11
IMF Fiscal Affairs and Research Departments
Workshop on Fiscal PolicyWashington, June 2, 2009
A couple of issues in automatic stabilisation: Efficiency effects and medium-term sustainability
by:Carlos Martinez-Mongay(*)
European CommissionDG ECFIN
(*) The views expressed in this presentation do not necessarily represent those of the European Commission
European Commission
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1. Distortionary taxes, the size of governments and the trade-off between stabilization and efficiency
2. Asset booms, composition effects and the trade-off between stabilization and sustainability
OUTLINE
European Commission
33
1. Distortionary taxes, the size of governments and the trade-off between stabilisation and efficiency
European Commission
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A simple AD/AS model:(1) Yd = 1(d-b) – 2(i-e) + d 1 , 2 > 0(2) Ys = Y* + ( –e) + s
(3) d = d* - t(Y –Y*)
(1) IS-type schedule(2) Lucas-Pillips supply functiond deficitb stock of public debti interest inflation (‘e’ expected)Y* potential output (Y – Y* is the output gap)d, s, demand and supply shocks(3) d* cyclically-adjusted deficit t automatic stabilisers (sensitivity of the deficit to the output gap, Y-Y*)
A simple model for automatic stabilisation (European Commission (2001); se also Artis and Buti, 2000, Blanchard, 2000, Buti,
Roeger, in’t Veld, 2001)
European Commission
55
Y = Y* + (d + bs)/[(1 + 1 t ) + b] + (d – (1 + 1 t ) s)/[(1 + 1 t ) + b]If automatic stabilisers are turned off (t = 0) Y = Y* + (d + bs)/( + b); s = 0, Y = Y* + d /( + b); d = 0, Y = Y* + bs/( + b); + (d – s)/( + b)s = 0, + d/( + b); d = 0, – s/( + b);If automatic stabilisers are turned on (t >0)s = 0 Y = Y* + d /[(1 + 1 t ) + b]; d = 0 Y = Y* + bs/[(1 + 1 t ) + b]; s = 0 + d /[(1 + 1 t ) + b];d = 0 - (1 + 1 t ) s)/[(1 + 1 t ) + b];s permanent Y – (Y* + s )= -{(1 + 1 t ) s/[(1 + 1 t ) + b]};
Shocks don’t come with labels: demand, supply, temporary, permanent
European Commission
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Do governments stabilize output?
Automatic stabilizers operate on the demand side. Progressive taxes and benefit (viz. unemployment) systems make surpluses grow more than output in expansions and less than output in recessions
Automatic stabilizers also operate on the supply side:• Avoid under-investment in recessions• Keep levels of physical and human capital• Growth close to potential
But distortionary taxes and benefit systems affect agent’s decisions to invest, work and save, which has an impact on economic efficiency.
A policy dilemma?
• Need to induce more flexibility in markets (short-run adjustment) and enhance potential output (long-run adjustment) by streamlining benefit systems and lowering distorting taxes
• Efficiency gains may come at the cost of less stability (more output volatility)
No policy dilemma if distortionary tax-benefit systems would hamper macroeconomic stability
European Commission
77European Commission
(1) TLfw )(
(2) Lw
T
w
Tw 1)1()1(
(3) Lt
tw 1)1(
)1(
(4) )()1(
)1(* e
t
tuu
Higher tax rates can lead to steeper aggregate supply curves
88
An extended AD/AS model with taxes in the supply curve
European Commission
Aggregate-demand curve
(1) ded yyidy *4
*321
Aggregate-supply curve
(2) ses ty
Monetary rule:
(3) yi
where *1 and *1 yyy Fiscal rule (SGP –automatic stabilisation)
(4) tyd
99
An extended AD/AS model with taxes in the supply curve
European Commission
5** yy
*33
4*4
5
Trade balance consistency implies:
where
.
s
t
2d
t
*6
t rr
ty
r
ty
2162 1 ttrt and 534526 )(1
(6)
Inflation can be obtained by equating (6) to ( – t) + s (i.e. (2) with e = 0)
1010European Commission
Under a demand shock (d0, s=0).
