Abstract
Results from panel regressions on a new dataset of government revenue windfalls and shortfalls in EU Member States demonstrate that macroeconomic developments have a significant impact on cyclically adjusted fiscal outcomes and indicators. In particular, the results show that an increase in household debt results in higher government revenue windfalls, while a higher trade balance leads to government revenue shortfalls. These revenue windfalls and shortfalls have distorted the signals from fiscal indicators that are used to measure the ‘underlying’ fiscal position and the governments’ fiscal efforts to improve debt sustainability. The paper also finds that temporary windfall revenues trigger permanent increases in government spending or decreases in tax rates. Taking account macro-economic indicators, such as the trade balance and private debt, provides relevant complementary information for medium-term budgetary planning, budgetary rules and surveillance.
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Source: Own calculations based on AMECO data
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Data availability
The analysis in this article uses a discretionary tax measure database covering the years 2000–2015, as well as estimates of discretionary fiscal measures that are internal to the European Commission over 2009–2018. The latter internal estimates can be provided on an aggregate basis upon request. (In addition, considering AMECO data (available as from 2010) instead of these internal estimates of discretionary fiscal measures, does not change the overall results of the study.)
Notes
Graph A.1. in the Annex shows the occurrence of (unexpected) windfall revenues over time in Member States.
In addition, macroeconomic imbalances may also substantially affect potential output, in terms of both level and composition (through sectoral reallocations, over- or under-investment and hysteresis effects), as well as potential output measurement leading to ex-post potential output revisions. Both indirectly affect cyclically-adjusted fiscal indicators.
While cyclically-adjusted budget balance indicators, such as the cyclically adjusted budget balance (CAB) and the structural balance (SB), are central elements in EU countries’ budgetary frameworks and in the EU fiscal framework, the fiscal effects of macroeconomic developments that go beyond cyclical effects are not explicitly and comprehensively considered.
Morris and Schuknecht (2007) note that the impact of discretionary tax changes makes it extremely difficult to estimate budget elasticities (to changes in asset prices) in a reliable way using econometric estimation. They suggest that ideally, these effects should be netted out, but notes that no such estimates of the revenue impacts of policy changes were available in a consistent data series across countries and time.
The term ‘deviations’ refers to gaps relative from estimated norms or equilibria usually defined. It does not necessarily reflect a situation of ‘macroeconomic imbalance’ in the sense of the MIP procedure, i.e. ‘trends giving rise to macroeconomic developments which are adversely affecting, or have the potential adversely to affect, the proper functioning of the economy of a Member State or of the economic and monetary union, or of the Union as a whole’.
Note that the ‘twin-deficit hypothesis’ literature on external and fiscal imbalances is beyond the scope of this study. As explained by e.g. Corsetti and Mueller (2006) and Afonso et al. (2018), the twin-deficit hypothesis suggests that the government and current account balance move in the same direction. Chinn and Ito (2019) also suggest a causal link going from fiscal tightening to external surpluses, consistent with a ‘twin-surplus hypothesis’. The effect that this paper aims to capture goes in the opposite direction, with revenues improving as the current account balance deteriorates. section “Methodology to assess the effects of macroeconomic developments on fiscal indicators” discusses how endogeneity concerns that may arise from this hypothesis are addressed.
Such as customs duty, excise duty, anti-dumping duty and value added tax.
Lendvai et al. (2011) adjust cyclically adjusted balances for absorption booms and show that standard approaches used to adjust budget balances for the cycle could miss part of the temporary revenues accruing during absorption booms when the current account deteriorates sharply.
Note that a breakdown of trade balances in exports and imports may provide additional information on drivers of tax windfalls, because imports and exports are not equally tax-rich. Therefore, a constant trade balance with different levels of imports and exports can have different fiscal effects via different budgetary elasticities.
An exception is revenues derived from exports of government-owned resources, on which the revenues may be higher than on the other parts of GDP. In this case, exports may lead to windfalls.
