Fiscal Adjustments
Determinants and Macroeconomic Consequences

Contributor Notes

Author’s E-Mail Address: mkumar@imf.org; dleigh@imf.org; aplekhanov@imf.org

The paper analyzes the determinants of success of recent fiscal consolidations in the OECD countries as well as the short-run and long-run effects of fiscal adjustments on economic activity by looking at fourteen case studies, panel data for OECD countries, and the results of simulations using a non-Ricardian multi-country dynamic general equilibrium model. The study finds that while fiscal consolidations tend to have short-run contractionary effects, they can be expansionary in the long run, provided that they do not rely excessively on cuts in productive government expenditure. They can also create positive spillover effects for the rest of the world.

Abstract

The paper analyzes the determinants of success of recent fiscal consolidations in the OECD countries as well as the short-run and long-run effects of fiscal adjustments on economic activity by looking at fourteen case studies, panel data for OECD countries, and the results of simulations using a non-Ricardian multi-country dynamic general equilibrium model. The study finds that while fiscal consolidations tend to have short-run contractionary effects, they can be expansionary in the long run, provided that they do not rely excessively on cuts in productive government expenditure. They can also create positive spillover effects for the rest of the world.

I. Introduction

This paper examines the experience of industrial countries that undertook fiscal consolidation, managed to stabilize public finances, and substantially reduce debt without adverse effects on the pace of economic activity. Complementing the analysis of a number of recent studies that have explored this issue, the novelty of the paper lies in using both case studies and econometric analysis, including model-based simulations, to explore a broad range of determinants of the success of fiscal adjustments. Using a cross-sectional framework, the paper studies the determinants of the success, as well as obstacles on the way to fiscal adjustment by examining the following: economic conditions at the start of consolidation; the composition of expenditure and revenue measures; the role of accompanying structural reforms; the contribution of institutional factors; and government actions aimed at garnering public support. The paper also examines the short and long-run effects of fiscal consolidations on economic activity.

The cross-country econometric study of the determinants of fiscal adjustment effort is complemented by fourteen case studies of fiscal adjustments in OECD countries, including each of the G-7, during the 1990s and 2000s. The analysis of the effects of fiscal consolidations on economic activity is based both on case studies and on simulations using the Global Integrated Monetary and Fiscal Model (GIMF) developed at the International Monetary Fund (IMF).

The case studies based on the OECD country experience suggest that budgetary difficulties tend to spur adjustment efforts, which are facilitated by a supportive domestic and international growth environment. Fiscal adjustments that rely on cuts in current expenditure have tended to be more durable than revenue-based consolidations. Higher governmental stability and higher institutional quality are also associated with more successful fiscal consolidations.

Regarding the macroeconomic effects of fiscal consolidations on economic activity, the case studies indicate that while adjustments tended to have a moderating influence on growth in the short run, it was not as pronounced as generally anticipated, and in a number cases, the consolidations could even be described as “expansionary.” The GIMF-based experiments suggest that the short-run contractionary effects are smallest when the consolidation involves increases in consumption taxes, and largest when it involves cuts in productive public infrastructure spending. In addition, fiscal consolidation can have positive long-run effects, particularly when the greater fiscal space available after debt has been reduced is used to cut capital income taxes. However, these long-run gains may not occur if the consolidation involves cuts in public infrastructure spending. Fiscal adjustment is also found to have substantial positive spillover effects when implemented by a large economy such as the United States.

The remainder of the paper is structured as follows: Section II identifies a number of recent adjustment episodes in the OECD countries; Section III analyzes case studies based on a selection of these episodes; Section IV conducts a cross-section analysis of the determinants of the adjustment effort; Section V examines the impact of consolidation on economic activity based both on case studies and simulations using the GIMF; and Section VI concludes.

