Households

Two-period lived consumers maximize utility over consumption and leisure when young subject to a budget constraint. Specifically, they

where c^t_t is consumption by generation t when young, c_t+1^t is consumption by generation t when old, l_t is leisure, z_t is the savings of the young, p_t is the price of the consumption good, R_t is the return on savings, and π_t is the profit received by the young from their ownership of the firm. Since wages are the numeraire and consumers have an endowment of w_t units of labor when young, then w_t - l_t is total labor income. Both labor income and profits are subject to a uniform income tax at a rate of t_t.

Assuming a simple Cobb-Douglas utility function, consumption by the young is given simply as a constant fraction of total after-tax potential income

Aggregate consumption in period t, assuming for simplicity zero population growth, is given by

Government

Government is subject to the usual flow budget constraint

where B_t is the stock of government debt and G_t and T_t are noninterest spending and tax revenue respectively. This flow budget constraint could, of course, be solved forward and a no-Ponzi game restriction applied to yield the usual intertemporal budget constraint. However, this has little impact on the results of the model and so is omitted here. From examination of the individual’s budget constraint, total taxes can be written as

Firms

There are N firms producing a single good under imperfect competition and facing a unit- elastic demand function and a cost function composed of both fixed costs (f_i) and marginal costs (m). Since the firms play an oligopoly game, they price goods at some margin over marginal cost given by

with 0 ≤ μ ≤ 1. As a result, total profits for each firm i are given as

where q_i,t is production by firm i. Aggregating across firms and recognizing that $p_t{\displaystyle \sum _{i=1}^N{q}_{i,t}=Y_t,}$ yields an expression for total profit

where $F={\displaystyle \sum _{i=1}^N{f}_i}$ is total fixed costs incurred by all firms.

Goods market clearing

Substituting (3) and (8) into the usual national income yields

It should be clear from (9) that it is the assumption of imperfect competition which drives the Keynesian properties of the model presented here (and allows for fiscal policy to effect aggregate demand with a multiplier). An expansionary change in the fiscal position increases aggregate expenditure which, in turn, raises firm profits (since π_t - μY_t – F). However, since firm profits comprise part of the individual’s budget constraint, the fiscal expansion has second-round effects by increasing private consumption and further increasing aggregate expenditure (and thus yields a multiplier effect). As Blanchard and Kiyotaki (1987) point out, the introduction of imperfect competition creates an aggregate demand externality whereby the economy is stuck at an inefficient equilibrium and activist demand management can be used to push the economy to an equilibrium with higher demand, higher profits, and higher aggregate consumption.

Demand stimulus provided by the fiscal position

Taking total differentials of (9), the impact of the fiscal position on aggregate demand is given by

That is, the demand impact is given by the change in expenditure and tax revenues weighted by their respective multipliers. If the marginal propensity consume is high (i.e., ø ≈ 1), the change in the overall balance (G-T) will be proportional (but not equal) to the fiscal demand stimulus.

Structural component of the fiscal position

Assume that government spending and taxation are given by

with primary spending and tax revenues made up of a “structural” component (given by their levels that would be generated if the economy were operating at full employment $Y_t^{*}$), and a cyclical component (reflecting the current position of the economy relative to full employment). The structural component of changes in the fiscal position can be written as

Table 1 provides three commonly used indicators of the structural component of the fiscal position (see Banca d’ltalia, 1999; Chand, 1993; Heller and others, 1986; and Roger and Ongena, 1999). It should be noted, however, that these indicators are not perfect representations of the structural part of the fiscal position and have a number of well-known weaknesses. First, the indicators adjust revenues solely for movements in GDP despite the fact that important tax bases (e.g., consumption and wages), while cyclical, may be poorly correlated with GDP movements. Second, the various methodologies capture the effect of the cycle in a linear way; as such they are unable to pick up nonlinear aspects of a downturn (as would be seen in corporate income taxes for example). Third, the elasticities used to calculate the structural balance are not derived from empirical relationships but instead are a product of marginal and average tax rates estimated from a country’s tax code applied to a simulation exercise using the OECD’s interlink model.³ Finally, the structural balance only adjusts for the effect of the cycle on unemployment-benefit spending, whereas there are clearly other cyclically sensitive components of government spending (such as social welfare payments), which are not adjusted.

Table 1.

