SWEDISH ECONOMIC POLICY REVIEW 15 (2008) 7-47
Rules, and their effects on fiscal policy in Sweden
Peter Claeys*
Summary
Fiscal rules aim at constraining public debt. In Sweden, a combination of procedural and numerical rules was introduced in response to
the severe 1991 fiscal crisis. These rules have been effective: public
debt has come down. The current fiscal framework does not rule out
future fiscal crises, however. Spending is not sufficiently kept under
control. Taxes are set procyclically, only to keep debt in check. Controls on debt sustainability require tighter spending rules, linked to
levels of taxation.
JEL classification: E60, E62, E65.
Key words: Fiscal policy, debt, sustainability, Markov switching, Sweden.
* Peter Claeys is a Research Fellow at the Universitat de Barcelona, Research Group AQRIREA.
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SWEDISH ECONOMIC POLICY REVIEW 15 (2008) 7-47
Rules, and their effects on fiscal
policy in Sweden
Peter Claeys*
The sustained high deficits in most industrialised countries in the seventies and eighties caused some concern about the sustainability of
public debt. This has raised an interest in ways of restraining this
“deficit bias”. Fiscal rules that constrain the ability of governments to
use spending and taxes at their discretion have generated much debate. In contrast to the academic discussions on monetary policy,
there are many practical proposals for implementing controls on fiscal
policy. Fiscal rules can take many forms. An improved design of the
budget process, which is often accompanied by some institutional
shake up, goes to the core of the political problem at the root of the
debt problem. Alternatively, a numerical target on deficit or debt ratios has been imposed. These rules seem to have disciplined fiscal
policy. Even if the Gramm-Rudman-Hollings Act never officially applied, the Clinton Administration nevertheless governed a substantial
reduction of public debt. The EU governments enshrined public debt
and deficit targets in the Treaty of Maastricht and strengthened these
provisions with the Stability and Growth Pact. These targets have
been met in different countries through a diversity of fiscal rules.
Some EU countries undertook major institutional reforms; others
built political agreement around debt consolidation; many imposed
simple numerical constraints.
As in most other OECD countries, Sweden also started to experience fiscal trouble in the late seventies. Debt soared by more than 40
per cent of GDP in a couple of years. The brief consolidation of debt
over the eighties occurred without any formal changes in the setting
of the budget. These informal agreements on fiscal discipline were
not sufficiently strong to prevent the most severe debt crisis of 1992.
* Peter Claeys acknowledges support by a Marie Curie Intra-European Fellowship within the 6th
European Community Framework Programme. Correspondence address: Universitat de Barcelona, Facultat de Ciències Econòmiques i Empresarials, Grup AQR IREA, Torre IV, Avinguda Diagonal, 690, E-08034 Barcelona, Spain. Email: Peter.Claeys@ub.edu tel: +34
934021010, fax: +34 934037242.
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
As economic conditions worsened dramatically both at home (financial crises) and abroad (EMS crisis, Russia), the deficit plunged to
double digits, and debt soared once more by 40 per cent of GDP in
less than a year (Figures 1 and 2). Fiscal rules were adopted in response to this fiscal havoc. Sweden is an exemplary case of a combination of both institutional and numerical fiscal rules. Initially, procedural reform put more centralised budget procedures in the hands of
the finance minister, strengthened the position of the government in
budget setting and led to some institutional changes related to the
budget process (Hallerberg, 2004). Numerical fiscal rules have been
put in place since 1997 and consist of three parts. The government
budget should aim at an overall structural surplus of one percent of
GDP.1 This surplus target is anchored to an expenditure rule for the
central government, which defines a rolling medium-term nominal
ceiling on spending for the next three years. This is not a rigid limit: a
built-in margin allows for some cyclical variation in spending and
gives some flexibility in the budget planning process. Finally, local
governments need to run balanced budgets, and any deficits have to
be offset within two years.2
Figure 1. Debt ratio to GDP
80
70
60
50
40
30
1970
1975
1980
1985
1990
1995
2000
2005
1 This was modified in 2006 from the initial two per cent surplus target as EU regulations classified some parts of the pension system as belonging to the private sector.
2 In addition, Sweden also needs to comply with the provisions of the Stability and
Growth Pact.
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Figure 2. Surplus ratio, and output gap
7.5
5.0
2.5
0.0
-2.5
-5.0
-7.5
-10.0
1970
1975
1980
1985
1990
surplus ratio
1995
2000
2005
gap
Note: vertical bars indicate the troughs of growth cycle recessions (ECRI).
Fiscal rules are not a panacea: they always present a compromise between simplicity and comprehensiveness (Kopits and Symansky,
1998). Rules often address past policy problems to redress the fiscal
situation, but do not look forward to possibly new threats to debt sustainability. As rules cannot provide clauses for all contingencies, several loopholes are open that governments can possibly exploit to run
up deficits under some circumstances. Fiscal rules are only as strong
as the political consensus that can be gathered in their favour (Debrun and Kumar, 2007). The violation of fiscal rules in recent years
attests to the ease with which fiscal rules can be modified. A pessimistic view would be that rules are mere statements by the government
about current policy, rather than working as a constraint on fiscal policy. Once debt consolidation shifts down on the priority ladder of
governments, fiscal policy may switch its stance. Political and economic circumstances may make it difficult not to give in to renewed
calls for spending hikes or tax cuts. Without sufficiently strong institutions to guarantee a continued concern for the sustainability of public finances, debt will rise again.
In this paper, I characterise these shifts in fiscal policy between alternating periods of debt consolidation and loose fiscal policies. I analyse the mechanism behind the deficit bias by looking in detail at both
spending and taxation decisions of Swedish fiscal policy since 1970. I
basically test fiscal rules for the sustainability of public debt. I outline
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
the arguments for the derivation of the empirical policy rules in Section 1. A concise overview of the empirical literature on systematic
fiscal policy shows how we may recast a test for debt sustainability à
la Bohn (1998) in terms of a fiscal policy rule. I discuss some major
problems in the identification of fiscal policy in Section 2. Tthen, I
follow traditions in the monetary policy literature in estimating fiscal
rules in which the surplus is gradually adjusted to its target level. I detail the behaviour of Swedish fiscal policy by decomposing fiscal rules
in spending and taxes in Section 3. I further examine the stability of
these fiscal rules to lay out the mechanism behind spending and taxes
that underlies debt creation in Section 4. Then, I compare the experience with fiscal rules in Sweden to that of similar open economies.
Conclusions follow in Section 6.
1. Fiscal rules
1.1. Sustainability of public debt, and fiscal rules
Discussions about fiscal policy rules have mostly been normative and
limited to practical policy proposals. These can be roughly divided
into two different types. A first group of rules explicitly imposes numerical deficit or debt targets. Balanced budget rules, a golden rule,
debt brakes, etc. all belong to this class. A second class changes the
rules of the game. A change in institutional arrangements is believed
to improve budgeting procedures. Both types of rules aim at correcting the deficit bias in fiscal policy. The objective is a sustainable path
for public finances.
Sustainability means that the public sector does not leave public
assets or liabilities with any positive probability, i.e., the sum of the
present discounted value of expected future primary surpluses suffices to pay off current debt. The period-by-period dynamics of total
debt bt are given by the accumulation of interest payments on past
fiscal imbalances and the current primary surplus, st, which is the difference between government revenues tt and government spending, gt3
bt ≡ (1 + rt )bt −1 − s t
where s t = t t − g t .
(1)
All fiscal data are expressed as a ratio to output here. Spending is inclusive of interest payments on public debt.
