IMF Fiscal Affairs and Research Departments Workshop on Fiscal Policy Washington, June 2, 2009

1. European Commission IMF Fiscal Affairs and Research Departments Workshop on Fiscal Policy Washington, June 2, 2009 A couple of issues in automatic stabilisation: Efficiency effects and medium-term sustainability by: Carlos Martinez-Mongay(*) European Commission DG ECFIN (*) The views expressed in this presentation do not necessarily represent those of the European Commission 1

2. European Commission OUTLINE • Distortionary taxes, the size of governments and the trade-off between stabilization and efficiency • Asset booms, composition effects and the trade-off between stabilization and sustainability 2

3. European Commission • Distortionary taxes, the size of governments and the trade-off between stabilisation and efficiency 3

4. European Commission A simple model for automatic stabilisation (European Commission (2001); se also Artis and Buti, 2000, Blanchard, 2000, Buti, Roeger, in’t Veld, 2001) A simple AD/AS model: • Yd = f1(d-pb) – f2(i-pe) + edf1 , f2 > 0 • Ys = Y* + w(p –pe) + es (3) d = d* - t(Y –Y*) • IS-type schedule • Lucas-Pillips supply function d deficit b stock of public debt i interest p inflation (‘e’ expected) Y* potential output (Y – Y* is the output gap) ed, es, demand and supply shocks (3) d* cyclically-adjusted deficit t automatic stabilisers (sensitivity of the deficit to the output gap, Y-Y*) 4

5. Y = Y* + (w ed + bes)/[w(1 + f1 t ) + b] p = p* + (ed – (1 + f1 t ) es)/[w(1 + f1 t ) + b] If automatic stabilisers are turned off (t = 0) Y = Y* + (w ed + bes)/(w + b); es = 0, Y = Y* + w ed /(w + b); ed = 0, Y = Y* + bes/(w + b); p= p* + (ed – es)/(w + b) es = 0, p= p* + ed/(w + b); ed = 0, p= p* – es/(w + b); If automatic stabilisers are turned on (t>0) es = 0 Y = Y* + w ed /[w(1 + f1 t ) + b]; ed = 0 Y = Y* + bes/[w(1 + f1 t ) + b]; es = 0 p = p* + ed /[w(1 + f1 t ) + b]; ed = 0 p = p* - (1 + f1 t ) es)/[w(1 + f1 t ) + b]; espermanent Y – (Y* + es )= -{(1 + f1 t ) es/[w(1 + f1 t ) + b]}; European Commission Shocks don’t come with labels: demand, supply, temporary, permanent 5

6. European Commission Do governments stabilize output? Automatic stabilizers operate on the demand side. Progressive taxes and benefit (viz. unemployment) systems make surpluses grow more than output in expansions and less than output in recessions Automatic stabilizers also operate on the supply side: • Avoid under-investment in recessions • Keep levels of physical and human capital • Growth close to potential But distortionary taxes and benefit systems affect agent’s decisions to invest, work and save, which has an impact on economic efficiency. A policy dilemma? • Need to induce more flexibility in markets (short-run adjustment) and enhance potential output (long-run adjustment) by streamlining benefit systems and lowering distorting taxes • Efficiency gains may come at the cost of less stability (more output volatility) No policy dilemma if distortionary tax-benefit systems would hamper macroeconomic stability 6

7. European Commission Higher tax rates can lead to steeper aggregate supply curves 7

8. European Commission An extended AD/AS model with taxes in the supply curve 8

9. An extended AD/AS model with taxes in the supply curve European Commission Trade balance consistency implies: where (6) and . Inflation can be obtained by equating (6) to (w–at)p + es (i.e. (2) with pe = 0) 9

10. European Commission 10

11. European Commission 11

12. European Commission Is there an efficiency-stabilization tradeoff? 12

13. European Commission Is there an efficiency-stabilization tradeoff? The cases of closed and small economies 13

14. Sample of 25 OECD countries over the period 1960-2000 (annual data). Joint estimation of output and inflation volatility (error terms are correlated; GMM) Output volatility: standard deviation of the output gap (% of the trend) over the period Inflation volatility: ratio between the standard deviation and the average of the GDP deflator Government size is measured as tax revenues (% of GDP) Other variables: Trade openness: Average of exports and imports in % of GDP Country size: Average of the GDP (PPS) Specialisation: Average share (%) of manufacturing GVA in total GDP Additional Instruments (determinants of government size): Per capita income (in 1995 PPS) Old-age dependency ratio: people over 65 in percentage of total population European Commission Is there an efficiency-stabilization tradeoff? Empirical evidence 14

