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Uncertainty in the Adjustment

The cyclical adjustment of the budget deficit is not just subject to uncertainty over the
output gap, but also to uncertainty over the impact of the output gap on revenues and on
spending and we should take account of both of these at the same time.¹²⁷ Tax revenues
tend to fall with the cycle and at least some items of expenditure can be regarded as
cyclically sensitive¹²⁸. Transfers to individuals in relation to their employment state are
clearly cyclically sensitive, and this sensitivity varies across countries. In our sample it is
low in Italy and high in Germany for instance, and hence we would expect the German
budget deficit to be more cyclically sensitive than that of Italy. Expenditure and taxes
generally move less than one for one with the level of spending, although in some
countries, such as Germany, tax rates are higher on cyclically sensitive variables. A slow
down in activity in Germany driven by weak consumption would reduce tax revenues
rather more than it would in the UK, for instance. Income taxes also fall less than in
proportion to the output gap because of the existence of thresholds and higher rates. As
we can see, the details of individual countries benefit and tax system should affect the
relationship between budgets and cycles.

There has been considerable debate about the scale of changes in revenues and spending
in relation to the cycle. It is widely thought that a 1% deviation in GDP from its trend
might cause a 0.5 percent of GDP change in the budget deficit. This figure is perhaps a
little high and it should differ noticeably between countries and will also depend on the
causes of the cyclical movement. A slowdown in activity driven by falling export demand
is likely to have noticeably less impact on revenues than one driven by weak consumer
spending, as the latter is more tax rich than the former. It is clear from this that producing
a single gross measure of the sensitivity of the budget to the cycle is at best misleading.
Although a single measure is simple and transparent, the trade off with information about
the causes of the shift in the budget may be too great.

Discerning discretionary fiscal policy moves is difficult, as it involves the detailed
analysis of budgets and their impacts. Changes in tax rates and the definition of tax bases
must be seen as discretionary movements in the government position, as must changes in
plans for expenditure on goods services and transfers. In general an improvement in the
budgetary position made by a conscious discretionary policy might be expected to have a
contractionary impact on the economy in the short term, although it might lead to lower
long-term real interest rates, and these might offset the contractionary impact of the
policy.

It is important not to assume that any non-cyclical movement in the budget represents
discretionary policy. Random variations in tax receipts or in spending may push the
budget outturn well away from its predicted level without there being a cyclical
explanation or a discretionary policy driving the change. Economic models cannot
encompass all of the factors driving the economy, and models explaining tax receipts are

More formally, if cabud=adj*OG and the adjustment factor and the output gap were independent
then var(cabud) = var(adj)*var(OG) + mean(adj)²*var(OG) + mean(OG)²*var(adj). It would be
possible for us to utilise this formulae, but OG and adj may not be independent, and hence it would
be misleading. Calculating the joint distribution of OG and adj is possible, but would be time
consuming, and we leave it to a later project.

Although we may be able to find a statistical relation between other items of expenditure and the
cycle, we regard such movements as discretionary, and we would not include then in our
adjustments.

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