ratio lasting about 25 years, followed by a substantial reduction afterwards (European Commission
(2005)).22
A further reason for why reforms that could be beneficial in the long run may imply budgetary
deteriorations at least in the short term is that the resistance to reforms coming from reform-losers
can be overcome by means of compensation packages having a cost on the budget. This could
either mainly take the form of increased expenditures (government transfers and subsidies) or that
of reduced revenues. A significant example of increase government transfers related to the
implementation of structural reforms is that of several Eastern European countries during the
transition process. The liberalization and privatisation of economic activities was often followed
by the temporary provision of government subsidies to permit the restructuring of firms. On the
revenue side, economic reforms were quite often implemented together with tax cuts; this seems
especially the case for product and labour market reforms (IMF, 2004). A related, but some how
different argument is based on a trade-off between budgetary adjustment and economic reforms
associated with the political costs of a restrictive macroeconomic stance. Fiscal consolidations
could in fact be politically costly due to possible losses of output and jobs in the short term. Given
that governments dispose of “political capital” in limited supply, whenever part of this political
capital is allocated in carrying out economic reforms, few could be left for adjusting budgets. By
the same token, expanding budgets could compensate for using up political capital in carrying out
reforms.
Finally, short-term budgetary losses associated with reforms could be the result of a deteriorating
output gap (and a consequent reduction in the cyclical component of the budget balance) resulting
in some cases from structural reforms. Some reforms permit to improve potential output but actual
output could react slowly, and this will result into a rising output gap. 23 Alternatively some
reforms could even have temporary effect on actual output which is negative, due for instance to
firm restructuring or increased job destruction due to the sectroal relocation of workers.
22 The ‘QUEST ageing model’ is a variant of the European Commission macro model, allowing for an overlapping
generations structure (see McMorrow and Roeger (2004) for a description). Demographic parameters are calibrated
to the main features of the Eurostat projections until 2050. The model distinguished between various tax and
expenditure categories and the government is constrained by an intertemporal budget constraint. The simulation
considers a pension reform that: i) shifts pension contributions into a non-government funded scheme so that the
amount of contributions received by government fall from 16% to 11% of the net wage; ii) reduces the pension
benefits paid by the government, guaranteeing accrued rights to PAYG pensions. Workers retiring at the time of the
reform are assumed to receive pension benefits from the government equal to 75% of the gross wage, as before the
reform. The cohorts in between receive pension benefits from the government between 50% and 75% of their gross
wage in proportion to their age, i.e., to the length of the period during which they have been contributing to the
PAYG system.
23 Hughes Hallet, Hougaard Jensen and Richter (2004) analyse the budgetary implications of a rising temporary
output gap associated with labour market reforms in the Oxford Economic Forecasting model.
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