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Successful fiscal adjustments can also be achieved by raising taxes

Date:20 March 2018
Associate professor Richard Jong-A-Pin and assistant professor Rasmus Wiese, who wrote the paper with Professor Jakob de Haan.
Associate professor Richard Jong-A-Pin and assistant professor Rasmus Wiese, who wrote the paper with Professor Jakob de Haan.

Since fiscal policies in several countries across the world have become unsustainable, it has become inevitable that governments should reduce their indebtedness. Consequently, policy debates no longer focus on the question whether government indebtedness should be reduced; instead they focus on how it should be reduced.

A dominant view in the economic literature is that fiscal adjustment packages that are heavily weighted toward spending reductions and not tax increases are most likely to reduce debt in the long-run. In a forthcoming paper we have re-examined this view. We have done so because we believe that previous studies have overlooked the importance of the variability of the budget balance within countries when identifying (successful) fiscal adjustments. In our view, disregarding this volatility is not innocuous.

In the economic literature, a fiscal adjustment is defined as a discretionary and significant decline in the general government’s budget balance. Significant in this case does not refer to statistical significance, but rather whether the change in the cyclically adjusted (primary) budget balance exceeds some subjectively selected threshold. Likewise, the success of an adjustment is, generally, based on the lasting effect the adjustment program has on reducing the government debt-to-GDP ratio and/or the budget deficit-to-GDP ratio, again based on some (subjectively selected) threshold.

But such a ‘one-size-fits-all’ approach is highly problematic as it fails to take into account that the budgetary processes in some countries may lead to a much more volatile budget balance than those in other countries. As such, a filter that does not consider volatility is prone to identify fiscal adjustments that are the result of the budgetary institutions in place (or other factors driving fiscal policy volatility), rather than deliberate attempts of politicians to improve the budget balance. An example, as we show in our study, would be Italy. However, the reverse is also true. In countries where the budgetary process leads to less volatile policy outcomes, such as in Switzerland, existing filters are less likely to detect significant changes in fiscal policy.

To overcome this problem, we apply an econometric technique (i.e., the Bai and Perron Structural Break filter) that does take volatility in the budget balance within a country into account. The episodes of (successful) fiscal adjustments that we identify differ substantially from previous work. More importantly, when we estimate the effect of the importance of expenditure-based adjustments relative to tax-based adjustments for the success of a fiscal adjustment, we find that the results also differ substantially. That is, our results suggest that the composition of the fiscal adjustment, i.e. whether it is spending- or revenue-based, does not affect the probability of its success.

We like to stress that our findings do not imply that fiscal adjustments should (always) be tax-based. In fact, there may be good reasons to prefer spending-based fiscal adjustments, but not that this will enhance the likelihood that the fiscal adjustment will be more successful than when it is tax-based.

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