I. Definition and Measurement of the Stance of Fiscal Policy

A statement to the effect that the stance of fiscal policy is conservative is usually supposed to mean that the current set of policies is more restrictive in its effect on the economy than some other set of policies. Thus, fiscal policy stance can only be understood by reference to some norm or base case; to say that a policy implying a budget surplus of X percent when the economy is at a level of activity Z is restrictive requires at least an implicit comparison with some other set of policies—for example, those implying a balanced budget.

II. Comprehensive Public Sector Accounting and Indicators of the Fiscal Stance

In two recent papers, Buiter (1983 and 1985) has criticized the conventional measure of the deficit and the fiscal stance indicators constructed by the Fund and the OECD, among others. Instead, Buiter (1983) advocates the use of comprehensive accounting for the public sector, which measures all changes in net worth of the public sector from whatever source.¹⁰ He faults the conventional measure of the deficit, even when that measure is expressed in real terms, because it excludes changes to the net worth of the public sector stemming from changes in the real values of the outstanding stocks of public assets. Changes in net worth that are excluded are those resulting from, among others, the impact of inflation on the real value of assets and liabilities whose value is fixed in nominal terms; the depreciation of real assets; exchange rate variations when assets and liabilities are denominated in foreign currencies; changes in relative prices (for example, changes in the value of public mineral rights resulting from a change in the relative price of minerals); and changes in the present value of future tax payments under current tax laws and of future expenditure commitments under current expenditure programs.

In the 1983 paper Buiter does not dismiss out of hand cyclically and inflation-adjusted deficits, noting that “inflation-accounting in the public sector is long overdue” (p. 345). He also argues that a traditional contracyclical fiscal policy can be interpreted as a device to reduce the gap between permanent and current income, a policy that increases economic welfare when consumers are liquidity constrained.

In the later paper, however, Buiter (1985) asserts the need for long-term budgeting that takes into account the future path of revenues and the financibility of the deficit, but he rejects conventional measures of the deficit, whether adjusted or not, on the grounds that none of the simple indicators of the fiscal stance can be derived from a model rich enough in features to be taken seriously.

Buiter recommends that national and international authorities begin constructing comprehensive balance sheets, presumably with the aid of a macroeconomic model, so as to encompass these kinds of changes to net worth in the measure of the deficit. This would be a prodigious but worthwhile task because conventional measures of the public sector balance may seriously misrepresent the options open to a government.

Is this proposal practicable, and, if it is, what purpose would it serve? In particular, could the measure of the change in net worth derived from this estimate replace the conventional indicator, or even the inflation-adjusted and cyclically adjusted version of the conventional indicator?

Unlike the conventional accounting measure, the comprehensive measure would require that assumptions be made about such macroeconomic phenomena as the rates of growth of real and nominal GDP, the evolution of the general price level and of interest rates, as well as the price of assets owned by the government. Changes in net worth from some of the sources noted above would be more easily estimated than others. For just two examples of difficult valuation problems, consider changes in the value of a missile system or in the value of national parks or natural reserves. More tractable would be the valuation of mineral royalty rights, but much uncertainty would attach to the estimate. Changes in net worth resulting from increases in the present value of future expenditures under an entitlement program could be estimated with the aid of a macroeconomic model, but inevitably the assumptions that would need to be made about the model’s exogenous variables and policy instruments would be somewhat arbitrary, as noted in the previous section. In particular, the future course of expenditures under an entitlement program may be determined by current legislation, given the macroeconomic environment, but the same is not true of other expenditures.

Nonetheless, at least some of these changes in net worth could be used to augment the conventional measure. The question remains whether the more comprehensive measure would be a better indicator of the stance of fiscal policy. To illustrate some of the implications of a broader measure, consider the case of a hypothetical economy that enjoys a discovery of a substantial reserve of petroleum in the public domain. The discovery will increase the public sector’s net worth, because it increases the value of the government’s mineral rights. This increase will not be reflected, however, in either the flow of funds deficit or in any of the conventional indicators of the fiscal stance, including those correcting for the effects of inflation and the business cycle. Does the exclusion of changes in the value of such assets from the public sector balance or from the indicators make them misleading?

