Fiscal consolidation and reforms: Substitutes, not complements

Coen Teulings 13 September 2012

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Many OECD countries suffer from high sovereign debts. Sooner or later, this problem must be addressed. That will require some form of fiscal retrenchment.

Quite often the fiscal problems are due to market rigidities, barriers to entry, and distortive tax systems. A programme of reform must therefore include both fiscal consolidation and institutional reform to enhance future growth. Growth and the larger tax base that goes with it provides the best prospect for solving the fiscal problems.

The obvious question regards timing. What should have priority: fiscal consolidation or institutional reform? A hard-line reasoning would argue that both should go hand in hand.

  • Immediate fiscal consolidation to convince financial markets that policymakers stand to get the budget under control, and
  • Institutional reform to increase the future tax base.

In this view, fiscal consolidation and institutional reform are complements. I believe the contrary.

The more consolidation is put in place, the smaller the scope for institutional reform. Policymakers therefore face a tradeoff. The argument does not rely on political fatigue, but on the distribution of wealth between generations:

  • Both consolidation and reform reduce the current generation’s wealth and hence their consumption.

There is a limit to the fall in current consumption that is helpful for the resolution of a country’s fiscal problems.

  • Too sharp a fall in consumption will lead to costly adjustment of production capacity, from consumption goods and non-tradables (which can only be sold on the home market) to investment goods and tradables (which can be sold abroad).

Fiscal consolidation and institutional reform are therefore substitutes, not complements. The more a policymaker focuses on the one, the less scope there is for the other. Whether consolidation takes the form of lower expenditures or higher tax rates does not matter at this stage.

The economic logic

My argument relies on the following reasoning.

  • Since sovereign debt is postponed taxation, it is equivalent to a claim of current generations on future generations.

Rents are traditionally viewed as a transfer within a generation, from the public to the special interest that benefits from the market distortion.

For example, consider an entry barrier, such as a limit on the number of cab licences. This system provides cab drivers with the market power to extract rents from the public. However, this is only part of the distributional effect. Since a licence is an entitlement to future rents, its market value is equal to the net discounted value of future rents. A driver wishing to enter the business has to buy a licence. Since the price of the licence is equal to the value of future rents, the incoming driver does not benefit from the entry barrier at all. All benefits accrue to the current generation of drivers.

  • The introduction of an entry barrier is equivalent to a shift of wealth from future generations to current generations.

The value of the licence is a claim of current generations on future generations, exactly like sovereign debt. This mechanism has previously been analysed by Yoram Weiss (1985) in the context of a labour union.

  • A policy of product-market reform that abolishes entry barriers is equivalent to redistribution from the current generation to future generations. 

This analysis provides an explanation for why this type of reforms is so difficult to implement in addition to the standard argument that special interests are better organised and therefore have a greater political clout than the public.

  • Future generations do not have direct political representation and market distortions such as entry barriers are therefore an easy way to extract rents from a group with limited political power.

From a macroeconomic point of view, the market value of licences and other claims on future rents are equivalent to sovereign debt. Both are transfers from future to current generations. In that sense, the macroeconomic effect of a €1 reduction of the value of licences is (almost) equal to the impact of a €1 reduction in sovereign debt.

To assess the significance of this effect I discuss a practical example from my own country.

A practical example: Netherland’s mortgage interest tax deduction

Interest payments on mortgages are tax deductible in the Netherlands. Since marginal tax rates are in the range of 40%-50%, the tax deduction pays for up to one half of the interest on mortgages. The yearly tax expenditures account for roughly 2% of GDP.

The Netherlands is a densely populated country with an extensive system of spatial planning. Housing supply is therefore highly inelastic. Hence, the implicit subsidy is likely to mainly increase the price of the existing stock of housing, rather than leading to much additional supply.

The upward effect on house prices is equivalent to the value of a cab license: both capture the net discounted value of future revenues, deductible interest payments in the first case, above market clearing prices for cab services in the second. Even assuming the discount rate to be as high as 10% (given the political risk of policy reform, this high value is not unreasonable), the net discounted value of future deductibility is 2%/10% = 20% of GDP. Lower discount rates would lead to an even larger net discounted value. Case studies suggest a decline in the total value of the stock of residential real estate in response to an abolishment of mortgage deductibility in the order of magnitude of 20 % of GDP (Donders et al. 2010).
Note that this argument only relies on the tradability of claims on future tax-deductibility of mortgage interest payments. Hence, a balanced budget reform of mortgage deductibility (the lower tax expenditure on mortgage deduction being returned to the current generation of taxpayers via lower tax rates) will nevertheless imply a transfer of wealth from current to future generations.

This transfer of wealth will obviously affect the path of aggregate consumption, from current consumption to future consumption.

