Non linear effects of fiscal policy.
The case of New Member States.
Joanna Siwinska-Gorzelak
Faculty of Economic Sciences
University of Warsaw
Objective
• The main goal of the paper is to assess the short run
effects of discretionary fiscal policy in New Member
States (NMS) and examine the factors that may lead to
“non-Keynesian” in these countries.
• Up to now, NMS have been largely excluded from the
analysis of non-Keynesian effects.
Private consumption and fiscal policy
• The standard Keynesian or “conventional” view of fiscal
policy holds that in the short run fiscal adjustments
(expansions) reduce (stimulate) disposable income,
consumption and aggregate demand and due to sticky
wages, prices or other misperceptions these shifts in
demand affect the factors of production and output.
• According to permanent income life cycle hypothesis
(PILCH) and its generalization – the Ricardo – Barro
Equivalence Theorem holds that the level of aggregate
demand is unaffected by the tax/debt mix or by
permanent changes in government spending – the
former leaves consumption decisions unaffected, while
the latter crowds it out; fiscal policy is thus ineffective
in stimulating or dampening output, at least in the
short-run.
Non-Keynesian effects of fiscal policy
• Giavazzi and Pagano (1990) analyzed the cases of
Denmark and Ireland and concluded that these were
“…the two most striking cases of “expansionary (fiscal)
stabilizations in Europe”.
• Since then, it has been well documented, that fiscal
policy can have “non-Keynesian” effects i.e. that fiscal
expansion can cause a recession and fiscal
retrenchments an expansion in economic activity.
• These effects do not fit into Keynesian nor Ricardian
tradition
Non-Keynesian effects of fiscal policy
• The models by Blanchard (1990), Bertola and Drazen (1993),
Sutherland (1997) and Perotti (1999) emphasize the demand
side of non-Keynesian effects.
• The models are neoclassical (i.e. based on PILCH) and each
holds that expectations of future fiscal policy changes can
give rise to nonlinear consumer behavior.
• Theoretical (and empirical) literature suggests that the nonKeynesian effects stemming from the demand side, may be
triggered by different set of factors than the non-Keynesian
effects operating through the supply side.
• For the former the crucial features of fiscal policy are the
ones, that influence agent’s expectations of future policy
changes, such as initial fiscal conditions (the level of debt and
deficit, the level of expenditures) or size of fiscal adjustment;
for the latter much more important is the composition of
fiscal policy change.
Blanchard’s (1990) model
• Blanchard’s (1990) assumes a critical level of taxation t*, such that
distortions caused by taxes, which exceed this level, imply a decrease in
output. Consequently, there is also an associated critical level of debt d*
that implies, through the government budget constraint, a future tax rate
above the critical level t* and a lower output.
• If consumers anticipate that this critical level of debt d* will be reached,
then a fiscal consolidation that stabilizes or lowers debt value, allows o
escape from the highly distortionary tax rate. Thus expected permanent
income is higher and consumption rises. To put it in other words: today’s tax
increase, which is does not exceed the critical value t* allows avoiding a
larger future increase that would exceed t* and hence lower output. As a
result, fiscal consolidation in “bad fiscal times” can be good news and raise
consumption.
• Blanchard notes, that if consumers have a constant probability of death (are
not Ricardian), then “in normal times” i.e. when the economy is far from
the critical debt level, despite a neoclassical structure, fiscal policy will have
Keynesian effects. The model thus shows, that consumers behave in a nonlinear fashion – in “normal times” they behave in a Keynesian way (provided
they have finite horizont), in “bad times” their behavior is reversed, what
gives rise to non-Keynesian effects.
Sutherland’s (1997) model
• The government implements restrictive fiscal policy, in form of a
large tax hike, when public debt reaches critical levels.
• At low values of debt the probability of fiscal contraction is very
low, thus a fiscal transfer from the government to households
produces a Keynesian effect, as the probability that the future
necessary increase in taxes will fall on the current consumer is low.
• The higher is the debt value, i.e. the closer it is to the trigger point
of fiscal stabilization, then a further increase in fiscal deficit causes
consumption to fall, as consumers know that there is a high
probability that the stabilization – a large tax increase - will take
place during their lives and that the future income loss will be
much higher than today’s government transfer.
• Again, non-linear consumer behavior gives rise to non-Keynesian
effects. This effect diminishes, when consumers have infinite lives in that case the results are Ricardian.
Perotti’s (1999) model
• Consumers; one group - rational and forward looking (PILCH), while the
other group is either liquidity constrained or myopic, so that the
consumption function of the latter group is purely Keynesian.
