Paolo MauroFiscal Affairs Department Fiscal Affairs Department

International Monetary Fund

Chipping Away at Public Debt

Sources of Failure and Keys to Success

in Fiscal Adjustment

The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

The state of the public finances in advanced The state of the public finances in advanced economies: taking stock of where we are now economies: taking stock of where we are now and where we need to go. and where we need to go.

Motivation/Background

3

Fiscal Outlook in Advanced Fiscal Outlook in Advanced EconomiesEconomies

(in percent of GDP)(in percent of GDP)

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

2.0

2000 2002 2004 2006 2008 2010 2012 2014 2016

60

70

80

90

100

110

120

2000 2002 2004 2006 2008 2010 2012 2014 2016

Overall Balance

Gross Government Debt

Fiscal Challenge: Stylized Facts

The scale of the debt problem is unprecedentedThe scale of the debt problem is unprecedented

G-7 PPP-Weighted Public Debt, 1950-2016, percent of GDP

Source: IMF Fiscal Monitor April 2011

-8 -6 -4 -2 0 2 4 6 8 10

CAPB 2010 (percent of GDP)

Req. CAPB by 2020 to reach 60% debt in 2030

Req. CAPB to stabilize 2010 debt levels

What we do in the book

Previous empirical studies identified fiscal Previous empirical studies identified fiscal adjustment episodes on the basis of adjustment episodes on the basis of ex postex post outcomes.outcomes.

Instead, we approach fiscal adjustment Instead, we approach fiscal adjustment plansplans on on the basis of large the basis of large envisagedenvisaged reductions in debts reductions in debts and deficits. and deficits.

One learns from successes but also failures. One learns from successes but also failures. Compare Compare ex postex post outcomes with outcomes with ex anteex ante plans plans Avoids sample selection / survivorship biasAvoids sample selection / survivorship bias

Analytical Framework

1.1. Individual Country Case Studies for each of the Individual Country Case Studies for each of the G7 countriesG7 countries

2.2. Cross-Country Statistical Analysis for the Cross-Country Statistical Analysis for the three-year plans of all EU Countries, 1991-three-year plans of all EU Countries, 1991-2007.2007.

What we do: two methods

G-7 Fiscal Adjustment PlansCountry Adjustment Plans Objectives/Design Comments/Outcome

Canada

1985-91 B. Mulroney • Reduce overall deficit by 3½ percent of GDP over six years.

Overall deficit objectives met, though not sufficiently ambitious in the first place.

1994-97 J. Chretien • Reduce overall deficit by 3 percent of GDP over three years.

Successfully met objectives and attained long-lasting reversal of debt dynamics

France

Plan Barre, 1976–77 • Austerity packages to curb inflation and current account deficit. • Reforms in 1982–84

Effective in reducing deficits and containing aggregate demand, but impact short-lived.

Virage de la Rigueur, 1982–84

1994–97 Plan to meet Maastricht criteria

• Introduced multiyear framework. Met Maastricht criteria. Difficulties in controlling expenditures.

2003– 07 Consolidation

• Fiscal adjustment focused on expenditure control; revenue-to-GDP ratios targeted to remain stable.

Some expenditure slippages, partly offset by one-off revenues.

Germany

1976–79 Plan • Cut deficit by 2¾ percent of GDP. Weak economic growth led government priority to shift from fiscal adjustment to stimulus.

1981–85 Plan • Cut deficit by 1¼ percent of GDP. Largely successful.

1991–95 Plan • Cut deficit by 1½ percent of GDP. Did not meet objectives.

2003–07 Plan • Cut deficit together with “Agenda 2010” structural reforms (labor market, pensions).

Largely successful.

Country Adjustment Plans Objectives/Design Comments/Outcome

Italy

1994 Economic and Financial Program Document (EFPD) for 1994–97

• Reduce the debt-to-GDP ratio beginning in 1996.• Strong interest in joining EMU. Initial plan did not aim at meeting Maastricht criterion of 3% deficit, but objectives made more ambitious in mid-course.

Attained lasting reduction in debt-to-GDP ratio, albeit at high levels. Maastricht criterion met through last-minute efforts.

2002 EFPD for 2002–05

• Planned for a 3 percent of GDP expenditure cut. Revenue ratio remained unchanged. Large expenditure and fiscal balance overruns.

Japan

1997–Fiscal Structural Reform Act

• Reduce deficit to 3 percent of GDP by FY 2003 Immediately derailed by Asian crisis and domestic banking crisis.

2002– Medium-Term Fiscal Adjustment Plans.

• Aim for primary surplus by early 2010s. • Introduced five-year rolling frameworks.

