Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects

Contributor Notes

* Alberto Alesina is Professor of Economics and Government at Harvard University. This paper was written while he was a visiting scholar in the European I Department of the IMF. He thanks Massimo Russo and the entire department for their hospitality. Roberto Perotti is Assistant Professor of Economics at Columbia University. For very helpful comments, the authors thank Massimo Russo, Michael Deppler, Alessandro Leipold, Alessaudro Prati, Vito Tanzi, and participants in two seminars in the European I Department and the National Bureau of Economic Research. This research is partially supported by a grant from the National Science Foundation.

In the last two decades, the debt-to-GDP ratios of many members of the Organization for Economic Cooperation and Development (OECD) have increased to levels historically observed only in the aftermath of major wars, as Table 1 documents. The policymakers of countries with fiscal problems face several critical questions:

Abstract

In the last two decades, the debt-to-GDP ratios of many members of the Organization for Economic Cooperation and Development (OECD) have increased to levels historically observed only in the aftermath of major wars, as Table 1 documents. The policymakers of countries with fiscal problems face several critical questions:

In the last two decades, the debt-to-GDP ratios of many members of the Organization for Economic Cooperation and Development (OECD) have increased to levels historically observed only in the aftermath of major wars, as Table 1 documents. The policymakers of countries with fiscal problems face several critical questions:

  • How large should the fiscal adjustment be?

  • Should one cut expenditures or raise revenues, and, more specifically, which components of spending and revenues should one adjust?

  • Will the fiscal consolidation last, or will it be reversed and will larger deficits soon reappear? and

  • Will the fiscal adjustment cause a recession?

Table 1.

Public Debt in OECD Countries

(Gross debt as a percent of GDP)

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Source: OECD.

1970.

The critical point that we stress in this paper is that all these questions are deeply interconnected.1 For instance, the composition of the fiscal adjustment influences both the likelihood of achieving a permanent consolidation of the budget and the macroeconomic consequences of the fiscal consolidation.

We identify two different types of fiscal adjustments, “Type 1” adjustments rely primarily on expenditure cuts, in particular, cuts in transfers, social security, government wages, and employment. Tax increases are a small fraction of the total adjustment, and, in particular, taxes on households are not raised at all or are even reduced. On the contrary, “Type 2” adjustments rely mostly on broad-based tax increases, and often the largest increases are in taxes on households and social security contributions. On the expenditure side, almost all the cuts are in public investment, while government wages, employment, and transfers are completely untouched or only slightly affected. We find that, even when the two types of adjustments are the same size in terms of reducing primary deficits. Type 1 adjust men is induce a more lasting consolidation of the budget and are expansionary, while Type 2 adjustments are soon reversed by further deteriorations of the budget and have contractionary consequences for the economy.

Type I adjustments are more permanent because they tackle the two items of the budget, government wages and welfare programs, that have the strongest tendency to automatically increase; in fact, these items have been increasing in the last three decades as a share of total government spending2. Concerning the macroeconomic consequences of the two types of adjustments, the literature, which we review below, has generally focused on credibility and wealth effects of fiscal adjustments on consumption. In this paper, we also emphasize the effects of fiscal policy on unit labor costs and competitiveness. In fact, we suggest that the unit labor cost channel may even be more empirically relevant for consumption than the wealth effects and credibility channels.

This paper is organized as follows. Section I critically reviews several theoretical arguments on the contractionary or expansionary effects of fiscal adjustments. Section II discusses problems affecting cyclical adjustments of fiscal variables and presents the procedure that we use. Section III provides the empirical evidence on fiscal adjustments in a sample of 20 OECD countries for the period 1900-1994. Section IV analyzes three countries—Ireland, Denmark, and Italy—as examples of Type 1 and Type 2 adjustments. The last section concludes.

I. Contractionary or Expansionary Fiscal Consolidations: The Theory

Keynesian Effects

The standard Keynesian argument is that a fiscal contraction has a temporary contractionary effect through an aggregate demand channel in a model with sticky prices and wages. A standard multiplier effect implies that spending cuts are more recessionary than tax increases.

Expansionary Effects of Fiscal Contractions: Demand Side

Wealth Effects on Consumption

A cut in government spending, if perceived as long lasting, implies a permanent reduction in the future tax burden of consumers, generating a positive wealth effect. However, even tax increases can have expansionary effects on consumption. Blanchard (1990a) argues that a tax increase today can have expansionary effects if it generates the expectations of less dramatic and disruptive tax increases tomorrow. Also, by resolving uncertainty about the course of future fiscal policy it may reduce precautionary savings.

Blanchard’s argument is an example of what Bertola and Drazen (1993) characterize as the “expectation view of fiscal policy.” That is, in an intertemporal model of consumption behavior, the effects of current fiscal policy depend on what expectations it generates for the course of future fiscal policy. In their words, “a policy innovation that would be contractionary in a static model may be expansionary if it induces sufficiently strong expectations of future policy changes in the opposite direction” (Bertola and Drazen, 1993, p.12). They consider a model in which government spending follows a random walk with a positive drift and national income is (for simplicity) constant. Bertola and Drazen argue that stabilizations often have a discrete character. That is. even if public debt accumulates rapidly, political constraints often delay the adoption of the appropriate stabilization policies.3 However, because of the feasibility constraint, sooner or later a stabilization will have to occur. Call the ratio of government spending to GDP at which with probability p a stabilization occurs, where stabilization is defined as a sharp drop in spending. If the stabilization does not occur at gc, it will occur with certainty later, when the ratio of spending to GDP reaches a much higher level, g¯. At that point, spending is set below gc so that a stabilization may again occur at gc, with probability p.

The Bertola-Drazen model implies that, at low levels of government spending, private consumption falls at less than one-to-one ratio to increases in government spending: this is because an increase in spending implies that a stabilization may come soon. Thus, higher government spending only partially crowds out private demand—a typical Keynesian result, obtained in a fully neoclassical model. When the economy reaches gc, and if the stabilization occurs, private consumption jumps up, reflecting the wealth effect or reduced expected future taxes. With probability 1 —p, however, the stabilization does not occur. In this case, consumption jumps down because the public realizes that political constraints will delay the stabilization. Thus, a failed stabilization has a contractionary effect because it signals the lack of political commitment to a “serious” attempt to reduce spending.

Bertola and Drazen’s point is consistent with arguments put forward by Giavazzi and Pagano (1996). The latter argue that large fiscal contractions can be expansionary precisely because they signal a permanent and decisive change in the stance of fiscal policy, while small adjustments may have the opposite effect for the opposite reason. The “small” adjustments (in Gia-vazzi and Pagano’s words) can be interpreted as an example of the failed stabilization at trigger point gc using the terminology of Bertola and Drazen.

Sutherland (1995) considers the effects of a stabilization in a model in which consumers have finite lives, as in Blanchard (1985). Each consumer faces a constant probability of death in every period of his life; thus the model does not imply Ricardian properties even with nondistortionary taxes and transfers. As in Bertola and Drazen (1993). the government is on an unstable fiscal path and a stabilization sooner or later has to occur. At a low level of debt, the model displays Keynesian features. This is because the stabilization is expected to occur in the distant future, when many of the current consumers will be dead. These consumers do not internalize fully the future increase in taxation. As debt increases, the model displays non-Keynesian features, namely, an increase in the fiscal deficit that is contractionary. This happens because current consumers expect that a stabilization will occur relatively soon, when they are still alive.

One problem with the expectation view of fiscal policy is that the critical variable driving the results is the effect of current policies on the public’s expectation about future policy changes, a variable that is intrinsically unobservable. A devil’s advocate might argue that any behavior of private consumption following any type of fiscal policy can be rationalized by an appropriate assumption about what the current fiscal policy signals about unobservable future policies.

A second channel for wealth effects arises from the fall in interest rates that may accompany a fiscal adjustment. Lower interest rates imply a higher market value of private wealth.

Credibility Effects

A fiscal consolidation, particularly a strong one in a high-debt country, may have important credibility effects on interest rates by reducing risk premiums. The latter can be of two types: (1) inflation risk premiums or (2) default or consolidation risk premiums. Default risk may be trivial for low-debt countries but may become significant for high-debl ones.4

A discrete change in the fiscal policy stance may have a significant credibility effect on interest rates, which would crowd in private investment and consumption of durable foods. For instance. Miller. Skidelsky, and Weller (1990) consider a model with a threshold above which the government is forced to impose a tax on bond holders. With random shocks on the level of debt, the risk premium increases as the debt level approaches that threshold, leading to a fall in private demand. A decisive stabilization that reduces the debt level to well below the threshold eliminates the risk premium, crowding in the components of private demand particularly sensitive lo interest rates.

