Selected Euro-Area Countries: Rules-Based Fiscal Policy in France, Germany, Italy, and Spain Supplementary Information

Fiscal deficits and the public debt has grown throughout much of the postwar period in most industrialized countries under the pressure of rising public expenditure, a trend that has begun to reverse after 1992. A number of studies argue that fiscal consolidation in association with expenditure restraint, particularly reductions in primary current expenditure, has proved more durable historically. All in all, the fiscal consolidation essential to qualify for European Monetary Union is a major achievement but also a difficult process in the four countries (France, Germany, Italy, and Spain).

Abstract

Fiscal deficits and the public debt has grown throughout much of the postwar period in most industrialized countries under the pressure of rising public expenditure, a trend that has begun to reverse after 1992. A number of studies argue that fiscal consolidation in association with expenditure restraint, particularly reductions in primary current expenditure, has proved more durable historically. All in all, the fiscal consolidation essential to qualify for European Monetary Union is a major achievement but also a difficult process in the four countries (France, Germany, Italy, and Spain).

I. A Survey of the Political Literature on Fiscal Policy and Fiscal Rules1

1. This chapter provides a brief survey of political economy arguments that explain deviations of fiscal policy conduct from a socially optimal benchmark.2 The first key question is, of course, what is the “optimal” conduct of fiscal policy—that is, what is the appropriate benchmark. The neoclassical theory of fiscal policy (see Barro, 1979, 1989; Lucas and Stokey, 1983; Lucas, 1986) stresses the importance of achieving tax smoothing; budget deficits should be used to cover temporary increases in government spending (such as, for example, those due to a war) while tax rates should be kept constant to minimize distortions.3 This generally implies that the budget will be countercyclical. Keynesian models of aggregate demand management stress the importance of fiscal policy as a stabilizer: fiscal policy should be expansionary during recessions and contractionary during expansions in order to moderate business cycle fluctuations.

A. Fiscal Policy Biases

2. The political economy literature provides possible explanations as to why governments may systematically deviate from these principles of fiscal policy. We divide theoretical arguments into those implying a bias towards budget deficits, and those implying a bias towards excess public spending. As we shall see, there is overlap between the two categories, since excess budget deficits can clearly be due to excess public spending.

Budget deficits

3. Alesina and Perotti (1995) provide a useful classification of political economy models of fiscal policy. We shall focus primarily on three types of models: (i) models based on “fiscal illusion” with opportunistic policymakers and naive voters; (ii) models of debt as a strategic variable; and (iii) models of distributional conflict.

4. The first class of models is in the spirit of the public choice literature: the key assumptions are that policy makers are opportunistic (that is, they care about electoral prospects, and not directly about private agents’ welfare) and use fiscal deficits to increase their electoral chances. Voters fail to understand the intertemporal budget constraint of the government—they overestimate the benefit of current expenditures and/or underestimate future tax burdens—and therefore do not “punish” politicians for fiscally irresponsible behavior. In this context, fiscal rules would be beneficial, because they would constrain such fiscally irresponsible behavior.

5. The second strand of literature emphasizes that the stock of debt has an effect on the policy choices of future governments, and can therefore be used to constrain its actions (Alesina and Tabellini, 1990; Tabellini and Alesina, 1990). In this context, a deficit bias can arise because different political parties, which face electoral uncertainty, have conflicting spending priorities. These factors imply that the current government does not fully internalize the cost of running budget deficits today, because the future spending that is going to be compressed may reflect the priorities of a different government. This deficit bias is increasing in the degree of political polarization (reflected in the difference between spending priorities) and in the degree of electoral uncertainty.4 In this class of models, parties before an election would agree on a balanced budget rule, but after the election the party in power prefers “discretion.”