• Increase in government expenditure stimulates pre-tax income, while taxes
dampen it. The distortions caused by taxes increase in a non-linear fashion,
as taxes enter the output function raised to the second power. Because
policymakers do not smooth taxes out, future taxes are expected to be
larger than today’s.
• The non-Keynesian effects of fiscal policy emerge when the unexpected
change in public spending or taxes changes the expectations about future
disposable income (mainly through altering of the future tax path) of
rational, unconstrained consumers.
• Note, that the “Keynesian” consumers have a constant propensity to
consume out of current income, and the bigger their proportion in the
society, the less likely it is for the non-Keynesian effects to appear.
• The “PILCH” consumers do not react to expected changes in fiscal policy.
Consumption only changes when fiscal policy is unexpected.
Perotti’s (1999) model
• An unexpected increase in public expenditure may exert positive or negative effect
on the consumption of “PILCH” consumers depending on the strength of output
stimulus as opposed to the negative effect of the implied (future) tax increase.
• If output stimulus outweighs tax distortions, consumption will increase as a result
of government spending shock, if the opposite is true, consumption will decrease.
• Therefore an increase in government spending may have perverse demand effects,
provided that the share of PILCH consumers is not too low and that the effect of
(expected) tax distortions outweighs the positive effects of spending.
• The latter effect is more likely when the present discounted value of financing
needs of the government is large – for instance when the government is struggling
with a mounting debt.
• Similarly the effect of tax increase may have different effects depending on the
expected path of future taxation. An unexpected tax increase today may stimulate
consumption of forward looking, unconstrained individuals, as it implies
significantly lower tax distortions in the future.
• Again, the emergence of non-Keynesian consumers’ reaction depends on the share
of unconstrained consumers and on the present discounted value of financing
needs of government. In “bad fiscal times” the PDV of financing needs of
government is large, so today’s tax increase implies a significant decrease in future
distortions.
Perotti’s (1999) model
• The model by Perotti (1999) holds that when the
PDV of future government financing needs is low,
fiscal policy will exert the usual Keynesian effects
due to the reaction of liquidity constrained
consumers PILCH consumers (provided that the
fiscal action is has been unexpected).
• When however the PDV of financing needs is high,
it is possible that the unexpected fiscal policy will
have perverse effects, because the PILCH
consumers expect a future perverse change in
income.
Keynesian and non-Keynesian episodes of fiscal policy in
OECD countries in years 1976-2001.
• As a measure of the output effects of fiscal policy change, I use the concept of
“corrected growth” developed by Cour et. al (1996).
• Corrected growth of country i equals the actual growth of country i minus the
actual growth in G7 countries and minus the difference between the potential
growth rates between country i and G7.
• A “Keynesian” fiscal adjustment/expansion is an episode, during which the
“corrected growth” is smaller/larger than in the preceding year.
• An episode is “non-Keynesian” when fiscal adjustment/expansion is coupled with a
“corrected growth” which is larger/smaller than in the preceding year.
Keynesian and non-Keynesian episodes of fiscal policy in
OECD countries in years 1976-2001
We isolated 40 fiscal expansions and 73 fiscal adjustments. Out of these 113 significant fiscal
policy changes, 50 were non-Keynesian.
Thus, a first conclusion emerges – non-Keynesian effects are not a random anomaly, they
seem to be quite a frequent phenomenon.
Keynesian
Non-
Keynesian
Non-Keynesian
expansions
Keynesian
adjustments
adjustments
expansions
Number of episodes
Average
change
of
balance,
in
23
46
27
-2,47
-2,62
2,24
2,53
1,58%
-1,38
-1,72
1.01
the
cyclically adjusted primary
govt.
17
%
of
potential GDP.
Average “adjusted growth”
Source: own calculations, OECD database
Empirics
• The empirical literature on demand-side non-Keynesian
effects, starting with the seminal contribution of Giavazzi
and Pagano (1990) confirms (although not uniformly) the
existence of non-Keynesian effects (or a somewhat weaker
phenomenon – the non-linear effects) for OECD countries
• The “trigger” factors: large fiscal imbalances (deficit and/or
public debt) and or size of fiscal shock (large fiscal
expansions and adjustments).
Effects of a positive public expenditure shock
• Constrained (myopic) consumers
– Both positive and negative effects due to current influence of G on disposable
income
• Unconstrained (rational)consumers
– Only unexpected shocks matter; expected shocks do not change the
consumption path of PILCH consumers
– Both positive and negative effect due to current effect on disposable income
– Negative effect due to expected increase in future taxation
– Both positive and negative effect due to future impact of the higher
government spending on disposable output.
