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).

IV. The Effects of Fiscal Policy Shocks on Aggregate Demand Under Rules and Under Discretion48

A. Temporary Spending Shock

99. With a binding spending rule, shocks leading to higher expenditures are ruled out by assumption, so we will focus on a spending rule that limits the amount of spending increases over the economic cycle. In the presence of such rule, an increase in public sector spending would be perceived as temporary. In a neoclassical framework (see, for example, Ahmed (1986) and Barro (1989)), this would entail, ceteris paribus, a small adjustment (or no adjustment) of private-sector spending, and therefore an increase in external borrowing (a current account deficit).

100. Consider now the case of a discretionary fiscal regime: in this case, the increase in spending may be perceived as being more persistent, because the government is not required to adjust future spending in line with the fiscal rule (and because the government has a spending bias by assumption). Given the bound of the intertemporal budget constraint, private agents will anticipate an increase in the future tax burden and adjust their current consumption behavior accordingly. This implies, ceteris paribus, a smaller increase (or no increase at all) in aggregate demand, and a smaller current account deficit.

101. Finally, consider a rule on the cyclically adjusted budget balance: in this case, the spending shock could be offset through lower future spending or higher future taxation. We already analyzed the former case. In the latter case, the effects would be more similar to those occurring under discretion, but the fact that tax increases may occur sooner rather than later would tend to reduce further private sector demand. Given the assumption of an excess spending bias, private agents may attribute a higher probability to a future tax increase (rather than a spending cut). This would imply an outcome similar to the one under discretion.

B. A Temporary Shock to Tax Rates

102. In analyzing the impact of an unexpected reduction in tax rates the key issue is again whether the public expects the government to meet its intertemporal budget constraint through higher future taxes or lower future government expenditure. Given the assumption of an excess spending bias, assume the former. In the presence of a cyclically-adjusted budget rule the perceived ‘temporariness’ of the tax cut would imply no impact at all on private sector consumption if consumers are fully Ricardian, or a very modest one if they have a discount rate higher than the rate of interest.

103. Under a discretionary regime, if the tax cut is perceived as lasting for a longer period, the response of private sector consumption maybe stronger.49

104. In the presence of a spending rule, there would be no constraints on whether the adjustment will take place through lower future spending or higher future taxes, and therefore the impact would be the same as in the discretionary case.

C. Permanent Spending Reductions

105. Suppose that the government announces and implements a reduction in government expenditure, announcing that this reduction will be permanent. In the presence of a spending rule, private agents may find the announcement credible. This would lead them to increase private consumption.

106. Under discretion, private agents may consider that lower spending may not be sustained: this would imply a smaller increase in private consumption than in the presence of a rule, and hence lower aggregate demand.

107. In the presence of a balanced budget rule, agents will not be sure as to whether there will be permanently lower spending and hence lower taxes (as in the case of a spending rule) or only a temporary decline in spending. The effect may therefore be similar to the one under discretion.

D. Permanent Reduction in Tax Rates

108. In the presence of a budget rule, an announced permanent reduction in tax rates would imply lower spending as well. This would imply higher private consumption.50

109. Conversely, under discretion agents may expect a more limited reduction in spending (and hence a future increase in tax rates) and would therefore increase private consumption by less.

110. Under a spending rule, a permanent reduction in tax rates would be credible if the rule in question is consistent with it. In this case, the effects would be the same as under a budget rule.

E. Empirical Issues

111. A number of studies have examined whether the cyclical response of the budget to shocks depends on different types of fiscal rules in US states, and the implications for macroeconomic volatility. Bayoumi and Eichengreen (1995) find evidence that the response of the budget to macroeconomic shocks is weaker under tighter budget rules, but Alesina and Bayoumi (1996) find no evidence of higher output volatility under more stringent fiscal rules. Kopits and Symansky (1998) use stochastic simulations to show that based on the historical covariance of shocks, tight fiscal rules increase output variability.

References

  • Ahmed, S. (1986), “Temporary and Permanent Government Spending in an Open Economy: Some Evidence form the United Kingdom,Journal of Monetary Economics 17, March, 197224.

    • Search Google Scholar
    • Export Citation
  • Alesina, A. and T. Bayoumi (1996), “The Costs and Benefits of Fiscal Rules: Evidence from US States,NBER Working Paper Series No.5614, June.

    • Search Google Scholar
    • Export Citation
  • Barro, R. J. (1989), “The Neoclassical Approach to Fiscal Policy.” in Modern Business Cycle Theory, edited by Robert J. Barro (Cambridge, MA: Harvard University Press).

    • Search Google Scholar
    • Export Citation
  • Bayoumi, T. and B. Eichengreen (1995), “Restraining Yourself: The Implications of Fiscal Rules for Economic Stabilization,IMF Staff Papers 42, March, 3248.

    • Search Google Scholar
    • Export Citation
  • Kopits, G. and S. Symansky (1998), “Fiscal Policy Rules,” IMF Occasional Paper 162.

48

Prepared by Gian Maria Milesi-Ferretti.

49

If the public expects an expenditure reduction (for example if there is a deficit bias but not an excess spending bias), the private sector will expect it to occur sooner under a budget rule, because the rule constrains the budget balance. In this case, the tax cut would stimulate an increase in private consumption which is larger under a rule than under discretion.

50

With distortionary taxes, the reduction in tax rates would tend to stimulate labor supply while the reduction in spending would tend to increase leisure because of a positive wealth effect. The net effect on production would be ambiguous. See footnote 67.