Determinants and Effects of Fiscal Counter-Cyclicality

Ensayos sobre Política Económica Volumen 35, Núm. 86 • Edición especial de 2018 137 Determinants and Effects of Fiscal Counter-Cyclicality Davide Furceri* João Tovar Jalles** Article Info: Received 8 June 2017; accepted 1 December 2017 Abstract JEL Classification E62 H50 H60 Keywords: fiscal policy fiscal stabilization output volatility time-varying coefficients weighted least squares This paper provides a novel dataset of time-varying measures of fiscal counter-cyclicality for an unbalanced panel of advanced and emerging market economies from 1980 to 2014. The use of time-varying measures of fiscal counter-cyclicality overcomes the major limitation of existing studies assessing the determinants and the effects of fiscal countercyclicality that rely on cross-country regressions and, therefore, are not able to account for country-specific as well as global factors. The key findings of the paper are as follows: (i) fiscal counter-cyclicality has increased over time for many economies over the last two decades; (ii) fiscal counter-cyclicality is positively associated with financial deepening, the level of economic development, trade openness, government size as well as with political factors; (iii) fiscal counter-cyclicality significantly reduces output volatility. Our results are robust to various specifications and endogeneity checks. Determinantes y Efectos de la Contraciclicidad Fiscal Resumen Clasificación JEL E62 H50 H60 Palabras claves: política fiscal estabilización fiscal volatilidad del producto coeficientes cambiantes en el tiempo mínimos cuadrados ponderados Este documento ofrece un novedoso conjunto de datos con medidas de la contraciclicidad de la política fiscal que son variantes en el tiempo, para un panel desbalanceado de economías avanzadas y emergentes desde 1980 hasta 2014. El uso de medidas fiscales contracíclicas que cambian en el tiempo, supera la principal limitación de los estudios existentes sobre la materia, que usualmente evalúan los determinantes y los efectos de la contraciclicidad fiscal basados en regresiones a través de países y, por lo tanto, no dan cuenta de los efectos específicos por país ni de los efectos globales. Los hallazgos más importantes del trabajo son los siguientes: (i) la contraciclicidad fiscal ha aumentado durante las últimas dos décadas en muchas economías; (ii) la contraciclicidad fiscal está asociada positivamente con la profundización financiera, el nivel de desarrollo económico, la apertura comercial, el tamaño del gobierno, así como con factores políticos; y (iii) la contraciclicidad fiscal reduce significativamente la volatilidad del producto. Nuestros resultados son robustos a varias especificaciones y verificaciones de endogeneidad. https://doi.org/10.32468/espe.8508 * ** Acknowledgments: The authors are grateful to Antonio Fatas, Justin Wolfers, Vitor Gaspar, Martine Guerguil, Ben Clements, Xavier Debrun for useful comments and suggestions on an earlier draft of the paper. We would like to also thank participants at the XIV Seminar of ESPE—organized by Banco de la República, to be held in Bogotá on October 20th, 2017—Ignacio Lozano and two anonymous referees for useful comments. The views expressed are those of the authors and do not necessarily represent those of the IMF or its policy. International Monetary Fund, Research Department, 700 19th Street NW, Washington DC, 20431, USA. E-mail: University of Palermo. International Monetary Fund, Fiscal Affairs Department, 700 19th Street NW, Washington DC, 20431, USA. Email: Determinants and effects of fiscal counter-cyclicality Davide Furceri y João Tovar Jalles/ 137-151 138 1. Introduction Several years after the Global Financial Crisis, economic growth in many advanced and emerging market economies remains well below precrisis rates. Medium-term growth expectations have been steadily revised downwards since 2011, highlighting uncertainties surrounding medium-term growth prospects (IMF 2015). At the same time, public debt-to-GDP ratios have increased in many advanced and emerging market economies, reaching historical high levels in some of them. Against this background, how can fiscal policy contribute to higher medium-term growth? Since output volatility can negatively affect mediumterm growth through its effects on investment and productivity, fiscal policy can foster medium-term growth by reducing aggregate macroeconomic volatility.1 The idea that fiscal policy can affect productivity growth by operating in a counter-cyclical way has been suggested by Aghion et al. (2005). Their argument is that firms’ ability to borrow to finance investment is typically reduced during recessions: to the extent that higher macroeconomic volatility translates into deeper recessions, it will have a negative effect on investment, especially on productivityenhancing long-term projects (for example, R&D investment) that are more subject to liquidity risks. This prediction finds empirical support in cross-country regressions (Aghion et al. 2005) as well as in studies based on sectoral- (Furceri and Jalles 2016) and firm-level data (Berman et al. 2007). Fiscal policy has a stabilizing effect on the economy if the budget balance-to-GDP ratio increases when output growth increases and falls when output growth declines: (i) the more countercyclical government spending is, the higher the effect of fiscal stabilization —a relatively high level of government spending when private demand is low will stabilize aggregate demand; (ii) the more pro-cyclical taxes are, the higher fiscal counter-cyclicality will be— if taxes fall more than output, when output falls, then taxes contribute to stabilize household’s disposable income. But how stabilizing is de facto fiscal policy and how fiscal counter-cyclicality vary over time, between countries and across phases of the business cycle? Which policy and structural variables determine the effectiveness of fiscal stabilizers? Finally, how much does fiscal countercyclicality contribute to lower overall macroeconomic volatility? This paper tries to answer these questions using a novel empirical strategy and estimating time-varying measures of fiscal counter-cyclicality for an unbalanced panel of 61 advanced and emerging market economies from 1980 to 2014. In particular, the contribution of the paper is twofold. First, to the best of our knowledge, this is the first paper that estimates time-varying measures of fiscal counter-cyclicality for a large set of economies, including emerging market ones.2 Second, we examine the effect of time-varying measures of fiscal countercyclicality on output volatility. The use of time-varying measures of fiscal countercyclicality overcomes the major limitation of existing studies assessing the drivers and the determinants of fiscal counter-cyclicality that rely on cross-country regressions and therefore are not able to account for country-specific as well as global factors. The key findings of the paper a (...truncated)