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When looking at the interaction between fiscal policy and demand conditions, two key sets of issues arise: (i) how do demand conditions affect fiscal positions (how do fiscal balances react to the cycle?); and (ii) how does fiscal policy affects demand (does it support growth, and how?). In this note, we focus on the first question; we include some references for those interested in the second set of questions.
In addition to output, fiscal variables may respond to changes in asset prices, real estate prices, interest rates, exchange rates, and commodity prices. To the extent these effects are not correlated with output fluctuations, they may not be captured by cyclical adjustment techniques and need to be estimated separately. For more detail, see Chapter III in IMF (2009a).
This assumes there are no other automatic factors (see footnote 2).
Fatás (2009) notes that fiscal variables that are acyclical (such as public sector wages) may in practice produce a more stabilizing effect on GDP than countercyclical variables (such as taxes) by their virtue of providing a certain amount of income regardless of economic conditions. This distinction may play a role when discussing the effectiveness of fiscal policy (i.e., its impact on income and growth), which should be measured in reference to outcomes, and not only in relation to the cyclical behavior of fiscal variables.
The methodology presented here is a simplified version of OECD/European Commission methods, which employs separate components of revenue to compute cyclically adjusted revenue and adjusts expenditures based on the deviation of the actual level of unemployment from structural unemployment. In the absence of information on revenue/expenditure components and unemployment rates, FAD has opted to perform cyclical adjustment on total revenue and spending by applying aggregate elasticities.
The elasticities are generally higher for corporate and personal income taxes, equal to 1 for indirect taxes, and less than 1 for social security contributions