The Fiscal Smile
The Effectiveness and Limits of Fiscal Stabilizers
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund
  • | 2 https://isni.org/isni/0000000404811396, International Monetary Fund

We study the smoothing impact of fiscal stabilizers (proxied by government expenditures or revenues) on business cycle volatility for a panel of EU countries in the period 1970-99. The results show that the business cycle volatility smoothing effect of fiscal stabilizers may revert at high levels. We present evidence that for government expenditure ratios exceeding an estimated value of about 38 percent, a further expansion in the size of the government could actually lead to an increase in cyclical volatility. This may call for a reconsideration of the use of fiscal stabilizers for business cycle smoothing.

Abstract

We study the smoothing impact of fiscal stabilizers (proxied by government expenditures or revenues) on business cycle volatility for a panel of EU countries in the period 1970-99. The results show that the business cycle volatility smoothing effect of fiscal stabilizers may revert at high levels. We present evidence that for government expenditure ratios exceeding an estimated value of about 38 percent, a further expansion in the size of the government could actually lead to an increase in cyclical volatility. This may call for a reconsideration of the use of fiscal stabilizers for business cycle smoothing.

I. Introduction

Fiscal policy, according to a typical textbook definition has three broad functions: allocation, distribution, and stabilization. Allocation policies deal with those activities in which it is believed, on practical or theoretical grounds, that government may allocate resources more efficiently than markets. The distribution function involves a reallocation of resources on the assumption that the market operates but produces less desirable outcomes than socially acceptable. The most obvious method of redistribution is through the income taxation system and through varied rates of indirect taxation.

The third main goal of fiscal policy is the stabilization of business cycle fluctuations. The usual underlying argument is that output volatility has a negative impact on long-term growth.2 This assumption is inspired by several theoretical underpinnings: A first argument is related to skill losses due to temporary unemployment during recessions with negative consequences on productivity and long-term growth (Martin and Rogers, 1997). A second line of argumentation rests on the observation that growth is usually low in periods of political instability. Hence, an increase in political uncertainty as a consequence of high business cycle volatility may depress the prospects for medium-term growth (Alesina et al., 1992). Another argument refers to credit-market imperfections that may force firms to cut their expenditure on research and development during downswings as banks usually do not accept human capital as collateral (Stiglitz, 1994). The most common argument stresses the importance of uncertainty for investment: If investment decisions are irreversible, it may be rational for firms to postpone them in times of uncertainty. To the extent that high business cycle fluctuations increase the uncertainty about the future prospects of the economy, the theory predicts a negative relationship between cyclical volatility and long-run growth via lower investment (Dixit and Pindyck, 1994).3

The stabilization of business cycle fluctuations through fiscal policy measures can work through (at least) three different channels. The first channel refers to the most typical stabilization effect of fiscal policy: the role of automatic stabilizers. Theoretically, automatic stabilizers smooth economic activity through the automatic response via taxes and the transfer system: In recessions fewer (personal income and corporate) taxes are collected and more unemployment benefits are paid,4 which both support incomes. However, during a boom the increase in government revenues from taxes and the reduction of transfer payments counteracts the expansion in aggregate demand. These kinds of taxes and transfers react automatically to changes in the economic situation and can therefore be regarded as direct fiscal stabilizers.5

There is, however, a second, indirect stabilizing channel of fiscal policy which is related to government expenditures that remain fixed in size independent of the stage of the cycle. By not responding to the cyclical condition of the economy they indirectly have a stabilizing function, too. The third channel through which fiscal policy can – at least in principle – have a stabilizing effect on the business cycle is the use of discretionary fiscal policy measures. Even if there is some empirical evidence for a stabilizing effect of discretionary measures (see, e.g., Van den Noord, 2000), the majority of the papers point at a pro-cyclical bias of these measures and therefore a destabilizing effect, a view also taken by international institutions.

Of these three stabilizing effects the automatic stabilizers are certainly the ones that are most relevant for the current debate on the optimal role of fiscal policy. The discussion on the effectiveness of automatic stabilizers has become more intense since the start of the introduction of the Maastricht criteria and the Stability and Convergence Programs. The goal set out in the Stability Programs implied that countries should reach a budgetary position ‘close to balance or in surplus’ in order to be capable of letting automatic stabilizers play fully and symmetrically over the business cycle and at the same time not breach the 3 percent deficit criterion of the Maastricht Treaty.