6. A third strand of literature shows how conflict between different social groups (represented by parties, interest groups, coalition members) can delay the adoption of necessary policy measures, such as, for example, spending cuts or tax increases to stem growth in public indebtedness caused by some exogenous factor (Alesina and Drazen (1991); Drazen and Grilli (1993)). Delays occur because groups cannot agree on burden-sharing for the necessary fiscal adjustment. These models predict that fragmented or divided governments and polarized societies would have more difficulty implementing fiscal adjustment than single-party governments and less polarized societies. Evidence presented in Roubini and Sachs (1989) and Grilli, Masciandaro and Tabellini (1991) for OECD countries and by Poterba (1994) and Alt and Lowry (1994) for U.S. states is consistent with these predictions.

Public spending

7. A number of contributions closer to the political science literature study the overprovision of public projects (“pork-barrel spending”) that can arise, for example, when programs have concentrated benefits and diffuse costs. One important factor in this strand of literature is the interaction between the organization of legislatures and fiscal decisions. In particular, one strand of the literature stresses the bias towards excess spending that can arise when representatives of geographically-based constituencies fail to fully internalize the financing costs of projects yielding benefits to their constituency, because these costs are borne by taxpayers as a whole (see, for example, Weingast, Shepsle and Johansen (1981)).5 Whether the spending bias will indeed cause excess spending depends on the rules that determine which projects will actually be undertaken; in the simplest case, in which each policymaker decides on the level of spending in his/her district and taxes are determined so as to balance the budget, the result will be a level of spending and taxation which is too high from society’s point of view.6

8. These models can be applied to the determination of public spending within a government, where each “spending” minister fails to fully internalize the costs that the higher taxes needed to finance spending impose on society at large (see, for example, von Hagen and Harden (1996)). The bias is stronger the more decentralized the decision system is, because of the existence of a common pool problem (everybody has to pay taxes, but only specific ministries and their constituents benefit from the spending). Kontopoulos and Perotti (1999) present evidence that countries with a larger number of spending ministers tend to have higher public spending. Finally, the model can be applied to spending decisions within a government coalition, implying that control on spending is more difficult the larger the number of parties in the coalition.

B. Implications for Fiscal Frameworks

9. The existence of “biases” in the conduct of discretionary fiscal policy is a possible justification for the imposition of fiscal rules.7 In principle, the ideal rule would be state-contingent, so as to allow the authorities sufficient flexibility to react to shocks while at the same time removing any inherent bias towards excess fiscal imbalances. However, there is a view that rules have to be simple in order to be verifiable, and that contingent rules would leave the door open to manipulation. If rules are not state-contingent, a critical trade-off arises between the elimination of a policy bias and the need to retain policy flexibility, as in the literature on rules versus discretion in monetary policy formation (Kydland and Prescott (1977); Barro and Gordon (1983)).8

10. Corsetti and Roubini (1997) explore these issues more formally. They present a simple model that extends Alesina and Tabellini (1990) in order to highlight the trade-off between deficit bias and margin for stabilization in the context of a closed and open economy. They first consider whether leaving the government a margin for stabilization policy (modeled as a “tax smoothing” role) contributes to worsening the deficit bias. They conclude that this is not the case. An interesting result they obtain is that the political deficit bias is enhanced in an open economy. Since in their model there is no default risk, in an open economy the government faces an infinitely elastic supply of funds at the given world interest rate, contrary to the case in a closed economy. This implies that additional borrowing to finance more expenditure is not discouraged by higher interest costs.9 Clearly, the scope for fiscal rules depends on the relative intensity of the deficit bias and the need for tax smoothing.10

11. Dur et al. (1997) show that a fiscal rule, imposed to address a deficit bias problem, may have undesirable effects on the composition of public spending, leading to a suboptimally low level of public investment.

12. A number of studies examine the rationale for fiscal rules in a monetary union. Chari and Kehoe (1997) argue that fiscal constraints in a monetary union can be desirable if no monetary policy commitment is possible. The reason is that national fiscal authorities take into account the incentive of the central bank to partially monetize debt, but do not internalize the costs of induced inflation on other member states. Beetsma and Uhlig (1997) study the rationale for a “stability pact” limiting fiscal imbalances in a monetary union, using a model in which politicians have a deficit bias and there is an incentive to erode debt through unexpected inflation.