Along similar lines, Alesina, Prati, and Tabellini (1990) show that, at a high level of debt, particularly if the debt has short maturity, self-fulfilling confidence crises may materialize. If a crisis occurs and the public is not willing to roll over the debt, the government is forced to tax bond holders or default. This model displays multiple equilibria for some levels of debt-to-GDP ratios. Thus, a fiscal adjustment that reduces the debt below the level at which multiple equilibria are possible may have large discrete effects on the risk premiums.

As for the “expectation theory” of consumption behavior, however, this argument also relies on a variable, “credibility of the adjustment,” that is ex ante unobservable. That is, it is not a priori obvious what makes an adjustment credible or not.

Supply-Side Effects

Labor Supply: Neoclassical Effects

While wealth effects on consumption from permanent reductions in government spending are expansionary on the demand side, the same wealth effects may reduce labor supply (Barro, 1981). If both consumption and leisure are normal goods, a wealthier individual will want to consume more of both, and he will therefore work less. In addition, the higher real wages induced by reducing Tobin’s q may crowd out investment (Baxter and King. 1993).

The standard substitution effect suggests that tax increases should reduce work effort and labor supply. Higher labor income taxes reduce labor supply. Thus, a permanent spending cut financed by a tax cut has two opposite effects on labor supply: the wealth effect reduces it while the substitution effect increases it.

In the case of a temporary cut in government spending, the wealth effect should be small and the substitution effect relatively large. Thus, for temporary spending cuts the substitution effect should predominate, while for permanent spending cuts the wealth effect should dominate. However. Baxter and King (1993) argue that the financing side of the government budget (that is. whether or not the spending cut is financed with distor-tionary taxes) is more important for its macroeconomic impact on supply than for its duration. Empirically, however, both the wealth effect and the substitution effect on individual labor supply are likely to be small5

Labor Market Structure

While the effect of taxes on individual labor supply may be small, their effects on aggregate labor supply in unionized labor markets may be much larger. With unionized labor markets, a permanent increase in labor taxation shifts the union’s aggregate supply of labor because it decreases the after-tax income of employed union members at any before-tax wage. In other words, an increase in labor taxation leads the union to demand higher real wages to compensate for the decrease in after-tax income.

Alesina and Perotti (1997) show that this effect depends on the structure of labor markets. The effect is weak in countries with decentralized labor markets (like the United States or Canada) and is also relatively weak in countries with highly centralized unions, where comprehensive union-government negotiations internalize the entire fiscal maneuver. That is. a centralized union will take into consideration at the bargaining table the spending side of the government budget as well; thus, for instance, the union will internalize the effects of higher taxes on more public goods or larger transfers. On the contrary, the effect of labor taxation on unit labor cost is greatest in countries where unions are strong enough to pass on tax increases to wages but not encompassing enough to internalize the connection between taxes and benefits of the fiscal maneuver. For example. Alesina and Perotti (1997) calculate that in the countries in the intermediate group an increase of the income tax of 1 percent of GNP causes an increase in relative unit labor costs of about 2 percent.

In summary, according to this channel, a tax increase affects unit labor costs of firms, influencing their competitiveness.

Why Composition Matters

The previous discussion has highlighted that tax increases and spending cuts may have very different effects. Several additional reasons suggest that even the composition of spending cuts may have important consequences on how permanent the fiscal adjustment is and on its macroeconomic consequences. 6 One can identify at least three reasons why the composition of cuts may matter.

Expectation Effect

Different types of spending cuts may be more or less permanent. Consider two types of spending cuts of the same magnitude. The first one relies only on a reduction in public investment, for instance in maintenance of public infrastructure. The second one includes cuts in welfare obtained by changing eligibility criteria for transfer programs and by cutting government employment. Even though the two types of spending cuts may have the same magnitude of impact, clearly the second one has more lasting effects than the first. In fact, maintenance of public infrastructure cannot be postponed forever; on the contrary, structural changes in the parameters that determine the extent of coverage of the “welfare state” by influencing the dynamics of entitlement have long-lasting effects. Thus, according to this argument, the composition of spending cuts, much more than the size perse, influences expectations about the future stance of fiscal policy, a critical point of the expectation view.

Political Credibility Effect

Governments that are willing to tackle the politically more delicate components of budgets, such as public employment, social security, and welfare programs, may signal that they are really “serious” about the fiscal adjustment. Not every government has the necessary strength to tackle these politically difficult issues. Typically, coalition governments lack the necessary cohesion to implement this type of adjustment, as shown by Alesina and Perotti (1995a).7 In fact, coalition governments succumb to intercoalition conflicts concerning the distributional consequences of the adjustment.08 However, single-party governments may have the necessary strength to cut transfers, social security programs, and the government wage bill9

Labor Market Effect

Cuts in the government wage bill may have different effects than cuts in nonwage government consumption. Lane and Perotti (1995) show that a fall in government employment shifts the aggregate demand for labor facing the union, thus improving profitability through two channels: a fall in unit labor costs, and a depreciation of the exchange rate in a flexible exchange system. On the contrary, a cut in nonwage government consumption does not have these effects because, at least up to a first degree of approximation, the private and public sectors have the same propensity to spend on the goods and services that enter into the definition of nonwage government consumption. Lane and Perotti (1995) present empirical evidence on a sample of OECD countries that shows that the composition of spending cuts strongly influences labor market variables in the direction described above.

The composition of tax increases may also influence the macroeconomic consequences of fiscal adjustment. For instance, Alesina and Perotti (1995b and 1997) show that taxes on households and social security contributions have the largest impact on relative unit labor costs, via union behavior.

In this paper, we will refer to adjustments that rely primarily on cutting transfers and government employment and wages while keeping taxes on households constant or even reducing them as “Type 1” adjustments. We will refer to adjustments that rely primarily on tax increases, particularly on households, while cutting public investment spending as “Type 2” adjustments.

II. Fiscal Impulse: Cyclical Adjustment

We are interested in discretionary changes in the fiscal position of a country. Thus we need a measure of fiscal impulse, defined as the discretionary change in the government budget balance. For this reason, we focus upon primary deficits rather than total deficits, since fluctuations in interest payments cannot be considered discretionary. The second, more difficult, issue concerns the cyclical correction. One needs to isolate the discretionary change in the primary deficit, defined as the difference between the actual change in the deficit and the change that would have occurred had the policymakers done nothing. Clearly, the problem is to define what doing nothing means. For instance, it may mean, among other things, that certain spending programs remain constant in nominal terms at last year’s level, or constant in real terms, or constant in their share of GDP. The following brief discussion highlights some possible methodologies; it is beyond the scope of the present paper to provide a comprehensive discussion of the issue of cyclical adjustment.10

The simplest approach to cyclical corrections is simply to ignore the problem and consider changes in the primary balance as a measure of fiscal impulse. A second measure, typically used by the OECD, defines the fiscal impulse as the difference between the current primary deficit and the primary deficit that would have prevailed if expenditures in the previous year had grown with potential GDP and revenues with actual GDP. This approach, however, relies on measures of potential output that might be questionable.

A third measure, used by the International Monetary Fund, is similar to the OECD’s but assumes that the benchmark year is not the previous one but a reference year when output was supposed to be at its potential level. In this paper, as in Alesina and Perotti (1995a), we use a fourth measure proposed by Blanchard (1990b). which maintains much simplicity and transparency while providing an attractive cyclical correction. Essentially, this measure uses a calculation of what the government budget would be if unemployment had not changed from the previous year. Specifically, this cyclical adjustment is an attempt to eliminate from the budget changes in taxes and transfers associated with changes in the unemployment rate.

