sachs, 1989) partly because of the cyclical government spending and partly because Keynesian stabilization policies were often adopted to face the largest supply shock occurring to the OECD economies.

In the 1991-95 period the government size reaches around 100% of nominal GPD in France, Italy and Germany and around 90% in Canada. The most spectacular increases occurred in Italy (36% points) and in France (23% points) though government size rose also outside of Europe: by about 20% points in Canada and in Japan so that Japan eventually reached the same government size as the US. The US and especially the UK are the only countries showing a small or a negligible government size increase.

Looking at the expenditure side, we recognize from Table 2 the same tendencies, i.e. that expenditure is increasing most in Italy and France, then in Canada and Japan. Again, this trend is smaller for Germany and negligible for the US and the UK. The revenue ratios soared following about the same ranking: Italy is the extreme case, then followed by Japan, France and Canada. The increases are smaller elsewhere and are generally concentrated in the last period. This is especially true for Germany which faced an abrupt unification shock after a decade of sound fiscal policy.

Changes in the composition of expenditures show (Table 5) that government consumption falls everywhere but in the UK. Yet G-7 countries differ in the relative weights given to wage (W) and nonwage (NW) government consumption (Table 3). Wage components are about 3/4 of total consumption for Japan, France and Italy though this figure tends to decline in Japan. In the US and in Canada the wage component is about 2/3 of total consumption while Germany and the UK are characterized by a larger portion of purchases which is stable for Germany and somewhat increasing for the UK.

Table 3.

Government Consumption: Employment and Wage Shares 1/

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Notes:

N = government employment as a percentage of total employment; W = wage component as a percentage of government consumption; Japan: 1991-94.

Table 4.

Components (%) of Total Receipts 1/

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Notes:

T = Total; B = Business; H = Households.

Table 5.

Components (%) of General Government Expenditure 1/

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Notes:

W = Wage Component; NW = Nonwage Component. Consumption components for the UK are available until 1994; Subs = Subsidies; SocSec = Social Security; Intst = Interest Payments; Inv = Gross Fixed Investment. Debt is obtained from OECD, Economic Outlook, various issues. The debt series (gross financial liabilities) for Italy and the UK have a break: in both cases I used the old series for the 1991-95 period.

Table 6.

Phases and Strength of Comovements

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Table 7.

Univariate Properties of Cyclical Components 1/

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Notes:

ρ(k) = autocorrelation at lag k; Ku = Kurtosis; Vol = Volatility (standard deviation of the cyclical component * 100).

Since net government lending (NLG) and primary balances (pnlg = NLG + YPEPG) contain negative values, I applied the HP filter to the log of the ratio between total revenues and total (primary) expenditures.

Table 8.

Comovements – Receipts Cross Correlations of Real GDP with Real Xt±j

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