Differences in follow-up help to explain why revenue-based consolidation plans appear more recessionary than spending-based plans

Roel Beetsma, Oana Furtuna, Massimo Giuliodori 05 September 2017

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In recent years, most EU countries have undertaken fiscal consolidation to ensure the sustainability of public finances. Research on the effects of these fiscal policy measures has flourished, and it has paid increasing attention to the composition effects of austerity measures.

The composition effects of austerity

Research based on the narratively identified consolidation dataset constructed by Devries et al. (2011) delivered the seemingly robust result that consolidations based on revenue increases have been more recessionary than consolidations based on spending reductions. Different explanations have been put forward to explain this finding (see the review by Alesina and Giavazzi 2012). Guajardo et al. (2014) found that monetary policy is more accommodative in the case of spending-based consolidations. Alesina et al. (2015a,b) proposed an alternative explanation, based on the positive effect on business confidence and private investment of spending-based consolidations. More recently, Alesina et al. (2017) have shown that the differing effects of the two consolidation strategies may be explained by the wealth effect of persistent spending cuts, which mitigates the direct effect of the consolidation on aggregate demand.

But are the two consolidation strategies executed to the same extent? Empirical work shows large, systematic differences between fiscal plans and implementation (Beetsma et al. 2009, and Frankel and Schreger 2013). In our recent work (Beetsma et al. 2017), we compare annual fiscal consolidation plans with ex post data based on real-time information. We discover that we tend to overestimate the actual amount of consolidation that has occurred. More importantly, the gap between announced and implemented consolidations tends to be larger for expenditure-based measures than for revenue-based measures (see Table 1).

Our sample combines the narratively identified annual consolidation measures in Devries et al. (2011) 13 EU countries between 1978 and 2008, and those in Alesina et al. (2015a, b) between 2009 and 2013.

Table 1 Average ex post deviation from planned consolidations (% of GDP)

The table shows the average shortfall, in percent of GDP of actual consolidation (measured using ex post figures) from the planned consolidation. Averages have been calculated over all consolidation years per country, or over all (country, consolidation year) combinations. The negative number in the column under 'Revenue' indicates that the actual increase in revenues is lower than the planned one, and a positive number in the column under 'Expenditure' indicates that actual expenditure reduction is smaller the planned reduction. The numbers in brackets indicate the number of episodes.

The average implementation slippage is larger for expenditure-based plans, which we explained in two (possibly complementary) ways:

  • Over-optimistic output growth forecasts. We refer to this as 'passive' non-follow-up. If output growth turns out to be lower than projected, revenue increases will fall short of planned increases, while spending reductions will fall short of planned reductions. We estimate the average shortfalls from passive non-follow-up using back-of-the-envelope calculations based on average revenue and spending elasticities for our country sample (calculated using Mourre et al. 2014), average revenue and spending ratios of GDP (OECD 2015), and an average over-projection of output growth of 0.5 percentage points (from Frankel 2011). In this case, the average shortfall from spending plans would be about 0.2% of GDP larger than the average shortfall from revenue plans.
  • Governments may only partially carry out the announced consolidation measures. We call this situation 'active' non-follow-up. We rationalise active non-follow-up in the case of spending consolidation plans in a simple framework in which political resistance to austerity – usually by protests or strikes – is uncertain when the plans are announced, but are more likely to be prohibitive for spending-based than for revenue-based plans when they are implemented. Data from 159 episodes of general strikes in the European Union plus Norway over the period 1980-2006 suggest that announcements of spending cuts have been more frequently followed by socio-political unrest than announcements of revenue increases (Figure 1).

Figure 1 Strikes in Western Europe by issue in dispute

Absolute numbers

Percentages

Note: For comparability, the light blue bars exclude Greece, Luxemburg and Norway, which are not in our fiscal consolidation dataset.
Source: Hamann et al. (2013, 2016).

Consequences of follow-up differences

A simple Keynesian framework can easily illustrate how differences in follow-up for the two consolidation strategies result in different effects on the economy. But how do anticipation effects shape the response of the economy to austerity announcements? We construct a new quarterly dataset on announcements of fiscal austerity measures, building on Beetsma et al. (2015). Our data allow us to pinpoint with a relatively high degree of precision the moment new consolidation information was released. We can therefore account for potential anticipation effects that occurred between the announcement and the implementation of consolidation measures.

If the private sector knew that governments tended not to follow up of consolidation announcements, that would be reflected in the response of private sector confidence. By measuring the effect of the announcements on private sector confidence, our dataset also allows us to investigate the extent to which the asymmetry in follow-up is reflected in the credibility of fiscal announcements. This means we are also uniquely positioned to measure how confidence affected the response of the economy following the announcements.