We use a simple implementation of Blanchard’s measure, constructed as follows. For each country, we regress transfers as a share of GDP (TRANSF) on two time trends (1960-75) and (1976-94) and the unemployment rate (U)

TRANSFt=a0+a1TREND1+a2TREND2+a3Ut+εt,(1)

Defining â0, â1, â2, andâ3as the estimated parameters of equation (1) and e t, as the estimated residual, we then compute what the variable TRANSF would have been in period ; if the unemployment rate had remained constant between t - 1 and t:

TRANSFt(Ut1)=a^0+a^1TREND1+a2TREND2+a3Ut+ε^t,(2)

We follow the same procedure to adjust tax revenues, defined as Tt (Ut-1). Using TRANSFt (Ut-1) together with all the other components of spending and Tt(Ut-1), we compute our measure of cyclically adjusted primary deficits.11 This measure of the fiscal impulse is then constructed as the difference between the cyclically adjusted primary deficit in period f and the same variable in period t - 1, as a share of GDP. We sometimes refer to this fiscal impulse variable as the “Blanchard fiscal impulse.”

Several reasons justify our choice for a cyclical correction. First, we find its simplicity attractive. This measure does not rely on possibly questionable and sometimes obscure measures of potential output or base years. Second, this simplicity does not come at a high price for us; in fact, since our focus is on large changes in the fiscal stance, cyclical factors typically should not play a major role. Clearly, one can think of exceptional circumstances in which major exogenous shocks have caused large changes in budget deficits, but these are probably more the exception than the rule. Third, as MeDermoll and Wescott (1996). who are pursuing a similar research strategy, adopt the OECD cyclical correction, it is useful to check on the robustness of results through a different approach. Finally, sensitivity analysis using different cyclical corrections suggests that our results are quite robust.

III. Fiscal Adjustments in OECD Countries

Definitions. Sample, and Basic Statistics

We consider a sample of 20 OECD countries for the period 1960-94. The countries are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, and the United States, Our definition of government as general government as defined by the OECD. which is our data source. We have 378 usable observations; all the country years lacking the complete set of data needed for our tests were excluded.

We focus upon periods of very tight fiscal policy, considering, in particular, relatively large budget adjustments, for two reasons. First, by considering large policy changes, we are less likely to be unduly influenced by cyclical factors. Second, macroeconomic and composition effects are more likely to be detectable in the case of large adjustments. We use the following definition of a tight fiscal policy:

Definition 1: A period of tight fiscal policy is a year in which the cyclically adjusted primary deficit falls by more than 1.5 percent of GDP or a period of two consecutive years in which the cyclically adjusted primary deficit falls by at least 1.25 percent a year in both years.

This definition allows for both a yearly definition of an adjustment and a two-year definition. While there is a certain degree of arbitrariness in this choice, as in any alternative, we show below, by reviewing related literature and performing sensitivity tests, that our results are not unduly sensitive to this particular definition.

Table 2 shows that, on average, the fiscal impulse is close to zero. However, this is the result of significant increases in primary expenditures and revenues of more than 0.3 percent of GDP a year. This observation reflects the well-known “growth of government” that has occurred in the last several decades in OECD countries. Our sample provides 62 years of tight fiscal policy, with an average improvement in the Blanchard fiscal impulse of more than 2.5 percent of GDP. This reduction in deficits is about equally distributed between higher taxes and lower spending.

We now need a definition of success.

Table 2.

Tight Fiscal Policies in OECD Countries: Changes in Primary Expenditures and Revenues

(In percent of GDP)

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Source: OECD.Note: Standard deviations in parentheses.
Table 3.

Successful Fiscal Adjustments in OECD Countries

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For cases of two-year adjustments, the second year is indicated.

Definition 2: A period of tight fiscal policy is successful if (1) in the three years after the light period the ratio of the cyclically adjusted primary deficit to GDP is on average at least 2 percent of GDP below the last year of the light period or (2) three years after the last year of ihe tight period ihe ratio of debt to GDP is 5 percent of GDP below the level of the last year of the tight period.

This definition allows for a measure of success on both the stock of debt and the flow of cyclically adjusted primary deficits. This definition is quite demanding, and about one-fourth of tight policies are successful. Table 3 lists all the cases of successful adjustments: 11 episodes, for a total of 16 observation years. As we discuss below, our results are not unduly sensitive to reasonable changes in this definition: in particular, we illustrate results obtained with a much more lenient definition of success.12

Success and Composition

Table 4 shows that successful adjustments are slightly larger in terms of fiscal impulse than unsuccessful ones: the difference is about 0.5 percent of GDP. While this difference is not trivial, more striking differences appear in the composition of adjustments. In successful cases (16 observation years), about 73 percent of the adjustment is on the spending side; in unsuccessful cases (46 observation years), about 44 percent of the adjustment is on the expenditure side.

Even more striking are the differences in composition of types of spending and sources of revenue. Table 56 consider a breakdown of the major components of the spending side. In unsuccessful cases, more than two-thirds of the cuts are in capital spending (public investment) while everything else, particularly government wages, is virtually untouched. In successful cases, cuts in capital expenditures are actually much lower in terms of GDP share than in unsuccessful cases, despite the larger amount of total spending cuts. In fact, only one-fifth of total spending cuts in successful cases are in public investment. The critical difference is that in successful adjustments the largest cuts are in transfers and government wages, which together account for about 50 percent of the total spending cuts. In successful adjustments, transfers and government wages are reduced by almost 1.1 percent of GDP a year while in unsuccessful cases the sum of these two components is less than 0.2 percent of GDP a year.

Cuts in the government wage bill may arise from lower wages and from lower employment. Table 7 shows that, while during successful adjustments the growth of government employment significantly drops, the rate of growth of this variable does not change either during or after unsuccessful adjustments. This outcome holds both for government employment alone and for the same variable as a share of the labor force.

Table 4.

Successful and Unsuccessful Adjustments in OECD Countries: Changes in Primary Expenditures and Revenues

(In percent of GDP)

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Source: OECD.Note: Standard deviations in parentheses.
Table 5.

Successful and Unsuccessful Adjustments in OECD Countries: Composition of Expenditure Cuts as Share of GDP

(In percent)

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Source: OCED. See Appendix for a precise definition of variables.Note: Standard deviations in parentheses.
Table 6.

Successful and Unsuccessful Adjustments in OECD Countries: Composition of Expenditure Cuts as Share of Total Expenditure Cuts

(In percent)

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Source: OECD. Computations from Table 5.Note: Standard deviations in parentheses.
Table 7.

Successful and Unsuccessful Adjustments in OECD Countries: Changes in Government Employment

(In percent)

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Source: OECD.Notes: “Before” is the yearly average of the two-year period before the liseal adjustment; “during” is the one-year adjustment period or yearly average of the two-year adjustment period; “after” is the yearly average of the two-year period after the adjustment. Standard deviations in parentheses.
Table 8.

Successful and Unsuccessful Adjustments in OECD Countries: Composition of Revenue Increases as Share of GDP

(In percent)

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Source: OECD. See Appendix for a precise definition of variables.Note: Standard deviations in parentheses.

Table 5 6 and 7 thus show that successful adjustments are based on broad-based spending cuts that do not spare the most politically sensitive parts of the budget, namely, transfers, social security, government wages, and employment; in fact, these components receive the largest share of expenditure reductions. As mentioned above, these are Type 1 adjustments. On the contrary, unsuccessful adjustments concentrate most of their cuts in capital expenditures (Type 2 adjustments), probably for two reasons. First, the effects of cuts in public investment, such as postponing the maintenance of infrastructure or delaying new capital projects, are less immediately visible to voters than cuts in their salaries or pensions checks.’13 Second, “creative accounting” is probably easier in the capital accounts.14

Table 8 and 9 display the composition of tax increases. In successful. Type 1 adjustments, tax increases are concentrated in business and indirect taxes. The increase in business taxes may be due to a larger base rather than to higher rates. In fact, we show below that the profit share tends to increase in successful adjustments. Taxes on households do not increase at all. and social security contributions are also spared almost completely. However, the tax increase in unsuccessful. Type 2 adjustments is widely spread across all components. The contrast between cases of success and failure is particularly striking for taxes on households and social security. The total share of tax increases of these two components is only 10 percent in successful cases and almost 50 percent in unsuccessful cases. As shown in Alesina and Perotti (1995b and 1997) and discussed above, these two types of taxes—taxes on households and social security contributions—have the strongest effects on unit labor costs, via union behavior. As we show in the next subsection, the movement of unit labor costs is. in fact, very different in successful and unsuccessful adjustments, and may help explain differences in the macroeconomic consequences of fiscal adjustments.