The recommendation to let automatic stabilizers fully play can be found in many official documents of international institutions such as the OECD, the IMF, or the European Commission. They are typically of the following form: ‘maintaining a medium-term policy focus with symmetrical use of automatic stabilizers is essential for non-inflationary growth’, ‘importance of letting automatic stabilizers work (both on the revenue and expenditure side)’ or ‘restrict the use of discretionary budgetary policy in order not to offset the built-in mechanism of automatic stabilizers’ (see, e.g., OECD, 2001, Heller, 2002, European Commission, 2001). Obviously there seems to be consensus in these international institutions that automatic stabilizers are effective in stabilizing the business cycle, provided that their working is not offset by discretionary fiscal policy. Empirically there are three broad categories of contributions dealing with the issue of the effectiveness of fiscal stabilizers, some of them focusing on the expenditure side, some of them on the revenue side of the budget. Most international institutions use their large-scale macro-models to estimate the elasticity of tax revenues or public expenditures with respect to changes in output or the output gap.6 The second approach is to characterize the response of output to tax and spending shocks in the past by means of structural vector autoregressive models in order to derive impulse-response functions (see, e.g., Blanchard and Perotti, 1998). Finally, Fatás and Mihov (2001a, 2001b) test the correlation between government size and output growth volatility within cross country as well as panel data studies. They find a strong and robust negative relationship both for OECD countries and across U.S. states. Summing up, the evidence from these various empirical studies suggests that fiscal stabilizers are indeed effective in reducing output variability.

This paper reassesses empirically the smoothing impact of fiscal stabilizers using a panel of EU countries. Our model setting partly builds on earlier work by Ramey and Ramey (1995) and Fatas and Mihov (2001a, 2001b). However, it extends it in several ways. First of all, while earlier work is mostly based on cross-sectional data and uses panel data only for selected aspects, our paper relies entirely on pooled estimation. Second, we use an extended set of economic and political variables that so far has not been used in this context.

We initially test the effectiveness of fiscal stabilizers within a linear framework but then take one step further: Are fiscal stabilizers subject to diminishing returns? Is there a threshold level beyond which their stabilizing effect might even revert? The hypothesis of a reversed effect for higher levels of fiscal stabilizers is certainly a new and strong notion in this context. But even if the smoothing impact might not be reversed, it seems evident that the effect of fiscal stabilizers on business cycle fluctuations could level out at a higher rate than the one implied by applying logs to the explanatory variable, accounting thus for ‘decreasing returns to smoothing’.

Allowing for a nonlinear effect sheds new light on the characteristics of fiscal stabilizers, as well as on the quantification and nature of the link between government size and cyclical volatility. While a related nonlinearity hypothesis, namely that government size could have a negative growth impact when it exceeds a certain threshold level, has been frequently formulated in studies (see, e.g., Barro, 1990, Slemrod, 1995), this is the first paper, to the knowledge of the authors, which addresses this issue in the context of fiscal stabilizers.

The paper is organized as follows. Section II investigates the impact of fiscal stabilizers on business cycle volatility within a linear framework where we also explicitly consider the potential endogeneity between the variables by performing instrumental variable estimation. Section III then investigates the possibility of nonlinearities in the relationship between fiscal stabilizers and business cycle volatility. Section IV applies the same methodology to the different subcomponents of government expenditures and revenues to examine which of these components can most directly be related to the stabilizing aspect of fiscal policy. Section V concludes. Details about the data and certain aspects of the econometric specification can be found in the appendix.

II. Do Fiscal Stabilizers Indeed Stabilize? – A First Approach

This section starts with some clarifications on our proxy for fiscal stabilizers. After a very basic investigation of the effectiveness of fiscal stabilizers we then examine the issue in an extended linear model setting.