II. Identifying Episodes and Determinants of Fiscal Adjustment

A. Identifying Episodes of Successful Fiscal Adjustment

Fiscal consolidations are usually deemed to be successful if they are sustained, and are substantive. A standard approach has been to define a fiscal consolidation (FC) relative to a specific improvement in the cyclically adjusted primary balance (CAPB), over a 1–3 year period. 2 In addition, a number of existing studies distinguish successful from unsuccessful consolidations by measuring the size of the fiscal adjustment, its duration, or its impact on the debt-to-GDP ratio (e.g. Alesina and Perotti, 1995, and Tsibouris and others, 2006). 3

For the purposes of the case study analysis presented in this paper, FCs are defined as years in which the ratio of the CAPB to cyclically-adjusted GDP improves by at least 1 percentage point. To determine how successful a given FC is, this paper follows Alesina and Perotti (1995), and Darby and others (2005), and focuses on the degree of debt reduction achieved over the following three years. In particular, the FC can be considered very successful if, three years after the start of the consolidation, the debt-to-GDP ratio is at least five percentage points below the level observed immediately prior to FC. Depending on the degree of debt reduction achieved, FC attempts are also categorized as either “moderately successful” or “unsuccessful,” as explained in Appendix I.

Based on this approach, fiscal adjustments are identified amongst the 24 OECD countries considered in this paper during 1990–2005. 4 To allow an evaluation of the success of FC that occurred during 2003–05, the paper relies on forecasts of public debt for 2006–07 provided by the OECD (2006). The full list of FC episodes is reported in Appendix Tables A1A3, along with the estimated and projected changes in the CAPB and debt ratios.

Fourteen of these fiscal adjustments are selected for the purposes of the case studies. These selected episodes include recent examples of FC by each of the G-7 countries and the adjustment in Germany since 2003. 5 In addition, they include selected recent consolidations in other OECD countries (Denmark, Ireland, the Netherlands, and New Zealand) and several episodes of adjustment that are deemed to have been particularly successful (Finland, Spain, and Sweden). All the FCs occurred during the 1994–2005 period, as reported in Table 1. The list is by no means exhaustive (for instance, case studies of successful consolidations in Australia and Belgium are not reported due to space constraints), and therefore the results should be interpreted in conjunction with those of the econometric analysis with a broader country coverage.6

Table 1.

Fiscal Consolidation Episodes Used for Case Studies

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Source: OECD, and IMF staff calculations.

B. Potential Determinants of Fiscal Consolidation Success

A wide variety of economic, political, and institutional factors have been identified as likely contributors to FC success (see, for instance, Alesina and Perotti, 1995, Von Hagen and Strauch, 2001, Darby and others (2005) and Alesina et al 2006). These include macroeconomic and political background before and during the consolidation; the design of adjustment (relative importance of expenditure and revenue measures); subnational government participation (for example, via cuts in the provincial wage bill); adoption of structural reforms (for instance, in the area of social security) and changes in institutional framework (for example, introduction of an medium-term expenditure framework, MTEF); and use of various strategies to mobilize public support for the adjustment (for example, highlighting long-run sustainability considerations in the government’s communication strategy). The findings of the literature regarding the relationship between these factors and FC success are briefly summarized below.

It has been widely suggested that budgetary difficulties can oftentimes lead to a consensus to deal with them. High and rising debt-to-GDP ratio has the potential to spur effective FC, and the empirical evidence is generally supportive of this notion (see, for example, Von Hagen and Strauch, 2001, henceforth VHS). It has been also suggested that domestic economic conditions can affect the likelihood of FC starting, and succeeding. The evidence on the direction of the impact is, however, inconclusive. On the one hand, Drazen and Grilli (1993) argue that reform is more likely when “things are going badly,” and VHS (2001) find that FC has a higher chance of becoming successful when the domestic economy is in a cyclical downturn, although the likelihood of a FC being attempted is higher during domestic economic expansions. On the other hand, Alesina and Perotti (1995) find that the probability of successful FC is lower when the economy is in recession.

While the success of FC is also likely to depend on the macroeconomic situation of major trading partners, there is no consensus on the direction of this effect. On the one hand, VHS (2001) find that FCs starting in periods when both the domestic and the international economies are weak are more likely to be successful. On the other hand, Alesina and Perotti (1995) and McDermott and Wescott (1996) find that many successful fiscal adjustments took place in the second half of the 1980s, i.e. a period of high OECD economic growth, and that efforts of FC in the early 1980s, when economic growth in the OECD was low, typically failed.

It has also been argued that the success of FC depends on a simultaneous easing of monetary policy: however, the empirical evidence for OECD countries is again inconclusive. Lambertini and Tavares (2005) find support for this hypothesis, while VHS (2001) report that the monetary policy stance has no explanatory power for the success of FC.