Table 9.

Successful and Unsuccessful Adjustments in OECD Countries: Composition of Revenue Increases as Share of Total Revenue Increases

(In percent)

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Source: OECD. Computations from Table 8.Note: Standard deviations in parentheses.

Macroeconomic Consequences of Fiscal Adjustments

Table 10 summarizes some basic statistics on macroeconomic conditions before, during, and in the immediate aftermath of successful and unsuccessful adjustments. The term “before” “refers to the two-year period before the beginning of the tight fiscal policy. The term “after” refers to the two-year period alter the last year of the tight policy. The term “during” is the year or the two-year period of the fiscal adjustment. All the variables in the table are yearly averages.

The rate of GDP growth, as measured in differences from the average of the seven major industrial countries, shows large differences between successful and unsuccessful cases. During successful adjustments, growth is more than 1 percent above the industrial country average, and this difference is statistically significant; afterward, growth falls but still is above the industrial country average. On the contrary, during and after unsuccessful adjustments, growth remains below the industrial country average Before successful adjustments, growth is not higher (relative to the industrial countries) than before unsuccessful adjustments; in fact, it is slightly lower. This observation suggests that adjustments are not successful simply because they are started in periods of high growth.

Unemployment relative to the industrial country average after a successful adjustment is at about the same level as before it. After an unsuccessful adjustment, unemployment relative to the industrial countries doubles from less than 1 percent to almost 2 perceni above the industrial country average.

Table 10.

Successful and Unsuccessful Adjustments in OECD Countries: Macroeconomic Conditions

(In percent)

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Source: OECD.Notes: “Before” is the two-year period before the adjustment; “during” is the adjustment period; “after” is the two-year period after the adjustment. GR is the yearly average growth of GDP relative to the average for the seven major industrial countries, weighted by GDP. U is the unemployment rate relative to the average for the seven major industrial countries. ΔI is the yearly rate of growih of private investment. ΔC is the average yearly rate of growth of consumption. i is a nominal long-term interest rate (ten-year government bond) relative to the average for the seven major industrial countries. r is the real long-term interest rate computed as i – inflation, relative to the seven major industrial countries. ULC is the yearly rate of change of relative unit labor cosls. EXCH RATE is the rate of change of the nominal effective exchange rate. TB is the trade balance. VAULC is the rate of change of the value-added deflator over unit labor costs; WSH is the wage share over GDP, and PSH is the profit share over GDP. See the Appendix for a precise definition of these variables. Standard deviations in parentheses.

The rate of growth of private investment shows a sizable difference between the two types of adjustments. An investment boom occurs during and after the successful adjustments. In unsuccessful cases, the rate of growth of investment falls during and after the adjustment, and it is much lower than in successful cases. The cumulative growth rate of investment during and after successful adjustments is about 25 percent, while it is only about 8 percent during and after unsuccessful cases. The rate of growth of consumption does not show large differences between the two types of adjustments. These observations on investment and consumption are intriguing, since the academic literature (theoretical and empirical) has typically focused on consumption much more than on investment.

Relative to the seven major industrial countries, nominal and ex post real long-term interest rates do not show strong differences between the two types of adjustments, although nominal rates do fall during successful adjustments and increase during unsuccessful ones.

Very interesting observations emerge from the evidence on unit labor costs and measures of competitiveness. The data on relative unit labor costs show that these costs significantly fall before and during successful cases while they are about constant in unsuccessful ones. The cumulative fall before and during successful cases is more than 10 percent. The behavior of relative unit labor costs can be influenced by two factors: a depreciation of the nominal exchange rate in an economy with nominal rigidities, and a containment of wage pressure. As Table 10 shows, both successful and unsuccessful adjustments have been accompanied and preceded by nominal depreciations. The depreciations have been somewhat larger in successful cases but significant as well in unsuccessful adjustments. However, while in successful cases the nominal depreciations have had an impact on competitiveness (unit labor costs), in unsuccessful cases they have not. These observations suggest that the behavior of real wages is significantly different in the two types of adjustments. As argued above, this difference may be linked to the composition of the fiscal adjustments, and in particular to the difference between the two types of adjustments in the behavior of government wages and employment, taxes on households, and social security contributions. The evidence on the trade balance confirms that net exports have performed better in successful than in unsuccessful adjustments.

The last three rows of Table 10 display indices of profitability and distributional shares. An index of the value-added deflator over unit labor costs (VAULC) shows a rather different behavior in successful and unsuccessful adjustments. In the former group, one observes a significant increase in this index of profitability during the adjustments, while in unsuccessful cases the same index is constant. The behavior of real wages, unit labor costs, and profitability also has clear implications for the distributional shares. While the wage share (WSH) goes down by about 3 points and the profit share increases by about 2 points during successful adjustments, these two shares are virtually constant in unsuccessful cases.

Table 10 suggests that perhaps the strongest channel influencing the macroeconomic consequences of fiscal adjustment goes through unit labor costs, via their effects on investment and exports. This channel may be at least as important, if not more so. than the channels typically emphasized in the literature, which are based upon “wealth effects cum expectations” on consumption and credibility effects on consumption. The discussion in the next section on three case studies sheds more light on this issue.

Needless to say. Table 10 is far from conclusive, and much more statistical evidence is necessary to disentangle the various channels through which fiscal adjustments can influence the economy. In particular, several critical issues need more attention.

First, more work is needed to disentangle the effects of exchange rate depreciations and wage moderation on the likelihood of success of fiscal adjustments. One interpretation of the evidence presented above is that the composition of successful adjustments induces wage moderation while the composition of unsuccessful ones does not. A critical exhibit in favor of this interpretation is that, during successful. Type I adjustments, government wages are cut. government employment does not increase much, and taxes on households are constant. According to the models and the empirical evidence presented by Alesina and Perotti (1995b and 1997) and Lane and Perotti (1995). these features should imply wage moderation on the part of the unions. On the contrary, the features of unsuccessful. Type 2 adjustments, namely, higher increases in taxes and no cuts in government wages or employment, have the opposite effects on unit labor costs. However, several major multiyear fiscal adjustments (see next section) arc preceded by a devaluation of the exchange rate. Disentangling the effects of wage moderation and fiscal variables from the effects of exchange rate depreciations on the supply side and the cost of firms is the critical next step to understanding the dynamics of fiscal adjustments.

Also. Table 10 shows that growth is significantly higher during successful adjustments than during unsuccessful ones. Our favorite interpretation of this finding is that the composition of the adjustment, through its credibility, wealth, and, especially, unit labor cost effects, influences growth. An alternative interpretation is that adjustments are successful because growth is, for some exogenous reason, particularly high during these episodes. While our evidence cannot be conclusive on this point, the alternative interpretation, which argues that growth explains success, fails to explain the difference in composition between successful and unsuccessful adjustments. If everything is driven by exogenous growth effects, successful and unsuccessful adjustments should look approximately the same in terms of their composition.

Sensitivity Analysis and Comparisons with Previous Results

Sensitivity analysis of our results shows that they are robust to changes in the definitions. For instance, we have relaxed the definition of success as follows:

Definition 3: A period of tight fiscal policy is successful if (1) the cyclically adjusted primary deficit as a share of GDP is on average lower than in the last year of the light policy, or (2) the debt-to-GDP ratio three years after the last year of the adjustment is below the level of the last year of the adjustment.

With this new definition, we now have 38 observation years of success, corresponding to 28 episodes, and 24 observation years of failures. Table 11 considers differences in the composition of expenditure cuts and tax increases and should be compared with Table 4 above. The differences between successful adjustments and unsuccessful ones in Table 11 are very similar to those in Table 4: in fact, they are slightly larger. The size of the adjustment in terms of fiscal impulse is virtually identical.

Table 12 considers the composition of spending cuts and should be compared with Table 6, The difference in the composition of successful and unsuccessful adjustments remains striking. Virtually all the adjustment in unsuccessful cases (84 percent of total spending cuts) is on public investment, while transfers and government wages slightly increase. In successful cases, cuts of transfers and government wages are almost one-half of the total expenditure reductions. The differences between the two cases in the composition of tax increases are qualitatively similar to those reported in Table 8 and 9.

As for the macroeconomic consequences, this alternative, more lenient definition of success produces results that are quite similar to those reported in 10; however, as should be expected, the differences between the successes and the failures are a bit smaller. The behavior of unit labor costs remains the most striking difference between the two types of adjustments.