122
2
*
*66
***
tr
t
t
r
t
y
t
td
*6
*6
***
12612212
t
d
r
tt
Ctt
where
*
*66
***
t
t
r
t
t
rC
1111European Commission
Under a supply shock (s0, d=0).
*t
6*6
***
2161
2
*t
*66
***t
*ts
2r
t)t1()t(
r
ttrr
t
y
2
222
1222 )(
)()(
B
tBtt
s
where
*
*66
****
t
tt
r
ttrrB
1212
Is there an efficiency-stabilization tradeoff?
European Commission
Table 1 Effect of a rise in taxes on output and inflation stabilisation
output inflation
Below t̂ Above t̂ Below t̂ Above t̂ Initial level of taxes
Shocks
demand shock +
supply shock + + +
Note: stabilising effect
destabilising effect
1313European Commission
Is there an efficiency-stabilization tradeoff? The cases of closed and small economies
*
*2
**1
****2
1
6
1
21 )1)((.
22
)1(ˆtr
ttt
1
21
2
)1(ˆ
Ct
1
41
2
)1(ˆ
St
1414
Sample of 25 OECD countries over the period 1960-2000 (annual data).
Joint estimation of output and inflation volatility (error terms are correlated; GMM)
Output volatility: standard deviation of the output gap (% of the trend) over the period
Inflation volatility: ratio between the standard deviation and the average of the GDP deflator
Government size is measured as tax revenues (% of GDP)
Other variables:
Trade openness: Average of exports and imports in % of GDP
Country size: Average of the GDP (PPS)
Specialisation: Average share (%) of manufacturing GVA in total GDP
Additional Instruments (determinants of government size):
Per capita income (in 1995 PPS)
Old-age dependency ratio: people over 65 in percentage of total population
European Commission
Is there an efficiency-stabilization tradeoff? Empirical evidence
1515European Commission
Table 3: Correlation between volatility, government size, openness and country size
Output stability (1)
Inflation stability (2)
Total expend. (3)
Current expend. (4)
Total revenue (5)
Tax revenue (6)
Trade openness (7)
Inflation stability
0.54*
Total expend.
-0.45* -0.41*
Current expend.
-0.50* -0.39* 0.99*
Total revenue
-0.40* -0.36 0.95* 0.93*
Tax revenue
-0.44* -0.38 0.94* 0.91* 0.96*
Trade Openness
-0.03 -0.12 0.40* 0.34 0.46* 0.45*
Country Size (8)
-0.35 -0.15 -0.21 -0.19 -0.29 -0.26 -0.71*
* Significant at 5%. Asymptotic critical value between 2x(1/25)0.5 = 0.40 and 2x(1/22)0.5 = 0.43 (1) Standard deviation of the output gap in percentage of trend GDP over 1960-
2000(a) (2) The ratio between the standard deviation and the average over 1960-2000(a) of
the annual percentage change in the GDP deflator (3) Logarithm of the average total expenditures (% of GDP) over 1960-2000(a) (4) Logarithm of the average current expenditures (% of GDP) over 1960-2000(a) (5) Logarithm of the average total revenues (% of GDP) over 1960-2000(a) (6) Logarithm of the average tax revenues (% of GDP) over 1960-2000(a) (7) Logarithm of the average exports and imports (half % of GDP) over 1960-
2000(a) (8) Logarithm of the average GDP (PPPs) over 1960-2000(a) (a) See footnotes in tables 1 and 2 for the exceptions.