3
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Solving forward (1), one obtains the intertemporal budget constraint IGBC (2)
 n bt + n  ∞  n g t + n − t t + n 
) + ∑ Et ∏(
).
bt = lim Et ∏(
n →∞
 j =1 1 + rt + j  n = 0  j =1 1 + rt + j 
(2)
The sustainability condition is met when the public sector does not
leave any public assets or liabilities with a positive probability. For this
to hold, the transversality condition needs to be satisfied, i.e. when
 n

b
lim Et ∏( t +n ) = 0.
n →∞
 j =1 1 + rt + j 
(3)
Some equivalent time series tests for fiscal sustainability can then
be derived under various assumptions on this condition. Cointegration between non-stationary government expenditures gt and revenues
tt can be shown—under some weak economic assumptions—to be a
necessary condition for the IGBC to hold. Conversely, this cointegration relation is also a sufficient condition under weak assumptions on
the data generating process of debt, viz. that it is an I(1) process
(Ahmed and Rogers, 1995). It then follows that the total government
deficit series is stationary when spending and revenues—or alternatively the primary surplus st and public debt bt—are cointegrated.4
Most of the empirical tests of fiscal sustainability have been based on
the (co)integration implications of the transversality condition. The
latter relation between the primary surplus and debt can also be rewritten in terms of a reaction function (4):
s t = θbt + µ t .
(4)
Bohn (1998) proves that a strictly positive reaction of the primary
surplus st to public debt in this “fiscal rule” is a robust sufficient condition for the sustainability of public finances.5
4 Such “bounded” sustainability implies that undiscounted public debt is finite in
the long run. With an unspecified cointegrating vector, only weak sustainability can
be said to hold (Quintos, 1995).
5 I.e., rejection of this null does not mean that fiscal policies are necessarily unsustainable.
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Governments can run higher surpluses and reduce public spending
or raise more taxes so as to pay off public debt. But there are alternative policies for stabilising public debt. Inflation erodes the real value
of outstanding public debt. Leeper (1991) and Sims (1994) argue that
prices or output will adjust to make the IGBC hold, whenever fiscal
policy disregards public debt. In that case, it is not monetary policy—
but fiscal policy—that eventually determines prices. If fiscal policy is
not sufficiently reactive to debt, fiscal policy is labelled as “active”. In
contrast, if fiscal policy responds to debt—or is “passive”—then the
budget constraint will be satisfied for all price paths. Monetary policy
retains the ability to control prices in this Ricardian environment. We
may test whether policy is active or passive with a fiscal rule similar to
equation (4). For a passive government, θ > 0 . The implications and
the underlying assumptions of this “Fiscal Theory of the Price Level”
have not gone unchallenged, and its validity is a fiercely debated issue.6
A less sanguine view on policy interaction takes account of other
economic effects on the path of spending, taxation and public debt.
Lower interest rates or higher inflation reduce the burden of interest
payments on outstanding debt. The debt position also becomes more
sustainable in a period of strong economic growth. We can redefine
the fiscal rule in terms of the surplus that would be needed to bring
about the stabilisation of public debt. We can write out the flow
budget constraint (1) to get:
bt =
(1 + q t )
bt −1 − s t .
( 1 + kt )
(5)
Apart from the surplus in every period, the increase in debt also
depends on real interest rates qt as well as nominal economic growth
kt . Debt remains stable if the debt-stabilizing surplus s t equals
bt −1 ( q t − kt ) /(1 + kt ) . If nominal GDP growth exceeds the interest
cost of debt, persistent deficits are still consistent with debt stabiliza-
6 Note that identification of different policy regimes with a fiscal feedback rule still
runs into identification problems. A passive rule is not uniquely defined from the
data generating process for surpluses and debt, and is observationally equivalent to
an off-equilibrium behaviour that is consistent with active fiscal policies (Cochrane,
1998).
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
tion as real economic growth and inflation outgrow the interest payments.
This presumes that interest rates and other economic variables are
exogenously determined. However, empirical evidence shows that
fiscal policy may have real economic effects (Blanchard and Perotti,
2002). Both fiscal and monetary policies react to—and have an effect
on—current economic conditions in the short term. Some recent
DSGE models have revived the interest in the public finance approach towards the joint determination of fiscal and monetary policies. In these Ramsey type of models, the government’s problem is
that of selecting the least disruptive combination of inflation and taxation that maximises the representative agent’s welfare for financing a
given level of public spending (Lucas and Stockey, 1983; Chari et al.,
1991).7 This approach has recently been popularised by marrying it to
the growing class of DSGE models with nominal price rigidities and
imperfect competition (Schmitt-Grohé and Uribe, 2004). These results carry relevant insights into the systematic setting of both fiscal
and monetary policy to economic conditions. A relevant joint decision problem for both authorities arises as both policies can minimise
the cumulative distortion in output that is caused by distortionary
taxation and sticky prices. Both fiscal and monetary policy makers
intend to maximise welfare by stabilising inflation and the resulting
output gap. Benigno and Woodford (2003) characterise time-invariant
optimal fiscal and monetary policy targeting rules. Both policies necessarily respond to inflation as well as output targets. Fiscal policy
needs to contribute to the traditional monetary task of inflation stabilisation, as tax rates affect real marginal costs (and hence prices).
Monetary policy needs to take account of alternative price and interest
rate paths for the government budget constraint. I will not analyse
such theoretical fiscal rules, but the arguments call for an analysis of
fiscal policy that includes economic responses of the budget.
This supposes a cooperative social planner. Alternatively, fiscal and monetary policy could be on a conflict course, or caught in a bad policy mix, as each can exploit
its own policy instrument at its discretion (Nordhaus, 1994). This gives rise to either an inflation or a spending bias (Adam and Billi, 2006). Leadership by one or
both policy makers avoids strategic moves and the non-cooperative races that are
associated with the Nash equilibrium, whenever there is no agreement on the policy
objectives (Dixit and Lambertini, 2003).
7
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
1.2. The identification of fiscal policy rules
There is no comprehensive framework for analysing fiscal policy.
Hence, it is useful to set some terminology for characterising fiscal
policy. The main distinction is between fiscal policy actions that can
be attributed to discretionary policy decisions on the one hand and
automatic responses of fiscal variables to cyclical economic conditions
(“automatic stabilisers”) on the other. By definition, we can decompose any indicator of fiscal stance f t into a structural (or cyclically
adjusted part fˆ ) and a cyclical component ( αy ) as shown in (6),
t
t
with α being the elasticity of the fiscal indicator with respect to output:
f t ≡ fˆ t + αy t .
(6)
The latter component includes the reduction of unemployment
benefits and transfer payments, or the increase in tax receipts in an
economic boom.8 Typically, one would attribute the structural part to
discretionary policy intervention. With a fiscal rule, in contrast, I express the indicator f t as a function h(• ) of cyclical conditions y t
and some other variables collected in Xt, for example, political variables, election cycles, etc.:
f t = h( y t , X t ) + ε t .
(7)
We can associate cyclical reactions of fiscal policy with automatic
stabilisers. But, in addition, the government may wish to steer the
economy and implement supplementary measures in response to economic conditions. The government may wish to further fuel a boom
by lowering taxes or increasing spending, or lean against the wind by
raising tax revenues and cutting spending. Any systematic cyclical reactions of discretionary policy are also included in the cyclical reaction. The non-systematic part is the true “policy shock” ε t .
The estimation of monetary policy rules has become a true research industry. In contrast, fiscal rules like (7) are not widely estimated. There are a number of reasons for this lack of evidence.
Figure 2 shows the close correlation between both the surplus and gap series, and
the common turning points at changes in the economic growth cycle.
8
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
First, fiscal policy indicators are not widely available. Data constraints limit the analysis: reliable measures of fiscal variables at a
quarterly frequency are available for a limited number of countries
only (Perotti, 2005).
Second, the estimation of monetary policy rules has been guided
by the validity of the Taylor Principle by which central banks should
not accommodate changes in the price level (Clarida et al., 2000).
There is no similar leitmotiv in fiscal rules. Plenty of papers limit the
analysis to gauging the cyclical sensitivity of some fiscal policy indicator in (7). Other papers mostly focus on the response of the fiscal
surplus to public debt (Bohn, 1998). Still another branch of the literature focuses on political determinants of fiscal policy. Consequently,
fiscal rules have hardly carried the normative policy prescriptions of
the monetary Taylor rule.