A number of studies have emphasized the importance of political economy factors in determining the outcome of FCs. For instance, coalition governments have been found to be less likely to succeed than single-party and minority governments (Alesina and Perotti, 1995). Alesina and others (2006) report that newly-elected governments, and governments in presidential systems with a large majority of the party in office have a higher likelihood of success. By contrast, frequent changes in governments tend to be associated with larger fiscal deficits, as documented by Alesina and Tabellini (1990), and Tytell and Wei (2004).

A number of studies (e.g., Alesina and Perotti, 1995, and VHS, 2001) have examined the composition of fiscal adjustments and found that while successful and unsuccessful adjustments involve, on average, the same improvement in the cyclically-adjusted primary balance, the former rely mostly on expenditure cuts and the latter tend to rely more on tax increases. Within expenditure, successful adjustments tend to be characterized primarily by cuts in transfers and wage bill. The limited expenditure cuts that occur during unsuccessful adjustments come mainly from government investment.

The involvement of the subcentral tiers of government has often contributed to the success of FCs. For example, Darby and others (2005) find that, for OECD economies over 1979–99, involvement of the subcentral tiers of government was crucial to achieving cuts in expenditure, particularly in relation to the overall size of the government wage bill. In addition, central governments appear to have exerted a strong influence on the expenditure of subcentral tiers through grant allocations, and control of these allocations appears to have had a considerable impact upon the overall success of FC attempts.

Governments used a wide range of strategies to mobilize popular support for fiscal consolidation, including involvement of independent fiscal agencies in the assessment of the unsustainability of a given fiscal policy stance; explicit references by governments to fiscal objectives that need to be attained to address sustainability concerns (i.e., emphasizing long-run pressures on social security, the importance of “halving the deficit by year x”, and the promotion of a “golden rule”); explicit references to an external anchor, in particular, the need to meet Maastricht criteria; including fiscal consolidation in a package of structural reform measures; and promoting enhanced fiscal transparency that facilitates monitoring of the fiscal stance by the public (as discussed by Tsibouris and others (2006)).

A number of studies suggest that higher-quality fiscal institutions make an important contribution to the success of FC. For example, higher-quality fiscal institutions were shown to be associated with greater expenditure discipline, even after controlling for political pressures (Fabrizio and Mody, 2006). 7 The contribution of institutional quality, as measured by strong and impartial bureaucracies and high democratic accountability, has also been found to be important for fiscal policy performance. 8 In particular, Alt and Lassen (2006) find that a higher degree of fiscal transparency is associated with lower public debt and deficits, after controlling for other explanatory variables.

III. Case Studies

The case studies provide a number of useful insights into the determinants of fiscal consolidations and their successes.9 It is important to emphasize that the analyzed episodes of fiscal consolidation differ widely in terms their size and composition, economic and political background, adjustment strategy, accompanying reforms, and outcomes. Nevertheless, a wide range of substantive conclusions do emerge from the analysis, and are summarized in this section.

A. Political, Macroeconomic, and Fiscal Background

(i) About three quarters of the surveyed fiscal adjustments were initiated by newly-elected governments (Table 2). This finding is intuitive for the following reasons. First, as in a number of European countries and in Canada in the 1990s, new governments are given an explicit mandate for fiscal adjustment. Secondly, new governments proposed new approaches to tackling old problems. Thirdly, new governments were better positioned to develop a medium-term strategy for fiscal adjustment with maximum ownership. Finally, political costs of initiating an adjustment may well be the smallest at the beginning of a government’s elective office, and would be expected to increase as an election date approached.

Table 2.

Recent Fiscal Consolidation Attempts in Selected Countries: Background

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Sources: Country authorities, OECD, Economist Intelligence Unit, and IMF staff reports.

(ii) Most fiscal consolidations were launched during economic downturns or the early stages of recovery from a recession. While launching fiscal consolidation during an upswing may have the obvious merits, including ensuring counter-cyclicality of fiscal policy, less than a quarter of the fourteen adjustment episodes were initiated against the background of a strong economic outlook (the exceptions being the U.K., New Zealand, and, to a lesser extent, Spain). This finding is consistent with the notion that it is easier to build a broad consensus about the need for fiscal consolidation during or shortly after a sharp downturn in economic activity.

