Abstract
With the new European fiscal compact, fiscal rules requiring balanced budgets net of the annual cyclical component have been introduced to limit growth in the ratio of debt to GDP. The objection may arise that such rules would have an adverse effect, especially in the long run on employment and growth. We test the unemployment proposition by investigating, with a panel of 22 OECD countries (1980–2009), the relationship between the non-accelerating inflation rate of unemployment (NAIRU) as the dependent variable, and fiscal policy indicators such as underlying net lending of government as a percentage of potential GDP (UNLG/pot.GDP), and general government total receipts as a percentage of GDP, controlling for additional variables. We find that both UNLG/pot.GDP and the increase in fiscal burden may be relevant in increasing the NAIRU in the long run. High budget deficits not only do not reduce unemployment, but also aggravate it in the long run. Results are robust to the presence of cross sectional correlation. These results suggest that deficits in excess of that allowed by the cyclical budget balance increase structural unemployment. Since high taxes appear to have the same effect, the EU fiscal compact, with respect to the structural employment objective, needs to include a rule on tax burden limits. Further analysis should test whether exogenous causes of high NAIRU have an impact on budget deficits.
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Notes
It should be mentioned that Keynes probably believed it was necessary to concentrate on the shorter term to “save capitalism”, in periods of great depression, such as the one during which he wrote his General Theory. The long term negative effects of fiscal policies increasing deficit and debt did not worry him because without any empirical evidence he assumed that in mature economies there is a structural excess of savings.
This view basically implies that public debt does not pose a problem if the government runs this debt in the home country: no resources are lost and public deficits merely reallocate resources from taxpayers to bond holders.
The intergenerational redistribution also justifies a non-Keynesian type of golden rule of public finance according to which government should finance public investments that yield long term benefits through public deficit, in order to make future generations contribute to the financing. If future generations benefit from current investment, their financing of the debt is fair and justified, otherwise they should bear all the costs but only part of the benefits.
More precisely the balanced budget rule states that ratifying members should achieve a general budget deficit less than 3.0 % of GDP, and a structural deficit less than 1.0 % of GDP if the debt level is below 60 % or else it shall be below 0.5 % of GDP.
Policies targeted to the labor market have been prominent in many countries, but the need to service or reduce public debt, originating from such policy choices, might result in higher unemployment as well as lower quality employment and output, which decrease the denominator of public debt/GDP ratios and endanger the sustainability of public finances. See Bertola (2011), who analyses the specific impact (on employment and unemployment rates) of unemployment insurance generosity and active labor market policies as compared with labor tax rate and public interest payments in different groups of countries: Nordic (Denmark, Finland, Norway, Sweden), Anglo-Saxon (Australia, Canada, Ireland, United Kingdom, United States), Continental (Austria, Belgium, France, Germany, Netherlands), Mediterranean (Italy, Portugal, Spain).
The NAIRU, i.e. the non-accelerating inflation rate of unemployment, is a notion formalized by Layard et al. (1991). More precisely, it is the unemployment rate prevailing in the absence of any temporary supply shocks and at a constant rate of inflation, after the dynamic adjustments of wages and inflation have taken place.
Underlying government net lending corresponds to the cyclically-adjusted financial balances cleared from the impact of the so called one-off transactions. Potential GDP is a supply side notion and can be regarded as the highest level of Gross Domestic Product that can be sustained without giving rise to increasing inflation. If actual GDP rises and stays above potential output, then production exceeds capacity (i.e. demand exceeds supply) and inflation tends to increase.
This paper focuses on the impact of fiscal policy on unemployment; we do not attempt to benchmark our effort against the empirical works explaining the changes of the NAIRU with imperfect competitive labor and product markets. In that strand of literature, in addition to the tax wedge, the proxies used to assess the impact of market imperfections are measures of unemployment benefit generosity, the degree of stringency of employment protection legislation, and union membership rates. For a comprehensive review of this approach see Bassanini and Duval (2006). A related approach contemplates dueling on the interaction between institutions and adverse economic shocks, where the former could amplify and lengthen fluctuations by delaying and/or weakening the required adjustment of wages and prices, and cause unemployment hysteresis. For an assessment of the impact of the latest financial crisis carried out using this approach see Bouis et al. (2011).
There is a growing literature on policy impact on productivity. This, however, is outside the scope of this paper. For a discussion of the issue see for instance IMF (2008).
UNLG takes on a negative sign in the case a of deficit and a positive sign in the case of a surplus.
To eliminate the cross dependence, the standard DF (or ADF) regressions are augmented with the cross sectional averages of lagged levels and first-differences of the individual series.
The variable Z is equal to the expression −3.813541 − 0.0916602*und_lend_gov_potGDP(−1) + 0.1248601*gov_rec_gdp(−1)
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Fedeli, S., Forte, F. & Ricchi, O. The Long Term Negative Relationship Between Public Deficit and Structural Unemployment: An Empirical Study of OECD Countries (1980–2009). Atl Econ J 43, 39–54 (2015). https://doi.org/10.1007/s11293-014-9437-z
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DOI: https://doi.org/10.1007/s11293-014-9437-z