In a very first step we want to get an impression of the interaction between fiscal stabilizers and the volatility of output growth. Our basic data set consists of yearly data on 14 EU countries covering the period 1970 to 1999.7

A. Fiscal Policy: Fiscal Stabilizers and Discretionary Policy

The first problem that arises is the definition of an appropriate proxy for fiscal stabilizers. We will focus on the most general measure: the average ratio of government spending to GDP. Obviously the automatic component of fiscal stabilizers does not only work from the expenditure side (unemployment benefits and other transfer payments), but also from the revenue side, mainly through personal income and corporate taxes. However, there seems to be no clear consensus in the empirical literature on which side of the government budget is more appropriate when investigating the impact of fiscal stabilizers: Van den Noord (2000) and Fatas and Mihov (2001a), for instance, argue on the importance of the government expenditure side, while the European Commission (2002) – although in a slightly different context – refers to the revenue side as being the one that is more influenced by the business cycle.

Our decision to concentrate our analysis on aggregate government spending should be seen in the light of the discussion on the various channels of fiscal stabilization as referred to in the introduction. By focusing on the expenditure side we do not only capture the direct effect of automatic stabilizers but also the indirect impact of government expenditures that remain fixed in size irrespective of the stage of the business cycle. This allows a more complete analysis of the issue of the effectiveness of stabilization policies. As a robustness check we will, however, also present evidence on the smoothing properties of public revenues and, more specifically, direct taxes.

The use of the original, unadjusted government expenditure series as a proxy for fiscal stabilizers is common within this strand of literature. We do, however, believe that this approach is not without criticism. Government spending does not only capture a reactive component that can be related to the automatic stabilization function, and the part of expenditures that is stable irrespective of the stage of the cycle, but also a third, autonomous component of spending that reflects discretionary fiscal policy measures. Empirical evidence for a negative relationship between government size and output growth fluctuations could thus, among other reasons, be due to discretionary policy measures. We will therefore focus our analysis only on the part of government expenditures that is left after filtering out discretionary policy measures.

In the literature there are several approaches to extracting the stabilizing component of government expenditure. One option is to look at the subcomponents of government spending or revenues that can be related more directly to the automatic stabilizing function. Another approach is the one adopted by the IMF and the OECD. Here a ‘cyclically adjusted’ fiscal balance is constructed by relating the budget deficit to the state of the cycle relative to a cyclical indicator such as the output gap.

The approach of this paper is a different one. We estimate an unobserved components model following Harvey (1985, 1989) in order to separate a trend, a cyclical component and an irregular part of the government expenditure ratio series. The irregular part is then assumed to represent discretionary fiscal policy measures and is subtracted from the data. The remaining part constitutes a better measure for the fiscal stabilizers.8 For the rest of the paper we will refer to it as adjusted government expenditure.9

B. Do Fiscal Stabilizers Reduce Business Cycle Volatility?

To get a first visual impression of the nature of the relationship between government size and output growth volatility we divide our data set into six subperiods (1970-74, 1975-79, 1980-84, 1985-89, 1990-94, 1995-99).10 Figure 1 shows a scatter plot that relates GDP growth volatility to the size of the government measured by logged adjusted government expenditures. By first eyeball inspection, a negative relationship between these two variables seems to prevail.

The following baseline regression is estimated to establish the effect of fiscal stabilizers on output growth volatility:

VOLGROWTHit=β(GOVEXPit)+uit(1)

where the left-hand variable is the standard deviation11 of output growth in period t (t = 1,…,6 stands for each of the sub-periods described above) for country i and GOVEXPit is the logged ratio of government expenditures over GDP, adjusted for the irregular component. The regression results for equation (1) – based on different assumptions for the error term – are presented in Table 1. The first column shows the result for the assumption that the error term is independent of the cross-sectional units (countries) and iid normal (that is, the panel is estimated as if it were a cross-country regression including a constant). The second column shows the results for the assumption of fixed country effects, that is,

uit=αi+εt(2)

where αi is a country-specific constant and εi is white noise. Finally, the third column shows the estimated β under the assumption of fixed country and time effects, that is,

uit=αi+δt+εit(3)

where αi and εit are defined as above, and δt is an exclusively time-dependent constant effect. All specifications reported in Table 1 show a negative coefficient β, and the coefficient is highly significant for the more general models (2) and (3). The results therefore seem to confirm that fiscal stabilizers have had a smoothing impact on the business cycle.12

C. Introduction of Controls

The results of the previous section suggest a negative relationship between government size and the volatility of output. Still, there might be additional variables that affect both volatility and government size. In other words, the results obtained so far could only represent an indirect link between volatility and government size. We thus add several variables to our baseline regression to control for this possibility.

