inventory, the change in the debt stock each period paying the long interest rate in the
issue period until it is replaced.130 The budget balance thus reads:
BUD = TAX + MTAX + CTAX - TRAN - GIP - GC*CED - GI*CED (7.5)
We normally assume budget deficits are kept within bounds in the longer term, and taxes
rise to do this. We can describe the simple fiscal rule as
Taxt = Taxt-ι + φ [GBRT - GBR] (7.6)
where Tax is the direct tax rate, GBR is the government surplus target and actual surplus.
The feedback parameter φ is designed to remove an excess deficit in less than five years.
If fiscal solvency is ‘off’, it is turned back on again after our experiment.
Brunila et al. (2002) use the Commission model QUEST to quantify the impacts of output
on the budget deficit, and we can evaluate the properties of our model similarly. In
general, output effects on the budget increase with the size of the government sector and
the share of cyclically sensitive components of taxation and spending, and hence we
would expect them to vary across countries. Country specific factors such as the degree of
openness and the flexibility of the labour market will also matter. Blanchard (2000) and
Barrell and Hurst (2003) suggest that supply shocks are different from demand shocks in
their impacts, and hence we only analyse the relation between output and the deficit in
response to shocks to demand. In order to do this we evaluate the impact of demand
changes on the economy and on tax revenues, and then look at the effects of tax changes
on output.
We may write the shock multiplier as (where tax is direct taxes, itax is indirect taxes, ctax
is corporation, tran is transfers, C is consumption, I is investment, X is exports and Y is
GDP):
Dy/DS = dy/dtax*dtax/dS + dy/ditax*ditax/dS + dy/dctax*dctax/S
+ dy/dtran*dtran/dS (7.7)
+dy/dC*dC/dS+dy/dI*dI/dS+dy/dX *dX/dS
The left hand side of this expression is the shock multiplier, which we evaluate for
consumption, investment and exports, and the last three terms represent the shock
multipliers if there were no automatic stabilisers. If we have a consumption shock then
dI/dS and dX/dS are set to zero by definition, and similarly for investment and export
shocks. In order to evaluate the impacts of shocks on the deficit we need to evaluate the
first four terms of the right hand side of this expression. This requires that we calculate
the impact of each shock on tax revenues and on transfer spending, and that we calibrate
the effect of an unanticipated change in tax revenues on output.
We first look a the impact of 1% of GDP changes in consumption, investment and export
volumes sustained for 1 year, when they return to baseline for one quarter and
subsequently the dynamics of the model are allowed to work. We assume that there is no
The perpetual inventory attempts to take account of countries like Italy and Belgium where there are
large proportions of short-term public debt.
200