Third, the heterogeneity of fiscal policy both in its setting (composition of revenues versus spending) and in its effects on different economic agents impedes a straightforward extension of fiscal rules as it
implies several identification problems. The main problem relates to
the automatic stabilisation component in fiscal variables. Not only do
cyclical fluctuations explain an important part of the variation in fiscal
variables because of the workings of the automatic stabilisers. Except
under the hypothesis of Ricardian equivalence, these fluctuations may
also be determined by the fiscal variable. If fiscal policy indeed has
real effects on the economy, then the fiscal policy shock is likely to be
correlated with the output gap in the policy rule. Second, there is a
potential joint dependence between the primary deficit and debt that
works via the interaction of the fiscal rule with the debt flow equation
(1). Applying OLS leads to biased and inconsistent estimates and the
degree of stabilisation would consequently be overestimated. Both
problems suggest instrumental estimation to correct for the endogeneity of output, and correctly label the estimation of this reaction
function as a fiscal policy rule. There are only a few papers that test
fiscal rules. Viren (2002) demonstrates how much the cyclical sensitivity of the budget is reduced for a pool of EU states. Lane (2003) examines cyclical properties of different government budget components: cyclicality is shown to vary substantially across budget items.
Ballabriga and Martinez-Mongay (2003) estimate non-linear fiscal policy rules for EU countries. Fiscal policy is found to be only weakly
countercyclical.
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Finally, the heterogeneity of fiscal policy also reflects the political
nature of spending and tax decisions. Structural breaks in fiscal policy
have not been so well documented. A range of eligible breakdates has
been suggested in the literature, mostly based on ad hoc arguments.
Narrative studies on the effects of fiscal policy use major US defence
spending increases such as the Korean, Vietnam or the Cold War to
identify fiscal shocks (Ramey and Shapiro, 1998). A common turning
point for European fiscal policy is supposed to be the consolidation
started under the Treaty of Maastricht (Wyplosz, 2005; Galí and Perotti, 2003). For Sweden, Ohlsson and Vredin (1996) relate fiscal outcomes directly to changes in government ideology. The long-term
orientation of fiscal policy probably undergoes more gradual transformations. Hence, fiscal rules are best understood by relating them
to different regimes. A few papers explicitly model continuous regime
changes in US fiscal policy (Davig and Leeper, 2005; Favero and
Monacelli, 2005).
2. Methodology
Fiscal data for Sweden are available at a quarterly frequency since
1970, and cover a broad range of spending and tax items. I can thus
characterise fiscal policy behaviour over a reasonably long sample and
over a period with relevant policy shifts. The budget data give sufficient details to look at the policy conduct of governments. In order to
characterise fiscal policy behaviour, I take as the baseline target rule of
the government a reaction function of a surplus objective s t∗ that is
set at some long-term level s * ,9 but also varies in response to cyclical
conditions and public debt,
s t∗ = s * + γ ( y te − y ∗ ) + θ ( bt − b ∗ ).
(8)
The surplus target fluctuates in response to expected deviations of
output y te from the desired target output level y ∗ . The output response γ does not only capture the automatic stabilisation responses
of some spending and revenue categories; it also includes the systematic discretionary intervention of the government to cyclical condiThis could, for example, correspond to a “golden rule” deficit which allows productive investment spending to be financed by issuing debt.
9
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
tions. If the government just lets the automatic stabilisers work over
the cycle, then γ=α. The government also attaches some direct weight
on debt by keeping under control deviations of debt bt from a steady
state long-term level for debt b*.
We can filter the surplus target by applying the definition equation
(6) to (8). Under the assumption that the long-term surplus and output level targets of the government are consistent, I obtain an expression for the cyclically adjusted instrument ŝ ∗t of the fiscal authority
sˆ∗t = sˆ* + ( γ − α )( y te − y ∗ ) + θ ( bt − b ∗ ).
(9)
The targeted cyclically adjusted surplus is in part structural, but is
also determined by any bias in output or debt stabilisation the government may have.
Fiscal policy is more typically characterized by implementation lags
than is monetary policy. Governments put in practice electoral promises and the budget process involves lengthy parliamentary processes.
Sunk decisions of previous government are not easily unwound.
Hence, the anticipated (endogenous) component of fiscal policy
should be adequately represented by simple feedback rules. I assume
that the fiscal instrument only gradually adjusts to its target level:10
s t = ρs t −1 + (1 − ρ )s t∗ + υ t .
(10)
This gives the following non-linear relation between the surplus
and public debt, and is the baseline empirical specification of the fiscal rule:
s t = ρs t −1 + (1 − ρ )[ω + γx t + θbt ] + υt
(11)
where the output gap is given by x t = y t − y . In this rule, ω equals
sˆ* − γ ( y ∗ − y ) − θ ( b ∗ − b ) and represents the long-term fiscal indicator adjusted for the deviation between the government’s output (debt)
target and long-term output (debt). The residual term υt captures dis-
Alternatively, the government may implement a policy that gradually converges
to some debt level.
10
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
cretionary exogenous deviations from the rule (which is interpretable
as a fiscal policy shock).
I test (11) as the baseline fiscal policy rule. Let us assume that the
fiscal instrument is the primary surplus ratio to GDP. The key interest
usually focuses on the systematic cyclical properties of fiscal policy. I
take as the output measure the gap calculated by OECD.11 If automatic stabilisers are allowed to work, then γ = α and the structural
surplus ŝ t is constant at its long-term level ŝ ceteris paribus. A positive
coefficient γ > α indicates additional discretionary intervention,
while γ < α procyclically magnifies the output gap. General government debt is consolidated across different government levels, and expressed as a ratio to GDP. Debt sustainability has commonly been
inferred from a positive coefficient, θ .12 The magnitude of this response is of minor importance: as long as a stabilising response to
public debt comes about on average, this is sufficient for sustainability
(Canzoneri et al., 2001).
Testing a fiscal policy rule as in (11) suffers from simultaneity because of the dependence between the surplus and debt, and the economic effects of fiscal policy. I therefore use a Generalised Method of
Moments (GMM) procedure to identify the equilibrium responses of
the reaction coefficients in the fiscal rule. In the set of instrumental
variables, I include lags of the output gap and debt. In addition, I
consider unit labour costs, growth in labour productivity and the
NAIRU as domestic supply side factors. A broad money aggregate
takes account of domestic monetary policy. Other instruments model
international monetary conditions (a synthetic interest rate of the
Euro Area, oil price index, the SEK/DEM exchange rate). I test
overidentifying restrictions with the J-test (Hansen, 1982); and I additionally compute the F-test on the first stage regression for each of
the endogenous right-hand side variables to test for weak identification.
Automatic stabilisers respond to real time changes in the economy. I choose the
contemporaneous output gap. In case the government gives additional fiscal impulses to the economy, it bases this decision on current output conditions available
at the time of planning government spending, rather than on data ex post. Unfortunately, real time data on the output gap in Sweden are available since 2000 only.
12 In FTPL terminology, a similar condition implies that fiscal policy is “passive”
(see Section 2).
11
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
3. Fiscal rules, and their effects
3.1. The baseline fiscal rule
Let us first consider a baseline fiscal rule, in which the government
stabilises debt with the primary surplus. Table 1 reports the GMM
estimates of the fiscal rule (11). The main finding is that the government does not sufficiently raise the primary surplus to pay off outstanding debt. The response to debt of the primary surplus is not significant. The negative sign rather indicates that deficits have been
growing in the wake of rising debt. The implication is that debt in
Sweden is not on a sustainable path. Time series tests for sustainability on the surplus and debt series give a similar result.13
Fiscal policy is not very sluggish. The budget surplus is less persistent than what it seems at first sight: after one year, about half of the
budget decision has already been reconsidered. This is much faster
than revisions of monetary policy, for example. These findings are in
line with the results of Ballabriga and Martinez-Mongay (2003) or
Galí and Perotti (2003) for Sweden.
The budget is remarkably responsive to the cycle: a 1 per cent improvement in the output gap strengthens the budget position by
about 1.40 per cent. This strong procyclical effect is known—as in
other Scandinavian countries—to largely be the effect of the extensive
welfare state and large automatic stabilisers built into the unemployment system. But the response is much stronger than the computed
elasticity of the total balance. Recent OECD studies show how the
output elasticity of the total budget balance is about 0.79 in Sweden.