Table 2 shows the results of the panel regression using as controls the unemployment rate, inflation volatility and GDP per capita. The main argument for the first control variable is that in times of weak economic performance a low unemployment rate UNEMPLit makes employers reluctant to dismiss workers as it might prove hard to find a worker of appropriate qualifications after economic activity has recovered. A low unemployment rate is thus likely to constitute a smoothing factor for the business cycle implying a positive relationship between the unemployment rate and GDP growth volatility. Our second control variable, inflation volatility VOLINFLit – measured by the standard deviation of the inflation rate – is included as an indicator for monetary policy that certainly interacts with GDP growth volatility. Logged real GDP per capita GDPpcit finally is added as a control based on the assumption that richer economies usually do not only have a more sophisticated system to counterbalance economic shocks but also a more developed financial system.

The new specification is thus:

VOLGROWTHit=β1(GOVEXPit)+β2(UNEMPLit)+β3(VOLINFLit)+(4)β4(GDPpcit)+uit

We also include time dummies as well as an additional dummy variable that accounts for the German unification. The negative and significant coefficient for government size confirms our previous results, pointing at the effectiveness of the fiscal stabilizers. The coefficients for unemployment and the inflation volatility display the expected positive signs and are highly significant. The coefficient for GDP per capita also appears significant albeit positive, suggesting that richer countries actually experienced more volatile business cycles.13

D. Accounting for the Potential Endogeneity of Fiscal Stabilizers

The problem with equation (4) is the potential endogeneity of government size. Rodrik (1998) comments that as long as one of the goals of governments is to reduce output growth volatility, economies that display higher volatility might choose larger governments to stabilize their cycles. In this case equation (4) would be subject to an endogeneity problem and OLS estimation could lead to biased results.

To account for endogeneity we need to find instruments for government size. A straightforward way to search for appropriate instruments is to estimate the following equation:

GOVEXPit=j=IKβjXj,it+uit(5)

where Xit is a set of K economic and political variables. All variables that display a robust and significant relationship with GOVEXPit in this equation but are not correlated with the error term of equation (4) are obvious candidates for instruments. This procedure will also shed light on the determinants of government size in the EU countries.

In a first step, we include four macroeconomic variables in our baseline specification (5): GDP per capita, the unemployment rate, openness, and interest payments on public debt. We expect a positive sign of the coefficient for GDP per capita because, according to Wagner’s Law, richer countries tend to have larger governments as some public goods are considered to be income elastic. The (partial) correlation between unemployment and government size is also expected to be positive as the unemployment benefits constitute an important fraction of government expenditures. Concerning openness (OPENit), measured as the average sum of exports and imports relative to GDP, Rodrik (1998) argues that there could be a correlation between an economy’s trade exposure and the size of the government as open countries are more subject to external shocks, and therefore choose a larger public sector as a stabilizer. A further explanatory variable that is assumed to have an impact on the government size is a measure for the interest payments on government debt as a percentage of GDP (INTPAYit). A higher debt level as well as a higher interest rate on government debt should be positively correlated with government expenditures.

In a second step, we add two political variables to the right hand side of equation (5): a government strength indicator and the number of elections. The reason for including these variables as suggested by the literature on the political economy of fiscal policy is that fiscal indicators (as levels of deficit, debt, or government expenditures) can only partly be explained by genuine macroeconomic variables, and that political variables such as electoral and political systems also have explanatory power.14

