Do expected downturns kill political budget cycles?

The Review of International Organizations https://doi.org/10.1007/s11558-020-09379-w Do expected downturns kill political budget cycles? Frank Bohn1,2 · Jan-Egbert Sturm3,4 © The Author(s) 2020 Abstract The political budget cycle (PBC) literature argues that governments expand deficits in election years. However, what happens when an economic downturn is expected? Will the government allow the deficit to expand even further, or will it resort to spending cuts and tax increases? When voters expect less than full automatic stabilization, our model shows that opportunistic government behavior leads to smaller deficits, thereby responding procyclically to expected downturns. Panel data evidence for 74 democracies covering the period 2000-2016 robustly supports the theoretical procyclicality prediction. Moreover, expected downturns remain significant when other context-conditional PBC effects are included in the empirical analysis. Keywords Political budget cycles · Elections · Growth expectations · Economic downturns · Precautionary voters · Automatic stabilization · Fiscal deficits JEL Classification D72 · E32 · E62 Electronic supplementary material The online version of this article (https://doi.org/10.1007/s11558-020-09379-w) contains supplementary material, which is available to authorized users.  Jan-Egbert Sturm Frank Bohn 1 Institute for Management Research, Department of Economics, Radboud University, P.O. Box 9108, 6500 HK, Nijmegen, The Netherlands 2 KOF Swiss Economic Institute, Zurich, Switzerland 3 KOF Swiss Economic Institute, ETH Zurich, LEE G 305, Leonhardstrasse 21, 8092, Zurich, Switzerland 4 CESifo, Munich, Germany F. Bohn and J.-E. Sturm 1 Introduction In recent years, two main stylized facts have emerged from the empirical literature on political budget cycles (PBCs): (i) they are detected in a variety of fiscal policy variables;1 and (ii) they are context-conditional (i.e. PBCs do not always occur under all circumstances).2 What is missing, in our view, is research on a form of context-conditionality that has nothing to do with a country’s type or institutions. How do opportunistic governments respond to the regular business cycle, more precisely, to expected changes in economic growth at the time of decision-making?3 We think this topic is important for two reasons. First, it is useful to understand under which circumstances opportunistic behavior creates distortions to fiscal policy and when not. That has probably also been the motivation for previous studies on context-conditionality. Second, we want to understand the underlying mechanism and develop a theoretical model for that. Even though expansionary fiscal policy is modeled to have a (more) beneficial multiplier effect in an economic downturn (which makes an increase in fiscal manipulation more advantageous), expected downturns may actually reduce the PBC effect. Our aim is to first theoretically show conditions under which such a reduction of political manipulation is feasible. We then proceed empirically and show that the PBC effect is virtually eliminated when downturns are expected. However, this does not happen because political opportunism has suddenly vanished. In an election year, as in an off-election year, any government that expects a worsening of economic conditions must choose between conducting additional 1 They occur, for instance, in debt, public expenditures, especially transfers, and expenditure shares. Evidence for cycles in debt is provided by Alesina et al. (1992) and Alesina et al. (1993) and Alesina and Roubini (1990), and confirmed by Drazen (2001). The notion of cycles in public expenditures and particularly transfers is supported by, for instance, Schuknecht (1996; 2000); Block (2002); Drazen (2001); Vergne (2009) and Schneider (2010). Cycles in expenditure shares are suggested by Veiga and Veiga (2007), Drazen and Eslava (2010), Benito et al. (2013), Aidt and Mooney (2014), Castro and Martins (2016), Klomp and De Haan (2016), and Arifin and Purnomowati (2017). 2 The term was coined by Franzese (2002) and picked up by e.g. Alt and Rose (2007) and Dubois (2016). PBCs can be found, for instance, in countries with limited checks and balances or access to free media (Alt and Lassen 2006a, b; Akhmedov and Zhuravskaya 2004; Klomp and De Haan 2016; and Veiga et al. 2017), in developing countries (Schuknecht 1996 and 2000; Block 2002; Shi and Svensson 2006; and Vergne 2009), or in new democracies (Brender and Drazen 2005), and are affected by the political system (Chang 2008 and Streb et al. 2009) and/or the electoral system (Aidt and Mooney 2014). Bojar (2017) discusses how individual characteristics favor the occurrence of PBCs. A literature survey is provided by De Haan and Klomp (2013). 3 There are many articles that focus on the relationship between economic fluctuations and electoral support for re-election chances. See, for instance, Lewis-Beck and Stegmaier (2000), Brender and Drazen (2008), and Chang and Lee (2010) and Goulas et al. (2015). However, we are only aware of two papers that look into the effects of recession expectations on fiscal outcomes: Bohn and Veiga (2019a, b). These papers concentrate on decision-making at the municipality level and produce results that are quite opposite, both theoretically and empirically, from ours. Do expected downturns kill political budget cycles? expansionary policies (to augment the countercyclical effect of automatic stabilisers4 that are already in the system), or instituting precautionary spending cuts or tax increases (to cope with the deteriorating fiscal budget caused by automatic stabilisers). However, in an election year, opportunistic behavior might distort such considerations. The political budget cycle literature suggests an already elevated level of the deficit in normal election years. So, why not, in order to make up for the expected loss in tax revenues (and/or increase in benefit payments), expand the deficit even further when an economic downturn is expected to hit in an election year? Would this not preserve the incumbent government’s fiscal latitude and with it its chance of winning the elections? The answer is that a government does not necessarily have to increase its fiscal latitude to increase its re-election chances; it merely needs to be more expansionary than what voters expect. If voters believe the government will not allow full automatic stabilization (through decreased tax revenues and/or increased benefit payments) in case of an expected economic downturn, but expect some spending cuts (or tax increases), it is sufficient for the government to make more moderate spending cuts (or tax hikes) than expected by voters.5 Based on panel data for 74 democracies covering the years 2000 until 2016, we study the impact of country-specific forecasts (our proxy for expectations) on government primary budget balances. To get a first idea, the effect of an expected downturn on the poli (...truncated)