consolidation might have positive consequences on output. The composition of the fiscal
adjustment thereby plays an important role (Alesina and Perotti, 1995). The effects of
consolidation on agents’ expectations on the future economic outlook - measured by
asset markets’ reaction (Giavazzi and Pagano, 1990) - suggests a role for permanent
wealth and supply-side effects of fiscal policy. Second, most VAR studies have so far
ignored the literature on the long-term growth effects of fiscal policies. The main
message of the endogenous growth models that have been developed is that higher
taxation unambiguously reduces output, but that these losses may be offset by using the
proceeds for productive spending items (Barro, 1990; King and Rebelo, 1990). These
seminal models have been made more realistic by allowing endogenous responses of
labour (Turnovsky, 2000). Typical tests of these growth models give empirical support to
the role of spending and taxes to long-term growth (Kneller et al., 1999). It can be argued
that additional government spending in catching-up countries such as Portugal and Spain
had rather different effects than further expansions of the budget in France and Germany,
for example. This provides an additional argument for including the former countries in
our analysis.
The examination of the growth effects is also of substantial policy interest. In the
assessment of EU Member States’ policies under the revised Stability and Growth Pact,
much attention is devoted to the quality of fiscal adjustments and the sustainability of
public finances. The implementation of major structural reforms that raise potential
growth - and hence have an impact on the long-term sustainability of public finances -
can be considered grounds for temporary deviations of budget balance. There is thus need
for a framework that assesses changes in fiscal instruments and distinguishes the short-
term demand from the longer run supply effects of such policies.
Methodology
We make a first step in setting up an empirical VAR model that allows for fiscal policy
having distinct long- and short-term effects on output. The approach in this chapter rests
on a combination of long-term restrictions and some assumptions on the short-run
elasticities of budgetary items.80 For the purpose of gauging a model-based fiscal
indicator, we basically take shocks with permanent effects on output to drive long-term
trends. Following Blanchard and Quah (1989), potential output is determined by so-called
productivity or technology shocks that permanently affect output. This can then be
complemented with further assumptions on the short-term behaviour of fiscal policies.
Shocks with transitory output effects are classified as either cyclical or fiscal, following
the elasticity approach of Blanchard and Perotti (2002).
There are a few applications of fiscal VARs that use similar restrictions, and are mostly inspired by a
practical interest in determining structural balances. See Bouthevillain and Quinet (1999), Dalsgaard
and de Serres (2001) or Bruneau and De Bandt (2003) who all specify an SVAR model in output and
the deficit ratio. They recover structural deficits from the contribution of fiscal shocks to the variance
of deficits. Likewise, a measure of the gap is constructed from the contribution of supply shocks to
output variations. Hjelm (2003) is closer to our model as he is interested in simultaneously
determining potential GDP and the cyclically adjusted balance. He uses Cholesky ordered long-term
restrictions in a model with output, employment and the budget balance to identify economic and
labour market shocks. The cyclically adjusted balance then is that fraction of the budget balance that
is not explained by business cycle shocks. This leaves only the supply and labour market shocks in
determining structural balance, but no separate role for the government is stipulated.
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