• Depending in the magnitude of these offsetting effects, the impact of
unexpected spending shock can be either positive or negative
• The magnitude of the adverse effects of spending shocks can be amplified
by large fiscal imbalances (expectations of a significant increase in future
taxation), by adverse economic conditions (amplification of the adverse
effect on disposable income)
• Non- linearity does not necessarily imply a non-Keynesian output effect, as
they may be too weak to offset the effects of fiscal policy.
Effects of increased taxation
• Constrained (myopic) consumers
– Negative effects due to current influence of T on disposable
income
• Unconstrained (rational)consumers
– Only unexpected shocks matter; expected shocks do not change
the consumption path of rational consumers
– Negative effect due to current decrease of disposable income
– Positive effect due to future decrease in taxes and hence increase
in expected (future) disposable income
• Depending in the magnitude of these offsetting effects, the impact of
unexpected spending shock can be either positive or negative
Empirical strategy
Estimate Euler equation of the form
cit  1 yit  2 fiscit  3 ( fiscit  dummy)   t
where:
cit – log difference of real, private consumption (i.e. percentage change)
yit – log difference of real, disposable household income
fisc – cyclically adjusted fiscal impulse
dummy variable that equals 1, when times are hard (public deficit is
excessive or economy is in recession)
Data source: OECD; 1970-2007.
Regression results; OECD countries
Income
Deficit
(1)
0.747***
(0.222)
0.775***
(0.0196)
Deficit*dummy_def
Deficit*dummy_gdp
(2)
0.725***
(0.217)
0.794***
(0.0201)
-0.160***
(0.0563)
(3)
0.591***
(0.212)
0.809***
(0.0191)
-0.152***
(0.0531)
-0.656***
(0.116)
Spend*dummy_gdp
Constant
Observations
R-squared
Number of countries
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
-0.0174***
(0.00490)
504
0.7
18
-0.0123***
(0.00463)
504
0.7
18
(4)
0.666***
(0.219)
0.798***
(0.0198)
-0.155***
(0.0554)
-0.388***
(0.146)
-0.0140***
(0.00481)
504
0.7
18
NMS
• Included are 10 NMS: Bulgaria, Czech Republic, Estonia,
Hungary, Latvia, Lithuania, Poland, Romania, Slovakia,
Slovenia
• Years: 1992-2007
• AMECO database
• Variables:
– Private final consumption expenditure
– Total current expenditure, excluding interest of general
government
– Gross national disposable income
– Final consumption expenditure of general government
– Total current revenue of general government
– Current taxes on income and wealth
Regression results; NMS
Expected income
Fiscal impulse
Fiscal impulse*dum_def
(1)
FE
0.866***
(0.154)
-0.0103
(0.0203)
-0.117**
(0.0522)
(2)
PW
0.903***
(0.155)
-0.00439
(0.0119)
-0.112*
(0.0570)
Exp*dum_gdp
(3)
FE
0.850***
(0.141)
-0.00990
(0.0185)
-0.0181
(0.0520)
-0.260***
(0.0552)
(4)
PW
0.879***
(0.143)
-0.00280
(0.0101)
-0.0396
(0.0525)
-0.240***
(0.0690)
0.00923
(0.00755)
118
10
0.388
0.00801
(0.00593)
118
10
0.446
Expenditure shock
Exp*dum_def
Constant
Observations
Number of countries
R-squared
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
0.00782
(0.00827)
118
10
0.257
0.00451
(0.00496)
118
10
0.376
(5)
FE
0.883***
(0.140)
-0.194***
(0.0713)
0.00606
(0.0143)
-0.129
(0.0784)
0.00876
(0.00749)
118
10
0.400
Conclusions
• Fiscal policy has a non-linear impact on private
consumption spending both in OECD and in New
Member States
• As usual, in case on NMS, the short time horizon
and poorer data quality imply that any estimation
results must be treated with considerable amount
of skepticism
• The non-linearity seems to be triggered by fiscal
imbalances and by recessions
• This implies that stabilizing the business cycle with
discretionary fiscal policy can be difficult…
References
• Blanchard O., (1990) Comment on “Can severe fiscal contractions be
expansionary?” NBER Macroeconomics Annual 1990, ed. by
Blanchard O., and Fischer S., MIT Press
• Cour P., Dubois E., Mahfous S., Pisani-Ferry J (1996) The cost of fiscal
retrenchment revisited: How strong is the evidence?
• Giavazzi F., Pagano M. (1990) Can Severe Fiscal Contractions Be
Expansionary? Tales of Two Small European Countries. NBER
Macroeconomics Annual
• Perotti R., (1999) Fiscal policy in good times and bad. The Quarterly
Journal of Economies, November
• Sutherland A. (1997) Fiscal Crises and Aggregate Demand: Can High
Public Debt Reverse the Effects of Fiscal Policy? Journal of Public
Economics 65.