Concentrating on the period just before EMU, we can see a substantial shift in
discretionary policies towards structurally positive net lending ratios. This is perhaps least
visible in Germany, but the initial conditions were probably not such as to urge a strong
and prolonged consolidation for reaching the Maastricht deficit limit. A substantial
consolidation had already taken place at the end of the eighties. In the other countries, the
structural effort was more drawn out. France started consolidation already in 1993, while
it gathered pace in Portugal and Spain only in 1995. This also confirms evidence in Fatas
and Mihov (2003a).
How has this consolidation been achieved? The right hand side panels of Figure 5.5 plot
the growth rates of structural expenditures and revenues. These reveal that structural
consolidations in the nineties have been based on a mixture of expenditure and revenue
measures. But the combination of adjustments in the policy instruments has changed over
time in a remarkably similar fashion in all countries. Initially, we see relatively moderate
expenditure growth and in some cases even relevant spending cuts (Germany and
Portugal). This strategy is reversed closer to the deadline of EMU. Tax increases start to
bear the largest burden for bringing down deficits. Given the urgency of qualifying for the
EMU criteria, taxes have seemingly been the easiest instrument to adjust. Notice the
rather close match between the VAR-measure of structural spending and revenues and the
(difference log of the) HP-trend on unadjusted total expenditure and revenues. The
measures of OECD and AMECO display slightly lower growth rates. This owes again to
our definition of the structural series. The efforts in reaching EMU led to the levelling off
or even moderate declines in debt ratios. A plot of the structural fiscal indicator to the
debt ratio shows how well the indicator captures these consolidations in debt (Appendix
5.B).
What went wrong then with the application of the Stability and Growth Pact in France,
Germany and Portugal upon entry in EMU? The causes are again rather similar across
countries. The increased tax revenues in the years prior to EMU led to a starting point of
structural surplus. The persistence in these tax rises improved actual balances thanks to
the favourable economic conditions at the time. But this has been exploited to increase
expenditures in a commensurate way. Especially in Portugal, the expansion in
expenditures seems to have held back an improvement in the structural position. The only
exception here is Spain that further brought down expenditure, even in the presence of
strong revenue increases. Simultaneously, the tax revenues that stream in during
economic boom seem to have been undone by decisions to bring down tax rates in most
countries. This considerably worsened the structural balance. As economic boom turned
into bust again, the decline in revenues led to a substantial worsening of actual balances,
pushing the deficit beyond the 3% threshold. However, the revenue declines have hardly
ever been matched by sufficient cutbacks in government spending in the following years.
Corrective measures in 2004 have improved the structural deficit. But the measures are
mainly taken on the revenue side again, by undoing once more previous decisions to cut
tax rates. To avoid further infringement of the budget rules, the adjustment in Germany
and France has taken place via the route of tax rises during economic slack. This has once
more reinforced the procyclical bias in fiscal policy-making. This also highlights the
mechanism by which spending gets locked in, and causes a ‘ratcheting up’ in the size of
government.
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