with structural VARs - with statistical methods for cyclically adjusting fiscal balances.
Our approach innovates on extant evidence in using a mixture of short and long-term
restrictions to identify economic and fiscal shocks in a small-scale empirical model in
economic growth and fiscal variables. This allows for permanent shocks to determine
trending behaviour of output and fiscal variables à la Blanchard and Quah (1989).
Discretionary fiscal adjustments are captured by filtering out the fiscal balance for
cyclical reactions of budget items, following Blanchard and Perotti (2002).
The quantitative indicator that we obtain is best seen in the light of the growing
theoretical literature on the qualitative effects of fiscal policy. Dynamic stochastic general
equilibrium models with nominal rigidities search for a rationale for fiscal stabilisation
policies. At the same time, these New Keynesian models attribute quite some importance
to both supply and demand side effects of fiscal policy adjustments. Our indicator is
consistent with such a distinction. We take a first step by restricting attention to overall
expenditure and revenues, but more elaborate models might incorporate refinements in
the compositional adjustments of budget balance. In contrast to statistical models for
adjusting fiscal balance, our economic indicator of structural balance has some attractive
practical properties. Uncertainty is explicitly quantified, and theoretical assumptions can
be explicitly tested. Also, the end-of-sample problem is reduced. The model is not
necessarily more demanding in terms of data availability.
The main result of our study is that both pre-EMU consolidations and expansions in
recent years are mainly based on revenue changes. The derailing of public finances comes
from tax reductions being implemented in good economic times. As total revenues
apparently remain constant, spending cuts are not implemented. As a consequence,
deficits show up again when economic boom turns into bust. The easy way out of deficits
is to reverse previous tax cuts, leading to a ‘ratcheting up’ of spending over the next
economic cycle. This procyclical bias in fiscal policies has not been eliminated with the
Stability and Growth Pact. Governments still implement bad policies in good times.
These policy reversals have negative economic effects. We find fiscal policy to have
minor supply but large demand effects. Procyclical policies unnecessarily induce
macroeconomic fluctuations.
The remainder of the chapter is organised as follows. In section 5.2, we briefly review
some recent fiscal developments in the EU, notably for the cases of France, Germany,
Portugal, and Spain. Our structural VAR approach towards disentangling these
developments, and the derivation of the fiscal indicator, is discussed in section 5.3.
Section 5.4 reports our empirical results, and section 5.5 concludes the chapter.
5.2 The Recent Fiscal Imbalances in the EU
The fiscal framework of EMU has been considered a means for implementing fiscal
consolidation. However, recent developments in several Euro Area countries raise the
question as to whether fiscal sustainability is endangered, in view of rising deficits and
debts at a moment when the effects of ageing populations will have a further burdening
effect. In 2005, Excessive Deficit Procedures (EDP) have been carried out for both
France and Germany, while yet another EDP was launched for Portugal. There are also
ongoing procedures for Greece and Italy, while several other EU Member States face a
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