Liu et al. (2015) incorporate the impact of asset price cycles in the calculation of structural fiscal balances.
See also Claessens et al. (2011), Bénétrix and Lane (2013). Credit growth and household debt indicators are relatively easily comparable across countries and highly correlated to house prices and equity prices, and so can consist of good proxies for internal imbalances variables. Bénétrix and Lane (2015) show how fiscal variables co-vary with the financial cycle, which they capture by the credit growth and current account balance.
Heinemann (2001), based on an econometric panel analysis on a sample of OECD countries over 1972–1996.
With progressive income tax and an imperfect indexation of brackets, for instance, inflation increases real tax revenues, at policy unchanged (Oates 1988). However, inflation may reduce real tax revenues for taxes with considerable lag between the taxable event and the moment the tax is paid (Olivera 1967, Tanzi 1977). Alesina and Perotti (1995) find that inflation tends to have positive effects on individual income taxes and social security contributions, and negative effects for corporate income taxation. In addition, inflation is expected to be neutral for proportional taxes without a significant collection lag, such as VAT. For social security contributions, two opposite effects are at play: as social security contributions are often paid as a flat rate of income up to a maximum value, inflation may dampen government revenues by reducing the real levels.
With imperfect indexation of eligibility for means-tested benefits (and of their level), inflation automatically decreases expenditure ratios. In addition, government expenditure limits are often set in nominal terms, so higher-than-expected inflation may decrease spending in real terms, absent discretionary measures. However, in the long run, private sector wage increases affect public sector wages with a lag, at least in OECD countries (Fernández-de-Córdoba et al. 2012), possibly triggering increases in public expenditure. During booms, governments expand employment and wages, while in downturns, lack of tax revenues can force the government to cut back the wage bill – the latter occurring with rigidities (Afonso and Gomes 2014).
It is also more difficult to make a distinction between policy and macroeconomic effects for expenditures, partly due to data availability. Discretionary tax measure and discretionary fiscal measure databases cover the years 2000–2015 and 2009–2018, respectively. Unlike the former, the latter covers both revenue and expenditure policy decisions.
Endogeneity concerns should be seen in the context of the ‘twin-deficit hypothesis’ that suggests that a larger fiscal deficit, through its effect on national saving, leads to an expanded current account deficit. If the twin-deficit hypothesis holds, both budget balance and current account balance (or trade balance) would be jointly determined and move in the same direction. The tax elasticity effect that we investigate, on the contrary, suggests that the budget deficit improves as the current account deteriorates. By netting out the effect of government expenditure and of discretionary revenue policy measures from our LHS variable of interest, the potential for endogenous effects is much reduced when compared to studies in the literature. What remains is the disposable income effect of windfall revenues which stem from e.g. the tax take on increased consumption of imports. This effect is of secondary order but may imply minor endogeneity issues. Correcting for Nickel bias and applying instrumental variables estimates confirm that these effects are minor in our setting.
Throughout the text, tables and graphs indirect taxes are referred to as VAT.
Econometric tests show that year-fixed effects are always jointly significantly different from zero. Autocorrelation of the explained variable is not always significantly different from zero but is kept throughout for consistency. Country-fixed effects might be discarded, as our explained variable is a first difference, unless we take account of heterogeneous long-term trends across countries. However, our LSDV estimators control for them, as the LSDV corrects for the Nickell bias, following Kiviet (1995) and Bruno (2005).
Unit root tests suggest that, while independent and explanatory variables are not stationary in levels, their first differences are.
Potential GDP for the change in structural balance.
Correlation is above 60% for more than 80% of the Member States on aggregate and above 64% of the cases by revenue components.
Another source for DRM from 2010 is the AMECO database. To use it, AMECO data from 2010 is merged with the data of the discretionary tax measure database before 2010. When using AMECO data from 2010, the discretionary fiscal measure database shares are used for the revenue breakdowns into components. Using AMECO data does not change the overall results, and the results shown are those using the discretionary tax measure and discretionary fiscal measure databases.