Alternative ways of measuring the size of governments
1616European Commission
Table 5. Instrumental variable estimates for macroeconomic stability
Tax
revenues (1) Country size (2)
Industry share (4)
Adj. R²
J-test (4)
[Output-gap volatility(5)] OG-IV1(6) -1.74
(0.26)*** -0.21 (0.07)***
0.43
2.98 [0.39]
OG-IV3(6) -1.94 (0.37)***
-0.33 (0.05)***
0.05 (0.03)**
0.51 5.45 [0.14]
[Inflation volatility (7)] GD-IV1(6) -0.22
(0.07)*** -0.03 (0.01)**
0.20
3.48 [0.32]
GD-IV3(6) -0.23 (0.08)***
-0.03 (0.01)**
0.002 (0.003)
0.19 4.24 [0.24]
Heteroskedastic-consistent standard errors in parenthesis; *** significant at 1%; ** significant at 5%, * significant at 10%. All the regressions include an intercept not shown here (1) Logarithm of the average tax revenues (% of GDP) over 1960-2000(a) (2) Logarithm of the average GDP (PPPs) over 1960-2000(a) (3) Average share of manufacturing gross value added in total GDP over 1960-2000 (4) Test for over-identifying restrictions; p-value between ‘[]’ (5) Standard deviation of the output gap in percentage of trend GDP over 1960-2000(a) (6) The instruments are trade openness (% of GDP), per capita GDP (1995 PPPs) and
the dependency ratio (% of total population). The three instruments are the logs of the averages over 1960-2000.
(7) Ratio between the standard deviation and the average over 1960-2000(a) of the annual percentage change in the GDP deflator
(a) See footnotes in tables 1 and 2 for the exceptions
Stabilization and the tax burden
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The average effective tax rate on labor income
European Commission
LETR = (SSC + PITR*(LETB – NWRV))/LETB
Where:
SSC social security contributions plus taxes on payroll and workforce
PITR*(LETB – NWRV) personal taxes on labour, with
PITR = PIRV /(COEL + NOS – NWRV – CORV – PWRV)
LETB is gross wages and salaries plus the imputed income of the self-employed
1818European Commission
Table 6: Labor related tax burden over time and countries
Period 1960-1980 Period 1980-2000 Difference
Country
Direct taxes
1
Social security
2
Labour taxes
3
Direct taxes
1
Social security
2
Labour taxes
3
Direct taxes
1
Social security
2
Labour taxes
3 Belgium 11.62 11.31 34.28 16.83 16.26 42.90 5.21 4.95 8.62 Denmark 24.06 1.81 32.35 28.70 2.55 41.32 4.64 0.74 8.97 Germany 11.33 13.03 35.21 11.87 17.90 40.71 0.54 4.87 5.49 Greece 3.30 7.67 14.94 6.27 11.94 23.40 2.97 4.26 8.46 Spain 3.71 8.76 17.45 9.26 13.01 28.54 5.55 4.25 11.09 France 6.20 15.18 29.86 8.90 20.11 39.30 2.69 4.93 9.45 Ireland 9.41 4.88 14.89 13.70 6.85 24.65 4.29 1.97 9.76 Italy 6.14 11.38 22.90 13.93 14.10 34.88 7.79 2.72 11.98 Luxembourg 15.36 11.53 30.16 17.06 12.54 33.53 1.70 1.01 3.37 The Netherlands 14.45 16.05 36.90 13.58 18.29 40.92 -0.88 2.24 4.03 Austria 10.23 11.20 29.09 12.42 16.23 37.31 2.18 5.03 8.22 Portugal 4.86 5.30 14.40 8.66 9.87 24.08 3.80 4.57 9.68 Finland 13.35 6.78 31.17 17.25 12.63 41.42 3.90 5.85 10.25 Sweden 18.42 9.06 41.23 21.18 14.33 47.67 2.76 5.27 6.44 United Kingdom 15.12 6.33 24.94 15.95 7.83 25.35 0.83 1.50 0.41 United States 13.29 4.60 18.35 13.09 7.00 22.00 -0.20 2.40 3.65 Japan 8.30 4.72 13.15 11.12 8.94 20.14 2.82 4.22 6.99
1:Direct taxes in percentage points of GDP 2:Social security contributions in percentage points of GDP 3:Labour effective tax rates in % of the tax base
Labor taxes in the sample
1919European Commission
Table 7: Macroeconomic stability and the tax mix
Output-gap volatility (1) Price volatility [GDP deflator] (2)
-2.44 -4.9 -2.58 -2.55 -0.31 -0.17 -0.46 -0.43
(0.56)*** (1.41)*** (0.62)*** (0.59)*** (0.18)* (0.36) (0.14)*** (0.14)*** Government Size (3)
