Fiscal space, government spending, and tax rate cyclicality patterns

Fiscal space, government-spending, and tax-rate cyclicality patterns: A cross-country comparison, 1960-2016

The upward trajectory of policy interest levels in OECD countries will impose growing fiscal challenges, testing their fiscal convenience of countercyclical policy and therefore their resilience. This column compares fiscal cyclicality across countries and identifies measures of fiscal space. The results reveal a mixed fiscal scenery, where over fifty percent of countries are characterised by limited fiscal space, and fiscal policy is either procyclical or acyclical.

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The Global Crisis focused attention on unsustainable leverage growth as an integral contributing element in growing the financial fragility connected with ‘bubbly’ dynamics. Essentially, an extended appreciation of financial and areas increases vulnerability to sharp asset valuation corrections. A deep enough correction may trigger banking crises and fire sales dynamics, potentially pushing the economy right into a prolonged depression, with growing contact with social and political instability. 1 Concerns about reliving the fantastic Depression explain the complex group of policies implemented by the united states and other affected countries in the aftermath of the Global Crisis – an enormous infusion of liquidity to get financial and banking systems, and bailing out systemic banks and prime creditors. The forced deleverage of private borrowers, and the growing concern with an extended recession, induced higher household savings and lower investment, further deepening recessionary forces.

Many countries thus attempted fiscal stimuli targeted at mitigating the deepening recessions. Stabilising the banking and financial systems, as well as the stimuli, finished up sharply raising countries’ public debt-to-GDP ratios, pushing advanced countries towards ratios of above 100% (see Figure 1). Similar trends put on emerging market economies (EMEs), driving their debt-to-GDP ratios upward, with some reaching well above 50%. Notwithstanding the actual fact that the common debt-to-GDP ratio of EMEs is below that of OECD countries, EMEs’ lower tax base-to-GDP ratios, in addition to the higher interest levels paid on the debt (because of sovereign risk premia), imply a rising fragility of the countries weighed against OECD countries. As such, as the debt-to-GDP ratio can be used frequently in policy discussions, accounting for tax base and the ratio of public debt to the common tax base might provide a more informative way of measuring the fiscal burden linked to the stock of public debt. 2

Figure 1 Public debt/GDP (%) in advanced economies, and emerging markets and developing economies

Source: World Economic Outlook; authors’ calculations.

Importantly, the post-crisis trajectory didn’t cope with leverage concerns. “At $164 trillion – equal to 225% of global GDP – global debt continues going to new record highs almost ten years following the collapse of Lehman Brothers. Weighed against the previous peak in ’09 2009, the world is currently 12% of GDP deeper with debt, reflecting a pickup in both public and nonfinancial private sector debt after a brief hiatus. All income groups have observed increases altogether debt, but, by far, EMEs are in the lead” (Fiscal Monitor 2018). Quite simply, stabilising an emergency triggered by an unsustainable leverage growth subsequently contributed to a potentially untenable upsurge in leverage/GDP ratios.

For days gone by decade, the monetary easing linked to the US Federal Reserve and the ECB policies in the aftermath of the crisis resulted in an unprecedented decline of policy interest levels and risk premia. These developments markedly reduced the flow costs of serving the rising public and private debt, thereby masking the increasing fragility linked to the rising aggregate leverage/GDP. This era has passed – the (up to now) robust recovery of the united states, the gradual unwinding of the Fed’s balance sheet, the projected upward trajectory of the Fed’s funds rate, and the recovery of the euro area will impose growing fiscal challenges that may test countries’ fiscal space and their capability to cope with projected higher interest levels by raising their resilience.

An integral resilience margin is securing fiscal space – that’s, the fiscal capacity of countercyclical policy targeted at mitigating business cycles and preventing an extended depression in the aftermath of financial crises (Auerbach 2011, Ostry et al. 2010, see also Gavin et al. 1996on the identification of fiscal procyclicality as a significant amplifier of developing countries’ vulnerability to shocks). Remarkably, over both decades resulting in the Global Crisis, an evergrowing share of fiscal policies in developing countries and EMEs had graduated from procyclicality to be countercyclical (Frankel 2011, Frankel et al. 2013). Cross-country studies offer several explanations. Woo (2009)presented some evidence showing that social polarisation, as measured by income and educational inequality, is consistently and positively connected with fiscal procyclicality, controlling for other determinants; gleam robust negative impact of fiscal procyclicality on economic growth. In a previous paper (Aizenman and Jinjarak 2012), two folks discovered that higher income inequality is strongly connected with less tax base, lower de facto fiscal space, and higher sovereign spreads. Vegh and Vuletin (2015) find that tax policy is less procyclical/more countercyclical in countries with better institutional quality and that are more financially integrated; tax and spending policies are conducted in a symmetric way over the business enterprise cycle. 3

From this background, in a recently available paper we assess definitions and empirical measures of fiscal cyclicality, compare fiscal cyclicality across countries and regions, and identify factors accounting for spending and tax policy cyclicality patterns (Aizenman et al. 2018). We link the capability of countercyclical policy to the fiscal space and the stage of economic and institutional development, as both are linked to the servicing capabilities of domestic and foreign debt. Our analysis targets differences in the united states groups and examine the role of economic structure (commodity versus manufacturing outputs), financial openness, along with institutions and socio-economic factors (political risks, polarisation, and ethnic polarisation).