If the increase is included, then the public sector’s balance is greater, other things being equal, and the stance of fiscal policy, as calculated by the Fund and OECD indicators, is less expansionary (more restrictive) than it otherwise would be. Note that this conclusion does not require that any of the petroleum be extracted. But has there been a contractionary shift in the stance of fiscal policy?

The discovery increases both the public sector’s net worth and the permament income of the economy. Some time can pass before any of the mineral is actually extracted, and unless the economy’s residents treat the discovery as effectively adding to their personal wealth and determine their consumption expenditures on the basis of that wealth, the resource discovery will not lead to an increase in consumption. Nonetheless, the permanent income or wealth of the economy is now higher, and an increase in aggregate consumption is both feasible and possibly desirable.¹¹ An increase in public expenditure or a discretionary reduction in taxes will allow such an increase to take place, so that the application of a simple rule—such as “avoid policies resulting in large positive stimuli to the economy as measured by a conventional indicator of the stance of fiscal policy”—could be quite inappropriate. In such circumstances a large stimulus may be good policy.

Nonetheless, an expansionary fiscal policy will have the same effects on the economy after the discovery as before—some combination of effects such as an increase in domestic absorption and interest rates, and a decline in the external current account balance—and the failure to implement an expansionary fiscal policy will not reduce domestic absorption or lead to a contraction of output. Moreover, inclusion of the change to net worth resulting from the resource discovery in the measure of the deficit and in an indicator of the fiscal stance will mean that this indicator can no longer be used as a guide to the impact of fiscal policy on current macroeconomic activity.

Suppose that instead of a resource discovery, the price of petroleum increases, so that the value of a publicly owned petroleum reserve is increased. Should this increase also be included in the measure of the public sector balance and in indicators of the fiscal stance? In this case, unlike the first case, it cannot be said that the permanent income of the economy is necessarily increased. Such an increase would depend on whether the economy is a net importer of petroleum and on the scale of its net imports in relation to its reserves. To take a specific example, if the increase in the present value of the annual net oil import bill were to exceed the increase in the value of the petroleum reserve, permanent income would undoubtedly fall.¹² Thus, although the public sector balance sheet looks better, the private sector’s balance sheet would look worse. In this case it would be the more broadly defined indicator that would give the wrong signal, and a policy based on the rule “avoid large increases in public sector net worth” could give the wrong results.

Some analysts have proposed augmenting the conventional deficit by a measure of the change in the present value of the unfunded liabilities of the social security system.¹³ At present, both cash-based measures of the government’s financial operations and those based on national accounting treat the operations of the social security system on a cash basis, in the sense that only current operations, not changes in the government’s accrued liabilities, are reflected in either measure. Should these changes be reflected in an indicator of fiscal policy stance?

The answer to this question turns partly on semantics and partly on assumptions about the way the accrued liabilities would affect economic behavior. If the change in the accrued liabilities results from a policy introduced in the current year, it is arguable that any change in economic behavior they bring about should be attributed to fiscal policy. Thus, for example, if one of the fiscal policy variables in the model in Section I represents policies affecting the social security system, and a change in these policies affects current macroeconomic activity, then the policies ought to be included. If, however, the increase in accrued liabilities results from policies taken in the past, it would not be included in the measure of fiscal policy stance determined by the model, unless the assumption was made that increases in the unfunded liabilities in relation to the trend rate of growth of GDP constitute discretionary fiscal policy by definition, analogous to the definition of cyclically neutral expenditure in the Fund’s fiscal impulse measure.

The crucial issue is whether the increase in unfunded liabilities would affect economic behavior. Many economists believe that consumption in the United States has been increased by the failure to adopt a fully funded social security system, although the estimates of the size of the increase vary greatly.¹⁴ A case can certainly be made for broadening the conventional measure of the deficit to include this change in net worth of the public sector, but it would be difficult to determine the size of the weight to be attached to it in an indicator of the stance of fiscal policy.

