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



We present metrics by which to assess the sustainability of public finances. A
straightforward indicator can be constructed by projecting the future path of
public budgets and how it is affected by various reforms. This is useful in par-
ticular if the underlying budget profile has a trend, e.g. a systematic tendency
towards deficits. However, it is not without problems to project a path with "un-
changed policies" in an fully specified intertemporal general equilibrium model,
and it is also often hard to interpret a given budget position in terms of the
needed scale for reforms. Accordingly, it is useful to translate the sustainability
problem into a readily interpretable indicator which can be directly controlled
by politicians. This provides a better impression of the order of magnitudes of
the needed policy reaction. Via sensitivity analysis it is possible to assess the
uncertainty involved.

A simple indicator of the need for reforms can thus be calculated by finding
the change in e.g. a tax instrument (defined on a broad tax base) needed to
balance the budget period by period. Note that this metric has no normative
implications as to whether the appropriate policy response is a tax increase.
Evaluating how this indicator is affected by a given reform proposal provides a
measure of the contribution of the reform to ensure sustainable public finances.
Moreover, sensitivity analysis can be performed straightforwardly. The period-
by-period indicator suffers from two shortcomings. First, it leaves a number
of indicators — one for each year - and not a single and easily interpretable
indicator. Second, by implicitly requiring budget balance on a period-by-period
basis, it disregards the possibility that variations in the budget position may not
necessarily pose a problem (smoothing), and in some cases be part of a reform
package (e.g. if it is phased in over a transition period).

These problems are overcome by calculating an indicator of fiscal sustain-
ability given by e.g. the permanent change in a tax instrument needed to ensure
that the intertemporal budget constraint of the public sector is fulfilled - the
sustainable tax rate. By evaluating how this indicator is affected by various
reform proposals, a measure can be derived on the overall contribution to an
improvement in public finances without concern for the particular timing of the
budgetary consequences. A further advantage of this indicator is that it allows
a smoothening of the effects over time, i.e. it allows for budget variation over
time, but ensures sustainability of public finances (the intertemporal budget
constraint is satisfied). The shortcoming is that it may suppress the underlying
time profile, and this provides important insights into the process of designing
reform proposals.

As we will argue below these two indicators are closely related, and the
application will show that it is useful to apply both metrics since this provides
more detailed information on the mechanisms affecting fiscal sustainability, and
also the appropriate way of designing reforms.

To assess the robustness and risk profile of the evaluation of the sustainability
of public finances it is important to perform sensitivity analysis. This can easily
be done by either of the two indicators.

The paper presents both of these indicators and shows applications by use of
an OLG-model for the Danish economy (the so-called DREAM-model, which is



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