Partially successful in the initial stages. Ultimately derailed by the global crisis

United Kingdom

Howe’s 1980 Medium-Term Financial Strategy

• Curb government borrowing to rein in the money supply and inflation. Envisaged 5½ percent of GDP cut in the deficit.

Expenditure overruns in social security, public wages, and support to public enterprises.

Lawson’s 1984 Budget • Rebalance the tax burden, shrink the state, and reduce public sector manpower.

Expenditure cuts beyond what was envisaged. Privatization of large public enterprises.

Clarke’s November 1993 Budget

• Eliminate the 8 percent of GDP deficit by 1998. Delivered a steady reduction in the fiscal deficit.

Darling’s 2007 Pre-Budget Report and Comprehensive Spending Review

• Planned modest reduction in the deficit, by reducing the growth of spending.

Derailed by global crisis: revenue underperformance, expenditure overruns, capital injections to banks.

G-7 Fiscal Adjustment Plans

CountryAdjustment

PlansObjectives/Design Comments/Outcome

United States

1985 Gramm-Rudman- Hollings

• President submit budgets consistent with GRH targets each year, and balanced budget by 1991.

Did not achieve targets but deficit would have been larger in absence of GRH.

OBRA–1990 (Omnibus Budget reconciliation Act)

• Reduce deficit by cumulative US$500 billion (equivalent to 8.5 percent of 1991 GDP) in 1991-95. • Introduced discretionary spending caps and pay-as-you-go (PAYGO) mechanism. Included some tax increases.

Unable to restrain the unexpected growth in spending for entitlement programs (notably, Medicare and Medicaid).

OBRA–1993 • Reduce the deficit by 1988 by 1¾ percent of GDP, relative to the no-policy-change baseline.• PAYGO continued and discretionary spending caps extended, with five-year nominal spending freeze. Some tax increases and measures to close loopholes.

Deficit reduction well in excess of targets, with stronger-than-expected economic growth and revenues, but also effective spending caps.

Source: IMF staff compilations.

G-7 Fiscal Adjustment Plans

Public Sector New Borrowing and Debt in the U.K.

(In percent of GDP)

Findings in Three Dimensions:Findings in Three Dimensions:

1.1. Rationale for and design of the envisaged fiscal Rationale for and design of the envisaged fiscal adjustmentadjustment

2.2. Degree of implementation and underlying Degree of implementation and underlying macroeconomic factorsmacroeconomic factors

3.3. Political and institutional determinants of the Political and institutional determinants of the implementation recordimplementation record

Key Findings

Envisaged composition of fiscal adjustment: Envisaged composition of fiscal adjustment:

Most plans focused on spending cuts, consistent with Most plans focused on spending cuts, consistent with the relatively large initial size of government, the relatively large initial size of government, particularly in Europe.particularly in Europe.

Macroeconomic assumptions:Macroeconomic assumptions:

Macroeconomic assumptions were mostly in line with Macroeconomic assumptions were mostly in line with those of independent observersthose of independent observers

Rationale for and Design of Fiscal Adjustment Plans

15

Revenue Increase Decrease Total

Increase 10 27 37

Decrease 0 63 63

10 90 100

Revenue and Expenditure Composition of 66 Plans(In Percent)

Expenditure

Envisaged composition of fiscal adjustment: Envisaged composition of fiscal adjustment:

Most plans focused on spending cuts, consistent with Most plans focused on spending cuts, consistent with the relatively large initial size of government, the relatively large initial size of government, particularly in Europe.particularly in Europe.

Macroeconomic assumptions:Macroeconomic assumptions:

Macroeconomic assumptions were mostly in line with Macroeconomic assumptions were mostly in line with those of independent observersthose of independent observers

Rationale for and Design of Fiscal Adjustment Plans

Implementation record and degree of ambition:Implementation record and degree of ambition: Evidence from study of 66 large adjustment plans in the EU Evidence from study of 66 large adjustment plans in the EU

sample: it is “OK to plan big.”sample: it is “OK to plan big.” Ambitious plans do tend to produce more adjustment than do Ambitious plans do tend to produce more adjustment than do

more modest plans, by a factor of one. more modest plans, by a factor of one.

Revenue-expenditure mix in outcomes versus plans:Revenue-expenditure mix in outcomes versus plans: Expenditure cuts did not materialize to the extent envisaged. Expenditure cuts did not materialize to the extent envisaged.

Revenues compensated in part. Revenues compensated in part.

Key role of economic growth: Key role of economic growth: Deviations of economic growth from initial expectations were a Deviations of economic growth from initial expectations were a

major factor underlying success or failure. major factor underlying success or failure.