The values of mineral or resource rights and of unfunded entitlement program liabilities are two examples of changes in public sector net worth that are not reflected in conventional measures. Others include contingent claims on government resulting from public insurance programs and contingent liabilities entailed by the possibility of default by beneficiaries of public lending programs, and the decline in net worth entailed by the depreciation of infrastructure and other publicly owned real assets. These phenomena can have significant implications for public policy, but unless their change can be shown to contribute to the impact of government operations on aggregate demand or financial markets, they do not belong in an indicator of the stance of fiscal policy.¹⁵

III. Concept of the Economic Deficit

Kotlikoff (1986) has argued that accounting labels such as “taxes,” “expenditure,” “transfers,” and “borrowing” are ill-defined and essentially arbitrary terms with no general basis in economic theory, and that neutral terms like “receipt” and “payment” would be more appropriate. The conventional nomenclature is arbitrary because receipts and payments may be labeled in a number of different ways. Nonetheless, the choice of nomenclature affects the calculated value of the deficit.

Kotlikoff gives an example of a transaction between the government and an individual that comprises a receipt by the government in one year of $1,000 and a payment to the individual of $1,500 ten years later. The receipt in year zero could be labeled “taxes,” and the payment in the tenth year “transfers.” Alternatively, the receipt could be labeled “borrowing,” and the payment “repayment of principal plus interest.” With the first set of labels, the deficit in year zero is $1,000 less than it would be without the transaction, and it is $1,500 more in the tenth year. With the second set, the deficit in year zero is unaffected, and in the tenth year it is increased by the part of the $1,500 that represents interest payments. However, the change in nomenclature obviously has no effect on the behavior of the economy, because the individual’s consumption possibilities are unchanged (Kotlikoff (1986)).

This argument overlooks what appears to be a crucial difference between taxation and government borrowing: taxes must be paid, but generally no one is obliged to lend to the government. Moreover, with the possible exception of social security contributions, the receipt by government of revenue is not paired with an obligation to make a payment at some future date. Finally, even if the classification of various items such as “revenue,” “expenditure,” and “financing” is not clear-cut, classifications are not usually changed from one year to the next.

Taking this last point first, it is an easy matter to demonstrate that with one set of labels a change in fiscal policy can leave the deficit unchanged, whereas with another set of labels the change in policy does alter the deficit. Consider a policy that entails an expansion in the coverage or an increase in the generosity of benefits of a pay-as-you-go old-age state pension program. The expansion of this pension system has no impact on the deficit when the conventional accounting definitions are employed because the expenditures and revenues of the government will increase by equal amounts. However, if contributions are treated as loans to the government and expenditures on pensions are treated as repayment of loans and interest, then the deficit will be affected.

Turning to the first and second points, Kotlikoff’s treatment of social security contributions as loans assumes that such contributions do earn an implicit return, albeit an uncertain one, and also—which may be more controversial—that the obligation to participate in a public pension plan and to make social security contributions does not reduce the wealth of the participant any more than the purchase of a bond would. In effect, the contributions are treated as if they created an obligation on the part of the government to repay the contributors. In the terminology of the Fund’s Manual on Government Finance Statistics, the contributions are a repayable receipt of the government (International Monetary Fund (1986, p. 97)).

The obligatory nature of the transaction is of little economic significance to Kotlikoff. Although many economists would assume that an increase in social security contributions, whether through an increase in rates or an extension in the coverage of the system, would reduce disposable income and hence reduce consumption expenditure, Kotlikoff takes as axiomatic the view that consumption in any period is determined by lifetime income—that is, by wealth. If social security contributions effectively give title to a future income stream of equal present value, they do not reduce wealth. Consequently, they do not reduce the consumption of contributors in any period.

The expansion of a pay-as-you-go system is an instance of a fiscal policy that creates what Kotlikoff would call an economic deficit, since it increases consumption expenditures and reduces the resources available for capital formation. Specifically, when the social security system’s expenditures are increased, the elderly, retired generation benefits from an increase in its wealth; it receives pensions without having to make contributions. Kotlikoff assumes that this generation spends all or most of the increase during its lifetime. Meanwhile, the younger, working generation, which “pays” for the increased expenditure, does not reduce its consumption proportionately, because its wealth is unaffected. As a result, aggregate consumption expenditure increases. In a fully employed economy, the resources available for investment are reduced.

The conventional measure of the deficit through flow of funds accounting has been criticized for not taking into account unfunded liabilities of the social security system, as noted in Section II. Kotlikoff’s critique is more basic, since the creation of an economic deficit does not depend on the need for future increases in rates of contribution to preserve the financial balance of a pay-as-you-go system. Even if rates can remain indefinitely at their initial levels, an increase in consumption and a shift in resources to the elderly take place. Moreover, the assumption that the propensity to consume of the elderly is higher than that of the young is unnecessary. All that is necessary is that perceived wealth increase, and this does happen, given Kotlikoff’s assumption that the contributions of the younger generation are akin to the purchase of securities.