The reform of the welfare state and the tax system has substantially
brought down the sensitivity of the budget to cyclical variations. The
elasticity shrunk to about 0.55.
Both the (primary) surplus and debt ratio are integrated of order one. In case one
controls for potential breaks in the time series, both the Zivot Andrews and the
Perron test indicate that the debt ratio is I(2). Further indication of unsustainable
fiscal policies is given by interest payments, which also behave as an I(2) process.
Cointegration tests instead show that both spending and revenues expand as a ratio
to GDP, but that taxes offset the increases in primary spending and interest payments. Similarly, the primary surplus and debt are cointegrated.
13
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Table 1. Fiscal surplus rule (1970:1-2006:4)
ρ
γ
θ
R2
F
dw
J
F1 γ
F1 θ
AQ break
Bai Perron
Primary surplus
ratio
0.89
(0.00)
1.46
(0.00)
1996:1
-0.02
(0.76)
1995:4
0.98
(0.00)
1.23
(0.44)
(0.00)
(0.00)
1995:1
(0.00)
[1994:1;1996:1]
1975 :4
1977 :4
1979 :1
1980 :3
1986 :2
1991 :4
1995 :4
2001 :4
Surplus ratio
0.85
(0.00)
1.40
(0.00)
1996:1
-0.10
(0.12)
1995:4
0.97
(0.00)
0.77
(0.79)
(0.00)
(0.00)
1993:4
(0.00)
[1992:2;1995:2]
1975 :4
1977 :4
1979 :1
1980 :3
1986 :2
1991 :4
1995 :4
2001 :4
Primary surplus
ratio to potential
GDP
0.85
(0.00)
1.45
(0.00)
1996:1
-0.04
(0.49)
1995:4
0.97
(0.00)
0.85
(0.90)
(0.00)
(0.00)
1993:4
(0.00)
[1992:2;1995:2]
1975 :4
1977 :4
1979 :1
1980 :3
1986 :2
1991 :4
1995 :4
2001 :4
Notes: coefficients of (11) are reported together with p-values in brackets; dates
below coefficient estimates are the significant Andrews Ploberger breakdate for that
coefficient; dw is Durbin Watson test; J the p-value for the Hansen test of over
identification; F1 the p-value for the F-test on the significance of instrumental variables in the first stage regression (test for weak instruments); AQ the supremum
Andrews Quandt break test on all coefficients, and its confidence interval; Bai Perron is a test for multiple breaks for all coefficients.
Even if one accounts for the uncertainty surrounding the assumptions on the output elasticities of different tax bases, a rise in the output gap of one per cent will still not lead to an improvement in the
budget stance of more than 0.47 to 0.62 per cent (Girouard and
André, 2005). The statistically significant difference to the actual
budget response lies with a countercyclical policy that gives additional
fiscal impulse to the economy in a recession, and reins in deficits in
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RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
economic booms. This finding also holds for the total surplus. This
should not come as a surprise, given that interest costs on debt may
vary over the cycle, owing to changes in the interest rate and inflation.
The result also continues to hold if we account for cyclical fluctuations using filtered data. I scale the data by potential GDP to remove
short-term cyclical reactions in the nominator: the cyclical response
remains as large. The finding of an active fiscal policy ignoring debt is
confirmed for all alternative definitions of the surplus.
Fiscal policy is a consequence of political bickering and its longterm orientations are hence likely to vary over time. The large deficits
in the early eighties and nineties that created the first and second big
boom in public debt have been alternating with periods of a tighter
fiscal stance (Figures 1 and 2). This instability could explain the finding of unsustainable fiscal policies in Sweden. I test the parameters in
the fiscal rule for structural breaks in three different ways. First, I
search endogenously for a joint break in all coefficients and estimate
this breakdate by least squares, testing its significance with the supremum Quandt LR test on the central 70 per cent of the sample. I modify the test to account for subsample variability by conditioning the
break test on a potential change in the residual variance before and
after the breakdate in the coefficients. Accordingly, the modified test
scales down periods of greater turbulence and magnifies relatively
small policy shifts in less turbulent periods. The confidence interval
around this break indicates how precisely we can locate a change in
the parameter (Bai, 1997). A major break in the fiscal rule occurs in
1993:4, and heralds the gradual reduction of the record -11.5 per cent
deficit to a 5 per cent surplus in 2000:3. This switch in fiscal policy is
quite precisely estimated to fall between 1993 and 1995.
Consolidation could be the effect of fiscal restraint, but could as
well be due to favourable economic conditions. Figure 2 shows that
the Swedish economy continued to grow over the nineties, and
boomed particularly strongly at the turn of the century. I test the output and debt reaction coefficient of the fiscal rule separately for a potential break with the same Quandt test. A change from a negative to
a positive response to debt occurs in 1995. This shift to a sustainable
fiscal policy is also visible from Figure 1. But we cannot exclude that
economic growth matters for consolidation at the same time. The link
between the surplus and output seems to have become substantially
weaker after 1996. This further confirms that tax reform has reduced
the reaction of the budget to the cycle (Girouard and André, 2005).
23
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Given the volatility of fiscal policy in Sweden, locating a single
break seems rather peculiar. A plot of the breakpoint test statistics
instead indicates several candidates for structural breaks (Figure 3).
Instability in fiscal policy is spread out over the eighties and nineties. I
therefore run the Bai Perron test that selects the n best breakpoints
for the fiscal rule (Table 1). Fiscal policy seems to be rather erratic at
the end of the seventies: there are no less than four breaks between
1975 and 1980. It is probably no surprise that this period also constitutes the start of the debt problem in Sweden. Only four other breaks
have occurred since then. The 1986 break indicates a switch to fiscal
restraint in the mid eighties. In 1991, the largest fiscal crisis in Sweden
occurred. Debt started to be put under control in 1995. Fiscal policy
once more shifted ten years after the 1991 crisis. However, something
has changed in the fiscal policy setting. In contrast to the previous
loosening of the fiscal stance, this did not lead to an increase in debt
in 2001.
Figure 3. Recursive Andrews Quandt LR test statistics for
stability of fiscal rule (11)
test statistics
exponential test
average test
3.2. Spending and tax rules
What kind of spending or tax policies (or a combination of both) did
Swedish governments pursue that led to fiscal havoc? Does the fiscal
policy strategy to consolidate debt differ from policies that create it?
Figure 4 shows that dramatic spending hikes in 1980, and once more
in 1991, have been far from offset by commensurate tax increases.
The tax burden hovers between 60 to 65 per cent of GDP, but the
variation in spending is much more pronounced. Public spending has
24
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
fallen from its 1993 peak of 75 per cent of GDP to about 55 per cent
today.
Figure 4. Spending, and revenue ratio to GDP
70
65
60
55
50
45
1970
1975
1980
1985
1990
spending
1995
2000
2005
revenues
Note: vertical bars indicate the troughs of growth cycle recessions (ECRI).
I estimate a fiscal spending rule by substituting for the spending
ratio to GDP in (11), and estimate this non-linear rule by GMM. It is
then evident that spending increases have greatly contributed to the
explosion of debt (Table 2). Only after 1993 does spending restraint
contribute to the gradual consolidation of debt.
25
Notes: see Table 1.
