Spring 2004 Forecast Presentation UK

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IMF Fiscal Affairs and Research
Departments Workshop on Fiscal Policy Washington,
June 2, 2009
A couple of issues in automatic stabilisation
Efficiency effects and medium-term
sustainability by Carlos Martinez-Mongay() Euro
pean Commission DG ECFIN () The views
expressed in this presentation do not necessarily
represent those of the European Commission
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OUTLINE

• Distortionary taxes, the size of governments and
  the trade-off between stabilization and
  efficiency
• Asset booms, composition effects and the
  trade-off between stabilization and sustainability

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• Distortionary taxes, the size of governments and
  the trade-off between stabilisation and
  efficiency

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A simple model for automatic stabilisation
(European Commission (2001) se also Artis and
Buti, 2000, Blanchard, 2000, Buti, Roeger, int
Veld, 2001)

• A simple AD/AS model
• Yd f1(d-pb) f2(i-pe) ed f1 , f2 gt 0
• Ys Y w(p pe) es
• (3) d d - t(Y Y)
• IS-type schedule
• Lucas-Pillips supply function
• d deficit
• b stock of public debt
• i interest
• p inflation (e expected)
• Y potential output (Y Y is the output gap)
• ed, es, demand and supply shocks
• (3) d cyclically-adjusted deficit
• t automatic stabilisers (sensitivity of the
  deficit to the output gap, Y-Y)

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Shocks dont come with labels demand, supply,
temporary, permanent

• Y Y (w ed bes)/w(1 f1 t ) b
• p p (ed (1 f1 t ) es)/w(1 f1 t ) b
• If automatic stabilisers are turned off (t 0)
• Y Y (w ed bes)/(w b)
• es 0, Y Y w ed /(w b) ed 0, Y Y
  bes/(w b)
• p p (ed es)/(w b)
• es 0, p p ed/(w b) ed 0, p p
  es/(w b)
• If automatic stabilisers are turned on (t gt0)
• es 0 Y Y w ed /w(1 f1 t ) b
• ed 0 Y Y bes/w(1 f1 t ) b
• es 0 p p ed /w(1 f1 t ) b
• ed 0 p p - (1 f1 t ) es)/w(1 f1 t )
  b
• es permanent Y (Y es ) -(1 f1 t )
  es/w(1 f1 t ) b

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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 agents 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

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Higher tax rates can lead to steeper aggregate
supply curves
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An extended AD/AS model with taxes in the supply
curve
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An extended AD/AS model with taxes in the supply
curve
Trade balance consistency implies
where
(6)
and
.
Inflation can be obtained by equating (6) to (w
at)p es (i.e. (2) with pe 0)
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Is there an efficiency-stabilization tradeoff?
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Is there an efficiency-stabilization tradeoff?
The cases of closed and small economies
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Is there an efficiency-stabilization tradeoff?
Empirical evidence

• 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

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Alternative ways of measuring the size of
governments
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Stabilization and the tax burden
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The average effective tax rate on labor income
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Labor taxes in the sample
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Is there an efficiency-stabilization tradeoff?
Empirical evidence
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Is there an efficiency-stabilization tradeoff?
Additional empirical evidence (Debrun et al,
2008)
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Is there an efficiency-stabilization tradeoff?
Additional empirical evidence (Debrun et al,
2008)
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2. Asset booms, composition effects and the
trade-off between stabilization and
sustainability
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Measuring automatic stabilizers in the presence
of composition effects

a) Cyclical effect (growth at nominal GDP) (b)
Composition effect (growth at base rate) (c)
Discretionary measures (d) Others
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Automatic stabilizers and asset booms. The case
of Spain

The longest expansion of the Spanish economy

Source AMECO
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Automatic stabilizers and asset booms. The case
of Spain

domestically led, especially by the housing
sector (and consumption).

Source AMECO and own calculations
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Automatic stabilizers and asset booms. The case
of Spain

The expansion 1995-2007 was underpinned by a
substantive fall of the risk premium, and
unprecedented demographic growth,

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Automatic stabilizers and asset booms. The case
of Spain

which induced a boom in asset markets

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Automatic stabilizers and asset booms. The case
of Spain
Asset markets have also driven the downturn
Source AMECO and own calculations
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A tax-rich expansion,
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Automatic stabilizers and asset booms. The case
of Spain

apparently of a structural nature

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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



Source AMECO and own calculations
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Automatic stabilizers and asset booms. The case
of Spain

which led to large composition effects

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Automatic stabilizers and asset booms. The case
of Spain

explaining between 2/3 and ¾ of the accumulated
increase in tax revenues

?REVt d0 a 1(REV a - ß GDP - t TREND)t-1
d1 ?GDPt d2 ?GDPt-1 d1 ?(HOUSE/GDP)t-2 d2
?(MGVA/GDP)t g1 I1t gm Imt et (1)
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Automatic stabilizers and asset booms. The case
of Spain Enough fiscal consolidation in good
times?

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Automatic stabilizers and asset booms. The case
of Spain A sustainable fiscal expansion?
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References
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
makers 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. int Veld,
2001, Fiscal policy in Europe how effective are
automatic stabilisers?, European Economy,
Economic Papers, N 177. Buti, M., W. Roeger, J.
int 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. int Veld, 2009, Fiscal Policy with
Credit Constrained Households, European Economy
Economic Papers, N 357.
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