Table 11.

Successful and Unsuccessful Adjustments in OECD Countries: (Relaxed Definition): Changes in Primary Expenditures and Revenues

(In percent)

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Source: OECD.Note: Standard deviations in parentheses.

In a separate test, we also have relaxed our definition of a tight policy, reducing (in absolute value) the threshold level for a tight policy. For instance, we have considered as a tight episode any two-year period in which the Blanchard fiscal impulse is lower than minus 1 percent, as opposed to minus 1.25 percent, as in definition 1. Our results do not change qualitatively. Further experiments combining different definitions of tight episodes and success confirm the general robustness of our results.15

Also, a comparison with our previous results (Alesina and Perotti. 1995a and 1996) confirms that the basic picture painted in this section is quite robust. In our previous papers, we have used a definition of tight policy that included only one-year adjustments. What we have done here improves upon this definition by broadening it to include a two-year period of “moderate adjustment” rather than accepting only one year of sharp adjustment. We have also improved upon our previous definition of success by focusing on not only the stock of debt but also the flow of deficits as criteria of success. Also, we use an updated data set in this paper that includes only series with a full set of usable observations. Finally, we consider many more macroeconomic variables and make some progress toward disentangling the macroeconomic effects of adjustments, particularly those related to the external sector and exchange rate movements.

McDermotl and Wescott (1996) use a similar methodology to ours. Their definitions are a combination of what we use in this paper and what we have used in our previous work. Their definition of tight fiscal policy allows for two- or three-year periods of consecutive tightening. Their definition of success is based only on improving the ratio of debt to GNP. They also use a different methodology for the cyclical adjustment. As far as the composition of fiscal adjustment is concerned. MeDermott and Westcott confirm our results on the spending side. This outcome is quite reassuring, given the several differences between their definitions and procedures and ours. McDermott and Westcott also make similar findings concerning the size of the adjustment in successful and unsuccessful cases. They interpret their findings to mean that the size of the adjustment is very important. We still find the differences in the composition of adjustment more impressive than the differences in size, particularly in light of the results of Table 11.

Using a rather different methodology based upon the estimation of consumption functions. Giavazzi and Pagano (1996) argue that large and persistent fiscal adjustments are expansionary while smaller ones are not because of credibility and wealth effects. Meanwhile, Bartolini, Razin, and Symansky (1995) use the multicountry model (MULTIMOD) to study the effects of fiscal adjustments in the major industrial countries. They find that adjustments have short-run output costs and long-run benefits. However, the recovery time for adjustments relying on increases in indirect taxes and expenditures is quicker than for other types of adjustments, a result that is quite consistent with our evidence presented above.

IV. Three Major Fiscal Adjustments

In the previous sections, we have argued that one can identify two types of fiscal adjustments. Type 1 adjustments rely primarily on spending cuts; the components of spending that receive the largest cuts are transfer programs and government employment and wages. Furthermore, in these adjustments, taxes on households are kept constant or even reduced. Type 2 adjustments rely primarily on tax increases, particularly on households, and spending cuts in public investment. We have shown that Type I adjustments are more permanent and expansionary, while Type 2 adjustments tend to be reversed by further deteriorations of the budget and have worse macroeconomic consequences.

In this section, we look at recent fiscal adjustments in Ireland. Denmark, and Italy. We argue that the Irish adjustment in the late 1980s (1986-1989) is a Type I adjustment. The Danish adjustment of 1983-86 has substantially different features from the Irish one and lies somewhere between Type 1 and Type 2. Finally, we suggest that the current Italian adjustment is a Type 2 adjustment, at least up until 1995.

The Irish Adjustment 1987-89

Ireland entered the 1980s with a serious fiscal problem: the borrowing requirement was nearly 16 percent of GNP. In 1982-84. a weak and divided coalition government engaged in a fiscal adjustment focusing almost completely on the revenue side. In particular, taxes on households were sharply raised. The only modest spending cuts were in public investment. The government’s actions look like a textbook case of Type 2 adjustment. The Irish pound was pegged to the currencies of the European Monetary Union (EMU), leading to a rapid disinflation with falls in interest rates. However, the stabilization failed to permanently consolidate the budget and had very strong negative effects on domestic demand. The fiscal balance continued to deteriorate in 1984-86. mostly owing to increases in the interest burden and primary spending: the latter grew by about 2 percentage points of GDP in those three years.

In 1987. the ratio of gross debt to GDP peaked at almost 120 percent. A new government elected in February of that year launched an adjustment program with totally different features from the failed one of the early 1980s. This adjustment led to a sharp drop in the debt-to-GDP ratio in the following five years (from almost 120 percent to slightly more than 90 percent) and to rates of growth well above OECD or major industrial country averages. The turnaround of the Irish economy that started in 1987 is remarkable.

Size and Composition of Adjustment

Table 13 summarizes several features of the Irish adjustment. Our measure of cyclically adjusted primary surplus, the Blanchard fiscal impulse, improved by about 8 percent of GDP from 1985-86 to 1990-91. The entire adjustment was on the spending side. The only moderate increase in household taxes during the adjustment was due entirely to a one-off tax amnesty in 1988. Total revenues (including taxes on households) as a share of GDP were lower in 1989-90 than in 1986.

The spending cuts were broad ranging, but the largest in terms of share of GDP were in transfers, which fell by more than 2.5 percent of GDP. The government wage bill and public investment received the second-largest reduction. Reductions in government wages were obtained by an agreement with the unions in 1987 to limit pay increases to 2.5 percent, well below inflation. Even more important was the large reduction in public employment. Between 1986 and 1989, total public employment was cut by about 10 percent. from 300,000 to 270,000. as the result of a hiring freeze instituted in 1987 and early retirement and voluntary redundancy schemes.16 Social spending was cut, mostly in the health sector.

Table 12.

Successful and Unsuccessful Adjustments in OECD Countries: (Relaxed Definition): Composition of Expenditure Cuts as Share of Total Expenditure Cuts

(In percent)

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Source: OECD.Note: Standard deviations in parentheses.

Tax Reform and Wage Bargaining

Broad tax reform was introduced in Ireland in 1988 and took effect in 1989. A cornerstone of the reform was a cut in marginal tax rates on the income of households. The top rate, which had been as high as 65 percent in 1984-85, was reduced to 56 percent; also, the standard rate was cut from 35 percent to 32 percent. These cuts were accompanied by an increase in standard allowances. As the Irish tax system is quite progressive, these tax cuts reached very low on the income ladder. The corporate income tax was also reduced from 47 percent to 43 percent.

Wage bargaining was decentralized throughout the 1980s. However, a centralized wage agreement was reached in 1987 in the context of the Program for National Recovery. The accord, which covered 1988-90, insured wage moderation both in the private and in the public sector. Most firms’ wage agreements were in line with the guidelines established by this acccord We claim that this tax reform and the wage bargaining agreements are related. As argued in the previous section, wage moderation was achieve probably because the unions internalized the increase in the after-tax disposable income owing to the tax cuts. In addition, the effects of a soft labor market with high unemployment played a part, and the more or less voluntary layoffs in the public sector probably increased the unions’ moderation at the bargaining table.

Macroeconomic Consequences of Adjustment

The year 1987 marked a remarkably positive turnaround for the Iris economy. Unemployment started to decrease in 1988 after a rising trend that had lasted 25 years. Table 14 shows that GDP growth, which was almost 2 percent below the major industrial country average before the adjustment, was well above that average during and after the adjustment Growth was sustained by both domestic and foreign factors. Domestic consumption grew at steady rates during and after the adjustment, mostly owing to consumer durables, particularly automobiles. Private investment increased, picking up the slack left by the contraction of public investment The external sector was sustained by the devaluation of the Irish pound in 1987 and by the policy of wage moderation adopted in the same year.

Table 14.

Fiscal Adjustment in Ireland: Macroeconomic Conditions, 1985–91

(In percent)

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Source: OECD.Notes: For the definition of the variables, see Table 10. For the definition of “before, “during,” and “after,” see Table 13.