(iii) Fiscal consolidations were also typically preceded by sharp deterioration in government fiscal balances accompanied by rapid increases in public debt levels. The rationale for this may appear self-evident, although there are plenty of instances where a deterioration in the fiscal positions has not been followed by relatively rapid adjustment. Notable exceptions are the recent cases of Denmark and New Zealand, where fiscal consolidations were to a significant extent motivated by the dire long-term outlook of public finances given the fiscal costs of aging population, and Ireland, where fiscal consolidation represented an attempt to arrest the deterioration of budget balance at an early stage.

B. Adjustment Basis

(i) Fiscal consolidations were approximately equally split between revenue-based and expenditure-based adjustments, with many episodes combining both types of measures (Table 3). On the expenditure side, a number of adjustments relied substantially on capital expenditure cuts (e.g., France, Italy, and more recently Ireland), and across-the-board sequestration of discretionary spending programs (e.g., Sweden, Finland, and more recently Japan).

Table 3.

Recent Fiscal Consolidation Attempts in Selected Countries: Adjustment Basis

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Sources: Country authorities, OECD, Economist Intelligence Unit, and IMF staff reports. The size of fiscal adjustment is estimated using the OECD data.

(ii) However, the consolidation attempts based on cuts in current expenditure were more sustained on average, possibly because cuts in current expenditure were often accompanied by structural reforms. Reduction in wage bill and social security spending (including social transfers, health care, and unemployment benefits) made an important contribution to fiscal adjustment in a number of cases (e.g., Canada, Finland, Spain, and more recently the Netherlands). Such cuts were usually facilitated by structural reforms aimed at improving the efficiency of public services provision and the incentive structure of insurance schemes. In contrast, tax increases and capital expenditure cuts were accompanied by structural changes in only a few instances (e.g., tax reforms in Canada and introduction of medium-term capital budgeting in Ireland). In addition, politically difficult measures, such as current expenditure cuts or general tax increases, may well have signaled a strong commitment to continued fiscal consolidation.

(iii) While revenue measures ranged widely from one-off tax surcharges to major overhauls of tax systems, successful revenue-based adjustments tended to rely to a significant extent on tax base broadening. In some instances (e.g., in Spain), tax reforms aimed at simplifying the tax system and reducing tax burden on small and medium-sized businesses resulted in higher tax buoyancy and higher revenues over the medium term.

(iv) Successful fiscal adjustments were often gradual: spanned periods of time of up to a decade (e.g., Finland, Sweden, Spain). The long duration of successful consolidations underscores the importance of anchoring policy objectives within a medium-term framework with a credible commitment to chosen strategies. It also highlights the lags between the adoption of certain types of core structural reforms (in particular, in the area of social welfare) and their full impact.

C. Adjustment at the Subnational Level

(i) A number of consolidation episodes were accompanied by the introduction of new mechanisms of policy coordination across different tiers of government (Table 4). In many cases fiscal adjustments involved actions on the part of subnational governments. Some countries prompted such actions by imposing numerical rules on local and regional authorities (the Netherlands, Sweden in 2000), while others adopted a cooperative approach to policy coordination, whereby the central and subnational governments negotiated fiscal targets, which then become binding (Denmark, Spain). At the same time, in the absence of formal mechanisms enforcement of collective decisions sometimes relied fundamentally on moral suasion and peer pressure, with fiscal adjustments nonetheless being successful (e.g., Spain). In some cases tight administrative controls over subnational public finance had already been in place (U.K., Ireland).

Table 4.

Recent Fiscal Consolidation Attempts in Selected Countries: Subnational Adjustments

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Sources: Country authorities, OECD, Economist Intelligence Unit, and IMF staff reports.

(ii) Clarification of expenditure responsibilities and revenue assignments of subnational governments made an important contribution to fiscal consolidation in several countries. Clarification of delineation of responsibilities between the tiers of government often helped to alleviate the problem of soft budget constraints and increased the political accountability of local authorities, potentially leading to net savings for the general government. Such reforms supported fiscal consolidations in Italy and Japan, although in some instances (e.g., U.S., France, and Germany) fiscal consolidation attempts appeared to lack support at the subnational level.

D. Structural Reforms

(i) In several cases, fiscal consolidations were accompanied by the introduction of a medium-term budget framework (Table 5). Multiyear budgeting helped to put fiscal consolidation into perspective, facilitating the adoption of other structural reforms and the communication of fiscal policy objectives to the voters. Several countries made important advances in incorporating the long-term fiscal sustainability analysis into the medium-term policy framework.

