As the Eurozone is entering into recession, fiscal policy has moved to centre stage. The extent of austerity has been widely attacked, including by IMF staff (Cottarelli 2012), while the design of fiscal policy, namely expenditure reductions versus tax increases (Alesina and Giavazzi 2012), has also come under scrutiny. Reflecting the growing intensity of this debate, Vox launched a debate to move closer to a consensus on the circumstances under which governments should relent on their efforts to reduce a fiscal deficit when policy credibility is still far from granted (Corsetti and Müller 2012).
This column summarises results from our recent study focusing on identifying links between “substantial” changes in government expenditures and “growth accelerations” (Carrère and de Melo 2012). We use event analysis, i.e. we reorganise the data around the event of interest – here a sizeable and sustained change in fiscal expenditures. In a large sample of countries where growth instability is pervasive, this approach helps unveil any relation between fiscal expenditures and growth. The focus is on identifying if developing countries have “fiscal space” for discretionary fiscal expenditures, but a cautious interpretation of the results should be informative in a broader context.
Lacking data on indebtedness (which would have allowed us to carry out formal tests of debt sustainability) and on all the non-discretionary components of expenditures such as wages, we define “discretionary” fiscal expenditures as total fiscal expenditures minus interest payments, which is equivalent to focusing on primary spending. We computed the primary fiscal deficit, def, as the difference between the total revenues and grants and discretionary fiscal expenditure (so a deficit is negative). Working on a five-year window, we defined a fiscal event in t when the following conditions were met:
- An increase in discretionary fiscal expenditure average growth of 1 ppa (percentage point per annum).
- If in deficit (i.e def < -2% of GDP), deficit does not increase.
- If in surplus (or in def > - 2% of GDP), the increase in discretionary fiscal expenditure does not lead to a deficit exceeding 2% of GDP.
Constrained by data availability over a large sample of countries, this naïve definition of a fiscal “event” cannot be interpreted as entirely discretionary (or unanticipated), and hence is only an approximate proxy for fiscal space (see Heller 2006 for discussion). So it is best to view these constructed “events” as significant changes in fiscal policy refraining from attributing any government objective to the event – even if, as we discuss at some length, in the case of developing countries, fiscal policy is procyclical, reducing the possibility of selecting fiscal events that would be automatically followed by a growth event.1 Hence, with procyclicality, if a growth event occurs in the years following a fiscal event, this should increase the deficit, and therefore weaken the probability of observing fiscal events followed by a growth event (recall that an increase in discretionary fiscal expenditure associated with an increase in the fiscal deficit does not qualify as a fiscal event).
Since we were interested in the relation between a “significant” change in fiscal spending and a “significant” change in GDP growth – something Hausmann et al. (2005) call “growth acceleration” – we took their criteria with a growth event occurring in t if the following conditions were met:
- An increase in the average per-capita growth of 2 ppa or more (percentage points per annum, ppa ).
- Growth acceleration sustained for at least 5 years [t;t+4].
- An average annual growth rate at least 3.5 ppa during the acceleration period [t;t+4].
- A post-acceleration output exceeding the pre-episode peak level of GDP.
After selecting the most relevant year for a growth event (a spline regression was used to prevent taking several years to capture the same event), we obtained 58 growth events and 95 fiscal events over the period 1972-2005. In this sample, the probability of occurrence of a fiscal event is about 10%, and the probability of a growth event once a fiscal event has occurred is in the 22%-28% range. The probability of occurrence of a fiscal event is higher for the bottom half of the income distribution of countries. For the developing country group, which was the focus of our study, fiscal events followed by growth events occur under situations of a significantly lesser deficit, giving support for watching the primary deficit. We also found that a shift in discretionary expenditures towards transport and communication was only observed for fiscal events followed by growth events and that these fiscal events followed by growth events also devoted fewer resources to general public services.
After controlling for the growth-inducing effects of positive terms-of-trade shocks and of any on-going trade liberalisation reform, the statistical analysis in which the probability of a growth event is conditioned on the occurrence of a fiscal event in surrounding years confirms that growth events are, on average, more likely when a fiscal event has occurred. Moreover, the probability of occurrence of a growth event in the five years following a fiscal event is greater the lower is the associated fiscal deficit, as shown in Table 1. For instance, a fiscal event associated with a fiscal deficit of 3% decreases the probability of occurrence of a growth event from 9.7% (probability of a growth event with no fiscal event) to 7.4% while a fiscal event with no primary deficit doubles the probability of occurrence of a growth event (still relative to a no fiscal event situation).
Table 1. Probability of a growth event following a fiscal event (conditional to the primary deficit)
Note: pp stands for percentage points.
Source: Carrère and de Melo (2012, table 4).
These results suggest that success of a growth-oriented fiscal expenditure package is associated with a stabilised macroeconomic environment (through limited fiscal deficit).
Alesina, A and F Giavazzi (2012), “The austerity question: ‘How’ is as important as ‘how much’”, VoxEU.org, 20 February.
Alesina, A and G Tabellini (2005), “Why is Fiscal Policy Often Procyclical?”, NBER Working Paper 11600, National Bureau of Economic Research.
Carrère, C and J de Melo (2012), "Fiscal Spending and Economic Growth: Some Stylized Facts", (forthcoming World Development) and FERDI WP#35
Cottarelli, C (2012), “Fiscal adjustment: Too much of a good thing?”, VoxEU.org, 20 February.
Corsetti, G and G Müller (2012), “Has austerity gone too far?”, VoxEU.org, 20 February.
Frankel, JA, CA Végh, and G Vuletin (2011), “On graduation from fiscal Procyclicality”, mimeo, Harvard University, University of Maryland, and Colby College.
Hausmann R, L Pritchett, and D Rodrik (2005), “Growth Accelerations”, Journal of Economic Growth, 10:303-329.
Heller PS (2006), “Understanding Fiscal Space”, IMF Policy Discussion Paper, PDP/05/4.
Ilzetski, E and C Végh (2008), “Procyclical Fiscal Policy in Developing Countries: Truth or Fiction?”, NBER Working Paper 14191.
Perotti, R (2007), “Fiscal Policy in Developing countries: A Framework and Some Questions”, World Bank Policy Research Working Paper, WPS4365.
Talvi, E and C Végh (2005), “Tax Base Variability and Procyclicality of Fiscal Policy”, Journal of Development Economics, 78(1):156-190.
Végh, C and G Vuletin (2011), “How is tax policy conducted over the business cycle?”, mimeo, University of Maryland and Colby College.
1 The paper reviews at length the evidence on the cyclicality of fiscal expenditures, coming to the conclusion that they are pro-cyclical. See also Perotti (2007), Alesina and Tabellini (2005), Frankel et al. (2011), Izletski and Végh (2005), and Végh and Vuletin (2011).