IV. Fiscal stance over the cycle: the role of debt, institutions, and budget constraints

OECD Economic Outlook, Dec, 2003

Introduction

This chapter describes the extent to which fiscal policy has been a stabilising or destabilising influence on economic activity in the OECD area over the last two decades, and investigates some of the institutional factors which may have led to the observed outcome. The concerns motivating the chapter relate to the fact that discretionary fiscal interventions may be pro-cyclical, as in the case of fiscal tightening during downturns especially. In part, this may be because of unsustainably high government indebtedness. But pro-cyclicality could also be due to implementation problems or to the institutional framework in which policies are designed and managed, including some rules-based approaches to fiscal stability, which may hamper the symmetrical operation of built-in stabilisers over the cycle.

Against this background, the chapter begins by assessing the extent to which the stance of fiscal policy has been pro- or counter-cyclical in the OECD area and for individual countries during 1980-2002, with pro-cyclicality defined as periods when fluctuations in cyclically-adjusted budget balances moved inversely with the output gap (towards surplus in downturns and vice versa). It then uses pooled cross-country and time-series data to assess the extent to which built-in stabilisers have been offset by discretionary action and how the institutional framework in which policies are designed and implemented may have affected policy outturns. The institutional factors investigated include the type of fiscal rule adopted, (1) the size of the tax burden, public expenditure rigidities, the political cohesion of government, and electoral systems and cycles.

The main conclusions to emerge from this chapter are:

--Sustainability problems, associated with indebtedness, seem to be a key determinant of whether fiscal stance is pro-cyclical during downturns. Abstracting from debt-sustainability issues, fiscal stance tends to be predominantly counter-cyclical in bad times, but with some evidence in the OECD area of discretionary pro-cyclical easing in upturns.

--The very institutional features of the policymaking process which make for high automatic short-term stabilisation, such as a large public sector and a high tax burden, may also at the political level lead to more pro-cyclical fiscal policy. High tax ratios allow for greater automatic stabilisation, but tax cuts implemented during upturns may reduce the scope for counter-cyclical easing in subsequent downturns.

--The constraints imposed by the Maastricht Treaty (MT) and, later, the Stability and Growth Pact (SGP) do not seem to have created a discernibly pro-cyclical bias during downturns in the Economic and Monetary Union (EMU) area as a whole.

--Fiscal tightening during downturns is somewhat less likely to occur in the presence of expenditure rigidities. This is the case when, for example, payroll outlays, which are harder to retrench than capital spending, account for a large share of government spending and when the government is a sizeable employer relative to the private sector.

--Political institutions also matter, and undesirable pro-cyclical retrenchment seems less prevalent in countries with more politically fragmented governments and electoral systems based on proportional representation, rather than plurality (i.e. "first-past-the-post" regimes). Electoral cycles have a role to play and pro-cyclical retrenchment appears to be less common in election years.

Trends in fiscal stance over the cycle

The area-wide general government budget balance has exhibited considerable cyclical variation since the early 1980s, with its cyclically-adjusted component fluctuating narrowly around -4.0 per cent of GDP until the early 1990s and moving considerably towards balance thereafter (Figure IV.1, Panel A). Since 2000, there has been a sharp downward swing in both actual and cyclically-adjusted balances. Regional differences behind these aggregate movements have remained significant. In particular, the experience of Japan contrasts with the reduction in the US deficit over the same period and the collective fiscal consolidation effort in the run-up to the 1997 qualification date for entry to the single currency in Europe (Panels B-D). Since 2000, the discretionary relaxation of fiscal stance has been particularly marked in the United States, and to a lesser extent in the United Kingdom (Panel F). It has been less dramatic in continental Europe, but began earlier--in 1999--in the large euro area economies (Panel E).

[FIGURE IV.1 OMITTED]

While fiscal adjustment has been counter-cyclical for extensive periods in the OECD area, notably from 1993 to 2000, it has also acted somewhat pro-cyclically in some cases, as evidenced by the periods when cyclically-adjusted budget positions were moving in opposite direction to the cyclical component of the budget balance. (2) This was true for the United States during 1982-86 and for the large European economies for most of the period up to 1993. By contrast, the period of retrenchment in the 1990s took place when output gaps were closing in the United States and Europe, reinforcing the cyclical buoyancy of revenues. However, fiscal stance in the larger euro area economies was pro-cyclical in 2000, becoming counter-cyclical in 2001.