26
1973:3
1977:4
1985:1
1996:2
1975:2
1987:4
1989:4
1996:2
1989:4
1972:4
1975:4
1989:4
1996:2
1989:4
1977:4
1980:2
1987:4
1994:3
1987:4
1978:4
1992:3
1997:4
2001:3
1997:4
1986:1
2001:3
2005:2
2006:1
2005:2
1973:3
1977:4
1983:1
1995:3
1983:1
1977:4
1979:4
1991:4
1995:4
1991:4
Bai Perron
1978:4
(0.09)
1992:4
(0.00)
[1992:2;
1993:2]
1989:4
(0.00)
[1989:2;
1990:2]
1992:4
(0.00)
[1992:2;
1993:2]
1992:3
(0.25)
-
1986:4
(0.20)
-
Transfers
-0.64
(0.00)
1995:3
0.17
(0.00)
1977:4
0.81
0.09
(0.23)
Subsidies
-0.33
(0.00)
2001:1
-0.02
(0.01)
1995:4
0.02
0.14
(0.16)
Investment
-0.14
(0.00)
2001:1
-0.05
(0.00)
1976:2
0.61
0.06
(0.38)
Wages
-0.54
(0.00)
1986:1
-0.06
(0.00)
1992:2
0.21
0.12
(0.07)
1993:1
(0.00)
[1992:3;
1993:3]
1993:1
(0.00)
[-;-]
AQ break
dw
J
R2
θ
γ
Consumption
-0.07
(0.21)
2001:1
0.04
(0.00)
1998:1
0.51
0.19
(0.35)
Interest
-0.05
(0.11)
2001:3
0.06
(0.00)
1998:2
0.85
0.09
(0.15)
Current
spending
-1.74
(0.00)
1995:3
0.08
(0.00)
1977:1
0.65
0.18
(0.21)
Total
spending
-2.19
(0.00)
1995:3
0.06
(0.04)
1993:1
0.65
0.60
(0.20)
Table 2. Fiscal spending rule (1970:1-2006:4)
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN, Peter Claeys
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
I look in somewhat more detail at different spending items. This
gives some interesting insights into the way debt was initially created,
and consolidation has been achieved afterwards. Figure 5 plots the
composition of total government spending over time. Over the seventies, social transfers as well as public wages gradually absorbed an
increasingly large share of the budget. This rise was only briefly interrupted by the 1979 spending cut. The spending boom of 1981 let the
share of transfers and spending on public wages grow to no less than
two thirds of total spending. The 1991 deficit plunge once more financed a strong increase in social transfers, as well as public consumption. The rising burden of interest payments gradually started to
crowd out various other spending categories. Public employment did
not increase much further after 1991. The contraction mainly came at
the expense of government investment, as well as subsidies.
Figure 5. Composition of government spending
(per cent of total)
100
90
80
70
60
50
40
30
20
1970
1975
1980
1985
consumption
subsidies
1990
wages
interest
1995
2000
2005
investment
transfers
The estimation of a spending rule for every budget item confirms
that the growing burden of interest payments has reduced the budgetary room for other spending items. This contraction has been especially pronounced for government investment. Break tests show that
government investment was the first budget item to suffer cuts due to
the fiscal trouble in the seventies. Likewise, subsidies have been reduced in the wake of higher debt. The significant cut in public wage
spending has by far been the most important way to fiscal restraint
after 1991. In terms of economic size, public wages nowadays absorb
27
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
about 15 per cent of GDP, but have come down from 23 per cent of
GDP in 1980. The main culprit of the debt problem is the continued
rises in public consumption and social transfers. After the 1991 debt
crisis, little effort has been made to tackle either of these major
spending items. The tendency to expand public consumption has only
been reversed since 1998. Public consumption has not been kept under control for long, though. The Bai Perron test indicates that already in 2001, public consumption was on the rise again. Likewise, a
strong increase in social transfers began in 1978, and this tendency
has not ever been reversed since.
Table 3. Fiscal tax rule (1970:1-2006:4)
γ
θ
R2
dw
J
AQ break
Total revenues
-0.17
(0.34)
1980:2
0.07
(0.00)
1976:2
0.35
0.07
(0.11)
1998:1
(0.30)
1975:3
1985:3
1996:1
2001:3
Bai Perron
Tax revenues
-0.29
(0.13)
1980:2
0.06
(0.01)
1976:2
0.40
0.48
(0.11)
1998:1
(0.21)
1975:3
1985:3
1994:4
2001:3
Notes: see Table 1.
Viewed from this perspective, the fiscal rules introduced in 1997
do not seem to have been very efficient. The major consolidation effort had already taken place before 1997. Hence, the spending cap has
not directly imposed a constraint on the budget decisions of the government. The spending cap rather reflected practices of the last consolidation. The reversal of spending behaviour in 2001 shows that the
rule is not binding enough. The nominal spending target is set without a clear reference to some basic level. The budgetary margin has
been completely used for additional spending in nearly all years (IMF,
2005).
28
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
The immediate measure for balancing budgets has instead been to
increase tax revenues (Table 3).14 In response to rising debt, tax rises
have been used to finance growing spending. Higher tax levels have
caught up with spending booms since the mid seventies. But the tax
burden has not noticeably come down in periods of spending cuts.
There are no significant breaks in the tax rule. The Bai Perron test
nonetheless indicates a break in both 1996:3 and 2001:3, and points to
the tax reforms undertaken in more recent years.
Table 4. Fiscal spending and tax rule, GMM system estimates
(1970:1-2006:4)
ρ
γ
θ
R2
dw
J
Correlation
Spending
Revenues
0.88
(0.00)
-1.07
(0.04)
1980:2
0.20
(0.03)
1976:2
0.97
1.83
0.90
0.00)
-0.34
(0.37)
1980:2
0.09
(0.06)
1976:2
0.40
0.48
(0.61)
0.77
Notes: see Table 1.
If the government were to minimise economic distortions and
keep tax rates constant, tax revenues would vary with the economic
conditions. Instead, total revenues are not responsive to the cycle.
Hence, automatic tax stabilisers are not allowed to work over the cycle. This is most likely the consequence of decisions to raise taxes to
contain the budget deficit, regardless of the current economic stance.
Spending is quite countercyclical, however. In contrast to spending
policies in other OECD countries (Lane, 2003), spending is considerably reduced during economic upturns. Hence, there does not seem
to be a relevant trade-off between debt and output stabilisation on the
spending side. Spending hikes that are decided upon in good economic times do not get locked in. The procyclical budget surplus is
I separately estimate a tax rule. As budget decisions concern both tax bases and
tax rates, the analysis of different tax items is less insightful. Therefore, I limit the
analysis of tax rules to total revenues.
14
29
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
mainly due to shifts in spending. The joint estimation of a spending
and tax rule with system GMM does not alter these conclusions. The
signs of the cyclical and debt coefficients are identical, and of a similar
size (Table 4).
4. Fiscal policy regimes
Fiscal policy may switch its stance due to political and economic circumstances. Even perfectly reasonable policy makers may find it justified to give in to renewed calls for spending hikes or tax cuts. But
policies contingent on these circumstances may turn out to be flawed
when conditions change. I detail the changes in fiscal behaviour over
time by estimating a Markov switching model in which the probability
of each regime can vary endogenously. A priori, there should probably
be two different regimes in fiscal policy: spending or taxes are either
passively adjusted to keep debt under control, or fiscal policy actively
disregards deficits.
4.1. Regime switching debt
The difference between an active or a passive regime for the surplus
shows up in the behaviour of the debt ratio over time. I follow Davig
(2004) in classifying debt behaviour in different states over time. In
particular, I assume the regime generating process to be a two-state
Markov chain. This Markov switching model for debt (12) is then estimated by maximum likelihood, using the EM algorithm. I assume
the debt ratio to be a simple AR(4)-model. I allow the intercept of this
model to shift between two different values, contingent on some latent state mt
bt = ω( mt ) + ΛL 4bt + ξ t .
mt = active passive .
(12)
Moreover, the persistence of fiscal series may reasonably be modelled with autoregressive parameters that are the same under both regimes. It is quite plausible that after a change in regimes, the debt ratio quickly shoots up but smoothly converges to a different level afterwards. I take account of higher variability of debt with regime varying heteroskedasticity.15
15
All computations were done in MSVAR for Ox (Krolzig, 1998).
30
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Figure 6 plots the time varying estimated probabilities associated
with each regime. The filtered probabilities (indicated by the bars)
only use the estimates of the MS model up to that point; smoothed
probabilities are based on the full sample estimates. In order to more
easily relate the regimes to the variations in the debt ratio, I also plot
the debt ratio and the mean debt ratio latent in the different states of
the MS-model.
