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Filling the Gap – An International Comparison of the Cyclical Adjustment of Budget Balances

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Abstract

The assessment of the direction of fiscal policy is both important and controversial. Because budgets are influenced by business cycles, disentangling the underlying fiscal position from the effect of the business cycle is difficult. The two main methods used by international institutions to determine this cyclical factor arguably do not fulfill the necessary requirements for obtaining correct results. This paper introduces an alternative disaggregated methodology which is not only able to incorporate theoretical considerations, but is also easily computable. To provide an empirical underpinning, we apply these methodologies to several countries.

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Notes

  1. For instance, suppose a fictive example in which the first economy is hit by a foreign demand shock, that is, has a negative export gap, while the second economy faces a negative consumption shock. Since exports have a smaller direct effect on the budget position than consumption, the cyclical effect on the budget is smaller in the first economy. Meanwhile, the aggregate approach reports the same cyclical effect.

  2. The general form of the univariate HP filter is min [∑(x−x*)2+λ∑(Δx−Δx−1*)2]. Note that economic time series generally grow exponentially, which means that Δx t also increases over time. As a consequence, the second smoothness term in the HP filter would give higher importance to the end of the sample. Log transformation renders the economic time series to I(1) series, implying that Δx t becomes constant and thus avoids over-weighting.

  3. It is apparent if X+Y=Z and HP(X)+HP(Y)=HP(Z) then x+y>z, when X, Y>1 thus HP(x)+HP(y)>HP(z), where small letters denote the logarithm of variables.

  4. Consider the case when the output gap estimation for period t at period t is positive, implying fiscal tightening, while the estimation for the same period at period t+k becomes negative, indicating that the fiscal tightening was inadequate policy decision.

  5. Neutral technological progress is not justified by empirical work.

  6. For a Kalman filter estimation of the time-varying capital share, see Kiss and Vadas (2004).

  7. Nevertheless, if incorporating TFP is desired, then this can be done by simply replacing TFP with TFP* in the denominator and extending equation (3) with an additional α t (ln TFP t −ln TFP t *) term.

  8. To understand the derivation of this constraint, divide Y t *=W t *+∏ t * by Y t and rearrange the right-hand side to obtain

    Note that labour and capital income shares then enter into the constraint, namely W t /Y t =α t and ∏ t /Y t =1−α t . If x t −x t * is small then X t −X t *−1≈x t −x t *, we obtain equation (4).

  9. Based on the empirical literature, we restrict the cointegration vector to [1 −1] in the consumption equation. Note that other cointegration vectors would imply 100% or minus infinity saving rate, which is unacceptable from both a theoretical and an empirical point of view. However, it is technically possible to assume other cointegration vectors and to estimate ρ in line with the other parameters.

  10. To understand why this weighting scheme provides the same result as the normalisation, consider the normalised x t

    Now the minimisation problem has the following form:

    Note that x t * can be estimated by x t *=σ x x̃ t *+x̄ t *, which results

  11. For instance, Buti and Van den Noord (2003), Kiss (2002) and Denmark in the annex of Bouthevillain et al. (2001). Based on their results, the Danish price gap from 1999 to 2000 could lift the cyclical component by 0.3% of GDP.

  12. We use GDP, private consumption and labour income share data taken from the EC's AMECO database. The fiscal elasticities of the 15 existing EU Member States plus the 10 new Member States are borrowed from Bouthevillain et al. (2001) and Orbán and Szapáry (2004), which are fairly close to the estimate of Coricelli and Ercolani (2002). In the case of Japan and the US, we apply unit elasticities to items and multiply them by the proportion of relevant fiscal revenues in the budget.

  13. Moreover, at present some EU Member States are allowed to compute the output gap using an HP filter.

  14. See, for instance, Stock and Watson (1998).

  15. See Carroll et al. (2000).

  16. If data on public taxes are not available, then one can focus on the main items, namely personal income tax and social security contributions paid by public employers and employees. The cyclical component can be adjusted by the effects of public wage shocks by calculating a public wage gap between public and private wage indexes. This public wage gap should be subtracted from or added to the cyclical wage gap as estimated using our disaggregated methodology.

  17. Significant differences in aggregated cyclical components can also be recognised when comparing the estimations of the EC, the IMF, and the OECD with the alternative estimations of the Bank of Finland. (see Brunila et al., 1999.)

  18. The markka was devalued by 12.3% in relation to the ECU on 15 November 1991.

  19. In 1994, the external debt service burden reached 42% of exports.

  20. The first step was a 9% depreciation of the currency, followed by the adoption of a pre-announced crawling peg system with a relatively narrow band. This was accompanied by the introduction of a temporary surcharge on imports of consumer goods.

  21. This concept is closer to the inflation gap as defined in Buti and Van den Noord (2003).

  22. The reason behind the higher GDP deflator was the higher deflators of government consumption, which is by definition outside the paper's scope.

  23. The driving force behind this higher increase was the high regulated price increase of goods and rents, rather than the increase in utility charges.

  24. The deficit exceeded the 3% of GDP reference value in 2001–2005 except for 2002, when it was 2.9% of GDP. This overshooting was revealed by statistical revisions of fiscal data in 2005.

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Authors and Affiliations

  1. Economics Department, Magyar Nemzeti Bank, H-1850, Szabadság tér 8/9, Budapest, Hungary

    Gábor P Kiss & Gábor Vadas

  2. Department of Economics, Central European University, H-1051, Nador 9, Budapest, Hungary

    Gábor Vadas

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  1. Gábor P Kiss
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  2. Gábor Vadas
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Kiss, G., Vadas, G. Filling the Gap – An International Comparison of the Cyclical Adjustment of Budget Balances. Comp Econ Stud 49, 259–284 (2007). https://doi.org/10.1057/palgrave.ces.8100200

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