15. European Commission Alternative ways of measuring the size of governments 15

16. European Commission Stabilization and the tax burden 16

17. The average effective tax rate on labor income European Commission 17

18. European Commission Labor taxes in the sample 18

19. European Commission Is there an efficiency-stabilization tradeoff? Empirical evidence 19

20. European Commission Is there an efficiency-stabilization tradeoff? Additional empirical evidence (Debrun et al, 2008) 20

21. European Commission Is there an efficiency-stabilization tradeoff? Additional empirical evidence (Debrun et al, 2008) 21

22. European Commission 2. Asset booms, composition effects and the trade-off between stabilization and sustainability

23. Tax revenue growth % (d) Tax base growth (c) (b) Nominal GDP growth European Commission (a) Trend GDP growth Period of analysis T0 T1 t Measuring automatic stabilizers in the presence of composition effects a) Cyclical effect (growth at nominal GDP) (b) Composition effect (growth at base rate) (c) Discretionary measures (d) Others 23

24. European Commission Automatic stabilizers and asset booms. The case of Spain The longest expansion of the Spanish economy… Source: AMECO 24

25. European Commission Automatic stabilizers and asset booms. The case of Spain … domestically led, especially by the housing sector (and consumption). Source: AMECO and own calculations 25

26. European Commission Automatic stabilizers and asset booms. The case of Spain The expansion 1995-2007 was underpinned by a substantive fall of the risk premium, and unprecedented demographic growth, …

27. European Commission Automatic stabilizers and asset booms. The case of Spain …which induced a boom in asset markets 27

28. European Commission Automatic stabilizers and asset booms. The case of Spain Asset markets have also driven the downturn Source: AMECO and own calculations 28

29. European Commission A tax-rich expansion, 29

30. European Commission Automatic stabilizers and asset booms. The case of Spain … apparently of a structural nature…

31. European Commission Automatic stabilizers and asset booms. The case of Spain …but probably just reflecting a significant divergence between national accounts and ‘actual’ tax bases, especially in indirect and corporate taxes Source: AMECO and own calculations

32. European Commission Automatic stabilizers and asset booms. The case of Spain which led to large composition effects 32

33. European Commission Automatic stabilizers and asset booms. The case of Spain … explaining between 2/3 and ¾ of the accumulated increase in tax revenues ∆REVt = d0 + α 1(REV – a - β GDP - t TREND)t-1+ δ1 ∆GDPt + δ2 ∆GDPt-1 + δ1 ∆(HOUSE/GDP)t-2 + δ2 ∆(MGVA/GDP)t + g1 I1t + … + gm Imt + εt (1) 33

34. European Commission Automatic stabilizers and asset booms. The case of Spain Enough fiscal consolidation in good times?

35. European Commission Automatic stabilizers and asset booms. The case of Spain A sustainable fiscal expansion?

36. References European Commission Andrés, J. R. Domenech and A. Fatás, 2004, The Stabilising Role of Government Size, ISEAD, 2004/44/EPS Artis, M. J. and Buti, M., 2000, « Close to balance or in surplus » -A policy maker’s guide to the implementation of the Stability and Growth Pact, Journal of Common Market Studies, 38(4), 563-592. Blanchard, O., 2000, Commentary, Federal Reserve Bank of New York Economic Policy Review, 6(1), 69-74. Brunila, A., M. Buti and J. in’t Veld, 2001, Fiscal policy in Europe: how effective are automatic stabilisers?, European Economy, Economic Papers, N° 177. Buti, M., W. Roeger, J. in’t Veld, 2001, Stabilising output and inflation: Policy conflicts and coordination under a stability pact, Journal of Common Market Studies, 39, 801-828. Buti, M. C. Martinez-Mongay, K. Sekkat and P. van den Noord, 2003, Automatic Fiscal Stabilisers in EMU: A Conflict between Efficiency and Stabilisation, SESifo Economic Studies, VoL. 49, 123-140. (see also OECD Ecocomics Department Working Papers, N° 335). Debrun, X., J. Pisani-Ferry and A. Sapir, 2008, Government size and output volatility: Should we forsake automatic stabilisation? European Economy Economic Papers N° 316. Gali, J., 1994, Government size and macroeconomic stability, European Economy Review, 38, 117-132. Fatás, A. and I. Mihov, 2001, Government size and automatic stabilisers, Journal of International Economics, 55, 3-28. Martinez-Mongay, C. and K. Sekkat, 2005, Progressive Taxation, Macroeconomic Stabilization and Efficiency in Europe, European Economy Economic Papers, N° 233 Martinez-Mongay, C. J. L. Maza Lasierra and J. Yaniz Igal, 2007, Asset Booms and Tax receipts: The case of Spain, 1995-2006. Roeger, W. and J. in’t Veld, 2009, Fiscal Policy with Credit Constrained Households, European Economy Economic Papers, N° 357. 36