It might not be surprising that there is a distinction between the
periods of debt explosion and debt consolidation. At the end of the
seventies, there is a shift from a low debt regime to a period of higher
debt ratios. The labelling of each regime with “low” or “high” debt is
perhaps not entirely adequate. The latent debt ratio of the low debt
regime differs by less than 1 per cent of GDP as compared to the
mean high debt ratio. This is the result of the unit root in the debt
ratio: convergence to a different level of debt is very slow under both
regimes.16
Figure 6. Debt ratio, Markov switching, AR(1) model,
2 regimes
75
debt ratio
mean debt ratio
50
1970
1.0
1975
1980
1985
1990
1995
2000
2005
1980
1985
1990
1995
2000
2005
1990
1995
2000
2005
probabilities of regime 1
0.5
1970
1975
probabilities of regime
1.0
2
0.5
1970
1975
1980
1985
filtered
smoothed
Another consequence of the persistence in fiscal series is that taking control of debt is a much more gradual process. At every consolidation of public debt, the low debt regime gains somewhat in probability. But even the consolidation after the 1991 crisis did not create
As a consequence, regimes are very persistent and the transition from one regime
to another is rather improbable.
16
31
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
a real gain in probability of the low debt regime. It was not until after
six years of continuous falls in the debt ratio that the regime once
more switched to “low debt”. Small reversals of fiscal policy, as for
example in 2005, might easily push the debt ratio back into the high
debt regime. The introduction of fiscal rules in 1997 had no immediate consequences on fiscal discipline.
4.2. Fiscal policy switching
Debt is the outcome of changes in policy conduct. I therefore estimate the baseline surplus rule by similar Markov switching techniques. In the fiscal rule (13), I test for changes in all coefficients of
the fiscal rule. I allow for changes in the reaction coefficients of fiscal
policy, as well as the persistence of the surplus. I also allow for a
change in the variance of the underlying shocks in each regime
s t = ρ ( m t )s t −1 + (1 − ρ ( mt ))[ω( m t ) + γ ( m t )x t + θ ( mt )bt ] + υt .
(13)
Coefficients may change stochastically over time, indicated by the
state mt . The regime generating process is again assumed to be a twostate Markov chain. There is no criterion for selecting the optimal
number of regimes in a Markov switching model. The classification in
two regimes of systematic policy behaviour corresponds to the active
and passive regime in fiscal policy. Under an active regime, fiscal policy disregards the path of public debt. A passive fiscal policy instead
consolidates debt by cutting spending or raising taxes. A two-regime
model classifies these regimes surprisingly well. As a robustness
check, I also present results for a three-regime classification, but this
does not substantially alter the main results.
32
0.90
0.93
Duration
10.02
13.53
Obs.
60.30
79.70
0.97***
0.97***
ρ
52.86*
53.89*
ϖ
0.28
1.24
σ
pii
0.95
0.90
Notes: see Table 5.
Regime 1
Regime 2
Label
low debt
high debt
Duration
20.83
10.44
Obs
97.3
49.7
0.94***
0.93***
ρ
33
0.09***
0.13
γ
0.01***
-0.01
θ
0.37
1.19
σ
Label
passive
active
Table 6. Fiscal surplus rule, Markov switching model, 2 regimes (1970:1-2006:4)
Notes: pii is the probability of staying in one regime; *** / ** / * indicates significance at 1/5/10%.
Regime 1
Regime 2
pii
Table 5. Regimes in the debt ratio, Markov switching model (1970:1-2006:4)
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN, Peter Claeys
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Table 6 and Figure 7 summarise the behaviour of fiscal policy under the two regimes. At the same time as the budget responds to public debt, the surplus also moves procyclically over the cycle (regime 1).
In contrast, if fiscal policy does not respond to debt in the active regime, it does not react to the cycle either (regime 2). Only the past
surplus is then significant in the setting of fiscal policy. Policy setting
in the active regime seems rather erratic.17 When fiscal policy behaves
as a random walk, the variance of policy shocks is three times higher
than under the passive regime. A period of debt build-up is very
much protracted: the creation of debt only takes two and a half years,
which is half the time for consolidating it again. A plot of the regime
probabilities corroborates the previous finding of quite some instability in fiscal policy from the mid seventies to the mid eighties. Fiscal
policy only intermittently pays attention to public debt, but more often entirely disregards its evolution. The government adopted a “stop
and go” approach to the consolidation of public debt in this period.
In the 1991 crisis, fiscal policy switched back quite suddenly to a loose
debt stance. That approach to fiscal policy has not disappeared at all.
Even after the fiscal consolidation of 1995, and after the adoption of
the set of fiscal rules, there is a period (2000:4-2002:3) in which the
Swedish government actively uses fiscal policy.
Figure 7. Markov switching fiscal surplus rule,
2 regimes, probabilities
1.00
probabilities of passive regime
0.75
0.50
0.25
1970
1.00
1975
1980
1975
1980
1985
probabilities of active regime
1990
1995
2000
2005
1990
1995
2000
2005
0.75
0.50
0.25
1970
17
filtered
1985
smoothed
There is no important difference in the persistence of fiscal policy in each regime.
34
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
But for what aim do governments use fiscal policy in an active regime? Periods in which the government willingly uses the budget to
reinforce automatic stabilisers are also periods in which debt is of
lesser concern. These periods are usually followed by periods of
strong growth in debt. Fiscal impulses that were intended to respond
to economic circumstances were not reversed afterwards. There is a
great deal of evidence of this procyclical behaviour in bad economic
times, and a consequent bad fiscal policy in good economic times,
also in other European countries. The effect of the set of rules introduced in 1997 did not prevent a similar policy reaction in 2000. Windfall revenues due to buoyant economic growth pushed up the surplus
(and pushed debt down). The favourable fiscal stance led to a gradual
tapering off of further efforts in consolidating debt in the following
years. Fortunately, as this was a positive shock to the surplus, debt did
not explode. Fiscal rules were not strong enough to control the behaviour of the government which had been so typical for the debt
crises of the eighties and nineties.
4.3. Debt, economic growth and monetary policy
Governments do not need to cut spending or raise taxes to stabilise
debt. Inflation and economic growth both erode public debt. The
surplus that the government effectively needs to achieve to bring
about the stabilisation of public debt depends on the evolution of real
interest rates qt as well as nominal economic growth kt . Following
(5), debt remains stable if the debt stabilizing surplus s t equals
b t −1 ( q t − kt ) (1 + kt ) . If nominal GDP growth exceeds the interest
cost of debt, persistent deficits are still consistent with debt stabilization as real economic growth and inflation outgrow the accumulated
interest payments.18 Figure 8 plots the time path of this implicit debt
stabilising surplus. Persistent deficits were consistent with a stable
debt to GDP ratio until 1980. This was the consequence of rather
high inflation exceeding interest rates. As in most other industrialised
countries, the warding off of inflation and a shift to less accommodative monetary policy have made real interest rates persistently positive
in Sweden since 1980. As a consequence, only in periods of strong
Strictly speaking, this only holds under the assumption that fiscal policy has no
real effects on the economy.
18
35
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
economic growth has it been possible to run deficits. This has only
been the case in three years (1987 till 1990). The recent decline in this
surplus is a combination of historically low real interest rates, and
strong economic growth.
Figure 8. Debt stabilising surplus (1970:1-2006:4)
0.06
0.05
0.04
0.03
0.02
0.01
0.00
-0.01
-0.02
1970
1975
1980
1985
1990
1995
2000
2005
I then substitute debt bt for this debt stabilizing surplus s t in the
fiscal rule (13). With this non-linear specification, we can test the relation between s t and s t whatever the effect of nominal GDP growth
and interest rates on fiscal variables (Favero and Monacelli, 2005). In
this way, the fiscal rule implicitly controls for variations in debt that
are not under direct control of the government itself. Fiscal policy is
passive when s t enters significantly with a coefficient that is not statistically different from one. In addition, the constant term ω should
not be statistically different from zero.19
Given that an exogenous component in the surplus would indicate an active policy. For spending or taxes, we may drop this restriction.
19
36
15.26
42.38
21.11
94.28
0.93
0.98
0.95
0.99
Regime 1
Regime 2
Regime 1
Regime 2
Notes: see Table 5.