Burning the candle at both ends

When policymakers view debt reduction and reform as complements and strive to implement both at the same time, they will face a sharp drop in consumption and high adjustment cost. The example above considers mortgage deductibility, but the same applies to liberalising professional services or to opening up various types of business.

  • To the extent that employment protection legislation and rent controls allow the current generation to extract rents from future generations (by selling off jobs or by subletting), the same argument applies.

The IMF and the EC should account for these trade-offs when evaluating policy proposals from member states.

  • Reform and fiscal consolidation are therefore substitutes.

Which of the two policies should have priority?

The answer is almost certainly 'reform'.

  • Fiscal consolidation usually implies increasing tax rates.; this increases the dead-weight loss of the tax system.
  • Reform reduces the dead-weight loss in the economy by eliminating rents.

There is only one reason for a reduction in sovereign debt to be preferable – the default risk on the payment of the claim.

  • In the case of a transfer to the current generation via sovereign debt, the default risk is born by the holder of the debt.
  • In the case of a transfer via the value of licences, the default risk is born by the generation that holds the claim on the rents.

When younger generations start revolting against the excess burden imposed by the current generation of insiders, it is the interest of the current generation itself that is at stake. This provides them an incentive to come to an agreement.

Conclusion

Despite the logic in favour of reform, policymakers tend to prefer consolidation. What mechanism can explain this apparently inefficient preference? A possible explanation is the lack of verifiability of the transfer of wealth due to institutional reform. While the success in improving debt dynamics can be easily monitored from national accounts data, an assessment of the size of the intergenerational transfer requires empirical inference on the market value of claims on future rents. A systematic account of these data is lacking. Here, proper accounting of the net discounted value of rents and economic reasoning still has a mission.

References

Donders, J, M van Dijk, and G Romijn (2010), “Hervorming van het Nederlandse woonbeleid”, CPB bijzondere publicatie, 84.

Pisany-Ferry, Jean and Coen Teulings (2012), "Eurozone countries must not be forced to meet deficit targets", Financial Times (electronic version)

Weiss, Yoram (1985), "The effect of labour unions on investment in training: a dynamic model", Journal of Political Economy, 93(5), 994-1007.

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Topics:  Macroeconomic policy Taxation

Tags:  Institutional reform, fiscal crises, Fiscal retrenchment, austerity

Comments

by Robert Ford and Paul van den Noord

We have read Coen Teulings’ column on “Fiscal consolidation and reforms: substitutes, not complements” with lots of interest, and share the overall analytical framework and concepts, which are clear and useful.  However, as always, the devil is in the detail and accordingly we do not arrive at the same conclusions as he does with regard to the (relative and absolute) merits of structural reform, or at least consider that these conclusions need to be qualified.

One point is that in our view Teulings overestimates the extent of inter-generational wealth transfers (from the present to the future) associated with (certain types) of structural reform. We think many of the benefits materialise here and now. There are two issues we consider important in this context:

  1. Many structural reforms transfer wealth within rather than between generations. Teulings’ example of taxi drivers is a case in point. Relaxing taxi regulation moves income from taxi drivers (owners, more exactly) to everyone else. Surely, when talking about people alive today versus those alive tomorrow, there is no shift. Both are, on average, better off because it will not take decades for liberalisation to have its effect.
  2. Even for reforms that do take a very long time to mature, future generations will pay less for the reformed services and will therefore have more money to spend on other things. This should make today’s share prices of producers of these other things go up – offsetting the capital losses on in the reformed (and eventually rent-less) sector. In other words, future efficiency gains are transmitted to present generations via the financial market channel.

Moreover, in an uncertain world where structural reform increases confidence that a country will pull through a sovereign debt crisis there should be positive effects on asset prices as well.   However, one can view reform and consolidation as substitutes in the sense that one can achieve a given growth objective with different combinations of the two. We think it is important to stress though that this does not necessarily lead to a corner solution in which one would resort exclusively to reform or exclusively to consolidation. In theory it is possible to derive a superior combination of the two, and that intergeneration equity is one of the criteria that could be applied to judge what combination to choose. And indeed, we have seen combinations of the two in reality.

More fundamentally, because both reform and fiscal consolidation (in the sense of ensuring fiscal sustainability) raise growth, at least in the long term, if the goal is to raise growth they can be regarded as complements. Indeed, if structural reform boosts growth even in the short term, which for some reforms is not farfetched, then it makes fiscal consolidation easier. There is another form of complementarity, encapsulated by the example of the Dutch mortgage interest deduction. Offsetting tax cuts aside, abolishing the deduction is both a welfare enhancing structural reform and a fiscal consolidation.

Robert Ford is Deputy Director of the Country Studies Branch, OECD. Paul van den Noord is Counsellor to the Chief Economist at the Economics Department, OECD