Nominal and real interest rates fell dramatically between 1987 and 1989 both in absolute terms and relative to Germany. Short-term real rates (defined as nominal minus actual inflation) fell from about 11 percent at the end of 1986 to about 7 percent in 1989. The differential of these rates with Germany’s fell from about 7 percent in 1986 to about 3 percent in 1989. Long-term rates also declined, with the differential of real rates with respect to Germany’s falling from about 5 percent in 1986 to about 2 percent in 1989. These developments are an indication of credibility effects in asset markets, as pointed out by Dombusch (1989).

Table 13.

Fiscal Adjustment in Ireland: Size and Composition, 1985–91

(In percent of GDP)

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Source: OECD.Note: “Before” is the two-year period before the adjustment, 1985–86; “during” is the period of the adjustment, 1987–89: “after” is the two-year period after the adjustment, 1990–91.

The increase in market value of private wealth owing to the fall in interest rates generated a positive wealth effect in consumption. As noted by Giavazzi and Pagano (1990). an effect on liquidity-constrained individuals, who obtained an increase in disposable income from the tax cuts, was a second source of the increase in private consumption. Interestingly, most of the increase in consumption came from durables, perhaps implying a strong interest rate effect.

All indicators of competitiveness show marked improvements in Ireland between 1986 and 1989. For instance, IMF staff calculations of relative unit labor costs fell by a cumulative 15 percent in this period. Our measure of relative unit labor costs fell by almost 12 percent in the same period. These developments were the result of the combined effect of wage moderation and the devaluation of the Irish pound. The trade balance improved during the adjustment despite the booming domestic demand (table 14).

The effect of wage moderation is apparent in the evolution of distributional shares (see Table 14). The wage share fell from about 54 percent before the adjustment to about 50 percent afterward, while the profit share gained about 5 points in the same period. IMF staff calculations of profitability also show a sharp improvement. For instance, the ratio of wholesale prices to unit labor costs increased by more than 20 percent between 1986 and 1989. The ratio of export unit values to unit labor costs displays a similar pattern.

The Danish Adjustment 1983-86

The fiscal position of Denmark deteriorated rapidly in the late 1970s. The largest deficits were registered in 1982. as the central government deficit exceeded 11 percent of GDP. The worsening of the fiscal balance was entirely due to a sharp increase in expenditures, from about 44 percent of GDP in 1978 to almost 54 percent in 1982. The ratio of gross debt to GDP reached almost 80 percent in 1982, and a large fraction of it (by OECD standards) was foreign debt.17 Average bond yield peaked at about 20 percent in 1982, when inflation was about 9 percent. The real interest rate differential between Denmark and Germany was about 8 percent in 1982. In October 1982, Standard & Poor added a credit watch to the AAA rating of Danish government bonds.

Also in October 1982, a convincing electoral victory established a cohesive conservative coalition in office in Denmark. This government launched a major fiscal adjustment program and implemented it in the following four years. At the same time, the government announced that the exchange rate was irrevocably fixed and that the series of devaluations in previous years had ended. As pointed out by Giavazzi and Pagano (1990), the credibility of this announcement was cemented by the lack of a Danish devaluation in March 1983, when the EMS underwent a general realignment.

Composition of Adjustment

Table 15 shows that the turnaround of Denmark’s fiscal position was remarkable: the largest in the recent history of any OECD economy. By 1989, our cyclically adjusted measure of budget deficit improved by more than 11 percent of GDP relative to 1981-82. The adjustment was divided about equally between expenditure cuts and tax increases.

Table 15.

Fiscal Adjustment in Denmark: Size and Composition, 1981–89

(In percent of GDP)

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Source: OECD.Note: “Before” is the two-year period before the adjustment, 1981–82; “during” is the period of the adjustment, 1983–86; “after” is the two-year period after the adjustment, 1987–89.

On the expenditure side, most of the cuts were in transfer programs and government wages (see Table 15). Cuts in transfer programs were broad ranging, focusing on unemployment insurance (freezing the maximum rate and reducing abuses), changes in the parameter of pension schemes, particularly for public employees, and cuts in sickness insurance funds. Transfers to local governments were also reduced in 1983-86. As shown in Table 15, transfers fell by more than 1 percent of GDP during the adjustment. Public employment, which had been growing rapidly before 1982, was frozen. In the context of the income policies introduced in 1982, government sector wages grew by less than inflation. Wage indexation was suspended until 1987, and the automatic link of public sector wages to wage increases in the private sector was eliminated. As a result of all these measures, the government wage bill was substantially reduced.

On the revenue side, most of the increase was due to direct taxes on households and businesses, with more modest increases in indirect taxes (Table 15). In the context of the policy of reducing net transfers, several social security contributions were increased, including contributions from employees to the unemployment fund and tax subsidies to private pension schemes. The result was a substantial increase in the tax burden for families during the adjustment.

Macroeconomic Consequences of Fiscal Adjustment

The average growth rate during Denmark’s adjustment in 1983-86 was about 3.3 percent a year, well above the major industrial country average (Table 16). Consumption and especially private investment both boomed. The latter grew by more than 13 percent a year and the former by more than 4 percent. The share of private investment grew by almost 2.5 percentage points of GDP relative to 1981-82, Exports increased steadily as a result of improved competitiveness (the reduction of relative unit labor costs), owing in part to the depreciation of the exchange rate in the early 1980s and to the wage moderation accord of 1982, coupled with the suspension of indexation clauses. The effect of this wage policy is reflected in Table 16 in the sharp drop of the wage share and the even larger increase in the profit share in the period 1983-86 relative to the previous two years.

Giavazzi and Pagano (1990) emphasize the expansionary consequences of the credibility and wealth effects in these four years. Interest rates dramatically fell immediately after the fiscal adjustment was announced and ihe implementation began. Giavazzi and Pagano (1990) calculate that their measure of an ex ante real interest rate fell from 6.7 percent in the 1979-82 period to 3.3 percent for the 1983-86 period of fiscal adjustment. Differentials with real German interest rates were at least halved, dropping from about 8 percent to less than 4 percent. Table 16 also shows a sharp drop of ex post real rates relative to the major industrial countries, from almost 5 percent before the adjustment to less than 2 percent during the adjustment, to less than 1.5 percent afterward. Another indicator of the credibility of the adjustment is the jump upward in indicators of consumer confidence.

Table 16.

Fiscal Adjustment in Denmark: Macroeconomic Conditions, 1981–89

(In percent)

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Source: OECD.Notes: For the definition of the variables, see Table 10. For the definition of “before,” “during,” and “after,” see Table 15.

The sharp drop in real interest rates, accompanied by the wage moderation achieved in 1982, the increase in the profit share, and the reduction in unit labor costs, all contributed to the boom in private investment.

Immediate Aftermath of Adjustment

Giavazzi and Pagano (1990) interpret the Irish and the Danish adjustments as two cases of expansionary fiscal consolidations and emphasize their similarities. However, the immediate aftermath of the two adjustments shows that they were quite different. While the Irish economy continued booming after the adjustment, the Danish economy moved into a recession in 1987-88, with growth rates of minus 0.6 percent and minus 0.2 percent, respectively. In fact, average growth in Denmark was more than 3 percent lower than in the major industrial countries in both 1987 and 1988 (Table 16). In 1989, growth was only 1.1 percent. Unemployment increased in 1988 from 7.9 percent to 8.7 perceni and continued lo climb in the following two years.

The underlying cause of the recession in Denmark lies in the fall in competitiveness. The real effective exchange rate (relative unit labor costs) as measured by the IMF fell by 8 percent in 1986 and almost 11 percent in 1987.

The current account deficit increased to almost 6 percent of GDP in 1986. The trade balance worsened during the adjustment, as shown in Table 16. particularly in 1985-86. The improvement of the trade balance after the adjustment was largely driven by the recession.

The decrease in competitiveness can be only partially explained by the appreciation of the real exchange rate (triggered by the combination of rapidly falling inflation and a fixed nominal rate). An important additional factor was the wage agreement of early 1987. which introduced sizable wage increases for 1987 and 1988. Their effects, after the restraint exercised during the adjustment period, is shown in Table 16 by the rebound of the wage share of more than 1 point of GDP from the average of 1983-86. The profit share, on the contrary, fell by about 2 percentage points.

Our interpretation is that the wage accord of 1987 incorporated union demands for compensation for the increases in income taxes of the previous four years, which had reduced workers’ after-tax income. Thus, the tax increases might have been the originating cause of the recession, via wage negotiations, as implied by Alesina and Perotti (1997).