-0.23 -0.34 -0.29 -0.29 -0.03 -0.04 -0.04 -0.05
(0.05)*** (0.08)*** (0.09)*** (0.09)*** (0.03) (0.02)* (0.02)** (0.02)** Country size (4)
1.43 1.04 0.85 0.86 0.07 0.21 0.23 0.23 (0.75)* (0.46)** (0.49)* (0.49)* (0.22) (0.12)* (0.11)* (0.12)**
Specialization (5)
0.20 0.05
(0.09)** (0.03)* Government Size* Time dummy (6)
1.45 -0.16 (0.81)* (0.21)
Government Size* Labor rate (7)
0.03 0.05 (0.30) (0.06)
Government Size* Direct taxes (8)
-0.03 0.00 (0.30) (0.07)
Government Size* Social Security (9) A-R² (10) 0.34 0.64 0.56 0.56 0.27 0.39 0.39 0.38
3.76 7.79 8.53 8.80 3.76 7.79 8.53 8.80 J (11) [0.43] [0.45] [0.38] [0.36] [0.43] [0.45] [0.38] [0.36]
Models estimated by IV methods (instruments: trade openness, per capita GDP, dependency ratio. Heteroskedastic-consistent standard errors in parenthesis; *** significant at 1%; ** significant at 5%, * significant at 10%. All the regressions include an intercept not shown here. (1) Standard deviation of the output gap in percentage of trend GDP over 1960-2000(a). (2) The ratio between the standard deviation and the average over 1960-2000(a) of the annual percentage change in the GDP
deflator. (3) Logarithm of the average tax revenues (% of GDP) over 1960-2000(a). (4) Logarithm of the average GDP (PPPs) over 1960-2000(a). (5) Average share of manufacturing gross value added in total GDP over 1960-2000. (6) The corresponding equation is estimated on a sample consisting of averages over the period 1960-1980 and the period
1981-2000. The resulting number of observation is 30. Government size is interacted with a dummy taking the value 1 over the second period and 0 otherwise.
(7) The corresponding equation is estimated on a sample consisting of averages over the period 1960-2000. The resulting number of observation is 17. Government size is interacted with labor taxes in percentage of total labor costs.
(8) The corresponding equation is estimated on a sample consisting of averages over the period 1960-2000. The resulting number of observation is 17. Government size is interacted with direct taxes in percentage of GDP.
(9) The corresponding equation is estimated on a sample consisting of averages over the period 1960-2000. The resulting number of observation is 17. Government size is interacted with social security contribution in percentage of GDP.
(10) Adjusted R². (11) Test for over-identifying restrictions; p-value between ‘[]’.
Is there an efficiency-stabilization tradeoff? Empirical evidence
2020European Commission
Is there an efficiency-stabilization tradeoff? Additional empirical evidence (Debrun et al, 2008)
2121European Commission
Is there an efficiency-stabilization tradeoff? Additional empirical evidence (Debrun et al, 2008)
22European Commission
2. Asset booms, composition effects and the trade-off between stabilization and sustainability
2323European Commission
Tax revenue growth
Tax base growth
Nominal GDP growth
t
%
(a)
(c)
Trend GDP growth
T0 T1
Period of analysis
(b)
(d)
a) Cyclical effect (growth at nominal GDP)(b) Composition effect (growth at base rate)(c) Discretionary measures(d) Others
Measuring automatic stabilizers in the presence of composition effects
2424European Commission
The longest expansion of the Spanish economy…
Source: AMECO
Automatic stabilizers and asset booms. The case of Spain
Real GDP growth in Spain and in the Euro Area
-6
-4
-2
0
2
4
6
8
10
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
%
Spain Euro area Average diff. Spain-Euro area
2525European Commission
… domestically led, especially by the housing sector (and consumption).