Table 5.

Recent Fiscal Consolidation Attempts in Selected Countries: Structural Reforms

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Sources: Country authorities, OECD, Economist Intelligence Unit, and IMF staff reports.

(ii) A number of fiscal consolidations were supported by structural reforms in the area of health care, unemployment benefits, and pensions. These reforms supported fiscal consolidations directly by raising the efficiency and reducing the cost of public service provision as well as indirectly by contributing to overall economic activity through strengthened incentives to work.

(iii) Structural reforms may also have facilitated future adjustment by developing the appropriate institutional framework. For example, recent fiscal consolidations in Denmark and New Zealand were facilitated by the previous successful consolidations of the 1990s, which laid the foundations of medium-term budgeting, incorporation of long-term fiscal projections, and improved expenditure control. In turn, fiscal consolidations provide an impetus for structural reforms, creating a virtuous circle of enhanced fiscal discipline and higher efficiency of government.

E. Mobilization of Popular Support

(i) The case studies point towards the importance of articulating a broad medium-term economic strategy and the role of fiscal discipline in it to mobilize popular support for the adjustment (Table 6). In the case of European countries in the 1990s such strategies were shaped by the objectives of EMU membership. In other instances, they may be seen in the context of long-term developments as well as past successful consolidation episodes (Denmark, New Zealand).

Table 6.

Recent Fiscal Consolidation Attempts in Selected Countries: Mobilization of Popular Support

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Sources: Country authorities, OECD, Economist Intelligence Unit, and IMF staff reports.

(ii) Political leadership is likely to have played an important role in ensuring commitment to fiscal consolidation. Fiscal consolidations may well have been associated with political costs and strengthened the opposition. Hence strong political leadership was needed to ensure continuity of the consolidation policies, as exemplified by the experiences of the U.S. and Japan.

(iii) The adoption of fiscal rules by themselves does not generally appear to be sufficient to produce a sustained fiscal adjustment. Nonetheless, fiscal rules developed in the course of fiscal consolidations, presumably signaling heightened policy commitment, do seem to have helped sustain the consolidation efforts. Such rules then often became a permanent feature of legislation (e.g., in Spain) facilitating future adjustments.

IV. Cross-Section Analysis

This section complements the above case study analysis with cross-section evidence based on the latest available data. While the above analysis focused on case studies of particular episodes of fiscal adjustment, this Section uses a wider sample of OECD countries over 1972–2006 and explores the relationship between the magnitude and durability of fiscal adjustment and a number of underlying determinants. 10

In particular, the analysis examines the correlation between the average fiscal policy stance over three years, as measured by the average CAPB, and the following five sets of variables: (i) public debt at the beginning of the first year; (ii) domestic economic activity at the start of the three-year period; (iii) trading-partner economic activity at the start of the three-year period; (iv) the level of inflation and the stance of monetary policy in the first year; and (v) political and institutional factors.

To facilitate the interpretation of the results, Subsection A examines bivariate relationships between each variable and fiscal policy effort individually, with conditional relationships evaluated in Subsection B using a more rigorous multivariate panel regression approach.

It is worth emphasizing that the approach and results of the empirical investigation reported below are consistent with existing studies. As such, the section complements and extends the results in the existing literature using the latest available data for the OECD countries.

A. Bivariate Relationships

The correlation coefficients between the CAPB and macroeconomic variables reported in Table 7 are consistent with prior work. Primary balances are, in general, positively correlated with the public debt-to-GDP ratio. The higher the public debt level, the tighter the cyclically adjusted fiscal stance over the subsequent three years. Table 7 also suggests a positive relationship between cyclically-adjusted primary surpluses and per capita real GDP growth. This finding is consistent with the notion that initiating and sustaining a deliberate fiscal consolidation is easier during periods of high growth. The unconditional correlation of the CAPB with the output gap is not statistically significant. There is also a negative and statistically significant correlation between the CAPB and inflation, suggesting that relatively tight fiscal policies are associated with a low-inflation environment. In addition, the relationship between the average CAPB and the real interest rate in the first year (measured by the short-run nominal rate minus current CPI inflation) is weak and not statistically significant.11

Table 7.

Cyclically Adjusted Primary Balance: Correlations with Explanatory Variables 1/

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Sources: OECD and ICRG.