The Italian Adjustment 1989-95

The beginning of fiscal adjustment in Italy can be dated to 1989. However, despite the reduction in the primary deficit that turned into a surplus in 1991, the debt-to-GNP ratio continued to increase, reaching 125 percent in 1994. Only in 1995 did this ratio decline slightly. Until 1993. the adjustment was completely on the revenue side. In fact, the ratio of primary spending to GNP increased between 1989 and 1993. Thus, the adjustment between 1989 and 1993 looks clearly to be a Type 2 adjustment. From 1993 to 1995. primary spending was cut and revenues fell; at first sight, therefore, one may be tempted to conclude that from 1993 onward the Italian adjustment has been a Type 1 adjustment. However, a more careful examination of the evidence calls into question this interpretation.

Site and Composition of Adjustment

Table 17 considers the fiscal adjustment of Italy’s general government, the definition which is most compatible with the one used for the other countries in this study.18 First, the overall size of the adjustment from 1989 to 1994-95 was much smaller than those of Denmark and Ireland, even though Italy’s adjustment stretched over a longer period. In terms of the share of GDP. the adjustment in the primary surplus was about one-half of the Irish adjustment and no more than one-third of the Danish adjustment, although Italy had a much higher ratio of debt to GDP than Denmark and a much heavier interest burden than Denmark or Ireland. Until 1993. the adjustment was totally on the revenue side, with revenues increasing by 6.3 percent of GDP to 48.3 percent. Meanwhile, primary expenditures rose by 2.7 percent of GDP. and total expenditures reached 57.8 percent of GDP in 1993. After the spending and tax cuts of 1994 and 1995. primary expenditures returned to their 1989 level as a share of GDP. while revenues were still 3.5 percent of GDP above the 1989 level. The reduction in revenues in the most recent two years was largely due to the one-off nature of many of the tax increases in 1992-93.

Table 17.

Fiscal Adjustment in Italy (General Government): Size and Composition, 1989–95

(In percent of GDP)

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Source: IMF.

The composition of the spending cuts in 1994-95 is revealing. The largest share of the cuts came from capital expenditures (1.1 percent of GDP). The remaining cuts in 1993-95 were mostly from government wages (almost 1 percent of GDP), with modest cuts on all the other items. However, despite these recent cuts, government wages in 1995 had about the same share of GDP as in 1989. and, over that same period, social security increased by 1.5 percent of GDP.

The fall in public investment was partly (or largely) due to the effects of criminal investigations: a good portion of this reduction was one-off in nature. A sizable part (0.6 percent of GDP) of the total cuts in the capital spending account fell into the category of “other capital spending.” This entry includes refunds of tax credits of the public. In 1993. this entry was unusually high (2.1 percent of GDP). In 1995. although tax refunds totaling almost 1 percent of GDP were planned (Lit 16.000 billion), only Lit 700 billion were disbursed. On average, about Lit 5.000 billion are disbursed every year. Thus, the postponement of tax refunds in 1995 was largely responsible for the so-called cut in capital spending.

The reduction of the wage bill resulted not only from a hiring freeze but especially from a less than full adjustment of public wages to inflation. An agreement with the unions in 1992 linked wages to planned rather than actual inflation. Since in the following three years actual inflation was higher than planned, real wages fell. The unions asked for an adjustment to wages to compensate for this difference and obtained large wage increases in the early months of 1996. Whether this adjustment will occur in full in the next few years is unclear. The point is that the reduction in real wages is the result of a rather convoluted and strategic use of projected and actual inflation, rather than a clear and permanent agreement with the unions on wage restraint.19

Social security was reduced more in 1995 than in 1994. As pointed out by the Bank of Italy (1996), these savings were temporary and due mostly to two one-off measures: (I) some temporary suspensions of “liquidazioni” (severance pay) of public employees and other postponements of pension payments, and (2) postponement of indexation payments from November 1995 to January 1996.

Pension Reform

In 1995. the Italian government adopted a comprehensive reform of the pension system, which had been one of the least solvent in the OECD. This reform, which followed a previous adjustment in 1992. replaced an incomes-based system with one that links benefits to contributions, although the system retains a “pay-as-you-go” nature. The reform also eliminated seniority pensions, which essentially permitted early retirement without penalties. In this paper, we are interested only in the effects of this reform on the current fiscal adjustment and on long-run cuts in spending.

The estimates for the budget impact of the reform in the short, medium, and long run are very difficult to make because they are based on uncertain predictions of macroeconomic and demographic variables. However, even the most optimistic ones (from the Italian Treasury) suggest that the savings both in the short run and in the long run are not very large. According to the Italian Treasury, in the medium run (1995 to 2005) the reform would save about 0.4 -0.5 percent of GDP a year, split equally between reduced spending and increased contributions. Peracchi and Rossi (1996) argue that these estimates are overoptimistic because they rely on forecasts that are not credible. The most pessimistic estimates, from the Bank of Italy, suggest that the reform may even have a negative impact on the government budget, even after the transition phase.

A recent ruling of Italy’s Constitutional Court concerning large pension arrears implies a further negative fiscal shock for the pension system. These payments will be financed by debt issues and should be about equal to the amount of savings generated by the pension reform over the next five years, as calculated by the Italian Treasury. In summary, the effects of the reform on the budget are highly uncertain and even in the most optimistic scenarios not very large.20

Contractionary or Expansionary Adjustment?

Table 18 clearly shows that the Italian fiscal adjustment has strong contractionary consequences for domestic demand, with the external sector containing the negative effect of domestic demand on growth. Italy’s growth rate shows a declining trend from 4.1 percent in 1988 to minus 0.7 percent in 1993. In the period 1989-94. the Italian growth rate was on average 0.7 percent below the average for the major industrial countries. As shown in Table 18. private investment literally collapsed in this period: in 1993, it fell by about 18 percent! This development contrasts sharply with the cases of Ireland and Denmark, where private investment boomed during the adjustment. Growth in private consumption was very sluggish and turned negative in 1993. There was no sign—at least until 1993—that interest rates incorporated a “credibility gain bonus.” The only good news for the economy in the period 1989-9.3 was the reduction in unit labor costs. In summary, the Italian adjustment had until 1993 all the features of a contractionary adjustment, driven completely by tax increases, rather than spending cuts.

Table 18.

Fiscal Adjustment in Italy (General Government): Macroeconomic Conditions, 1989–94

(In percent)

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Source: OECD.

Note: For the definition of the variables, see Table 10.

Recent developments in Italy in 1994-95 are also quite instructive. The recession of 1993 was contained by the growth of almost 9 percent in export volume. The rate of growth in 1994-95 was also almost exclusively driven by the export sector. In 1994 and 1995, export volume grew by 10.7 percent and 13.6 percent, respectively, with a trade surplus of about 4 percent of GNP. These external developments were fueled mostly by the large real devaluation—about 25 percent—of the exchange rate, which began in September 1992 when the lira left the EMS. A second factor influencing competitiveness was the relative wage moderation achieved after 1993. Note that this wage moderation coincided with the end of major tax increases. All the measures of competitiveness indicate substantial gains on the order of 20 percent for Italy in the last three years—the largest such improvement, along with Sweden’s, in the OECD.

The interest rate differential relative to Germany’s ten-year government bonds fell in 1993 from more than 6 percent to less than 3 percent at the end of the year. By the beginning of 1995. this differential was back to almost 5 percent. The differential on 3-month treasury bills in 1995 was about 4 percent, the same level as at the beginning of 1993. This pattern points to the market’s doubts about the credibility and persistence of the fiscal adjustment, even after the 1994-95 spending cuts. This behavior of interest rate differentials is in sharp contrast to the Danish and Irish experiences.

This evidence points toward a clear conclusion: not only did the 1989-93 fiscal adjustment negatively affect private demand, but the 1994-95 adjustment also had the same effect and would have had negative growth consequences if” it had not been accompanied by a massive depreciation of the real exchange rate. In summary, the Italian adjustment until 1993 was certainly a Type 2 adjustment. Some of the spending cuts in 1995 appear to be Type 1 adjustments, but they were accompanied by too many one-off measures and are of uncertain duration.