Implementation Record and Underlying Macroeconomic

Factors

European Union: Planned and Actual Adjustments, 1991-2007

(Percent of Potential GDP)

Implementation record and degree of ambition:Implementation record and degree of ambition: Evidence from study of 66 large adjustment plans in the EU Evidence from study of 66 large adjustment plans in the EU

sample: it is “OK to plan big.”sample: it is “OK to plan big.” Ambitious plans do tend to produce more adjustment than do Ambitious plans do tend to produce more adjustment than do

more modest plans, by a factor of one. more modest plans, by a factor of one.

Revenue-expenditure mix in outcomes versus plans:Revenue-expenditure mix in outcomes versus plans: Expenditure cuts did not materialize to the extent envisaged. Expenditure cuts did not materialize to the extent envisaged.

Revenues compensated in part. Revenues compensated in part.

Key role of economic growth: Key role of economic growth: Deviations of economic growth from initial expectations were a Deviations of economic growth from initial expectations were a

major factor underlying success or failure. major factor underlying success or failure.

Implementation Record and Underlying Macroeconomic

Factors

EU sample: Actual versus Planned Structural Fiscal Adjustment

(Percent of potential GDP; means reported, except for implementation

ratios, which are medians)

∆PLAN ∆ACTUAL

error = ∆ACTUAL minus ∆PLAN (0 is perfect

implementation)

Revenues 0.1 1.0 0.9 0.5

Cyclical 0.2 0.5 0.3 1.2

Structural -0.1 0.5 0.6 …

Expenditures -2.3 -1.0 1.3 0.4

Primary -1.8 -0.3 1.5 0.2

Interest -0.5 -0.6 -0.1 1.0

Structural primary balance 1.7 0.9 -0.8 0.8

Median implementation ratio =

∆ACTUAL/∆PLAN (1 is perfect

implementation)

Implementation record and degree of ambition:Implementation record and degree of ambition: Evidence from study of 66 large adjustment plans in the EU Evidence from study of 66 large adjustment plans in the EU

sample: it is “OK to plan big.”sample: it is “OK to plan big.” Ambitious plans do tend to produce more adjustment than do Ambitious plans do tend to produce more adjustment than do

more modest plans, by a factor of one. more modest plans, by a factor of one.

Revenue-expenditure mix in outcomes versus plans:Revenue-expenditure mix in outcomes versus plans: Expenditure cuts did not materialize to the extent envisaged. Expenditure cuts did not materialize to the extent envisaged.

Revenues compensated in part. Revenues compensated in part.

Key role of economic growth: Key role of economic growth: Deviations of economic growth from initial expectations were a Deviations of economic growth from initial expectations were a

major factor underlying success or failure. major factor underlying success or failure.

Implementation Record and Underlying Macroeconomic

Factors

22

VARIABLES (1) (2) (3) (4) (5) (6)

Overall balance base effect -0.61*** -0.61*** -0.53** -0.82*** -0.85*** -0.53***(0.17) (0.16) (0.19) (0.22) (0.24) (0.13)

Initial fiscal balance -0.26 -0.38 -0.27* -0.39**(0.22) (0.24) (0.16) (0.18)

Real GDP growth surprise 0.34*** 0.34*** 0.12 0.52*** 0.53*** -0.029(0.059) (0.059) (0.13) (0.088) (0.094) (0.079)

Plan ambition -0.37 -0.19 -0.29 -0.29 -0.14 -0.29(0.47) (0.32) (0.47) (0.33) (0.29) (0.33)

0.18 0.24(0.18) (0.19)

Time dummies Yes YesObservations 66 66 66 66 66 66R-squared 0.456 0.422 0.662 0.367 0.320 0.177

Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

Baseline Regressions With Core Variables

Fixed Effects FE Instrumental Variables

Dependent Variable: Implementation error = actual minus planned adjustment

Deviation of initial deficit from 3% of GDP level

Features influencing degree of implementation:Features influencing degree of implementation:

1.1. Monitoring of fiscal outturns and policy response to data Monitoring of fiscal outturns and policy response to data revisionsrevisions

2.2. Binding medium-term limitsBinding medium-term limits

3.3. Contingency reservesContingency reserves

4.4. Coordination across levels of governmentCoordination across levels of government

5.5. Fiscal rulesFiscal rules

Political Factors and Public Support for Fiscal Political Factors and Public Support for Fiscal Adjustment: Adjustment:

Lower fractionalization in the legislative body and perceptions Lower fractionalization in the legislative body and perceptions of greater political stability are to some extent associated with of greater political stability are to some extent associated with better implementation of plans.better implementation of plans.

Public support is crucial for implementation success.Public support is crucial for implementation success.

