Designing fiscal policy for steady, enduring growth

Several years after the peak of the Global Crisis, substantial risks to the global economy abound. Prospects for economic growth have been repeatedly marked down. Public debt to GDP ratios in many Eurozone countries are at levels not seen since World War II. Several countries are significantly out of step with their medium-term fiscal targets. Monetary policy in several major economies is constrained by the zero lower bound. China, the largest economy in the world in purchasing power parity terms, is undergoing an epochal economic rebalancing and ensuing growth moderation, with important spillovers.

Against this background of heightened risks and uncertainties, constrained monetary policy, and limited budgetary space, how can fiscal policy contribute to steady and enduring growth? Here, we argue that fiscal stabilisation through automatic stabilisers can play a prominent role. 

Fiscal policy can influence medium-term growth through its support to macroeconomic stability. A large body of theoretical and empirical work has shown that high macroeconomic volatility dampens output growth. For example, in a sample of 92 countries as well as a sample of OECD countries, Ramey and Ramey (1995) find that countries with higher volatility have lower growth. This suggests that lower volatility can increase growth insofar as it helps avoid wasteful fluctuations in employment and growth. Lower macroeconomic uncertainty also provides a favourable environment for physical and social capital, thereby supporting medium-term growth.

Fiscal policy has a stabilising effect on an economy if the budget balance increases when the output gap rises, and decreases when the output gap falls. The April 2015 Fiscal Monitor introduced the ‘FISCO’, a fiscal stabilisation coefficient that measures the systematic response of a country’s overall fiscal deficit to changes in the output gap, whether the response is automatically driven or resulting from discretionary actions. If the fiscal stabilisation coefficient is equal to one then, when the output gap increases by one percentage point of GDP, the general government deficit also increases by one percentage point of GDP. The Monitor estimates that the average fiscal stabilisation coefficient is 0.7 for advanced economies (Figure 1), most of which as a result of automatic stabilisers. For advanced economies, a significant – but plausible – increase in the fiscal stabilisation coefficient by 0.1 (equivalent to one-standard deviation of cross-country variation in the sample) is estimated to reduce output volatility by 15% and increase growth by 0.3 percentage points.

Figure 1. Advanced economies, fiscal stabilisation coefficients

Source: IMF Fiscal Monitor, April 2015.

In the EU, automatic fiscal stabilisation is traditionally measured as the semi-elasticity of the overall fiscal balance to changes in the output gap, as described in Mourre et al. (2014) and used in the EU fiscal framework. The aggregate semi-elasticity is derived from the sensitivities of individual tax and expenditure categories to output fluctuations. The size of automatic stabilisers appears strongly and positively correlated with the ratio of government expenditure to GDP (Figure 2). However, in practice the influence of automatic stabilisers can be larger or smaller than suggested by the expenditure ratio depending on the country's tax and spending structures. For example, if the output gap decreases by 1 percentage point, the headline budget balance would deteriorate automatically by around 0.3%-0.6% of GDP, depending on the country.

Figure 2. Government size and automatic stabilisers

Source: European Commission and OECD.
Note: The automatic stabilisers are here measured as the semi-elasticity of the budget balance to the output gap, as found in Mourre et al. (2014) for EU countries.

How, then, can the stabilisation properties of fiscal policy be enhanced? Adapting (discretionary) fiscal policy continuously to economic circumstances seems impossible in practice. It requires good answers to a panoply of questions: How to gauge the state of the economy in real time? How to calculate the required fiscal policy response? How to ensure timely legislative or executive decisions? How to implement policy actions on time? Empirically, Fatás and Mihov (2003) find that countries with the most volatile public consumption also tend to have the most volatile business cycles. The aggressive use of discretionary fiscal policy may therefore harm economic growth through the amplification of business cycle fluctuations. This may arise either because fiscal policy interventions are poorly designed and react untimely to the business cycle, or because they are also driven by objectives unrelated to stabilisation (i.e. equity, resource allocation, electoral motivations).

Automatic stabilisers – by acting in real time – solve the problem of recognition, design, decision and implementation lags. By design, automatic stabilisers also automatically reverse when the business cycle improves, which is not necessarily the case for discretionary policies.

But, in practice, this has not always been the case. Fiscal policy decisions often undermine the functioning of automatic stabilisers, especially in good times. In good times politicians are tempted to spend the (temporary) revenue windfall. The pro-cyclical bias not only contributes to macroeconomic volatility, it also creates an upward drift in public debt over time. Letting automatic stabilisers operate fully would ensure a symmetric response to the business cycle. It would ensure that in ‘good times’ fiscal space is gradually built up. 

Clearly, long-term sustainability of public finances is crucial if fiscal policy is to play a larger role in stabilising the economy. Protecting credibility with the public and financial markets is essential. Prudent public finances are particularly called for in countries that value large welfare states and have a strong dislike for macroeconomic volatility. As former Swedish Finance Minister Anders Borg (2014) put it, “surplus Keynesianism still works”.

Automatic stabilisers were not designed with macroeconomic stability and growth in mind. They are the by-products of policies put in place to serve other objectives. From the perspective of Musgrave (1959), automatic stabilisers reflect political and/or societal choices regarding insurance and redistribution. Therefore, there may be room to improve substantially on the design of automatic stabilisers. It should be possible to do so without undermining their original motivation. That is a form of structural fiscal policy that can be designed in a budget neutral way.