16.80
12.88
0.94
0.92
Duration
Regime 1
Regime 2
pii
42.30
100.70
47.80
95.20
80.50
62.50
Obs
γ
37
Surplus
0.75
0.25
0.20
2.33***
Spending
56.33***
-1.03**
56.33***
-2.17***
Tax
59.55***
-0.25
59.55***
-0.22**
ϖ
39.71***
3.24***
38.33***
6.02***
0.96
-2.62**
θ
σ
4.73
1.42
5.67
2.25
0.32
1.11
Passive
Passive
Active
Active
Passive
Active
Label
Table 7. Fiscal rules, debt stabilising surplus, Markov switching model, 2 regimes (1970:1-2006:4)
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN, Peter Claeys
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
The reaction coefficients of the baseline surplus rule neatly correspond to an active and passive regime (Table 7). Moreover, the government chooses to stabilise debt or smooth the cycle, but cannot do
both. Under the passive regime, debt consolidation comes at the expense of cyclical stabilisation. In the periods in which I locate the active regime (1975-1985, 1990-1995 and 2000-2002), there is instead a
strong procyclical response of the surplus.20 This also makes the surplus about three times as variable in the active regime as under debt
consolidation.
Switches in fiscal policy are not sudden. The creation and stabilisation of public debt each takes three to four years on average. The
shift in real interest rates and economic growth plays some role in explaining some particular episodes. At the beginning of the eighties,
the debt stabilising surplus switches because of volatile real interest
rates. Fiscal policy has nonetheless continued to be lax since 1975. As
long as cyclical considerations prevailed, fiscal policy intentionally disregarded public debt in that period. It is also much clearer that in the
mid eighties, not all opportunities were taken to consolidate debt with
buoyant economic growth.
Figure 9. Fiscal spending rule, debt stabilising surplus,
2 active regimes
1.0
probabilities of active regime (1)
0.5
1970
1.0
1975
1980
1985
1990
1995
2000
2005
1990
1995
2000
2005
probabilities of active regime (2)
0.5
1970
1975
1980
1985
filtered
20
smoothed
The plot of regime probabilities is similar to Figure 7.
38
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
A combination of spending and tax policies causes policy to be active or passive. I replace the surplus by the spending or tax ratio in
(13), and estimate Markov switching rules with two states by ML. I
then identify spending to be active if there is a positive reaction to
debt. Likewise, taxation is passive if there is a positive response to
debt developments.
Given the results of section 3.2, it should not come as a surprise
that spending is always classified in the active regime (Table 7).
Spending hikes have been the major driving force for the explosion of
debt. There have been no periods in which the government deliberately strived to reduce total government outlays in response to the rise
of public debt. The main reason is that various Swedish governments
chose to stabilise the economy at the expense of running up debt.
This trade-off between cyclical and debt stabilisation is clearly reflected in the two spending regimes. Policymakers felt little urgency to
consolidate, as debt was seemingly under control before 1975 and in
the mid eighties. Spending could grow without limits over periods in
which real interest rates were low or economic growth strong enough
to stabilise public debt (Figure 9). Too much spending restraint was
not needed in that case.21 In contrast, as an economic crisis loomed,
the government gave additional spending impulses to the economy.
This accounts for a large part of the increases in spending in the late
seventies and the early eighties (Lindh and Ohlsson, 2000). The finding of a countercyclical spending policy is thus not due to a benign
policy maker steering the economy with spending cuts in economic
booms. But there has been a marked change in spending growth since
the 1991 fiscal crisis. The continued economic expansion of the nineties has eased the pressure to spend on various items. This has made
debt consolidation through spending cuts much easier. At the same
time, the introduction of the procedural fiscal rules seems to have
worked in maintaining stronger control on spending hikes.22 The
spending caps introduced in 1997 consolidate current practice at that
time. Furthermore, these rules locked in spending decisions, as the
regime of moderate growth persists up to the present day. The small
reversal of spending growth in 2000 only slightly increased the prob21 The 1980 spike in this regime is due to the increase in real interest rates that fuelled interest payments on outstanding debt.
22 Moderate spending growth moreover has the beneficial effect of reducing the
variability of fiscal policy. In the seventies or eighties, policy was about three times
as volatile as over the last 15 years.
39
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
ability of switching to a regime of high spending growth. The boost to
spending is not the main culprit behind the slippage to an active fiscal
regime.
Figure 10. Fiscal tax rule, debt stabilising surplus, 2 passive
regimes
1.00
probabilities of passive regime (1)
0.75
0.50
0.25
1970
1.00
1975
1980
1975
1980
probabilities of passive regime (2)
1985
1990
1995
2000
2005
1990
1995
2000
2005
0.75
0.50
0.25
1970
filtered
1985
smoothed
Taxation has always been used to stabilise debt, and can therefore
be classified as passive at all times. But once more, this is the blend of
a policy that gives more emphasis to the cycle or to debt, but does not
stabilise both contemporaneously. It is somewhat intricate to separate
out the discretionary intervention of the government in the tax system
from the underlying economic fluctuations. For given tax rates, total
tax receipts would usually move together with the cycle. Total revenues are procyclical. Discretionary changes in tax rates can offset this
quantity effect and instead make tax revenues acyclical or countercyclical. In economic booms, taxes are cut; in recessions, taxes are
raised again to avoid growing fiscal deficits. This is exactly what has
occurred in Sweden. Under a first regime, taxes are raised very aggressively in response to debt regardless of the current economic stance
(Table 7). In the early seventies, increases in spending are offset by
adequate tax measures that keep debt under control (Figure 10). A
similar policy is followed at the end of the eighties. However, the
economic boom did not fully translate into more revenues because
tax policy was slightly relaxed. Tax revenues are not responsive to
40
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
output. Under a second regime, tax policy is used in a more discretionary way. Tax hikes magnified the economic cycle during the economic slack of the early eighties, but contributed little to consolidate
debt.
At present, and since the 1991 crisis, fiscal policy in Sweden is still
in such a regime. This has had no immediate consequences on the
economy so far. The main reason is that over the nineties, the prolonged economic boom has made it possible for taxation levels to
come down without affecting total tax revenues too much. Due to the
gradual consolidation of spending, the combination with a procyclical
tax policy did not blow deficits. Windfall tax revenues have not been
used to further consolidate debt, however. The sudden drop from a 5
per cent surplus at the 2000 peak of the boom to a new deficit in just
two years shows what can go wrong. The end of the economic boom
made an abrupt end to the bright estimates of tax receipts. At the
same time, spending started to rise again. The fiscal spending caps
have not worked to restrain further increases in spending. Rather, the
safety margin on spending caps has nearly been entirely consumed for
new spending hikes. The consequence is that fiscal policy switched to
an active regime over the period 2000-2002. This combination of
procyclical tax and relaxed spending policies did not have any dramatic consequences for public debt, as this occurred after a period of
economic boom in which debt had been reduced. The fiscal framework could be less resilient in a period of prolonged economic bust.
For example, in an economic recession, spending might easily grow
faster than the ceiling imposed three years earlier (and likely faster
than the safety margin). In particular, unemployment benefits or social transfers would rise. Compliance with the fiscal rules would require spending cuts in other expenditure areas. Possibly, taxes would
need to be raised in order to stick to the 2 per cent surplus target.
Such a procyclical policy is not only economically costly. It may also
be politically unpopular. The fiscal rules may not survive the stress
test of another economic crisis, and this might again trigger a fiscal
crisis.
5. Fiscal policy rules in a small open economy
Fiscal policy in Sweden is rather unusual, given the sheer size of the
budget. Moreover, Sweden is a small open economy and prone to
changes in economic conditions abroad. This is likely to have some
41
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
impact on the setting of tax policy or spending. How does the systematic behaviour of Swedish fiscal policy compare to that in some
other small open economies with a large welfare state? Finland has
experienced an economic and fiscal crisis of the same depth as Sweden between 1991 and 1993. Both the Netherlands and Denmark experienced serious fiscal trouble at the beginning of the eighties. Denmark is renowned for the so-called “non Keynesian” consolidation
that mainly focused on the reduction of spending and few increases in
taxes, which is argued to have had positive effects on economic
growth. The Netherlands have instead adopted a much more gradual
approach to consolidation. Norway stands slightly apart as its natural
reserves have a direct impact on the budget.
