Appendix 1: Impact of Fiscal Consolidation on the Debt Ratio
Appendix 2: The Cyclically-Adjusted Debt Ratio: Definition and Measurement
This appendix analyzes some practical issues raised by the concept of cyclically-adjusted debt ratio (CADR).
Appendix 3: A Rule of Thumb For The Cyclically-Adjusted Debt Ratio
We propose a simple formula to compute the CADR under the assumption that there is no large change in the structural fiscal position over the period considered:
as the CADR and nominal debt ratios are equal at the start date.
For G, long-term growth could be used, while the average deficit ratio over a full cycle (for instance, over the last 5 years) could proxy the variable: Deficit
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This paper received useful comments and suggestions from Swarnali Ahmed, Jochen Andritzky, Nathaniel Arnold, Aqib Aslam, Benjamin Carton, Carlo Cottarelli, Lorenzo Forni, Dmitry Gershenson, Phillip Gerson, Emine Hanedar, Martine Guerguil, Kotaro Ishi, Bernd Lucke, Esther Perez Ruiz, Alasdair Scott, Ikuo Saito, Justin Tyson, and Yingbin Xiao. It also benefited from the discussions during the surveillance meeting seminar held at the IMF on April 10, 2012, and the joint IMF-OECD Workshop on December 12, 2012 (OECD, Paris). Raquel Gomez provided excellent research assistance.
The European Commission has analyzed a similar concept in the context of the discussions on the debt reduction benchmark (see EC, 2011).
In this paper, “debt” refers to public debt in gross terms, unless otherwise indicated.
Fiscal multipliers are defined as the ratio of a change in output to an exogenous change in the fiscal deficit with respect to their respective baselines. In the formulas of Appendix 1 and the simulations of Section III, multipliers are calculated as ratios of nominal variables. These “nominal” multipliers may be larger than standard multipliers calculated in real terms. Indeed, when real GDP declines with fiscal tightening, inflation also decelerates; thus, the decline in nominal GDP is larger than the decline in real GDP. This is one of the reasons why our simulations should be based on higher-than-average multipliers (see Section II.C).
We use a simplified framework where the size of automatic stabilizers is measured by the revenue ratio.
Several factors explain why the negative effect of fiscal tightening on output eventually disappears (even when the tightening is permanent). These include: (i) anticipating lower output and inflation in the future, the central bank may lower interest rates; (ii) fiscal tightening may be perceived as credible and reduce the risk premium on interest rates; (iii) the currency may depreciate in response to lower interest rates; and (iv) households may anticipate a decline in their tax burden in the future and increase current consumption.
All formulas are calculated relative to baseline. Absent fiscal multipliers, a one-off permanent tightening would improve the fiscal balance by 1 percent of GDP in each period, and lower public debt by N percent of GDP relative to the baseline after N periods.
A recent literature review extends and updates earlier IMF work by Spilimbergo and others (2009) and finds that average first-year multipliers amount to 0.8 for spending and 0.3 for revenue measures (Mineshima and others, 2013). Since about two-thirds of recent fiscal adjustments in advanced economies rely on spending measures, this gives an average overall multiplier of 0.6 for the first year.
Obviously not all countries may currently experience multipliers close to 1. Multipliers depend on country characteristics, as reflected in the wide range of spending multipliers across OECD economies. In line with the theory, simple correlations suggest, in particular, that fiscal multipliers tend to be smaller in more open economies, in countries with larger automatic stabilizers and higher interest rates (IMF, 2012).
The finding that first year spending multipliers are higher than revenue multipliers is in line with a number of recent studies (Mineshima and others, 2013), although this result is debated. For instance, IMF (2010) finds that spending-based adjustments are less contractionary and notes that this is partly due to the fact that central banks lower interest rates more in case of expenditure-based consolidations (perhaps because they regard them as more long-lasting). However, when policy rates are already low, the interest rate response becomes less likely, which may imply that, in the current environment, the Keynesian theory prediction prevails.
For certain countries the argument that the constraint imposed by the zero lower bound restricts the ability of monetary policy to become more accommodative needs to be qualified somewhat. In those countries where sovereign debt spreads and private sector borrowing rates are high, despite the fact that the policy rate is near the zero lower bound, monetary policy would effectively become more accommodative if further actions caused spreads to fall in those countries.