Alternative Indicators of the Structural Component of the Fiscal Position

Where Y* and Y are potential and actual output, $\overline{Y}$ is trend output (a moving average of the actual output over the cycle), UB is the level of unemployment benefits, U* and U are the natural and actual rate of unemployment, ε and εlag are elasticities, t₀ is the revenue-output ratio and g₀ is spending to potential output in some base year, and V is the elasticity of changes in unemployment benefits to changes in output.

Table 1.

Alternative Indicators of the Structural Component of the Fiscal Position

Indicator	Interpretation	Formula
Structural balance	What would be the fiscal position if the economy were at potential output?	$T\times (\frac{Y^{*}}{Y})\times {(\frac{Y_{-1}^{*}}{Y_{-1}})}^{\epsilon lag}-(G+UB\times (\frac{U^{*}-U}{U}))$
Fiscal stance	How does the current fiscal position relate to the fiscal position at a point in the past, when the economy was at potential output?	$(t_0\times Y-T)-(g_0\times Y^{*}-G)$
Cyclically adjusted balance	What would be the fiscal position if the economy were at the mid-point in the cycle?	$T\times (1-\epsilon (\frac{Y-\overline{Y}}{Y})-\epsilon lag(\frac{Y_{-1}-\overline{Y_{-1}}}{Y_{-1}}))-(G-v(\frac{Y-\overline{Y}}{Y}))$

Where Y* and Y are potential and actual output, $\overline{Y}$ is trend output (a moving average of the actual output over the cycle), UB is the level of unemployment benefits, U* and U are the natural and actual rate of unemployment, ε and εlag are elasticities, t₀ is the revenue-output ratio and g₀ is spending to potential output in some base year, and V is the elasticity of changes in unemployment benefits to changes in output.

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Table 1.

Alternative Indicators of the Structural Component of the Fiscal Position

Indicator	Interpretation	Formula
Structural balance	What would be the fiscal position if the economy were at potential output?	$T\times (\frac{Y^{*}}{Y})\times {(\frac{Y_{-1}^{*}}{Y_{-1}})}^{\epsilon lag}-(G+UB\times (\frac{U^{*}-U}{U}))$
Fiscal stance	How does the current fiscal position relate to the fiscal position at a point in the past, when the economy was at potential output?	$(t_0\times Y-T)-(g_0\times Y^{*}-G)$
Cyclically adjusted balance	What would be the fiscal position if the economy were at the mid-point in the cycle?	$T\times (1-\epsilon (\frac{Y-\overline{Y}}{Y})-\epsilon lag(\frac{Y_{-1}-\overline{Y_{-1}}}{Y_{-1}}))-(G-v(\frac{Y-\overline{Y}}{Y}))$

Where Y* and Y are potential and actual output, $\overline{Y}$ is trend output (a moving average of the actual output over the cycle), UB is the level of unemployment benefits, U* and U are the natural and actual rate of unemployment, ε and εlag are elasticities, t₀ is the revenue-output ratio and g₀ is spending to potential output in some base year, and V is the elasticity of changes in unemployment benefits to changes in output.

How does the structural component of the change in the fiscal position relate to the demand effect of fiscal policy given by (10)? From (10) and (13), the difference between the demand effect and the change in the structural component is

It is clear that the two are equal if and only if øμ(1-t) = γ - τ = 1, which will never be true since øμ(1-t) < 1. Therefore, using the change in the structural balance as a proxy for the fiscal demand stimulus can either over- or underestimate the demand stimulus and may even predict its direction incorrectly (depending on the combination of parameters).

Discretionary policy component of the fiscal position

Assume that the structural component of primary spending and taxation is made up of two parts: that which is determined by policy and that which is due to changes in exogenous factors—such as oil prices, inflation, or exchange rates⁴—which are not related to the output gap.

where σ_t and θ_t are exogenous shocks and G^p $(Y_t^{*})$ and T^p $(Y_t^{*})$ are spending and tax policies at full employment. The discretionary policy component of the fiscal position is therefore given by

It is clear that, by definition, the change in the primary structural balance will be a good approximation of the change in discretionary fiscal policy only if the exogenous factors that affect the fiscal position are relatively unimportant (i.e., dσ and dθ ≈ 0) and the structural indicator appropriately removes the cyclical component from the fiscal aggregates.

Does the change in the primary structural balance provide a better indicator of discretionary fiscal policy than the change in the primary balance?