Fiscal Institutions and Political Factors

Spelling out how policies will respond to shocks. Spelling out how policies will respond to shocks.

Monitoring and accountability: Implementation of plans Monitoring and accountability: Implementation of plans should be supported by reliable and timely information.should be supported by reliable and timely information.

The revenue-expenditure mix of fiscal consolidation plans The revenue-expenditure mix of fiscal consolidation plans needs to reflect country-specific societal preferences and needs to reflect country-specific societal preferences and structural fiscal characteristics. structural fiscal characteristics.

Structural reforms underpin successful implementation of Structural reforms underpin successful implementation of large fiscal adjustment plans.large fiscal adjustment plans.

Build public support—public support for fiscal adjustment, Build public support—public support for fiscal adjustment, rather than a comfortable legislative majority, is what rather than a comfortable legislative majority, is what matters. matters.

Implications for Planned Adjustments

Thank you!Thank you!

To find out more: To find out more: Chipping Away at Public DebtChipping Away at Public Debt—Sources of Failure and Keys to Success in —Sources of Failure and Keys to Success in Fiscal AdjustmentFiscal Adjustment, Wiley. , Wiley.

Background SlidesBackground Slides

VARIABLES (1) (2) (3) (4) (5) (6)

Overall balance base effect -0.82*** -0.83*** -0.84*** -0.68*** -0.87***(0.22) (0.22) (0.21) (0.21) (0.22)

Initial fiscal balance -0.27* -0.27* -0.31 -0.39** -0.30** -0.30*(0.16) (0.16) (0.19) (0.16) (0.13) (0.17)

Real GDP growth surprise 0.52*** 0.50*** 0.49*** 0.45*** 0.50***(0.088) (0.089) (0.080) (0.088) (0.087)

Plan ambition -0.29 -0.26 -0.33 -0.40 -0.46 -0.29(0.33) (0.32) (0.33) (0.32) (0.28) (0.34)

Positive overall balance base effect -0.92***(0.34)

Negative overall balance base effect -0.71**(0.31)

Positive growth surprise 0.37(0.29)

Negative growth surprise 0.58***(0.16)

Fiscal rule strength 0.61**(0.30)

Change in government stability 3.07***(1.12)

Parliamentary fractionalization -3.62*(2.09)

Observations 66 66 66 66 66 65R-squared 0.367 0.380 0.375 0.426 0.493 0.382Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

Additional Regressions With Political Variables and Asymmetries

Dependent Variable: Implementation error = actual minus planned adjustment

FE Instrumental Variables

VARIABLES (1) (2) (3) (4) (5) (6) (7) (8)

Overall balance base effect -0.70*** -0.82*** -0.72*** -0.87*** -1.22*** -0.85***(0.20) (0.21) (0.20) (0.20) (0.34) (0.18)

Initial fiscal balance -0.14 -0.13 -0.19 -0.30** -0.15* -0.14 -0.30** -0.30***(0.11) (0.12) (0.11) (0.13) (0.091) (0.097) (0.12) (0.10)

Real GDP growth surprise 0.38*** 0.37*** 0.34*** 0.54*** 0.52*** 0.45***(0.056) (0.049) (0.048) (0.092) (0.090) (0.064)

Plan ambition -0.0044 0.033 -0.076 -0.26 0.11 0.14 -0.16 -0.15(0.19) (0.21) (0.19) (0.18) (0.16) (0.16) (0.20) (0.15)

Positive overall balance base effect -1.64*** -1.69***(0.47) (0.47)

Negative overall balance base effect -0.46** -0.64**(0.18) (0.25)

Positive growth surprise 0.21** -0.087(0.090) (0.30)

Negative growth surprise 0.48*** 0.82***(0.066) (0.23)

Fiscal rule strength 0.41* 0.38**(0.23) (0.16)

Change in government stability 2.68*** 2.25***(0.82) (0.70)

Parliamentary fractionalization -0.47 -1.18(2.64) (1.67)

Observations 58 58 58 57 58 58 58 57R-squared 0.582 0.611 0.602 0.713 0.496 0.534 0.437 0.665Robust standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

Fixed Effects FE Instrumental Variables

Regressions with Outliers Removed

Dependent Variable: Implementation error = actual minus planned adjustment

29

-8

-6

-4

-2

0

2

4

6

2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029

Cyclically Adjusted Primary Balance

Primary Balance

30

40

50

60

70

80

90

100

2007 2009 2011 2013 2015 2017 2019 2021 2023 2025 2027 2029

General Government Gross Debt – to – GDP ratio

Advanced economies: Illustrative scenarios for primary Advanced economies: Illustrative scenarios for primary balance adjustment and debtbalance adjustment and debt