The first political variable in our specification is a measure for the strength of the government (STRENGTHit) vis-à-vis the opposition. In general, each party in parliament has a certain number of opportunities to form coalitions with other parties when it comes to set up a government. That implies that each party has a certain degree of power to make or break a government coalition. Very often, this power is poorly reflected by only looking at the share of seats in parliament of a party. Power can thus be measured more adequately by applying voting power indices to the distribution of seats in parliament. The two most frequently used government power indices are the Shapley-Shubik-Index (Shapley and Shubik, 1954) and the Banzhaf-Index (Banzhaf, 1965). The government strength variable we use is the normalized Banzhaf-Index, defined as the weighted sum of the governing parties’ power indices.15 It is defined over the unit interval and takes the value of one for a single party majority government whereas coalition governments have a value of smaller than one. The so-called ‘weak government hypothesis’ suggests a negative relationship between government strength and fiscal expenditures (see, e.g., Roubini and Sachs, 1989) and it relies on a prisoner’s dilemma type of problem. Although a general cut of expenditures might be a desirable target for all parties in a coalition, none of the ministers has an incentive to stick to consolidation agreements in his field because this might upset the party’s own voters. Therefore we would expect higher expenditures in coalition governments – the ones with a lower strength index – than in single party governments.16

Another political variable that could potentially be of relevance as explanatory variable is the number of legislative and executive elections (ELECTit). The hypothesis is that not only discretionary policy might be driven by the electoral cycle but that also the fiscal stabilizing part of government expenditures could be expanded before elections. This would suggest a positive correlation between the number of elections and government expenditures, even when adjusted for the discretionary part.

In a third step we include the size of the economy as a further variable, measured through population (POPit). Alesina and Wacziarg (1997) suggest that the correlation between openness and government size is not a direct one, but that the link is mediated by country size. They show that country size is negatively related to government size as well as to trade openness.

The final specification based on equation (5) is thus:

GOVEXPit=β1(GDPpcit)+β2(UNEMPLit)+β3(OPENit)+β4(INTPAYit)+(6)β5(STRENGTHit)+β6(ELECTit)+β7(POPit)+uit

The first column in Table 3 shows the regression results including the four macroeconomic variables mentioned above. All of them appear highly significant. GDP per capita, the unemployment rate, and the measure of the interest payments on government debt all enter with the expected positive signs. The negative coefficient of openness, however, seems to contradict the hypothesis of Rodrik (1998). The reason could be that as shocks are highly correlated in Europe there is less demand for large governments as an insurance against external shocks. On the other hand, the high degree of synchronization also implies that a small open economy could profit from fiscal measures of their main trading partners aimed at counterbalancing shocks and could therefore free-ride on the stabilizing effects of such measures. A different argument finally suggests that open economies can take over norms form their main trading partner countries, thereby reducing the scope of government expenditures.

The second column shows the results based on the extended set of explanatory variables. STRENGTHit enters with a positive sign, indicating that stronger governments were associated with higher government expenditure ratios. Hence our results do not seem to support the weak government hypothesis17. The coefficient for ELECTit is positive but not significant. In the third column, the coefficient for the size of the economy enters with the expected negative sign and is significant. The fourth column reestimates the model without the election variable but without any significant change for the main results.

Based on these results the variables interest payments, openness, government strength, and population are the obvious candidates as instruments in equation (4). The results of the reestimation of equation (4) using instrumental variables are presented in Table 4. The Sargan test for the validity of instruments takes a value of 8.7, so we cannot reject the null of no correlation between the instruments and the errors in equation (4).

Even though the coefficient for government size is still negative, it is not significant any longer. This result weakens prior empirical evidence, namely that fiscal stabilizers have reduced output volatility. However, it could also be an indication for omitted nonlinearities in the relationship between government size and economic volatility. We will take explicit account for that possibility in the following section.

III. A Nonlinear Effect of Fiscal Stabilizers?

The results of the previous section provide no clear-cut picture concerning the smoothing capacity of fiscal stabilizers. Can we infer that the evidence obtained so far is a consequence of nonlinearities that have not been explicitly modeled? The linear model already gives evidence for diminishing returns to the stabilizing property of government spending. We could, however, hypothesize that the effectiveness of this fiscal policy tool is subject to extra diminishing returns that go beyond the ones already implied by the use of the logarithm of government expenditures, possibly even reverting beyond a certain threshold. If such nonlinearities exist, the conclusion of a smoothing impact of fiscal stabilizers of previous studies may not hold for all levels of government expenditures but has to be investigated with reference to the size of the government.