The change in the primary structural balance, and both quantitative and qualitative indicators of the change in discretionary policy, are shown in Figure 1.⁶ Overall, the change in the primary structural balance does a mixed job in tracking policy changes during the 1990s. It does not appear to capture well the neutral stance of 1991–92, and it underestimates the scale of expansionary policy in various years (even taking into account possible lags in the execution of the stimulus packages).⁷

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Japan: Cluinge in Primary Structural Balance and Size of Supplementary Budgets

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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On the tax side, the government did little in terms of a policy response to the worsening economic conditions prior to 1994 (when a 20 percent reduction in the personal income tax was announced). The next major change in tax policy did not occur until 1997 when, in April, the government increased the consumption tax by 2 percentage points. Following these attempts at consolidation, economic conditions worsened and the government switched to an expansionary stance with tax stimulus packages announced in April 1998 (providing direct rebates to income taxpayers) and in November 1998 (involving cuts to personal and corporate income tax). Figure 2 graphs the estimated size of these various tax measures, along with the calculated change in structural revenues; there appears to be little relation between the two. In the early 1990s, structural revenues declined despite the absence of tax measures, suggesting that the structural revenue indicator fails to adjust fully for the impact of the cyclical downturn during this period or that other exogenous factors (such as the exchange rate or inflation) were simultaneously weakening revenues. Similarly, an expected large increase in structural revenues in 1997, given the increase in the consumption tax, does not show up in the data.⁸

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Japan: Change in Primary Structural Revenue and the Size of Tax Policy Changes

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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On the expenditure side there was a long list of spending measures introduced throughout the 1990s, largely reflecting the government’s efforts to stimulate the economy with higher public works spending. With regard to the change in structural spending in Figure 3, there appears to be a closer relationship between the direction of structural primary spending and the qualitative evidence on the timing of the expenditure packages, although there are still some anomalies.⁹ However, changes in structural spending are quite far from approximating the size of the policy changes contained in the supplementary budgets.¹⁰ For example, from December 1992 to December 1993, a total of 3Vi percent of GDP in new spending (predominantly new public investment) was authorized in supplementary budgets but the structural stimulus implied in that year shows a change of only around 1 percent of GDP (followed by a withdrawal of stimulus in 1994).

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Japan: Change In Primary Structural Expendilllre and Size of Supplementary Budget Spending

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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How should these findings be interpreted? First, it appears that the measured structural balance in Japan is not orthogonal to the cycle, indicating an underestimation of the cyclical component of the fiscal balance. Second, while approximating changes in policy direction during some years, the structural balance seems to do poorly at estimating the magnitude of policy changes.

If the primary structural balance is of little use in estimating the size of discretionary policy changes, does it at least provide a clearer picture than the primary balance? As Figure 4 shows, there is little to choose between the primary balance and the structural primary balance as an indicator of policy change. Neither the change in the primary structural balance nor the change in the primary balance appears to be an accurate representation of discretionary policy changes. There are two notable episodes where the two indicators differ. First, in 1998 the primary structural balance appears to miss the increased stimulus being provided through the supplementary budgets while the primary balance at least partially picks this up. Second, in 1996 the primary balance underestimates, relative to the primary structural balance, the spillover from the August 1995 supplementary budget.

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Japan: Change in the Primary Structural Balance, Primary Balance and the Size of Supplementary Budgetes

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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Does the Change in Structural balance provide a useful indicator of the demand stimulus arising from changes in the fiscal position?

The demand stimulus, as measured by the weighted change in the fiscal position, is shown in Figure 5 along with the structural balance.¹¹ It seems that the structural balance and demand impact indicators correspond closely (which is not surprising since much of the demand stimulus was provided by spending changes which have a multiplier close to one). In 1991, the impact on aggregate demand indicator suggests a withdrawal of stimulus while the change in the structural balance would imply no demand stimulus.¹² In 1993,1995, and 1999, the change in the structural balance seems to overestimate the size of the demand stimulus; during these years, a large part of the stimulus was provided either by a fall in revenues or by shifts in spending to low multiplier categories (which the structural balance implicitly weights the same as changes in spending).

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Japan: Change in Strnctural. Balances and Impact of fiscal on AggregateDemand

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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Summary of findings from the Japan case study

Some broad conclusions can be drawn from the examination of the experience in Japan during the 1990s:

• Structural indicators of fiscal aggregates do a poor job of quantifying the scale of discretionary changes in fiscal policy;

• The primary balance and primary structural balance provide equally poor descriptions of changes in fiscal policy;

• There is some evidence that the structural representations of fiscal aggregates do not fully control for the endogenous effect of the cycle on the fiscal position; and

• The structural balance gives a reasonable estimate of the demand impact of fiscal policy, but is unable to capture the demand effects of compositional changes in the fiscal position (since the structural measure implicitly weighs all components of fiscal changes equally).