V. Conclusion

The single most important idea lhat we hope to communicate in this paper is that the composition of fiscal adjustments matters for their likelihood of success and for their macroeconomic consequences. In our view, the academic literature focuses too much on aggregate models that disregard composition and distributional effects. Also, the emphasis of the Maastricht criteria has shifted the discussion too much toward the simple arithmetic of primary surpluses, deficits, and debt-to-GDP ratios and away from the “how” of cutting deficits to meet these criteria, as if the how did not really matter. Nonetheless, it does.

Rather than reviewing in detail our results, we conclude by discussing several issues open for further research:

  • A fair amount of evidence suggests that, in some cases, fiscal contractions can be expansionary. An important question is through which channel the expansion occurs. We have argued that models that emphasize the effect of the composition of the adjustment on unit labor costs in unionized and open economies are at least as relevant empirically as models that focus upon credibility and wealth effects. This argument needs a more thorough empirical investigation.

  • Even though we have taken some steps toward linking the composition of the budget to its macroeconomic effects, one should disaggregate even more the government accounts, For instance, our variable “transfers.” which is quite important for our argument, still includes social security, unemployment compensation, and other social assistance programs. A more disaggregated study in a multi-country sample should clarify which components of the “transfers” variable are more important in determining the success or failure of adjustments.

  • A very important policy decision concerns the policy mix. particularly exchange rate policy, that should accompany a major fiscal adjustment. Several major successful adjustments have been preceded by devaluations, but devaluations have also accompanied some unsuccessful adjustments. The question is whether a devaluation helps to determine the success of the adjustment and its macroeconomic consequences. We have suggested in our paper that a devaluation might help, but that it would not do the trick if the composition of the adjustment did not have the features that we have discussed at length. Further research on this topic not only is fascinating from an academic perspective but also has important policy implications, for example, in connection with the effects of fiscal adjustments before or after a monetary union.

  • In our statistical analysis of the sample of OECD countries, we have focused on the general government. An intriguing issue is the role of local governments during major fiscal adjustments. Are the adjustments typically carried out by the central government? How do local governments participate in the effort? Is there a shifting of responsibility between the two layers of government? Hints made in the discussion of the Italian case suggest that this might be an important area of exploration.

  • Finally, one may wonder why policymakers are often hesitant to engage in vigorous Type 1 fiscal adjustments, considering that they do not seem to have contractionary effects. Perhaps the answer lies in their distributional effects. We have hinted above that the functional distribution of income is tilted in favor of profits during successful adjustments. A more careful study of the distributional consequences of major fiscal adjustments is an excellent topic of research.

In summary, the fiscal adjustment efforts lhat several OECD countries are currently undertaking are strictly linked to the problem of reforming the welfare state, whose weight has been increasing in the last few decades. Any fiscal adjustment that avoids dealing with the problems of social security, welfare programs, and inflated government bureaucracies is doomed to failure.

APPENDIX Definition of Variables

Fiscal Variables

All variables used are from the OECD. unless otherwise indicated in the text. Transfers = the sum of social security benelits. social assistance “rants, unfunded employee pension and welfare benefits, transfers to the rest of the world, transfers to private nonprofit institutions serving households, net casualty insurance premiums, and other transfers.

Public investment = government gross fixed capital formation, that is. the outlays, purchases, and own-account production of producers of government services on additions of new durable goods (commodities) to their stocks of fixed assets. Excluded are the outlays of government services on durable goods for military use.

Government consumption (divided into its wage and nonwage components) = the value of goods and services produced for their own use on current account, that is. the value of their gross output less the sum of the value of their commodity and noneommodity sales and the value of their own-account capital formation not segregated to an industry. The value of their gross output is equal to the sum of their intermediate consumption of goods and services, compensation of employees, consumption of fixed capital, and indirect taxes.

Subsidies = all grants on the current account made by the government lo private industries and public corporations.

Direct taxes on income = levies by public authorities at regular intervals, except social security contributions, on income from employment, property, capital gains, or any other source.

Indirect taxes = taxes assessed on producers in respect of their production, sale, purchase, or use of goods and services that they charge to the expenses of production. Also included are import duties and the operating surplus, reduced by the normal margin of profits of business units and of fiscal and similar monopolies of government.

Social security contributions = social security contributions received by the government.

For a more detailed discussion of the construction of a measure of primary deficit and the cyclical adjustment, see the appendix of Alesina and Perotti (1995a).

Other Variables

GR = (yearly rate of GDP growth of each country year) - (average GDP growth of seven major industrial countries, with GDP weights).

U= (unemployment rate of each country year) - (average unemployment of seven major industrial countries, with GDP weights).

Al= rate of growth of private business investment.

AC = rate of growth of private consumption.

i= (nominal interest rate on ten-year government bonds) - (average nominal interest rate on ten-year government bonds in seven major industrial countries, with GDP weights).

r = (nominal interest rate on ten-year government bonds - inflation) - (average real interest rate in seven major industrial countries, with GDP weights). The real interest rate in each of the seven industrial countries is obtained as the nominal rate minus inflation.

ULC = rate of change of unit labor costs in manufacturing, as calculated by Alesina and Perotti (1997) on OECD data.

EXCH RATE = rate of change of the nominal effective exchange rate. TB = trade balance.

VAULC= rate of change of the value-added deflator over unit labor costs in manufacturing.

WSH= wage share. PSH = profit share.

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1

For earlier results on related issues, see Alesina and Perotti [ 1995a and 1996).

2

See Tanzi and Sehukneeht (1995) for a discussion of the transformation of the composition of government budgets in OECD countries in the last century.

3

For instance, Alesina and Drazen (1991) model this delay as a result of a war of attrition among groups disagreeing on how to share die burden of the stabilization, so that lime is necessary to resolve the political stalemate.

4

For some empirical discussion of default risk premiums in high-debt OECD countries, see Alesina and others (1992). They show that, although a rough measure of default risk is not influenced by the level of the ratio of debt to GDP at low levels of debt, it is affected by the debt level at high levels.

5

Sec, for instance. Pencavcl (1986). For a general treatment of the neoclassical approach to fiscal policy, see Barro (1989).

6

For a discussion of composition effects on fiscal adjustments, see also Perotti (1996a),

7

This result is consistent with previous empirical results by Roubini and Sachs (1989) and Grilli, Masciandaro, and Tabellini (1991), which suggest that coalition governments are less fiscally responsible.

8

A model of a war of attrition among coalition members may rationalize this effect; see Alesina and Drazen (1991) and Spolaore (1995). Hor a similar argument based upon a “tragedy of the common” game, see Velasco (1996).

9

According to the results obtained by Alesina and Perotti (1995a), both left-leaning and right-leaning governments have been able in about equal proportion to achieve successful fiscal stabilization.

10

For overviews, see McKenxie (1989) and Perotti (1996b).

11

See the appendix in Alesina and Perotti (1995a) for details.

12

One may argue that a definition of success should allow lor differences across countries based upon initial conditions. However, the data would be too diffuse and impossible lo analyze if different definitions of success were allowed for different initial conditions. We leave this problem lo future research.

13

See Rogoff (1990) for an insightful discussion of the impact of political cycles on budget composition; this explains how opportunistic policymakers cut public investment before elections because it is less visible to voters than transfers.

14

See our discussion on Italy below, Tanzi (1994), and Alesina. Marc, and Perotti (1996).

15

All these results, including the macroeconomic consequences of a more lenient definition of success, are available upon request.

16

In order to facilitate voluntary resignations, the government sponsored retraining programs to help individuals leave the public sector. These relatively cheap programs were quite successful.

17

External debt was about 35 percent of GDP.

18

Fiscal data for Italy are drawn from the IMF. specifically from the March 1996 background paper and appendices on recent economic developments in Italy. Since data for 1995 arc particularly important for the Italian adjustment, we could not use our OECD data set. which we adopted above, as those data end in 1994. Also, for Italy, it is particularly useful to contrast the central government data with the general government data.

19

See Alesina. Mare, and Perotti (1996) for a discussion of the persistent bias in the government’s forecasts of inflation.

20

Concerning the short-term fiscal adjustment, one of the problems of the reform is the widely acknowledged very slow phasing-in period. IMF staff calculations suggest that several relatively simple and politically feasible measures to accelerate the adjustment could have led to additional savings of about .50 percent of GDP in 1995 and slightly more in the following year. Although not huge, this amount is far from trivial: it is larger than the actual cuts in social security in 1994-95.