Our hypothesis that nonlinearities as outlined above might exist is partly based on the literature that deals with growth effects of fiscal policy. Here theoretical results (see, e.g., Barro, 1990) predict a negative growth effect in countries where the size of government exceeds a certain threshold. Under the assumption that there is a robust negative correlation between volatility of output and long-term growth, the resulting inverse U-shaped relationship between government size and growth would translate into a U-shaped relationship between government expenditures and cyclical output volatility. Higher levels of public spending are furthermore associated with either higher taxes or larger budget deficits. The adverse effects of high tax burden on production are related to disincentive effects and market distortions, high deficit levels will at some point create an environment of uncertainty due to the loss of credibility of fiscal policy (see, e.g., Giavazzi et al., 2000 and Perotti, 1997). Both of these effects could, in due course, lead to higher output growth volatility.

A recent contribution by Buti and Van den Noord (2003) provides a theoretical framework that explicitly predicts a nonlinear relationship between government size and GDP growth volatility. The key aspect of their model is that automatic stabilizers do not only work on the demand side but that they also change the slope of the aggregate supply curve, thus counteracting the stabilizing property. The authors show that this effect can lead to a U-shaped relationship between government size and cyclical volatility.

A initial indication of the presence of nonlinearities can be drawn from Figure 2 that shows the residuals of equation (4), estimated under the restriction β1 = 0 (that is the part of GDP growth volatility that cannot be explained by the right-hand side variables other than GOVEXPit in equation (4)) against the fitted levels of government expenditures over GDP using the instruments and exogenous variables. This is the variable actually used instead of GOVEXPit for the instrumental variables estimation. The visible parabolic relationship suggests testing the nonlinearity hypothesis more thoroughly.

As a very first attempt to examine empirically the evidence for nonlinearities in the relationship between business cycle volatility and government size we apply the linearity test proposed by Hansen (1999). We test the linear model against a piecewise linear model where the effect of government expenditure on growth volatility depends on the level of government expenditure, and explicitly estimate the threshold level of government expenditures separating the two regimes. Although the methodology in Hansen (1999) does not account for instrumental variable estimation, it could provide first evidence for nonlinearities in the relationship. The threshold estimation procedure identifies exactly one threshold at a (logged) government expenditure ratio of 3.67, and rejects the null of linearity at the usual 5 percent significance level. For government size levels below the threshold there is a significant negative relationship between the government expenditure ratio and GDP growth volatility, providing evidence for the effectiveness of fiscal stabilizers in this range. Beyond the threshold level, however, the coefficient is negative but not significant, indicating that the smoothing effect of fiscal stabilizers does not apply in this region.

This first evidence opens the question of the specific nonlinear form to be tested. Here a useful econometric tool is the Nearest Neighbor Fit method (see, e.g., Cleveland, 1993 and 1994). This nonparametric approach fits for each data point in the sample a local linear regression line, weighting the other observations: Data points that are relatively far from the point being evaluated get small weights in the sum of squared residuals, while closer data points get higher weights. The resulting nonlinear curve is presented in Figure 3. The parabolic form suggests a leveling out of the smoothing capacity of fiscal stabilizers with the possibility of a reversed effect beyond the minimum.

Based on this evidence we modify our model by letting the government expenditure ratio enter in a quadratic form. Equation (4) is reformulated as:

VOLGROWTHit=β1(GOVEXPit)+β2(GOVEXPit)2+β3(UNEMPLit)+(7)β4(VOLINFLit)+β5(GDPpcit)+uit

Table 5 shows the results of the linear model as well as the new model with the quadratic specification18. The coefficient for government size is highly significant for the linear as well as for the quadratic variable, thereby confirming the evidence for nonlinearities. The fitted parabolic curve, the ‘fiscal smile’, has its low point at 3.63 (in logs) which is corresponding to a government expenditure ratio of approximately 38 percent, a value close to the one indicated by the threshold technique.19 This value also supports the simulation results in Buti and Van den Noord (2003). The authors show that under a reasonable set of assumptions on their underlying structural model the size of the government in several euro area countries exceeds the critical level beyond which the stabilization effect may actually revert.