Source: AMECO and own calculations
Automatic stabilizers and asset booms. The case of Spain
SPAIN-INVESTMENT CONTRIBUTION TO GDP GROWTH
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
1971-1975 19982-1991 1995-2007
%
EQUIPMENT DWELLINGS OTHER CONSTRUCTION OTHER INVESTMENT
26European Commission
The expansion 1995-2007 was underpinned by a substantive fall of the risk premium, and unprecedented demographic growth, …
Automatic stabilizers and asset booms. The case of Spain
Interest rates, exchange rates and demography
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
%
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
%
Population Real short term interest rate (rhs) Reer (rhs)
2727European Commission
…which induced a boom in asset markets
Automatic stabilizers and asset booms. The case of Spain
0
50
100
150
200
250
300
350
400
450
500
1990 19911992 1993 19941995 1996 19971998 1999 20002001 2002 20032004 2005 20062007 2008
Ind
ex b
ase
1995
=10
0
0
100 000
200 000
300 000
400 000
500 000
600 000
700 000
800 000
Housing starts in Spain (rhs) Spanish housing prices
Euro area housing prices Spanish stock market (IBEX-35)
Euro area stock market (Dow Jones Euro STOXX)
2828European Commission
Source: AMECO and own calculations
Automatic stabilizers and asset booms. The case of Spain
SPAIN-INVESTMENT CONTRIBUTION TO GDP GROWTH
-4.50
-4.00
-3.50
-3.00
-2.50
-2.00
-1.50
-1.00
-0.50
0.00
0.50
2008 2009 2010
%
EQUIPMENT DWELLINGS OTHER CONSTRUCTION OTHER INVESTMENT
Asset markets have also driven the downturn
2929European Commission
A tax-rich expansion,
-1
0
1
2
3
4
5
6
TOTAL IND. TAXES DIR. TAXES SOC.SEC.
% G
DP
1995-2007 1995-2008
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
DIR TAXES CORPORATE PERSONAL
% G
DP
Diff %GDP 1995-2007 Diff %GDP 1995-2008
-0.5
0.0
0.5
1.0
1.5
2.0
INDIRECT TAXES HOUSING VAT OTHER VAT OTHER
Diff %GDP 2007-1995 Diff %GDP 2008-1995
30European Commission
Automatic stabilizers and asset booms. The case of Spain
… apparently of a structural nature…
General Government Tax Revenues(indirect and direct taxes and social contributions, ïn %GDP)
32.0
33.0
34.0
35.0
36.0
37.0
38.0
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
-1.5
-1.0
-0.5
0.0
0.5
1.0
Cyclical component (RHS) Cyclically-adjusted tax revenues
Tax revenues
31European Commission
Source: AMECO and own calculations
Automatic stabilizers and asset booms. The case of Spain
…but probably just reflecting a significant divergence between national accounts and ‘actual’ tax bases, especially in indirect and corporate taxes
TAX BASES FOR INDIRECT TAXES
87
89
91
93
95
97
99
101
103
Inde
x 19
80=1
00
50
100
150
200
250
300
350
Inde
x 19
80=1
00
Private consumption (%GDP) Private consumption and dw ellings (%GDP)
Dw ellings (%GDP)( (rhs)
TAX BASES FOR CORPORATE TAXES
0
100
200
300
400
500
600
700
800
19911992 19931994 1995 19961997 19981999 20002001 20022003 2004 20052006 20072008
Inde
x 19
91=1
00
CORPORATE PROFITS NET OPERATING SURPLUS
3232European Commission
which led to large composition effects
Automatic stabilizers and asset booms. The case of Spain
Decomposing changes of direct taxes and selected categories of direct taxes (% of GDP)
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
1982-1991 1995-2007 Personal 95-07 Corporate 95-07%
