Designing Fiscal Policy For Steady, Enduring Growth

by Marco Buti and Vitor Gaspar

Appeared originally at Voxeu.org 10 December 2015

Designing fiscal policy for today’s complex and uncertain economic climate is a problem that perplexes governments worldwide. This column proposes a solution – a new fiscal architecture with strengthened but budget-neutral automatic stabilisers. It won’t be easy, but overcoming predominantly political challenges will help foster steady and enduring growth.

Several years after the peak of the Global Crisis, substantial risks to the global economy abound. Prospects for economic growth have been repeatedly marked down. Public debt to GDP ratios in many Eurozone countries are at levels not seen since World War II. Several countries are significantly out of step with their medium-term fiscal targets. Monetary policy in several major economies is constrained by the zero lower bound. China, the largest economy in the world in purchasing power parity terms, is undergoing an epochal economic rebalancing and ensuing growth moderation, with important spillovers.

Against this background of heightened risks and uncertainties, constrained monetary policy, and limited budgetary space, how can fiscal policy contribute to steady and enduring growth? Here, we argue that fiscal stabilisation through automatic stabilisers can play a prominent role.

Why fiscal stabilisation?

Fiscal policy can influence medium-term growth through its support to macroeconomic stability. A large body of theoretical and empirical work has shown that high macroeconomic volatility dampens output growth. For example, in a sample of 92 countries as well as a sample of OECD countries, Ramey and Ramey (1995) find that countries with higher volatility have lower growth. This suggests that lower volatility can increase growth insofar as it helps avoid wasteful fluctuations in employment and growth. Lower macroeconomic uncertainty also provides a favourable environment for physical and social capital, thereby supporting medium-term growth.

Fiscal policy has a stabilising effect on an economy if the budget balance increases when the output gap rises, and decreases when the output gap falls. The April 2015 Fiscal Monitor introduced the ‘FISCO’, a fiscal stabilisation coefficient that measures the systematic response of a country’s overall fiscal deficit to changes in the output gap, whether the response is automatically driven or resulting from discretionary actions. If the fiscal stabilisation coefficient is equal to one then, when the output gap increases by one percentage point of GDP, the general government deficit also increases by one percentage point of GDP. The Monitor estimates that the average fiscal stabilisation coefficient is 0.7 for advanced economies (Figure 1), most of which as a result of automatic stabilisers. For advanced economies, a significant – but plausible – increase in the fiscal stabilisation coefficient by 0.1 (equivalent to one-standard deviation of cross-country variation in the sample) is estimated to reduce output volatility by 15% and increase growth by 0.3 percentage points.

Figure 1

.Advanced economies, fiscal stabilisation coefficients 

Source: IMF Fiscal Monitor, April 2015.

In the EU, automatic fiscal stabilisation is traditionally measured as the semi-elasticity of the overall fiscal balance to changes in the output gap, as described in Mourre et al. (2014) and used in the EU fiscal framework. The aggregate semi-elasticity is derived from the sensitivities of individual tax and expenditure categories to output fluctuations. The size of automatic stabilisers appears strongly and positively correlated with the ratio of government expenditure to GDP (Figure 2). However, in practice the influence of automatic stabilisers can be larger or smaller than suggested by the expenditure ratio depending on the country’s tax and spending structures. For example, if the output gap decreases by 1 percentage point, the headline budget balance would deteriorate automatically by around 0.3%-0.6% of GDP, depending on the country.