Standard baseline explanatory variables of the fiscal reaction functions indicator are also included in the regression model but a priori not expected to affect windfall revenues. As a baseline, we consider the usual explanatory variables in this literature, including political economy ones (election years), the economic cycle, population structure and ageing, budget constraints (debt level, interest rate, EDP procedure, fiscal objectives achievement). The political economy variables are relevant for fiscal outcomes that can be affected by policy. While these variables would not be expected to affect windfall revenues, they can be expected to affect budget balance variables or expenditures, or possibly revenue variables that have not been adjusted for discretionary policy measures.
In addition to the data shown, we performed less systematic tests for a wider set of macroeconomic variables.
A Bayesian model averaging test including all macroeconomic variables of interest and running all possible regression models also confirms the results.
We add the following adjusted house price indicator: (real house price)*(share of property related taxes in GDP), taken from Taxation Trends in the European Union, 2019 edition, DG TAXUD, European Commission.
In the main analysis below, we exclude unit labour costs and focus the analysis on trade balance and household debt, also because of correlation of unit labour costs and other price variables with nominal GDP which is the denominator of all other variables. However, we show the results of the regressions in the Annex when considering the trade balance, household debt and nominal unit labour costs as the variable for each of the three categories of macroeconomic variables – i.e. those associated with external balance, internal balance and price/competitiveness.
The analysis also shows that for the macroeconomic variables linked to external imbalances, the change in the current account balance is a strong alternative explanatory variable (instead of the trade balance). The full analysis has been performed also with the current balance results. Similar outcomes are obtained as with the trade balance. The results are not shown here.
In addition, there could be some measurement issues (for discretionary measures or output gap).
Morris and Schuknecht (2007).
Note that calculation of the expenditure benchmark in the EU fiscal framework is based on a long-term average of potential output and thus addresses effects of some procyclicality of the potential output measure.
We consider the same \(\beta\) for all countries, based on a panel regression with all EU countries. Tests by country group suggest that, while there are some differences between Member States, the coefficients may be close for most countries.
Here as well, some caveats remain, notably as the coefficients β to estimate the effect of macroeconomic developments on fiscal effort are based on a panel regression, thus do not consider country specificities. Robustness test with estimates for country groups (not shown), however, confirm that findings are robust. The ‘underlying fiscal effort’ (adjusted for the effects of macroeconomic developments) also does not rely on the definition of norms/equilibria for macroeconomic variables that are used in the next subsection to estimate the effects of macroeconomic developments on cyclically adjusted fiscal positions.
We consider the same \(\beta\) for all countries, based on a panel regression with all EU countries. Tests by country group suggest that, while there are some differences between Member States, the coefficients may be close for most countries.
For the trade balance norm, we consider the required trade balance to stabilise the NIIP over 10 years. This norm is consistent with what is used in the Alert Mechanism Report of the European Commission in the context of the MIP surveillance, as well as with the external balance assessment methodology of the IMF. For the household debt norm, we consider fundamentals-based benchmarks that are used by the European Commission when assessing macroeconomic situations of Member States. They are derived from regressions capturing the main determinants of credit growth and taking into account a given initial stock of debt.
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The views expressed in this article do not necessarily represent the views of the European Commission, the University of Paris Nanterre, or the INSEE. We would like to thank A. Cepparulo, K. Leib, P. Lescrauwaet, P. Mohl, G. Mourre, L. Pench, L. Piana, V. Reitano, and A. Turrini for their precious comments and suggestions.
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Langedijk, S., Poissonnier, A. & Turkisch, E. The impact of macroeconomic developments and imbalances on fiscal outcomes. SN Bus Econ 3, 105 (2023). https://doi.org/10.1007/s43546-023-00466-9
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DOI: https://doi.org/10.1007/s43546-023-00466-9