Output effects of fiscal consolidations

Carlo Favero, Francesco Giavazzi 07 September 2012

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The austerity debate turns on a central economic logic – how does fiscal policy affect output? This is a tricky question since declining output can affect fiscal policy just as much as fiscal policy can affect growth. Governments, after all, don’t make policy in a vacuum.

The key to estimating the effects of fiscal policy on output is this identifying shifts in fiscal policy that are 'exogenous'. Policy changes that are not a response to the state of output – as would be the case, for instance, of a fiscal expansion induced by a fall in output.

Following the approach pioneered by Romer and Romer (2010), Devries at al. (2011) have collected and described – using the records available in official documents – the multi-year fiscal consolidation plans announced (and then implemented or revised) by 17 OECD countries over a quarter of a century (1980-2005). Among all these stabilisation plans the authors have selected those that were designed to reduce a budget deficit and to put the public debt on a sustainable path, which should guarantee their 'exogeneity'.

Using the Devries et al (2011) data, we find that it matters crucially how the consolidation occurs (Alesina et al. 2012).

  • Fiscal adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones.

The difference is remarkable in its size and it cannot be explained by different monetary policies during the two types of adjustments. We find instead that:

  • The heterogeneity in the effects of the two types of fiscal adjustments is mainly due to the response of private investment, rather than that to consumption growth.

Interestingly, the responses of business and consumers’ confidence to different types of fiscal adjustment show the same asymmetry as investment and consumption: business confidence (unlike consumer confidence) picks up immediately after expenditure-based adjustments.

The main innovation of our paper is the analysis of fiscal plans -- a combination of tax increases and spending cuts, some unanticipated, other anticipated, all announced at the same date – rather than of individual shifts in taxes and spending, as the literature has so far typically done. This is important because individual shifts in taxes and spending occur very rarely: actually almost never in the Devries et al. (2011) sample. Studying individual shifts in taxes or spending – as the literature typically does – thus means investigating the effects of a style of fiscal consolidation that (almost) never occurs in the data.

The study of multi-year fiscal plans also allows us to make progress on the question of anticipated versus unanticipated shifts in fiscal policy and permanent versus transitory shifts. A plan usually consists of some ‘unanticipated’ correction, to be implemented in the same year of the announcement, and a series of anticipated corrections to be implemented in the following years. Fiscal consolidations are typically permanent policy shifts in some countries, where unanticipated corrections are positively correlated with the following anticipated ones. Other countries, instead, typically announce plans that have transitory elements, so that a negative correlation emerges between anticipated and unanticipated corrections. There is strong evidence of a correlation between unanticipated and anticipated shifts in taxes and spending that is heterogeneous across different countries. Figure 1 illustrates two extreme cases: Italy and the US.

In the US fiscal adjustment are usually permanent: there is a positive correlation between the unanticipated shifts in taxes and spending introduced by a stabilisation plan, and the future (anticipated) shifts announced upon the introduction of the plan. In the case of Italy, instead, the correlation between the unanticipated shifts in taxes and spending introduced by a stabilisation plan, and the future (anticipated) shifts announced upon the introduction of the plan is negative. In other words, fiscal stabilisations are temporary measures: when multi-year fiscal plans are introduced, agents know that at least part of the measures will be undone in the future.

Figure 1. Unanticipated (solid) and anticipated one-year-ahead (dotted) fiscal adjustments

We capture the differences between transitory and permanent stabilisations by allowing the fiscal multiplier to depend on the way the adjustment occurs. Allowing for this heterogeneity in the style of fiscal consolidations results in much more precise estimates of tax and spending multipliers. Interestingly, however, the wide variety of styles produces results that yield a strong common message: tax-based plans induce prolonged and deep recessions, while spending-based plans are associated with very mild and short-lived recessions, in some cases with no recession at all.

We then distinguish between ‘tax-based’ and ‘expenditure-based’ fiscal adjustments. An adjustment is labelled as tax-based (expenditure-based) if the sum of the unexpected and announced tax (expenditure) changes is larger than the sum of the unexpected and announced expenditure (tax) adjustments. Figure 2 reports the impulse responses of output growth to expenditure based and tax based fiscal corrections plans.

  • The patterns differ across countries but in all of them the difference between expenditure based and tax based adjustments is large and statically significantly.
  • In all countries, tax-based adjustments are recessionary and there is no sign of recovery for the three years of the time horizon.

In the case of expenditure based adjustments in some countries output does not move, i.e. there is no recession; in others (US and Canada, for example) there is a short recession and then in year 2 output is back to the pre-adjustment level.

Figure 2. The effect of tax-based (red) and expenditure-based adjustment (blue) on output growth

References

Devries P, J Guajardo, D Leigh, and A Pescatori (2011), “A New Action-based Dataset of Fiscal Consolidation”, IMF Working Paper No. 11/128, IMF.

Alesina, A, C Favero, and F Giavazzi (2012), “The Output Effects of Fiscal Consolidations”, CEPR Discussion Paper 9105, August.

Romer, C and DH Romer (2010), "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks", American Economic Review, 100(3):763-801.

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Topics:  Global crisis Macroeconomic policy

Tags:  fiscal policy, fiscal crises, austerity

Director of the PhD Programme at Bocconi University and CEPR Research Fellow

Professor of Economics, Bocconi University; and Research Fellow, CEPR