Unconditional correlations evaluated using non-overlapping three-year averages of CABP over 1972–2005, and variable measured in the first year; p-values in parentheses. Values significant at the 1 percent level are marked with ***; at the 5 percent level, with **.

Table 8.

Recent Fiscal Consolidation Attempts in Selected Countries: Subsequent Developments

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Sources: Country authorities, OECD, Economist Intelligence Unit, and IMF staff reports.

Cuts in current expenditure are correlated with a strong and statistically significant subsequent improvement in primary balances. In contrast, while the correlation between increases in cyclically-adjusted revenues and subsequent average fiscal surpluses is positive, it is of a substantially smaller magnitude and not statistically significant. Consistent with the previous findings, including those of Alesina and others (2006), the relationship between governmental stability and fiscal policy effort is positive, as is the relationship between institutional quality and the capacity to maintain a tight fiscal policy stance.12

B. Multivariate Analysis

This subsection looks at the determinants of fiscal policy effort using multivariate panel regressions. 13 As before, the dependent variable is the three-year average of the CAPB. The panel regression results for the macroeconomic variables (growth, output gap, inflation, interest rates) are summarized in Appendix Table A4. 14 Lagged debt is estimated to be significantly positively associated with subsequent fiscal effort. A 10 percentage point improvement in the debt-to-GDP ratio is associated with a 0.5 to 0.7 percentage point improvement in the CAPB ratio. This result is consistent with the notion that countries in this sample appeared to attempt to stabilize the debt-to-GDP ratio.

Regarding the contributions of fiscal adjustment composition, the results reported in Appendix Table A5 suggest that countries that implement cuts in current expenditure tend to succeed in maintaining a tight fiscal policy stance. In particular, the CAPB ratio has, on average, improved by 1.1 percentage points over the three years following a 1 percentage point reduction in cyclically adjusted current expenditure. The effect of fiscal consolidations that rely on current expenditure cuts thus appears to be long-lasting. On the other hand, a 1 percentage point increase in cyclically adjusted revenue is correlated with only 0.4 percentage point improvement in the average CAPB over the following three years.

The results also suggest that higher governmental stability and higher institutional quality have significant explanatory power for subsequent fiscal consolidation success. Frequent changes of government and poor institutions are associated with higher fiscal deficits. Again, these results are consistent with the prior literature.

V. Macroeconomic Developments Following Fiscal Adjustments

This section discusses a number of factors that can, in principle, mitigate the possible contractionary effects of FC in the short run, and allow FCs to have expansionary effects on economic activity over the medium term. The discussion starts by reviewing the channels by which fiscal policy has been found, both in theory and empirical literature, to affect output. The section then reports the results of model-based simulation experiments (using the IMF’s Global Integrated Monetary and Fiscal Model—GIMF) that distinguish the effects on output according to the composition of fiscal adjustment. Finally, the section reviews the case-study evidence.

A. Prior Work

The traditional presumption that short-term fiscal multipliers are always positive has been challenged on both theoretical and empirical grounds. In theory, it has been noted that once the impact on risk premiums and expectations is taken into account, the negative demand impact of lower fiscal deficits may be more than offset by an increase in private domestic demand. A growing empirical literature has also critically reassessed the short- and long-term effects of fiscal policy among different countries and time periods. One of the more remarkable findings of this literature has been the possibility of negative fiscal multipliers connected to strong fiscal consolidations. The famous adjustment episodes in Ireland and Denmark in the 1980s—where consolidation was followed by a sharp upturn in growth— triggered several studies suggesting that negative multipliers may in fact be more widespread than suggested by conventional wisdom (Giavazzi and others, 2000). If such instances were indeed quite common, and if the effect of fiscal adjustment on economic activity were related to specific policy design or economic conditions, this could have a profound influence on fiscal policy advice. Finally, fiscal adjustments in large economies may induce positive spillovers for other economies, as discussed in Kumhof and others (2005).

B. GIMF Simulations

This subsection uses simulations based on GIMF to investigate how fiscal consolidations affect economic activity both in the short run and in the long run, depending on the composition of the fiscal adjustment.

The model

GIMF is an open economy general equilibrium model developed at the IMF that is equipped for both monetary and fiscal policy analysis (Kumhof and Laxton, 2007). The model’s nominal and real rigidities, monetary policy reaction function, multiple non-Ricardian features, and a fiscal policy reaction function yield plausible macroeconomic responses to changes in fiscal and monetary policy. For the purposes of this paper the model is calibrated to include a large open economy (calibrated with U.S. data) and the rest of the world.