Economic deficits can be created by a reform that replaces one kind of tax with another, even if the yield of the new tax is no different from that of the old. For example, a shift from a tax on income to a tax on consumption would shift resources from the elderly, who are net dissavers— they are in the phase of the life cycle at which their consumption expenditure exceeds their income—to younger generations, who are accumulating wealth and spending less than they earn.¹⁶

Changes in the economic deficit in the sense intended by Kotlikoff can even be created by governmental measures that would not be regarded as having anything to do with fiscal policy. An instance would be the introduction of an environmental measure that restricted the use of industrial capital and consequently reduced the value of the existing stock of capital.

How would an across-the-board reduction in personal income taxes be treated in this framework? The answer is not obvious—it would depend, among other things, on how the reduction in taxes was distributed across generations, on the degree of progressivity of the tax system, and on the distribution of income. Above all, it would depend on how the reduction in revenue was to be financed. If the reduction is financed by the issue of bonds now, combined with a subsequent increase in taxes later, the impact of the tax reduction also depends on the distribution of the burden of the future tax increase. When the same people who benefit from the tax reduction pay the subsequent increase in taxes, the reduction in taxes has no effect on the economy. The increase in current income resulting from the reductions leads to an increase in financial saving, and in the private sector’s holdings of public debt of equal amounts. There are no liquidity constraints to be relieved by the increase in current income, and permanent income is unchanged. Hence, there is no increase in consumption.

If older persons benefit from the tax reduction, however, subsequent generations pay for it, and consumption increases because the marginal propensity to consume of the first group, as we have seen, will be higher than that of the second. If the tax reduction is to be financed by the creation of money, the impact of the reduction on consumption will depend on the distribution across generations of holdings of money and other financial assets whose values are fixed in nominal terms. Nonetheless, the use of inflationary financing would have many ramifications beyond its impact on consumption.

The discussion to this point suggests the following conclusions. First, no simple model could determine with any precision the magnitude of the impacts of different measures on consumption and capital accumulation. The most it might do is to indicate whether the impact is positive or negative. Second, the analysis is irrelevant for an understanding of the short-run impacts of fiscal policy in an economy that is experiencing deficient aggregate demand or is significantly cash-constrained; the available evidence on cash constraints in the United States and other economies has to be assessed before Kotlikoff’s critique can be fully evaluated.

The presence of liquidity constraints would change the analysis. Thus, suppose that the taxes paid by a given generation are shifted forward in time from midlife to early adulthood, when current income is typically lower. The life-cycle model would imply that consumption would be high relative to income in the earlier period if households can borrow on the strength of their future income. However, if they cannot borrow, their consumption in this period would be less than it would be if they could borrow.

In these circumstances, a tax reduction now that is financed by an increase in taxes in the later period is akin to a loan, and it is quite possible that consumption will increase. It is important to understand, however, that this increase depends on current income being low relative to future income, and that liquidity-constrained households behaving as the life-cycle model predicts would not invariably increase their consumption by the full amount of the tax reduction.

Recent studies suggest that a significant proportion of consumers in the United States are liquidity constrained, essentially because consumption is more sensitive to fluctuations in current income than would be predicted by the life-cycle model in the absence of cash constraints.¹⁷ For example, Hall and Mishkin (1982) found that some 20 percent of consumption is by liquidity-constrained households. Mariger (1986) estimated a figure of 19 percent with his preferred model. Flavin (1981) also found that liquidity constraints are an important determinant of consumption. In view of the relative ease with which consumer credit is obtained in the United States, and the relative absence of institutional rigidities affecting credit markets, it is arguable that liquidity constraints would likely be more important in most other economies, and in particular in less industrialized economies. Rossi (1988), who reported results of tests of consumption behavior for a sample of developing countries, concluded that liquidity constraints are a significant influence. It is also arguable that there is a psychological dimension to the liquidity constraint—some people do not like to borrow, even if “objective” criteria imply they can afford to do so.