In order to provide an intuition about the magnitudes of this nonlinear effect let us consider the following exercise. For a country displaying a government expenditure ratio corresponding to the median value of the distribution in our panel (40.63 percent), an increase of public spending by one percentage point will, ceteris paribus, raise the standard deviation of output growth by 0.02 points. The same increase in government spending for a country situated at the 25 percentile of the distribution (expenditure ratio: 35.87 percent) will lead to a decrease in business cycle volatility of 0.01 points. A country at the 75 percentile (spending ratio: 44.14 percent) finally would increase cyclical volatility by 0.04 points when expanding government expenditures by one percentage point.

It is an additional useful illustration to assign to each country a different symbol, as done in Figure 4. To be more specific: the point cloud may not consist of single country cases that actually support the estimated parabolic curve individually, but it could be the cross-country differences that pay responsible for the ‘fiscal smile’. Figure 4 reveals several clusters of countries. Spain and Greece are countries with a sufficiently low government spending ratio to experience a stabilization effect of an increase in public expenditures. A larger group of countries lying at the right part of the curve (Sweden, Denmark, Netherlands, France, Belgium) seem to support the finding that a further increase in the size of the government can have destabilizing effects once a certain level is reached. Two further countries (Italy and Finland) actually mimic the parabolic curve. There is, however, the interesting case of Germany and Austria, which seem to show a negative relationship between government size and business cycle volatility although the data points almost entirely lie to the right of our estimated low point of the curve. This may raise the issue of whether an efficient use of government revenues and an appropriate design of the tax system could shift the curve to the right.

To sum up, our results indicate a nonlinear relationship between government size and output growth volatility. For relatively low levels of the government expenditure ratio fiscal stabilizers have the desired impact in that they reduce business cycle fluctuations. This effect, however, is not without bounds. For higher levels the effect is, at best, not significant, but it might as well reverse.20

IV. Towards A Narrower Definition of Government Size – Which Fiscal Components Stabilize Most?

In the previous sections we have established the link between fiscal stabilizers and output growth volatility. On the one hand, we have found no clear indication of a negative relationship in a linear setting. On the other hand, we have provided evidence of nonlinearities in the sense that the effect of fiscal stabilizers on business cycle fluctuations could even reverse for higher levels.

Fiscal stabilizers obviously do not only work from the expenditure side but also from the revenue side. The aim of this section is to analyze the nature of the smoothing effect from the revenue side. Using a disaggregated data set allows us furthermore to investigate which subcomponents of government expenditure or revenue can be most directly related to the stabilizing aspect of fiscal policy and whether there is also evidence of nonlinearities for the subcomponents.

We therefore rerun our estimation by first substituting government spending by the overall measure revenues (REVENit) that is computed as the sum of direct and indirect taxes and social security and other transfers received by the government. We then repeat this procedure using as subcomponents of government expenditures nonwage government consumption (GOVCONSnwit), wage government consumption (GOVCONSnwit), government gross investment (INVESTit), subsidies (SUBSIDit), and social security transfers paid by the government (SOCSECit). Furthermore, we also use transfers (TRANSit), that is, the sum of subsidies, social security transfers, and other transfers paid by the government. On the revenue side we look at two subcomponents: direct taxes (TAXdirit) and indirect taxes (TAXindirit).

Intuitively the subcomponents on the spending side that are most directly related to the theoretical definition of fiscal stabilizers are social security transfers and subsidies. Investment, on the other hand, can be expected to consist to a large part of discretionary measures. From the two government consumption measures the wage part might contain a discretionary as well as a fiscal stabilizing part while the nonwage fraction should not be closely related to fiscal stabilizers. On the revenue side indirect taxes do not show the standard attributes of fiscal stabilizers like progressivity so that we expect regression results to deviate substantially from the ones derived in the previous sections. Direct taxes, on the other hand, should show a high degree of stabilizing properties, possibly also leveling out beyond a certain threshold.

We thus rerun the linear and quadratic regressions (4) and (7) using these different fiscal policy measures as explanatory variables. All fiscal measures are used as logs of the share in GDP and those that are expected to contain a significant discretionary part (INVESTit and GOVCONSwit) are adjusted following the same approach applied to the government expenditure ratio. In all cases the estimation is done using the same instruments selected for the case of the overall government expenditure measure.

