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What do we really know about fiscal sustainability in the EU? A panel data diagnostic

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Abstract

We assess the sustainability of public finances in the EU-15 over the period 1970–2006 using stationarity and cointegration analysis. Specifically, we use panel unit root tests of the first and second generation allowing in some cases for structural breaks. We also apply modern panel cointegration techniques developed by Pedroni (Oxf Bull Econ Stat 61(1):653–670, 1999; Econom Theory 20(3):597–625, 2004), generalized by Banerjee and Carrion-i-Silvestre (Cointegration in panel data with breaks and cross-section dependence, European Central Bank, Working Paper 591, 2006) and Westerlund and Edgerton (Econ Lett 97(3):185–190, 2007), to a structural long-run equation between general government expenditures and revenues. While estimations point to fiscal sustainability being an issue in some countries, fiscal policy was sustainable both for the EU-15 panel set, and within sub-periods (1970–1991 and 1992–2006).

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Notes

  1. The countries are: Belgium, Denmark, Germany, Ireland, Greece, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal, Finland, Sweden and the UK.

  2. Examples of empirical tests of fiscal sustainability on an individual country basis are provided, for instance, by Hamilton and Flavin (1986), Trehan and Walsh (1991), Wilcox (1989), Hakkio and Rush (1991), Tanner and Liu (1994), Quintos (1995), Haug (1991), Ahmed and Rogers (1995), Payne (1997), Bohn (1998), Fève and Hénin (2000), Uctum and Wickens (2000), Bergman (2001) and Afonso (2005).

  3. For the validation of theoretical results, the real interest rate is sometimes assumed in the literature to be stationary, but this is a much more difficult assumption for the nominal interest rate.

  4. McCallum (1984) discusses whether this is a necessary condition to obtain an optimal growth trajectory for the stock of public debt.

  5. Afonso (2008) provides evidence of overall Ricardian behaviour on the part of EU-15 governments.

  6. For instance, Hakkio and Rush (1991) suggest that an analysis based on ratios (to GDP) is more appropriate for growing economies.

  7. This implies that the growth rate of the debt-to-GDP ratio should be less than the factor ((1 + y)/(1 + r))(s+1).

  8. Hamilton and Flavin (1986) first used these procedures. See also Trehan and Walsh (1991) and Hakkio and Rush (1991).

  9. Quintos (1995), Ahmed and Rogers (1995) and Bergman (2001) discuss the necessary conditions for sustainability in terms of the order of integration of public debt.

  10. AMECO codes: GDP at current market prices, .1.0.0.0.UVGD; gross domestic product, at 2000 market prices, .1.1.0.0.OVGD; general government consolidated gross debt, excessive deficit procedure (based on ESA 1995) and former definition (linked series) (% of GDP); .1.0.319.0.UDGGL, .1.0.319.0.UDGGF; general government debt (level), .1.0.0.0.UDGGL, .1.0.0.0.UDGGF; general government total expenditure (% of GDP), .1.0.319.0.UUTGE, .1.0.319.0.UUTGF; general government total revenue (% of GDP), .1.0.319.0.URTG, .1.0.319.0.URTGF; general government interest payments (% of GDP), .1.0.319.0.UYIG, .1.0.319.0.UYIGF (database updated on 04/05/2007).

  11. Note that to make the analysis robust, we also compared the results of panel data unit root tests with those obtained with individual unit root tests (see Sect. 7 for a summary of the results). For complete details on this comparison see the working paper version in Afonso and Rault (2007).

  12. A common feature of the panel tests mentioned above is that they maintained the null hypothesis of a unit root in all panel members. Therefore, their rejection decision actually indicates that at least one panel member is stationary, with no information about how many series or which ones are stationary. This possibility for a mixed panel implies that some of the members may be stationary while others may be non-stationary (see Taylor and Sarno 1998 and Taylor and Taylor 2004 for further details).

  13. It should be noted that before carrying out the second generation panel unit-root tests that account for cross-section dependence, we have first implemented the simple test of Pesaran (2004) and have computed the CD statistic to test for the presence of such cross-section dependence in the data. This test is based on the average of pair-wise correlation coefficients of the OLS residuals obtained from standard augmented Dickey–Fuller regressions for each individual. Its null hypothesis is cross-sectional independence and is asymptotically distributed as a two-tailed standard normal distribution. The null hypothesis is always rejected regardless of the number of lags included in the augmented DF auxiliary regression (up to five lags) at the 5% level of significance. This confirms that the members of our panel are cross-sectionally correlated.

  14. Note that another possibility would be to use a procedure as the one advocated by Breuer et al. (2002) whereby unit root testing is conducted within a seemingly unrelated regression (SUR) framework. An advantage of this procedure is that the SUR framework is another useful way of addressing cross-sectional dependency.

  15. We are grateful to C. Hurlin for making available his Matlab codes to us.

  16. It should be noted that these tests assume cross-sectional independence among panel units.

  17. We are grateful to J. Lee for providing us with the GAUSS codes, which we have adapted for our analysis, and that are available upon request.

  18. We are grateful to A. Banerjee and J. Carrion-i-Silvestre for providing us with their GAUSS codes (for a detailed discussion of the method used, see the end of the paper).

  19. We are grateful to J. Westerlund for making available his GAUSS codes to us.

  20. Similar results, not reported here, are obtained with the implementation of the panel data tests of the second generation by Moon and Perron (2004) and Choi (2006).

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Acknowledgments

We are grateful to Ad van Riet, Jürgen von Hagen, participants at the 10th Banca d’Italia Public Finance Workshop (Perugia), at the 2008 EcoMod International Conference on Policy Modeling (Berlin), and to an anonymous referee for helpful comments and suggestions and to Simone Ruiz for assistance with the data. The opinions expressed herein are those of the authors and do not necessarily reflect those of the European Central Bank or the Eurosystem. Christophe Rault thanks the Fiscal Policies Division of the ECB for its hospitality. UECE is supported by FCT (Fundação para a Ciência e a Tecnologia, Portugal), financed by ERDF and Portuguese funds.

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Authors and Affiliations

  1. European Central Bank, Kaiserstraße 29, 60311, Frankfurt am Main, Germany

    António Afonso

  2. Department of Economics, UECE—Research Unit on Complexity and Economics, ISEG/TULisbon—Technical University of Lisbon, R. Miguel Lupi 20, 1249-078, Lisbon, Portugal

    António Afonso

  3. LEO, University of Orléans, Rue de Blois, UMR 6221, B.P. 6739, 45067, Orléans Cedex 2, France

    Christophe Rault

  4. BEM, Bordeaux Management School, Bordeaux, France

    Christophe Rault

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  1. António Afonso
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Correspondence to Christophe Rault.

Appendices

Appendix A

See Table 13.

Table 13 Summary of standard individual unit root test results
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Appendix B: panel unit root tests, additional results

See Tables 14 and 15.

Table 14 Panel data unit root tests for the government debt-to-GDP ratio (1970–2006)
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Table 15 Panel data unit root tests for the primary balance-to-GDP ratio (1970–2006)
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Afonso, A., Rault, C. What do we really know about fiscal sustainability in the EU? A panel data diagnostic. Rev World Econ 145, 731–755 (2010). https://doi.org/10.1007/s10290-009-0034-1

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