Abstract
The global financial and economic crisis has revived the debate in the academic literature and in policy circles about the size and effectiveness of automatic fiscal stabilisers. Especially in the euro area where monetary policy is centralised and discretionary fiscal policy making is constrained by the EU fiscal rules, knowing the size and the effectiveness of automatic stabilisers is crucial. While automatic stabilisers are a fairly established concept in the fiscal policy literature, there is still no consensus about their actual nature and their effectiveness. This paper shows that differences in opinion mirror a deeper disagreement over how the budget would look like without automatic stabilisers. This issue is addressed by defining two types of counterfactual budgets giving rise to two different interpretations about the nature of automatic stabilisation. Simulations with a structural model confirm that the degree of smoothing is conditional on how the counterfactual budget, i.e. the budget without automatic stabilisers, is defined.
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Notes
Our analysis is purely positive and we are not concerned with normative implications of automatic stabilisers. Some of the macroeconomic literature would suggest that sizeable macroeconomic fluctuations may be desirable adjustment to shocks from a welfare perspective and a normative analysis should consider the potential of automatic stabilisers to remove or mitigate welfare losses associated with nominal and real rigidities in the economy.
See e.g. Afonso et al. (2010).
Although the post-2007 economic crisis has increases the importance of unemployment benefits in some euro area member states, their share of GDP remains limited, especially when compared to the tax-to-GDP ratio of about 40 % of GDP.
Given the uncertainty about the temporary or permanent nature of shocks, strong automatic stabilisers may therefore not always be desirable. In the same spirit, there could be potential conflicts between automatic stabilisation and structural reforms.
While this can neutralise the income effect of taxation on aggregate, it should be noted that to the extent that there are distributional effects these will not be fully neutralised (e.g. corporate profit tax is borne by non-constrained households who own the firms, while neutralisation through lump-sum transfers will benefit all households equally).
The progressivity in the income tax system adds around 3 percentage points to the output stabilisation, i.e. with a linear tax system the output smoothing is 0.25 and 0.10 respectively.
In the absence of better productivity measures, general government output is valued at costs, and changes in government wages affect GDP and value added not only in nominal terms but also in volume terms.
For detailed information, see http://ec.europa.eu/economy_finance/research/macroeconomic_models_en.htm
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Acknowledgments
We thank Lukas Vogel, an anonymous referee and participants of the 16th edition of the Annual International Conference on Macroeconomic analysis and International Finance of the University of Crete for useful comments on an earlier draft.
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The views expressed in this paper are those of the authors and should not be attributed to the European Commission.
Appendix
Appendix
1.1 The QUEST Simulation Model
QUEST III is the global macroeconomic model that is used for macroeconomic policy analysis and research in DG ECFIN. It belongs to the class of New Keynesian DSGE models with microeconomic foundations derived from utility and profit optimisation and includes frictions in goods, labour and financial markets.Footnote 10 The simulations in this paper are based on a model set-up with three sectors (tradable goods, non-tradable goods, construction), three types of households (liquidity-constrained, credit-constrained and unconstrained), and two regions, namely the euro area and the rest of the world.
The regions are populated by households and firms. More precisely, each region is home to three different types of households:
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Non-constrained households: These households are infinitely-lived and forward-looking. They have full access to financial markets to make optimal inter-temporal choices. They consume, invest in productive capital, residential property, land and financial assets (government bonds, debt of domestic and foreign households). They own the firms in the tradable, non-tradable and construction sectors and receive income from labour, from renting capital to firms, from selling land, from financial assets and profit income from firm ownership. The share of this group of households in the total population is set to 0.6.
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Credit-constrained households: The credit-constrained households are infinitely-lived and forward-looking, but with a higher degree of impatience. They make optimal inter-temporal choices, but are subject to collateral constraints on their borrowing. Credit-constrained households consume and invest in residential property. Their ability to borrow depends on the current value of their housing collateral. The collateral constraints tighten when the value of residential property falls and relax when its value increases. The share of this group is set to 0.2.
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Liquidity-constrained households: These households cannot borrow against future income, and they do not save present income via financial and real investment. In every period they consume their current disposable wage and transfer income. (share 0.2)
Tradable goods, non-tradable goods and housing services are imperfect substitutes in the consumption and investment/intermediate bundles of households and firms. In addition, tradable goods produced in one region are imperfect substitutes for tradable goods produced in other regions. The regions have monetary and fiscal authorities that are committed to rules-based stabilisation policies. Monetary authorities set interest rates to respond to output gap and inflation gap relative to their targets. Government consumption consists of purchases of goods and services, held constant in real terms in default setting, and the government’s wage bill, with wages indexed to private sector wages as default. Government investment is also kept constant in real terms, while transfers to households are mainly consisting of pension payments which are fixed in nominal terms. Unemployment benefits are modelled separately and fixed in nominal terms as default and paid to all unemployed. The government pays interest on its debt, which includes a sovereign risk premium which depends on the debt-to-GDP ratio. The government collects revenue from personal income taxes, social security contributions from employers and employees, consumption taxes, and corporate profit taxes. A lump-sum tax (or transfer) acts as residual term.
The calibration of the regions’ economic size, trade openness, bilateral trade linkages and sector structure (tradable, non-tradable, construction) is based on the GTAP database, while structural model parameters are based on estimates reported in Ratto et al. (2009).
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in’t Veld, J., Larch, M. & Vandeweyer, M. Automatic Fiscal Stabilisers: What They Are and What They Do. Open Econ Rev 24, 147–163 (2013). https://doi.org/10.1007/s11079-012-9260-6
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DOI: https://doi.org/10.1007/s11079-012-9260-6