Proceedings from the ECFIN Workshop "The budgetary implications of structural reforms" - Brussels, 2 December 2005



current debt levels to the threshold yield an indicator for the sustainability of
fiscal policy (see e.g. Tobin and Buiter (1976), Zee (1988) and Bagnai (2004))1 .

Both of the approaches mentioned here share the property that they are
relatively simple and therefore also easy to apply. However, they rely on rather
mechanical assumptions concerning e.g. primary balances, and the forward
looking elements in the approach are mainly captured by the dynamics implied
by the debt accumulation equation allowing no role for future changes in con-
ditions impinging on public revenues and expenditures. Furthermore, it is very
difficult to asses the consequences of structural reforms especially if the reforms
due to either implementation lags or effect lags only show their effects gradually
over time.

Empirical methods

An approach to empirical test of fiscal sustainability was proposed by Hamil-
ton and Flavin (1986) and has since been extended by various authors into a
VAR framework (see e.g. Carriero, Favero and Giavazzi (2005), Polito and
Wickens(2005)). The basic idea is to test for stationarity of primary balances
and debt levels. If unit roots in the primary balance or debt levels can be
rejected it is not possible to reject the hypothesis that the intertemporal bud-
get constraint for the government will be fulfilled2 . Leaving aside econometric
problems concerning the problems of unit root tests (sensitivity to alternatives
close to a unit root) the main shortcoming of this approach is that it is back-
ward looking and thereby completely disregards the forward looking aspects
currently raising concerns of sustainability in many countries. These methods
may be useful in characterizing historical periods but cannot be used to as-
sess future consequences of say demographic changes and the consequences of
proposed reforms.

Intertemporal approaches

Recently a number of analysis have taken explicit outset in the intertemporal
budget constraint. Most well-known is generational accounting (see e.g. Auer-
bach et.al. (1999), Kotlikoff (1995). The basic idea is to use the intertemporal
budget constraint in combination with estimations of the contribution rates of
currently living generations to calculate the tax burden resting on future genera-
tions. By comparing the latter to the burden on newborns the inter-generational
profile can be evaluated.

Obviously this calculation is based on various assumptions, but it is straight-
forward to make sensitivity tests to variations in the underlying assumptions.
An alternative closure is to consider the permanent decrease in government
spending or the permanent increase in taxes to restore generational balance
(see e.g. Cardarelli et.al. (2000)).

1 The IMF method of critical debt levels also falls into this category. The aim is to determine
threshold levels for the debt level] (public or foreign) which would trigger a "crisis", see e.g.
IMF(2003).

2 An alternative method is to test for how primary surpluses respond to public debt, since
a sufficient condition for sustainability is that an increase in debt leads to higher budget
surpluses, cf Ballabriga and Martinez-Mongay (2005). See Turini(2005) for an evaluation of
the short-term budgetary effects of structural reforms.



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