That said, there is also evidence of decreasing returns to fiscal stabilisation above certain size of government, e.g. through disincentives to supply labour, high marginal tax rates, deadweight effects or misallocation of resources. Buti et al. (2002) show in the context of the Eurozone that, if the initial level of government expenditure and thus of the tax burden is high, reducing the tax burden may lead to higher output stabilisation, reaping a double dividend of market efficiency and stabilisation. Debrun et al. (2008) find that the marginal effect of an increase in government size is negligible for expenditure levels above 40% of GDP, increasing the likelihood that the gains in terms of stabilisation are offset by efficiency losses. This suggests that in the majority of advanced countries any further increase in government size would not increase the effectiveness of automatic stabilisers. In a context of high debt levels, this raises a key policy issue, namely how to boost automatic stabilisers without increasing the size of the government.

The effectiveness of 'traditional' automatic stabilisers in smoothing output fluctuations can be enhanced by adjusting the features of selected revenue/expenditure categories to increase their response to economic activity. In Figure 3, this corresponds to rotating line AA clockwise to BB.  

Introducing automatic changes to tax and expenditure parameters in response to macroeconomic developments may further enhance fiscal stabilisation. To put it in a nutshell, this will consist in automating adjustments in policy levers (such as tax rates and the replacement rate or duration of unemployment benefits) rather than simply letting budgetary aggregates respond to tax bases or the number of people entitled to social transfers. It can also mitigate the shortcomings of discretionary policy action already discussed. In Figure 3, automatic triggering of parameter changes beyond a certain threshold of output gap (or employment) corresponds to introducing a kink in the curve so that line AA shifts after a certain point to line CC. This pattern may be particularly suited for countries which enjoy little fiscal scope. Triggers would need to be carefully designed and clearly defined in advanced to ensure predictability.

Figure 3. Avenues for increasing automatic fiscal stabilisation

On top of avoiding pro-cyclical provisions in the tax code (for example tax loss carry-forward), possible avenues, combining both strategies, include:

• Personal income tax. A budget-neutral shift within personal income taxation with higher rates for top incomes and lower rates for lower incomes can increase stabilisation. However, consideration needs to be given to possible effects on incentives for work. For countries with collection lags (e.g. income tax based on actual income of the previous year), moving to an estimated income for the current year would strengthen the link between tax payments and the economic cycle;
• Corporate income tax. Pre-payments based on the estimated profits for the current year would allow linking tax payments to the current state of the economy more closely;
• Unemployment benefits. The design of unemployment benefits can be enhanced to increase their generosity or coverage during recessions. This raises disposable incomes of constrained households with a high marginal propensity to consume, and boosts total consumption. However, reform would need to avoid possible disincentives to work. One option is to include stronger tapering over time;
• Automatic investment tax deductions during recessions. Automatic tax deductions reduce the cost of capital and ease credit constraints. This in turn helps stimulate investment;
• Cyclical loss-carry backward. This measure allows deduction of corporate tax losses against past profits and provides companies immediate tax refunds during recessions;
• Automatic transfers to local governments. Subnational governments are often bound by balanced budget requirements, which fuels pro-cyclicality. Making transfers to local governments counter-cyclical would mitigate this effect.

The complexities, risks and uncertainties associated with the current global developments suggest the need for an upgrade in fiscal policy. Such upgrade amounts to structural change in fiscal policy. We propose to strengthen automatic stabilisers in a budget-neutral way. This is particularly important in the Eurozone countries, as fiscal policies have the responsibility of smoothing country specific disturbances, when their finances are relatively constrained.

Reforming automatic stabilisers, nonetheless, represents a difficult political challenge. Substantial changes to tax and expenditure structures may affect vested interests. Such changes could also be seen as removing too much discretionary authority from policymakers in the future, which is likely to face significant political resistance. Furthermore, during the economic upswing, there may be political pressure to prevent the automatic unwinding of supportive policies intended only for low cyclical conditions. This would result in pro-cyclicality in good times and economic distortions, which would in turn compromise the rebuilding of fiscal buffers and lead to, or aggravate, macroeconomic imbalances. However, overcoming these political challenges will foster fiscal policy for steady and enduring growth.

Borg, A (2014), “Fiscal Policy in the Shadow of Debt: Surplus Keynesianism Still Works”, What Have We Learned? Macroeconomic Policy After the Crisis 1: 183-192, Cambridge: MIT Press.

Buti, M, C Martinez-Mongay, K Sekkat and P van den Noord (2002), "Automatic Stabilisers and Market Flexibility in EZ: Is There A Trade-Off?", OECD Economics Department Working Papers, No. 335, OECD Publishing.

Debrun, X, J Pisani-Ferry and A Sapir (2008), "Government Size and Output Volatility: Should We Forsake Automatic Stabilisation?", European Economy, Economic Papers 316.

Fatás, A and I Mihov (2003), "The Case for Restricting Fiscal Policy Discretion", Quarterly Journal of Economics 118(4): 1419-47.

IMF (2015), "Can Fiscal Policy Stabilise Output?", in Fiscal Monitor April 2015: Now is the Time: Fiscal Policies for Sustainable Growth.

Mourre, G, C Astarita and S Princen (2014), "Adjusting the Budget Balance for the Business Cycle: the EU Methodology", European Economy, Economic Papers 536.

Musgrave, R A (1959), The Theory of Public Finance: A Study in Public Economy, New York: McGraw-Hill.

Ramey, G and V Ramey (1995), "Cross-Country Evidence on the Link between Volatility and Growth”, American Economic Review 85: 1138-51.