We estimate a narrative panel vector autoregressive model including macro and confidence variables, proxied by a consumer confidence indicator and the long-term interest rate, and investigate the impulse responses to fiscal announcements, distinguishing between revenue and expenditure shocks. Following a revenue-based announcement, GDP and consumption declined significantly, while the long-term interest rate rose significantly. In contrast, after a spending-based consolidation announcement none of these variables reacted significantly (Figures 2a and 2b).

Figure 2a Impulse responses baseline model: Revenue-based plans

Figure 2b Impulse responses baseline model: Spending-based plans

Note: The 90% confidence bands around the mean impulse responses are constructed using standard bootstrapping with 1,000 replications.

The estimates including the ex post budgetary variables confirm the difference in follow-up. Revenue-based consolidation announcements are, on average, followed by a strong and highly significant increase in revenues, while spending changes substantially less following a spending-based consolidation announcement. Following a revenue-based consolidation announcement, we observe a significant deterioration in private-sector confidence. This is reflected in a significant increase in the long-term interest rate and a significant reduction in consumer confidence, while neither of these variables responds to a spending-based announcement.

A counterfactual, in which our confidence variables are muted in response to the fiscal consolidation announcement, suggests there is a role for the confidence channel in the transmission of revenue shocks. The presence of the confidence channel seems to strengthen the purely Keynesian effects of the differences in the follow-up between the two types of consolidation strategies.

Implications for the debate on fiscal consolidations

A lot of empirical research has argued that spending-based consolidations are less recessionary than revenue-based consolidations. We find that at least part of the observed differences in the economic responses may be due to differences in follow-up between the two strategies. This implies that better follow-up of announced spending contractions may result in negative Keynesian responses similar to those that follow announced revenue increases. This does not mean that plans to contract spending are necessarily a bad idea. They may be advisable for reasons of sustainability of the public budget or to reduce a bloated public sector. But it does imply that they may not necessarily provide a 'cheaper' route to budgetary consolidation than revenue increases.

References

Alesina, A, O Barbiero, C Favero, F Giavazzi and M Paradisi (2015a), 'Austerity in 2009-13,' Economic Policy, 30(83): 383-437.

Alesina, A, O Barbiero, C Favero, F Giavazzi and M Paradisi (2017), 'The Effects of Fiscal Consolidations: Theory and Evidence,' NBER working paper 23385.

Alesina, A, C Favero and F Giavazzi (2015b), 'The Output Effects of Fiscal Consolidation Plans,' Journal of International Economics, 96(Supplement 1): S19-S42.

Alesina, A and F Giavazzi (2012), 'The austerity question: "How" is as important as "how much",' VoxEU.org, 3 April.

Beetsma, R, B Bluhm, M Giuliodori and P Wierts (2013), 'From Budgetary Forecasts to Ex-Post Fiscal Data: Exploring the Evolution of Fiscal Forecast Errors in the EU,' Contemporary Economic Policy, 31(4): 795-813.

Beetsma, R, J Cimadomo, O Furtuna and M Giuliodori (2015), 'The Confidence Effects of Fiscal Consolidations,' Economic Policy, 30(83): 439-489.

Beetsma, R, O Furtuna and M Giuliodori (2017), 'Revenue‐ versus Spending‐Based Consolidation Plans: The Role of Follow‐up,' CEPR Discussion Paper 12133.

Devries, P, J Guajardo, D Leigh and A Pescatori (2011), 'A New Action-based Dataset of Fiscal Consolidation,' International Monetary Fund working paper WP/11/128.

Favero, C and F Giavazzi (2012), 'Measuring Tax Multipliers: The Narrative Method in Fiscal VARs,' American Economic Journal: Economic Policy, 4(2): 69-94.

Frankel, J (2011), 'Over-optimism in Forecasts by Official Budget Agencies and its Implications,' Oxford Review of Economic Policy, 27(4): 536-562.

Frankel, J and J Schreger (2013), 'Over-Optimistic Official Forecasts and Fiscal Rules in the Eurozone,' Review of World Economics, 149(2): 247-272.

Guajardo, J, D Leigh and A Pescatori (2014), 'Expansionary Austerity? International Evidence,' Journal of the European Economic Association, 12(4): 949-968.

Hamann, K, A Johnston and J Kelly (2013), 'Unions against Governments: Explaining General Strikes in Western Europe, 1980-2006,' Comparative Political Studies 46(9): 1030-1057.

Hamann, K, A Johnston and J Kelly (2016), 'The Electoral Effects of General Strikes in Western Europe,' Comparative Politics 49(1): 63-82.

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

OECD (2015), Economic Outlook, November, Paris: OECD.

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Topics:  Macroeconomic policy

Tags:  fiscal austerity, fiscal consolidation, expenditure cuts, revenue increases, confidence channel

MN Professor of Pension Economics and Vice-Dean of the Faculty of Economics and Business, University of Amsterdam, Member of the European Fiscal Board

PhD candidate in Economics, University of Amsterdam and Tinbergen Institute

Professor of Empirical Macroeconomics at the Amsterdam School of Economics (University of Amsterdam)

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