It would be interesting to see how these countries have handled
the pressure of public finances. Norway introduced a stabilisation
mechanism to build up fiscal reserves at times of high oil prices.
Finland introduced a similar set of spending caps over three years but
these are stronger than in Sweden: they aim at a gradual reduction of
spending. Dutch fiscal policy initially coped with public debt through
a reform of its fiscal institutions in the eighties. The fiscal framework
was further strengthened with spending caps and tax plans in 1994. In
contrast to the Swedish spending rule, spending is subject to strict
limits and can only increase with the planned cyclically adjusted tax
intake. Additional windfall revenues can only be used for tax reductions or debt consolidation.
I estimate a fiscal surplus, spending and tax rule for all four countries. Unfortunately, data are not available at the quarterly frequency.
Hence, I use annual fiscal data over the period 1970-2006. The set of
instrumental variables for the GMM procedure is similar. I also repeat
the estimates for Sweden on annual data.
In none of the countries is the reaction of the fiscal surplus to
public debt significant (Table 8). We could always classify fiscal policy
as active in Northern Europe. A significant break in the debt response
occurs already in 1984 in Denmark, and in 1992 in both Finland and
the Netherlands. Fiscal policy also becomes passive after these dates,
as it does in Sweden after 1995. Only in Norway has public debt been
growing at a much higher rate since 1999.
42
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Table 8. Small open economies, fiscal surplus rule
(1970-2006)
Sweden
0.63
(0.00)
2.09
(0.00)
0.32
(0.10)
1995
ρ
γ
θ
Surplus rule
Norway
0.82
(0.07)
1.69
(0.22)
0.80
(0.27)
1999
Finland
0.50
(0.00)
0.68
(0.00)
-0.02
(0.53)
1992
Denmark
0.66
(0.00)
0.02
(0.98)
-0.06
(0.32)
1984
Netherlands
0.65
(0.24)
1.02
(0.58)
-0.28
(0.33)
1992
R2
0.83
0.80
0.68
0.76
0.06
F
dw
J
F1 γ
(0.00)
1.61
(0.29)
(0.00)
(0.00)
2.59
(0.71)
(0.00)
(0.00)
2.09
(0.82)
(0.00)
(0.00)
2.32
(0.72)
(0.00)
(0.00)
2.51
(0.98)
(0.36)
θ
(0.00)
(0.00)
(0.00)
(0.00)
(0.00)
Denmark
44.95
(0.00)
-1.44
(0.00)
1996
0.16
(0.00)
-
Netherlands
48.03
(0.00)
-0.85
(0.31)
0.05
(0.30)
1993
F1
Sweden
65.15
(0.00)
-1.99
(0.00)
0.09
(0.05)
1995
ω
γ
θ
Spending rule
Norway
46.54
(0.00)
-1.65
(0.00)
0.05
(0.69)
-
Finland
43.62
(0.00)
-1.29
(0.00)
1990
0.12
(0.00)
1992
R2
0.57
0.78
0.43
0.81
0.02
F
dw
J
F1 γ
(0.00)
0.54
(0.24)
(0.00)
(0.00)
0.22
(0.36)
(0.00)
(0.00)
0.78
(0.99)
(0.00)
(0.00)
1.11
(0.31)
(0.00)
(0.00)
0.07
(0.09)
(0.00)
θ
(0.00)
(0.00)
(0.00)
(0.00)
(0.00)
Denmark
55.66
(0.00)
0.47
(0.21)
1984
0.01
(0.77)
1986
Netherlands
48.07
(0.00)
-0.68
(0.25)
0.00
(0.89)
1993
F1
ω
γ
θ
Sweden
60.93
(0.00)
0.09
(0.67)
0.01
(0.78)
2000
Tax rule
Norway
42.76
(0.00)
-0.04
(0.86)
1999
0.33
(0.00)
1984
Finland
47.35
(0.00)
-0.24
(0.03)
0.11
(0.00)
1984
R2
0.08
0.53
0.98
0.16
0.22
F
dw
J
F1 γ
(0.00)
0.36
(0.36)
(0.00)
(0.00)
0.32
(0.32)
(0.00)
(0.00)
0.57
(0.19)
(0.00)
(0.00)
0.60
(0.55)
(0.00)
(0.00)
0.23
(0.08)
(0.00)
F1 θ
(0.00)
(0.00)
(0.00)
(0.00)
(0.00)
Notes: see Table 1.
43
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
Large spending hikes, whether sudden as in Finland or more gradual as in the Netherlands, have substantially contributed to the increase in public debt. This seems to be the consequence of a similar
destabilising spending policy. Spending is very countercyclical, and
this is due to spending hikes in an economic bust. With the exception
of the Netherlands, a worsening of economic conditions results in a
more than proportional increase in spending. The means by which
consolidation has been achieved are strikingly similar across countries.
Fiscal consolidation has implied significant reductions in spending
since the beginning of the nineties. After the initial 1984 consolidation, public spending in Denmark has not been kept under further
control. In contrast, the introduction of the Dutch spending rule allowed a reduction of public spending from 54 per cent to 44 per cent
of GDP in about six years. Nonetheless, its implementation has been
less strict since 2000. As in Sweden, consolidation has in first the instance relied on tax increase. But these initial tax increases have not
continued after the mid eighties, once the tax share exceeds 50 per
cent of GDP. In the Netherlands, in contrast to the other countries,
the tax burden has been substantially reduced since 1993.
In summary, the mechanism that creates debt by lavish spending in
an economic bust, and raises taxes in an attempt to stabilise debt is
not typical for Sweden. A gradual consolidation strategy implies
bringing down spending and tax levels. Such policies remain prone to
a sudden reversal if debt is not further consolidated.
6. Conclusions
Fiscal policy rules address problems of debt sustainability. In Sweden,
the derailing of public debt in the early eighties only led to informal
agreements to consolidate debt. This fiscal framework did not survive
a stress test when external economic factors deteriorated. Debt exploded by about 40 per cent of GDP between 1990 and 1992. This
fiscal crisis urged a reform. Initially, procedural reform aimed at placing the budget decision power more firmly in the hands of the finance
minister and the government and additionally led to some institutional
changes. Numerical rules, introduced in 1997, aim at an overall structural surplus of two percent of GDP. This surplus target is anchored
to an expenditure rule for the central government, which defines a
rolling medium term nominal ceiling on spending for the next three
44
RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN,
Peter Claeys
years. In addition, local governments are bound by a balanced budget
rule.
I estimate empirical fiscal rules to test sustainability for Swedish
fiscal policy over the period 1970-2006. I look in detail into government spending and taxes to lay out the mechanism behind debt creation and consolidation. The characteristics of fiscal crises are remarkably common over time. Unconstrained fiscal policy responds to
economic instability by boosting spending and raising taxes. Institutional reform did not put a brake on the continued rise in government
spending, in particular on public consumption and social transfers.
Taxes are raised, regardless of the economic stance, to fill budget
gaps. The combination of unrestrained growth in spending, and the
belated rise in taxes, has caused growing deficits.
The fiscal spending rule has been useful in limiting additional increases in the budget. It put in stone the efforts of the consolidation
of the nineties, but does not address the problems of spending management in normal times. Spending rules have not eradicated destabilising policies. I find evidence that over the period 2000-2002, similar
mechanisms once more started to cause fiscal problems. Debt did not
rise thanks to favourable economic conditions. The main policy implication is that a further refinement of fiscal rules is necessary to
avoid future fiscal crises. A better control of further rises in spending
is necessary. This could happen by relating the increase in the level of
public spending to some economic criterion. I think in particular of
the level of debt (“debt brake”), potential growth (“balanced spending”) (Danninger, 2002), or the current surplus target. This would
provide for an expenditure target in the medium to long term that is
robust to economic fluctuations in the short term.23 This decision
should also reflect a longer-term view on the sustainability of public
finances. This probably implies some discussion across tiers of government as well. The desired level of spending should also be related
to the level of taxation. Preferably, this should allow for a gradual adjustment in taxation in order to avoid procyclical shifts in taxation.
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See also the work of the Commission of the Swedish Ministry of Finance.
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