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

OECD Economic Outlook, Dec, 2003

(1.) The OECD Economic Outlook, No. 72 (December 2002) provides an overview of the main provisions of fiscal rules in member countries, including the date of enactment. See Chapter V, "Fiscal Relations across Levels of Government", for an overview of fiscal rules at the sub-national level in the OECD area and selected non-member countries.

(2.) Fiscal stance is counter-cyclical when it contributes to cushioning the economy from business cycle fluctuations. Pro-cyclicality occurs when, in an upturn, spending rises and/or revenue decreases, leading to a fall in the budget balance.

(3.) These raw correlations, although illustrative, may be affected by measurement errors arising from the fact that cyclically-adjusted budget balances are not observed directly but are calculated on the basis of the estimated sensitivity of tax revenue and certain expenditure items to the business cycle. The biases due to measurement errors can be mitigated in the more formal multivariate analysis below.

(4.) In this respect, Auerbach (2002) argues that fiscal policy in the United States has become more sensitive over time to both the business cycle and pre-existing fiscal imbalances, since a rising public debt has led to a progressive tightening of fiscal stance. This assessment is shared by Wyplosz (2002), who discusses the effect of indebtedness on the cyclicality of fiscal policy in selected OECD countries. Likewise, Ballabriga and Martinez-Mongay (2002) show that, for the EMU countries during 1979-98, indebtedness was indeed associated with greater pro-cyclicality.

(5.) There is a growing body of empirical evidence that a corrective fiscal contraction in a downturn may become expansionary, and hence counter-cyclical. For example, Giavazzi et al. (2000), as well as Alesina and Ardagna (1998), among others, show that fiscal contractions may be expansionary in indebted countries and that the composition of adjustment, via tax increases and/or expenditure cuts, affects the expansionary potential of fiscal retrenchment.

(6.) The OECD methodology for calculating cyclically-adjusted budget balances, most recently documented in Van den Noord (2000), does not take account of the effects of fluctuations in asset and real estate prices on tax buoyancy, which have been particularly pronounced since the 1990s.

(7.) It is difficult to construct a comprehensive taxonomy of fiscal rules, particularly of regulations on budget procedures and institutions, spanning a sufficiently long period, and to control for differences in the way compliance with these rules is monitored and enforced. Regardless of their main provisions and coverage, fiscal rules have only been introduced relatively recently in most countries, in the form of, sometimes quantitative, constraints on budget balances, borrowing, expenditure levels or rates of growth, and indebtedness.

(8.) Evidence provided by Sorensen et al. (2001) suggests that states that have relatively tight balanced-budget rules seem to have less pronounced swings in both revenue and expenditure over the cycle than states with less stringent fiscal rules. This is consistent with the evidence reported by Bohn and Inman (1996), which, although sensitive to the cyclical indicator used to gauge fiscal responsiveness, indicates that stringent fiscal rules encourage precautionary savings in good times, which can be used subsequently to finance counter-cyclical measures in bad times. By contrast, also using US state data, Alesina and Bayoumi (1996) argue that fiscal rules have indeed reduced flexibility in state-level fiscal policymaking without, however, having a hearing on the cyclicality of state fiscal policy.