The results of the estimation of equations (4) and (7) for the different subcomponents of government expenditures and revenues are given in Table 6. The results for total revenues show the same characteristics as those of the government spending ratio: Accounting for the possibility of endogeneity, the coefficient for total revenues is negative but not significant. Using a nonlinear model, however, the coefficients are highly significant for the linear as well as for the quadratic term. Therefore the same implication holds that the smoothing effect of fiscal stabilizers from the revenue side may vanish for higher levels. The fact that a similar result applies to direct taxes while this is not the case for indirect taxes supports the hypothesis that it is personal and corporate income taxes that are most directly related to the theoretical definition of fiscal stabilizers. One can interpret this result under the light of the recent discussions on tax reforms that usually assume a trade-off between efficiency and stabilization effects. Our results suggest that for countries with a high tax burden, tax cuts can both increase efficiency and contribute to a less volatile business cycle at the same time.

Concerning the subcomponents on the expenditure side there is evidence for nonlinearities only for nonwage government consumption whereas the other components do not show any parabolic relationship.

The main result is therefore that of those subcomponents that are expected to be most directly related to fiscal stabilizers, only revenues and direct taxes show the hypothesized smoothing impact (for lower levels). This effect, however, reverts for higher levels and could actually increase cyclical volatility. Subsidies and social security transfers, on the other hand, do not have a smoothing impact, neither in the linear nor in the nonlinear model setting.

V. Conclusions

The effect of fiscal stabilizers (proxied by the government expenditure share adjusted for discretionary policy) on cyclical volatility is studied for a panel of EU member states in the last three decades. The smoothing impact of fiscal stabilizers is tested within a linear as well as a nonlinear framework. Evidence from the linear model concerning the effectiveness of fiscal stabilizers is mixed. While the basic OLS results confirm the finding of prior empirical studies that fiscal stabilizers have reduced business cycle fluctuations this effect is no longer significant when doing instrumental variable estimation to account for potential endogeneity of government size.

However, the results based on a quadratic nonlinear model setting indicate a smoothing effect for lower levels of government size, but the ‘returns to smoothing’ diminish in a stronger fashion than the one implied by the logarithmic specification. For countries with a high government expenditure ratio the smoothing effect vanishes and cyclical volatility may thus even rise. The results appear robust to the exclusion of outliers, modifications in the specific nonlinear form, the use of a different set of control variables and instruments, as well as a generalization of the adjustment mechanism for the government expenditure ratio. On a disaggregated level, we find that the nonwage government consumption, direct taxes, and total revenues display the nonlinearity mentioned above, namely a stabilizing property up to an estimated threshold which then eventually reverts. The validity of the main findings on the revenue side strengthens our results against the background of the discussion on which side of the budget to use as a proxy for fiscal stabilizers.

Our results suggest that it may be necessary to reassess the role of the fiscal stabilizers – which are nowadays generally preferred by both international institutions and economists vis-à-vis discretionary fiscal policy – in the nonlinearity context. The preference for a rules-based fiscal policy, notably in Europe, stems from the fact that the last three decades were marked by prolonged periods of pro-cyclical fiscal policy21. This asymmetric reaction of fiscal policy to the economic cycle led political institutions to the conclusion that a purely rules-based fiscal policy (in the same reign as monetary policy) would lead to a better economic outcome in the sense of reduced volatility. Given the negative relationship between government size and cyclical volatility in prior studies, this notion seems justified. However, the nonlinear model setting of our paper reassesses this view in a critical way. The discussion on the effect of fiscal stabilizers and optimal government size may gain realism by taking into account nonlinearities such as the ones modeled in this study.

Coming back to the policy recommendations of international institutions to let fiscal stabilizers play fully, our conclusion is that these assessments should be supplemented by taking into account a second dimension: the absolute level of fiscal stabilizers. One should be aware of the fact that the government size plays a crucial role in determining the nature of the returns to smoothing of fiscal stabilizers. Therefore, although the full operation of fiscal stabilizers could be desirable, their overall extent may have to be reconsidered. Hence we conclude ‘let the fiscal stabilizers play, but handle them with care’.