of 1
991
and
2006
GDP
resp
ectiv
ely
Composition Others Discretionary
Decomposing changes of indirect taxes and selected categories of indirect taxes (% of GDP)
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
Indirect taxes 82-91 Indirect taxes 95-07 VAT Housing 95-07 Other VAT 95-07 Other 95-07
in %
of
20
06
GD
P
Composition Others Discretionary
3333
∆REVt = d0 + α 1(REV – a - β GDP - TREND)t-1+ δ1 ∆GDPt + δ2 ∆GDPt-1 +
δ1 ∆(HOUSE/GDP)t-2 + δ2 ∆(MGVA/GDP)t + g1 I1t + … + gm Imt + εt (1)
Automatic stabilizers and asset booms. The case of Spain
Estimations of excess collection associated with the composition effect
3.03.6
4.45.0
0.01.02.03.04.05.06.0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
% G
DP
Estimation by econometric model
Observed changes
… explaining between 2/3 and ¾ of the accumulated increase in tax revenues
European Commission
34European Commission
Automatic stabilizers and asset booms. The case of Spain
Enough fiscal consolidation in good times?
30
31
32
33
34
35
36
37
38
39
40%
GD
P
-6
-4
-2
0
2
4
6
1995 1997 1999 2001 2003 2005 2007
% G
DP
CA tax revenues (lhs) CA balance (rhs) Interest Payment (rhs)
35European Commission
Automatic stabilizers and asset booms. The case of Spain
A sustainable fiscal expansion?
PUBLIC DEFICIT AND DEBT
-11
-9
-7
-5
-3
-1
1
3
5
2006 2007 2008 2009 2010
30
35
40
45
50
55
60
65
Public surplus/deficit (% GDP, lhs) Public debt (% GDP, rhs)
60%
-3%
forecast
3636
References
European Commission
Andrés, J. R. Domenech and A. Fatás, 2004, The Stabilising Role of Government Size, ISEAD, 2004/44/EPS
Artis, M. J. and Buti, M., 2000, « Close to balance or in surplus » -A policy maker’s guide to the implementation of the Stability and Growth Pact, Journal of Common Market Studies, 38(4), 563-592.
Blanchard, O., 2000, Commentary, Federal Reserve Bank of New York Economic Policy Review, 6(1), 69-74.
Brunila, A., M. Buti and J. in’t Veld, 2001, Fiscal policy in Europe: how effective are automatic stabilisers?, European Economy, Economic Papers, N° 177.
Buti, M., W. Roeger, J. in’t Veld, 2001, Stabilising output and inflation: Policy conflicts and coordination under a stability pact, Journal of Common Market Studies, 39, 801-828.
Buti, M. C. Martinez-Mongay, K. Sekkat and P. van den Noord, 2003, Automatic Fiscal Stabilisers in EMU: A Conflict between Efficiency and Stabilisation, SESifo Economic Studies, VoL. 49, 123-140. (see also OECD Ecocomics Department Working Papers, N° 335).
Debrun, X., J. Pisani-Ferry and A. Sapir, 2008, Government size and output volatility: Should we forsake automatic stabilisation? European Economy Economic Papers N° 316.
Gali, J., 1994, Government size and macroeconomic stability, European Economy Review, 38, 117-132.
Fatás, A. and I. Mihov, 2001, Government size and automatic stabilisers, Journal of International Economics, 55, 3-28.
Martinez-Mongay, C. and K. Sekkat, 2005, Progressive Taxation, Macroeconomic Stabilization and Efficiency in Europe, European Economy Economic Papers, N° 233
Martinez-Mongay, C. J. L. Maza Lasierra and J. Yaniz Igal, 2007, Asset Booms and Tax receipts: The case of Spain, 1995-2006.
Roeger, W. and J. in’t Veld, 2009, Fiscal Policy with Credit Constrained Households, European Economy Economic Papers, N° 357.