Ricardian equivalence does not hold for four reasons. First, the model features overlapping generations agents (OLG) with finite lifetimes, i.e., a nonzero probability of death in each period. These agents are myopic in the sense that they perceive debt-financed tax cuts as an increase in their human wealth, and attach a low probability to having to pay for them in the future. 15 Second, workers have a life-cycle labor productivity pattern that implies a declining rate of productivity as workers age. This feature means that workers discount the effects of future payroll tax increases as they are likely to occur when individuals become older and less productive. Third, the model contains liquidity constrained consumers (LIQ) who do not have access to financial markets to smooth consumption, and change their consumption one-for-one with changes in after-tax income. Finally, the model includes payroll and capital income taxes that are distortionary because labor effort and private investment respond to relative price movements that result directly from variations in tax rates.

A particularly important feature of GIMF for fiscal policy analysis is that it relaxes the assumption of conventional models that all government spending is wasteful and does not contribute to aggregate supply. Instead, GIMF allows for productive public infrastructure spending that adds to the public capital stock, and enhances the productivity of private factors of production. Real rigidities embedded in the model include consumer habits that induce consumption persistence, investment adjustment costs that induce investment persistence, and import adjustment costs. Nominal rigidities include sticky prices and wages, and pricing to market. (For further details regarding the model, see Kumhof and Laxton, 2007).

Calibration

Following Kumhof and Laxton (2007), the model is calibrated to contain two countries, the United States and the rest of the world. The fiscal parameters, such as the ratios to GDP of government transfers, purchases of goods and services, and public investment are calibrated based on data from the authorities. The productivity of public capital is calibrated following Ligthart and Suarez (2005) who present a meta analysis of large number of studies of the elasticity of aggregate output with respect to public capital, and estimate this elasticity at 0.14. Accordingly, the model is calibrated so that a 10 percent increase in public investment is associated with a long-run increase in GDP of 1.4 percent. Given that public investment represents 3 percent of GDP, this elasticity of 0.14 implies an average annualized rate of return on public investment of about 3 percent over 50 years (net of depreciation). 16 The depreciation of public capital is set at 4 percent per year. The remaining parameters values are set following Kumhof and Laxton (2007).

The experiments

Each of the five fiscal adjustment experiments conducted using the model involves a permanent reduction in the debt-to-GDP ratio of about 15 percentage points. This adjustment is implemented by reducing the fiscal deficit by 2.5 percent of GDP in the first two years of the adjustment, and then keeping fiscal deficit 0.5 percentage points of GDP below the original level.

In each scenario, the reduction in the fiscal deficit relies on a different adjustment tool, as follows: (a) increases in payroll taxes; (b) increases in consumption taxes; (c) increases in corporate income taxes; (d) reductions in government purchases of goods and services; and (e) both reductions in both government purchases and cuts in productive government investment. To stabilize the public debt at the lower level, the additional fiscal space available due to the lower interest costs is used either to reduce the initial tax increases (in simulations a, b, and c), or to undo part of the expenditure reductions (simulations d and e). The results are reported in terms of deviations from the baseline scenario, a steady state in which the economy is operating at its potential and the public debt-to-GDP ratio remains stable.

Results

Figures 1 and 2 report the implications of each fiscal adjustment strategy for the principal macroeconomic variables, including GDP and consumption, both in the United States and in the rest of the world. Fiscal tightening induces a near-term reduction in output in all scenarios. The fiscal consolidation that relies on cuts in consumption taxes has the smallest contractionary effect, reflecting the broad base of consumption taxes and, therefore, their relatively low distortionary effects. However, cuts in productive government investment induce a much sharper short-run negative impact on economic activity. In all scenarios the adverse effect of fiscal tightening on the aggregate demand is in part offset by monetary stimulus that occurs because the central bank manipulates nominal interest rates to lower real interest rates in response to the inflation decline. In addition, the short-run contraction is mitigated by the ability of households to smooth consumption. However, credit-constrained households who cannot smooth their income experience a sharp cut in their consumption in the short run.

Figure 1.
Figure 1.

Impact of Fiscal Consolidation on the Domestic Economy (United States)

Citation: IMF Working Papers 2007, 178; 10.5089/9781451867428.001.A001

Figure 2.
Figure 2.