Our study reveals a mixed fiscal scenery, where over fifty percent of the countries are characterised by limited fiscal space, and fiscal policy is either procyclical or acyclical. More limited fiscal capacity and itsvolatility are positively connected with fiscal cyclicality, while public debt-to-GDP is statistically significant in a number of cases, suggesting that the ratio of public debt to the tax baseprovides a robust fiscal-space explanation for studying government spending and tax rate cyclicality. 4 The cyclicality is asymmetric – normally, a far more indebted (in accordance with the tax base) government spent more in memories (positive growth) and scale back the spending a lot more in bad times (weak economy).

We also find a country’s sovereign wealth fund includes a countercyclical effect inside our estimation. Our analysis depicts a substantial economic impact of an enduring interest-rate rise on fiscal space – a 10% upsurge in public debt over the tax base is associated normally with an upper bound of a 6.1% upsurge in government spending procyclicality (see Figure 2, bottom panel for the cross-country distribution of the effect). For bothgovernment spending cyclicality and tax rate cyclicality, we find no one-size-fit-all explanation for all (OECD and developing) countries in both bad and the good times. Fiscal space, trade and financial openness, the share of natural resource and manufacturing exports, inflation, and institutional risks are linked to the cross-country patterns of fiscal cyclicality, suggesting the measured cyclicality is context-specific and fiscal/monetary/political economy interactions are in work. Inside our paper, we rank the explanatory factors across countries and regions, and discuss policies to improve the fiscal convenience of countercyclical policy.

Figure 2 Public debt, tax base average, and government spending cyclicality, 2010-2016

Notes: Public debt/tax base average over 2010-2016 (top panel); The estimated change of government spending cyclicality connected with public debt/tax base increases by 10% (lower panel). 5

References

Aizenman J, Y Jinjarak, H Nguyen, D Park (2018), “Fiscal space and government spending & tax-rate cyclicality patterns: A cross-country comparison, 1960-2016,” NBER Working paper 25012.

Aizenman, J and Y Jinjarak (2012), “Income inequality, tax base and sovereign spreads,” FinanzArchiv: Public Finance Analysis 4(68): 431-444.

Alesina, A, C Favero and F Giavazzi (2015), “The output aftereffect of fiscal consolidation plans,” Journal of International Economics 96: S19-S42.

Auerbach, A J (2011), “Long-term fiscal sustainability in major economies,” BIS, Working Paper 361.

Frankel, J (2011), “A remedy to fiscal procyclicality: The structural budget institutions pioneered by Chile,” Journal Economía Chilena 14(2): 39-78.

Frankel, J A, C A Vegh and G Vuletin (2013), “On graduation from fiscal procyclicality,” Journal of Development Economics 100(1): 32-47.

Gavin, M, R Hausmann, R Perotti and E Talvi (1996), “Managing fiscal policy in Latin America and the Caribbean: Volatility, procyclicality, and limited creditworthiness,” Inter-American Development Bank, Working paper 326.

Jordà, Ò, M Schularick and A M Taylor (2013), “When credit bites back,” Journal of Money, Credit and Banking 45(2): 3-28.

Leeper, E, N Traum and T Walker (2017), “Unscrambling the fiscal multiplier morass,” American Economic Review 107(8): 2409-54.

Ostry, J, A Ghosh, J Kim and M Qureshi (2010), “Fiscal space,” IMF Staff Position Note SPN/10/11.

Rajan, R G (2006), “Has finance made the world riskier?” European Financial Management 12(4): 499-533.

Vegh, C A and G Vuletin (2015), “How is tax policy conducted over the business enterprise cycle?” American Economic Journal: Economic Policy 7(3): 327-370.

Endnotes

[1] Rajan (2006) remarked that banking deregulation through the 1980s-2000s increased leverage and risk taking, adding to a greater contact with financial stability connected with tail risks. Schularick and Taylor (2012) and Jordà et al. (2013) provided empirical evidence linking leverage, business cycles, and crises.

[2] The euro crisis provided a vivid exemplory case of how concentrating on public debt/GDP below a particular threshold caused failing to discover the large heterogeneity of the tax base/GDP in the Eurozone (Aizenman et al. 2013). Similarly, the interest expense had a need to serve the general public debt as a share of tax revenue might provide a robust way of measuring the responsibility of serving the general public debt and become more informative compared to the interest cost of the general public debt/GDP ratio.

[3] Related strands of the literature examine fiscal multipliers (Leeper et al. 2017, Ilzetski et al. 2013); fiscal rules (IMF 2017); and large fiscal adjustments (Alesina et al. 2015). Empirically, fiscal cyclicality, fiscal multipliers, fiscal rules, and large fiscal adjustments are intertwining issues.

[4] Public debt/tax base in public areas finance is akin the web debt to earnings before interest depreciation and amortisation ratio in the organization sector (aka debt/EBITDA). Net debt to earnings ratio is a measurement of leverage, just how many years it could take for a company to repay its debt if net borrowing is zero, and EBITDA are held constant; used frequently by credit history agencies. “Ratios greater than four or five 5 typically tripped alarm bells because this means that a company is less inclined to have the ability to handle its debt obligations, and thus is less inclined to be able to undertake the additional debt necessary to grow the business enterprise”, see here.

[5] Iraq, Japan, Singapore, Egypt, Greece, Libya, Yemen, and Jamaica show limited fiscal capacity predicated on the 2010-2016 data, accumulating public debt four to eight times bigger than their tax base (Iraq has public debt approximately forty times greater than its tax revenue). Based on the calculation, fiscally fragile countries are mostly in sub-Saharan Africa (Republic of Congo, Nigeria, Rwanda Seychelles,) and some cases in East Asia and the Pacific (Vietnam, Indonesia, Cambodia, and Japan).

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