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Appendix I: Threshold Approach to Identifying Fiscal Consolidation Success

For the purposes of this paper, a fiscal consolidation attempt is defined as a year in which the cyclically-adjusted primary balance-to-GDP ratio increases by at least 1 percentage point. FC can be either successful or unsuccessful. Following Alesina and Perotti (1995) and Darby and others (2005), the measure of success of a fiscal consolidation (the success index, S) takes into account the degree of debt reduction achieved over the following three years.

The index takes the highest value (S = 3) if the debt-to-GDP ratio falls by at least 5 percentage points in the three years following a FC. If the debt-to-GDP ratio is stabilized within ½ of a percentage point of the initial level or if it decreases by less than 5 percentage points, S is set to equal 2. The index takes the lowest value (S = 1) if the debt increases by more than ½ percent of GDP. The values of the index are reported in Tables A1A3.

Table A1.

Fiscal Consolidations with Highest Success (S = 3), 1990–2005

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Source: OECD.
Table A2.

Fiscal Consolidations with Moderate Success (S = 2), 1990–2005

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Source: OECD.
Table A3.

Fiscal Consolidations with Low Success (S = 1), 1990–2005

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Source: OECD.

Appendix II: Cross-Section Methodology, Data, and Results

The empirical specifications estimated in this paper are based on Equation (1), the fiscal policy reaction function that is consistent with the prior literature.

capbi,t=ρdi,t1+j=1JβjXj,i,t+αi+εi,t,t=1,,T,i=1,,N(1)

In Equation (1), capbi,t is the ratio of the cyclically-adjusted primary balance to cyclically adjusted GDP in country i and year t; di,t-1 is the public debt-to-GDP ratio observed at the end of period t-1; αi is a country-specific intercept (fixed effect); and Xj,i,t denotes an additional control variable j that explains the evolution of the CAPB. Equation (1) captures the fiscal reaction concept as follows: the coefficient ρ measures the response of the CAPB to deviations of public debt from the implicit target level, while the composite term, j=1JβjXj,i,t represents the response to other conventional explanatory variables. To investigate the extent to which changes in the CAPB are sustained over time, the specification in Equation (1) is estimated for three-year non-overlapping averages of the CAPB, i.e., with 13k=02capbi,t+k as the dependent variable. The three-year non-overlapping periods are: 1972–74, 75–77, 78–80, 81–83, 84–86, 87–89, 90–92, 93–95, 96–98, 1999–2001, and 2003–05. Each right-hand-side variable is measured in the initial year of each three-year period.

All panel data regression equations are estimated using an annual data sample covering 1972–2005 and 24 OECD countries. The sources of the data are the OECD (2006) Economic Outlook and the International Country Risk Guide (2006).

Table A4.

Estimation Results: Core Macroeconomic Controls

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Absolute values of t-statistics in parentheses. Values significant at the 1 percent level are marked with ***; at the 5 percent level, with **; at the 10 percent level, with *. All equations are estimated with country fixed effects. The three-year non-overlapping averages are: 1972–74, 75–77, 78–80, 81–83, 84–86, 87–89, 90–92, 93–95, 96–98, 99–2001, and 2003–05. Each right-hand-side variable is measured in the initial year of each three-year period.

Table A5.

Estimation Results: Adding Composition, Political, and Institutional Factors

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Absolute values of t-statistics in parentheses. Values significant at the 1 percent level are marked with ***; at the 5 percent level, with **; at the 10 percent level, with *. All equations are estimated with country fixed effects. The three-year non-overlapping averages are: 1972–74, 75–77, 78–80, 81–83, 84–86, 87–89, 90–92, 93–95, 96–98, 99–2001, and 2003–05. Each right-hand-side variable is measured in the initial year of each three-year period.

1

The authors are grateful to Mark De Broeck and Robert Gillingham for valuable comments and suggestions.

2

Focusing on the change in the CAPB in percent of cyclically adjusted GDP permits a more accurate measure of fiscal effort than the unadjusted primary balance, as the CAPB focuses on discretionary changes in fiscal policy net of contributions of cyclical factors.

3

Data on the cyclically-adjusted primary balances and public debt for all countries considered in this paper are taken from the OECD. The OECD’s method of computing the cyclically-adjusted fiscal balance is described in Giorno and others (1995). For tax revenues, the cyclical components are calculated by multiplying output gaps estimated using a production function approach by estimated elasticities with respect to output. In terms of revenues, four different types of taxes are distinguished in the cyclical adjustment process: personal income tax; social security contributions; corporate income tax and indirect taxes. The sole item of public spending treated as cyclically sensitive is unemployment-related transfers. For a recent update of the tax elasticities used to calculate the cyclical component of tax revenues, see Girouard and André (2005).

4

The 24 OECD countries considered in the analysis are as follows: Australia, Austria, Belgium, Canada, Denmark, Germany, Finland, France, Greece, Ireland, Iceland, Italy, Japan, Korea, Luxembourg, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, and the United States.

5

The adjustment in Germany does not formally qualify as a consolidation episode as the gradual improvement in primary structural balance has not exceeded 1 percent of GDP in any year. Nonetheless, it presents an interesting case of a recent multiyear consolidation initiative.

6

It is worth emphasizing that, unlike the case study analysis, the econometric cross-section analysis does not rely on specific thresholds for identifying consolidations. Rather, the cross-section approach relates the full data set on primary balances to the underlying determinants of fiscal policy using statistical inference.

7

The quality of fiscal institutions is typically measured using indices composed of variables that evaluate the budget-preparation stage, budget authorization stage, and budget implementation stage (for example, as constructed by Gleich, 2003, and Yläoutinen, 2004).

8

See for example, IMF (2003). Interestingly, Abiad and Baig (2005) find that, in emerging market countries, better-quality institutions are associated, on average, with larger deficits. They interpret this seemingly counterintuitive finding as indicating that better institutions are associated with lower risk premia and, hence, a lower need for fiscal adjustment.

9

A number of recent studies have employed a case study approach to analyzing fiscal adjustments, including Tsibouris and others (2006), Haputmeier and others (2006), and Annett (2006).

10

All the data used in the cross-section analysis come from the OECD Economic Outlook (2006) database.

11

While some studies, such as VHS (2001) find that easing monetary policy can encourage governments to undertake a consolidation, others, such as Tabellini (1986) have argued that monetary tightening—in the form of lower monetary financing of budget deficits—might raise the governments’ incentives to initiate FC.

12

The stability of the government is measured using an index ranging from 1 to 12 which is computed by the International Countries Risk Guide (2006) and takes into account the governments’ unity, legislative strength, and popular support. Institutional quality is measured by a composite index constructed from the International Countries Risk Guide index components “bureaucracy quality,” “law and order,” “democratic accountability,” “corruption,” and the country’s “investment profile.”

13

For the details of the econometric methodology employed see Appendix 2.

14

Given the high correlation between domestic and average OECD growth, the panel framework focuses on domestic economic activity only without explicitly including average OECD growth and output gaps.

15

The model’s overlapping generations structure with finitely-lived agents makes it particularly well suited to analyzing the implications of public sector deficits and debt both for the United States and for the rest of the world. The model is complementary to the IMF’s Global Fiscal Model that has been used to analyze a variety of fiscal policy and structural reform issues.

16

The average annualized rate of return of 3 percent is obtained as follows. A 10 percent increase in public investment, i.e. an investment of 10 percent × 3 percentage points of GDP = 0.3 percentage points of GDP, yields, after about 50 years, a 1.4 percent increase in GDP. The geometric average annual rate of return over the 50-year period is thus (1.40.3)1/501=0.031, i.e. about 3 percent.

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