It needs to be emphasized, however, that these studies do not point unambiguously to the conclusion that Kotlikoff’s approach is invalid. If 80 percent of consumption in the United States is by households that do not experience liquidity constraints, and these households smooth consumption over time in the manner predicted by the life-cycle hypothesis, tax reductions could be mostly offset by increases in household savings, and vice versa, unless they affect different generations. Altonji and Siow (1987) did not find much evidence against the assumption of perfect capital markets. Moreover, the existence of liquidity constraints taking the form of credit rationing or differential borrowing and lending rates does not automatically rule out the possibility that consumption will not be affected by a tax cut; for example, it is possible that lenders may reduce the maximum value of loans in response to a tax cut, on the grounds that future tax increases will increase the likelihood of default if credit limits are not reduced by an amount proportionate to the increase in current disposable income entailed by the tax cut (Hayashi (1987)).

Another related and problematic assumption underlying the Kotlikoff approach pertains to the interpretation by households of the government’s financing constraint. Would households automatically assume that a tax reduction now would be financed by a tax increase of equal present value at some future date? Any tendency to discount the future at a rate higher than the rate at which the government borrows implies that a tax reduction increases household wealth, and using the reduction to finance consumer durable expenditure—not consumption expenditure in the life-cycle model—would not be irrational behavior.

IV. Appraisal and Conclusions

It is worth emphasizing that any measure of the stance of fiscal policy must be specific to one particular model of the economy. Thus, in “ultra-rational” models in which the unexpected announcement of a future increase in government expenditure raises long-term interest rates and depresses investment and aggregate output in the present, even the sign of a conventional fiscal impulse measure would be wrong (see Buiter (1985, pp. 48–49)).

Kotlikoff’s critique of fiscal indicators based on standard accounting labels is itself dependent on a neoclassical model of the economy and assumes that liquidity constraints are unimportant. A tax reduction now that is financed by an increase later, however, is not a matter of indifference to cash-constrained households contending with imperfect credit markets. In a cash-constrained world, the component of wealth contributed by current income is important, and buying on the installment plan raises the purchase price. In such a world, summary indicators of the budget stance derived from flow of funds accounts can serve a purpose.

Nonetheless, there are some fiscal policy changes—such as a substantial change in the tax regime—whose impact on aggregate demand no simple model could capture and that would not be reflected in a change in the budget balance. The summary indicator approach is probably most reliable for modifications to existing tax regimes and expenditure programs, rather than for wholesale tax reforms and substantial changes in the composition of expenditure. In any case, the summary indicator approach is not intended to capture the impact of fiscal policy on the rate of capital accumulation.

Two other criticisms of the summary indicator approach also deserve comment. It is often argued that the indicator approach is misguided because of its failure to consider the sources of financing of the public sector’s operations. Thus, in the simple monetarist model, fiscal policy cannot be expansionary unless it is validated by an increase in bank financing. Does it follow that it is useless to determine whether the fiscal stance has changed?

This question is partly one of semantics, but there is a point to the exercise regardless of the way an increased deficit is financed. That is because, even in a simple monetarist world with the money supply held constant, an expansionary fiscal policy has some impact on the economy. A tax reduction leading to an increase in the deficit is associated with higher interest rates and capital market pressures. An increase in the deficit entailed by a fortuitous decline in inventory investment is not associated with these effects.¹⁸

It is quite true that an expansionary fiscal policy does not result in an expansion of output in all models. Nonetheless, even in ultrarationalist models expansionary fiscal policy is invariably asssociated with capital market pressures and interest rate increases. Whatever the model, the autonomous component of the public sector balance has an effect that differs from its endogenous component. For this reason, the separation of fluctuations in the public sector balances into their autonomous and cyclical components is a valuable exercise, even though the distinctions made are inevitably arbitrary.

A second criticism is that the various summary indicators are easily misused. Thus, a given measure shows that policy became more restrictive at a time when inflation accelerated, and the inference is made that the measure countenances a more expansionary policy, which most people would regard as clearly inappropriate. This inference is incorrect. The estimation of the fiscal stance and its evolution implies nothing about which stance is appropriate. It does not follow that because the fiscal stance has been tightened, it should not be tightened further. The moral to be drawn from this criticism is that summary indicators should be used with care.