Does the change in the primary structural balance provide a better indicator of discretionary fiscal policy than the change in the primary balance?

The change in the primary structural balance and the measured change in policy are shown in Figure 6.¹³ As can be seen from Figure 6, while capturing the sizeable policy expansion in 1990 and the corresponding withdrawal of stimulus from 1992–94, the change in the primary structural balance poorly captures the tightening of policy in 1995,¹⁴ and also seems to underestimate the policy effort that was put in place in the run-up to EMU (both of which seem clear from the quantitative and qualitative evidence).

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Germany: Change in the Primary Structural Balance and Size of Policy Changes

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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Examining the structural revenue and spending components separately provides an even more mixed picture. The change in structural revenues seems to go in exactly the opposite direction of policy changes in 1993 (when the VAT was increased to replace the expiring solidarity surcharge) and in 1995 (when the solidarity surcharge was reimposed) (see Figure 7). Similarly, the structural revenue picture would suggest a withdrawal of stimulus in 1999 although the tax changes during that year were likely revenue neutral (or if anything, slightly expansionary with the reduction in the personal income tax burden). Throughout the period the change in structural revenues seems to be a poor guide of the size of the tax policy changes.

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Germany: Change in Primary Stuctural Revenue and the Size of Tax Policy Changes

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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The structural spending picture suggests continual expenditure restraint following the 1990-91 spending on reunification, which is in line with both the qualitative and quantitative evidence during this period (see Figure 8). Overall, the structural spending indicator appears to be a reasonable proxy for the direction of expenditure policy changes during the period but, as in Japan, it is a poor guide to the size of such policy changes. This is particularly true for 1997, where the structural spending indicator seems to underestimate the large effort made that year to achieve the Maastricht conditions.

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Germany: Change in the Primary Stuctural Expenditures and the Size of Expenditure Policy Changes.

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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Given that the primary structural balance is a poor representation of policy changes in Germany, does it at least provide a clearer picture of policy change than the primary balance? Figure 9 shows the primary and structural primary balance together. The primary and structural primary balances seem to offer a similar picture of the direction of policy except in two years—1993 and 1996—where growth took a sharp downturn. In 1993 the structural balance provides a more reliable indicator of policy direction, while for 1996 there is little to choose between the two indicators. There appears, therefore, to be some evidence to favor the structural balance as an indicator of policy change in Germany—where automatic stabilizers are stronger—than in Japan. However, the fact remains that neither the structural primary nor primary balance provides a good indicator of the size of policy adjustments.¹⁵

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Germany: Change in the Primary Structural Balance, Primary Balance and Change in Policy.

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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Does the change in the structural balance provide a useful indicator of the demand stimulus arising from changes in the fiscal position?

Figure 10 shows the relation between the weighted budget balance and the structural balance. As is clear from the figure, the change in the structural balance appears to be a poor indicator of the level of demand stimulus. In 1992, 1993, and 1996 the structural balance incorrectly predicts the direction of the demand stimulus. For example, in 1992, while policy measures, primarily on the revenue side, reduced the deficit, the structural balance was unable to pick up the fact that the revenue consolidation was outweighed by both an increase in total spending and a shift of spending from low to high multiplier components. In 1993 and 1996, on the other hand, the structural indicator (adjusting for the cyclical downturn at the time) indicates a withdrawal of stimulus even though the deficit in these years rose (mostly due to higher unemployment spending). Overall, the structural balance in Germany is a deceptive indicator of the size of economic stimulus being provided by the fiscal position. In a downturn the structural indicator can indicate a reduction in stimulus despite an increase in the overall balance (e.g., if the government is pursuing procyclical fiscal policies that work against the automatic stabilizers). Similarly, where there are sizeable compositional changes in fiscal policy (e.g., from low to high multiplier components) the structural balance provides misleading information on the size and even the direction of fiscal stimulus.

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Germany: Change in Primary Structural Balance and Impact of Fiscal on Aggregate Demand

Citation: IMF Working Papers 2002, 101; 10.5089/9781451852523.001.A001

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Summary of findings from the Germany case study

The preceding discussion of the conduct of fiscal policy in Germany during the past 10 years leads to some general conclusions:

• The structural indicators of fiscal aggregates, particularly structural revenue, are imperfect descriptors of the size of discretionary policy changes in Germany.

• Unlike Japan, structural indicators are preferable as indicators of policy direction.

• The change in the structural balance is a misleading indicator of the demand impact of fiscal policy in Germany.