The first year is the year when fiscal policy is tightened; in the following charts, this is year t+1. All the simulations are relative to the baseline (or counterfactual scenario) with zero GDP growth, a balanced budget, and a constant debt ratio.
The three groups are defined on the basis of the debt ratios observed in 2011 for the 17 euro area countries. The average debt and revenue ratios for each group are then used in the simulations (the average debt ratios are, respectively, 38, 73, and 113 percent of GDP). Simulations use different multipliers (high, low, and downturn), derived from the literature survey by Mineshima and others (2013).
For example, the IMF (2011) shows that fiscal consolidation has negative effects on output which persist into the medium term. DeLong and Summers (2012) also argue that fiscal tightening may have hysteresis effects on potential output.
This could for instance consist in cutting expenditure by 1 percent of GDP in the first year, another percent in the second year etc.
We found broadly similar results under an alternative scenario with long-term interest rates decreasing by 50bp for each percentage point of GDP of fiscal consolidation (elasticities are derived from Haugh and others, 2009).
While most of the countries listed in Table 1 did not start consolidating before 2010, some introduced fiscal stimulus measures in 2008 and 2009.
In Portugal, a statistical reclassification required by Eurostat raised the debt stock by including some public sector enterprises in the consolidated accounts of the public sector.
Chung and Leeper (2007) also estimate a structural VAR, explicitly incorporating an inter-temporal budget constraint.
The VAR estimation takes into account the possible deceleration of inflation caused by the real GDP decline (which is itself due to fiscal tightening).
In this case, the estimated relationship between revenue and spending would partly reflect historical patterns. It could be that in the past, changes have offset each other, leaving the fiscal balance broadly unchanged.
Our empirical results are subject to caveats, including issues related to the predictability of structural shocks, since economic agents may receive news about future fiscal measures. Leeper and others (2012) show that such “news shocks” are particularly relevant for tax measures, because the process of changing taxes is subject to long lags. This may result in incorrect identification of structural shocks. Since this section merely serves as an illustration of our simulation results, we abstract from these considerations.
This empirical estimate is consistent with previous simulation results. With a revenue ratio of 30 percent of GDP, a public debt ratio of 100 percent of GDP (corresponding to the 1970-2011 averages), and a spending multiplier of 1.5, the formula of Section II.B. predicts that a fiscal shock of 1 percent of GDP would initially increase the debt ratio by about 1 percentage point in the first year.
gt denotes nominal GDP growth. Δ denotes a change over time; ΔX = Xt – Xt–1.
Targeting the nominal debt ratio is only one of the many reasons for which fiscal policy can be procyclical. For instance, some governments are forced to follow such course of action, because they have lost market access.
The size of the required discretionary tightening needed to bring down the debt ratio increases when fiscal multipliers and/or the initial debt ratio are larger.
Most countries pursue both debt and fiscal balance targets (see the EU fiscal governance framework, for instance).
In this appendix, Δ refers to a change relative to baseline (not relative to the previous period).
Fiscal multipliers are defined as the ratio of a change in output to an exogenous change in the fiscal deficit with respect to their respective baselines. In our definition, multipliers are cumulative.
YN is only affected by the initial shock (with a N-year multiplier), as there are no further shocks in subsequent years.
The impact of a permanent tightening on GDP could well be temporary. Equation (4) assumes that a permanent consolidation has a permanent output effect.
For instance, the CADR proposed by the European Commission only corrects the numerator and the denominator for the cyclical developments over the period t-3 to t (EC, 2011).
CADRt is affected by the start date but the effect is unlikely to be large. Indeed, the only difference between two alternative CADRs in period t is the sum of the cyclical deficits between their respective start dates, and this sum is bounded, as cyclical deficits eventually zero out over a full cycle.
We used different assumptions on potential growth, discretionary fiscal policy, and initial fiscal conditions.
Nonetheless, selecting a start date when the output gap is zero would result in the CADR presenting an interesting feature. In this case, the nominal debt ratio and the CADR would coincide at the beginning of each cycle—a property that would bring the CADR closer to the cyclically-adjusted balance concept. Appendix Figure 1 provides a visual illustration of this point.
Under simple assumptions, the cyclically-adjusted balance ratio is approximately equal to the difference between the nominal balance ratio and the product of the expenditure ratio and the output gap.