Impact of Fiscal Consolidation in the United States on the Rest of the World

Citation: IMF Working Papers 2007, 178; 10.5089/9781451867428.001.A001

Over the medium to long term, fiscal adjustment is seen to yield substantial output gains. These occur when the additional fiscal space available after the reduction in public debt and the associated interest costs is used to cut distortionary taxes. For example, a long-run cut in payroll taxes stimulates output by encouraging labor supply. The supply-side gains are largest when the long-run tax cuts fall on capital income. In addition, when the fiscal consolidation occurs in a large economy such as the United States, long-run output gains also accrue because the increased government savings raise the supply of loanable funds and, other things equal, the real interest rate declines. The lower interest rate in turn crowds in private activity both in the domestic economy and in the rest of the world. Finally, the analysis also reveals that, if the adjustment involves cuts in public investment, the long-run output gains associated with fiscal consolidation may not occur. In particular, as the long-dashed line in Figure 1 illustrates, when the adjustment involves a 10-percent cut in public investment, the long-run output gains become negligible.

C. Evidence from Case Studies

In most cases fiscal consolidations were followed by periods of robust economic growth (Table 8). While economic recovery was somewhat slow in Italy, and moderate decelerations of economic growth in the first years after fiscal adjustments were observed in Canada, the U.S., and New Zealand, other economies performed strongly following the initiation of consolidations. Although this observation may partly reflect the fact that the majority of surveyed fiscal consolidations were initiated during recessions or the early stages of economic recovery, it does suggest that fiscal tightening did not have a pronounced negative impact on economic activity. In some cases, there is evidence of a firming in activity with lower interest rates crowding in the private sector, and strengthening of incentives to work following structural reforms.

Overall, the experiences of the surveyed countries are broadly consistent with the view that fiscal consolidations do not have pronounced short-run adverse effects on activity. Indeed, in many cases they are accompanied by economic expansions, lower interest rates, and strengthened incentives to work.

In addition, most fiscal consolidations were supported by a decline in global interest rates. Lower interest rates led to a decline in the debt service expenditure, reinforcing the consolidation efforts, which in turn further reduced interest rate spreads. This positive dynamics played a particularly important role in fiscal consolidations in countries with particularly high levels of public debt, as in the case of Italy.

VI. Conclusion

This paper has analyzed the determinants of successful fiscal consolidations in OECD countries as well as the impact of fiscal adjustments on economic activity in the short and in the long run, on the basis of selected case studies of fiscal consolidations, cross-country econometric analysis for 24 countries, and GIMF-based simulations.

The analysis revealed that fiscal consolidations tend to be initiated during times of fiscal distress, as reflected in high and rising public debt levels, and relatively weak economic activity. Consolidations based on current spending restraint generally have higher chances of succeeding. Strong political leadership is typically required to sustain a fiscal adjustment effort, with strong institutions playing an important supportive role.

Case studies further suggest that while fiscal adjustments tend to have a moderating influence on growth in the short run, some fiscal consolidations appear to have had expansionary effects. The GIMF-based experiments suggest that the short-run contractionary effects are smallest when the consolidation involves increases in consumption taxes, and largest when they involve cuts in productive public infrastructure spending. In addition, fiscal consolidation can have positive long-run effects, particularly when the greater fiscal space available after debt has been reduced is used to cut capital income taxes. However, these long-run gains may not occur if the consolidation involves cuts in public infrastructure spending. Fiscal adjustment is also found to have large positive spillover effects when implemented by a large economy such as the United States.

There are a number of areas for further research. Perhaps the most important one relates to the distributional effects of fiscal adjustments. This is especially so given the ongoing process of globalization and structural changes in the world economy. Another area to explore would be the extent to which simultaneous adjustments in a range of countries might have effects that differ substantially from adjustment in a given country. Such simultaneous adjustment might be warranted by common challenges such as aging of populations or climate change that are being faced by a large number of countries both within the OECD and outside. It is by no means evident that adjustments undertaken in a large number of countries would necessarily be contractionary given the likely beneficial effects of deficit reductions in a number of countries for global interest rates.

Fiscal Adjustments: Determinants and Macroeconomic Consequences
Author: Mr. Alexander Plekhanov, Mr. Manmohan S. Kumar, and Mr. Daniel Leigh