13. The models of spending bias described in the previous section highlight how budgetary institutions can have an impact on fiscal outcomes—for example, the spending bias can be reduced by a strong finance minister with agenda-setting powers, by negotiated spending targets for each ministry, or by setting an overall spending ceiling. Indeed, imposing a binding aggregate spending constraint forces agents bargaining over spending to fully internalize the resource cost of their spending bids.

1

Prepared by Gian Maria Milesi-Ferretti.

2

In particular, it draws on Alesina and Perotti (1995), Drazen (2000) and Milesi-Ferretti (1997).

3

The neoclassical theory of fiscal policy can offer precise normative insights under the maintained assumption that distributional considerations can be addressed by lump-sum transfers. In reality, however, fiscal policies are used to redistribute resources across heterogeneous political groups and individuals, raising the question of how to define an appropriate benchmark of “virtuous” fiscal behavior. Clearly this is an open question, but for the purpose of this chapter we shall take as given the desirability of reducing fiscal imbalances.

4

A different, but related argument is made by Lizzeri (1999) in a game-theoretic model of redistributive politics. Uncertainty about the outcome of future elections implies that voters cannot predict whether politicians will in the future choose to redistribute resources to them. Voters are therefore favorable to politicians that promise them large current transfers, financing current expenditure through borrowing.

5

In Weingast, Shepsle and Johansen (1981) projects also bring political benefits to the district in which they are undertaken.

6

When spending decisions do not entail approval for all projects (as is the case, for example, when a minimum winning coalition decides on the projects to be undertaken), results are ambiguous and depend on the voting rule. In a dynamic setting, similar considerations can give rise to “excessive” fiscal deficits. Velasco (1999) emphasizes the bias in fiscal policy arising when government resources are “common property;” the tendency to run budget deficits arises because each group perceives the return on public savings to be too low, because the rate of return is adjusted by what other groups will appropriate. This enhances the tendency to overspend. Chari and Cole (1993a) show that a deficit bias can arise in the presence of political uncertainty, because accumulated government debt reduces the bias towards excess government spending, in a fashion similar to Persson and Svensson (1989) and Alesina and Tabellini (1990).

7

Some studies have examined the impact of rules in the absence of any underlying distortion in the conduct of fiscal policy. For example, Schmitt-Grohé and Uribe (1997) show that in a neoclassical growth model a balanced budget rule can make expectations of higher tax rates self-fulfilling if the fiscal authority relies on changes in labor income tax rates to balance the budget. This happens because the expectation of high tax rates lowers labor supply and therefore output, forcing tax rates to be raised to balance the budget.

8

In the context of monetary policy, an inflation bias can result from a credibility problem in the relation between the policy maker and the private sector. In the case of fiscal rules, instead, the relevant bias, as we have seen, can be determined by political and distributional factors; problems of time consistency can arise because current and future governments may have different preferences over social outcomes. Expectations over future electoral outcomes play an important role in shaping both policy decisions and voters’ electoral choices.

9

This point was often considered in the context of the Maastricht debate. Indeed, the move towards a common currency lowered borrowing costs for high-debt countries by removing inflation and exchange rate risk premia on interest rates. However, Bayoumi, Goldstein and Woglom (1995) find that U.S. states face a steeply rising supply curve for credit.

10

The nature of the trade-off between flexibility and deficit bias is apparent in some of the empirical work on the link between statutory fiscal restraints and budgetary outcomes within U.S. states. ACIR (1987) and von Hagen (1991), among others, find that states with such restraints run smaller budget deficits, while Bayoumi and Eichengreen (1995) find that the counter-cyclical responsiveness of state budgets is significantly reduced by more stringent balanced budget rules.

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