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Fiscal Performance, Fiscal Rules, and Country Size

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Klaus Schmidt-Hebbel - Catholic University of Chile
Raimundo Soto - Catholic University of Chile

ERF Training on Advanced Panel Data Techniques Applied to Economic Modelling

29 -31 October, 2018
Cairo, Egypt

Published in: Government & Nonprofit
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Fiscal Performance, Fiscal Rules, and Country Size

  1. 1. Fiscal Performance, Fiscal Rules, and Country Size Klaus Schmidt-Hebbel kschmidt-hebbel@uc.cl Raimundo Soto rsotom@uc.cl LAC Regional Study on Fiscal Rules and Economic Size The World Bank, DC, September 2017
  2. 2. Spreading of de jure Fiscal Rules • Fiscal rules started spreading in the 1990s, in both industrial and developing/emerging countries – Only 4 countries had rules in place in 1982 – Increased to 48 countries in 2000 and 78 in 2015 • Most rules are for target levels of the budget balance and/or the public debt • National rules vs supranational rules • Source: IMF Data base on de jure fiscal rules, extending now through 2018
  3. 3. Countries with Fiscal Rules, 1985-2015 Source: IMF Fiscal Rules Dataset, 2017
  4. 4. National and Supranational Fiscal Rules, 1985-2015 Source: IMF Fiscal Rules Dataset, 2017 National Rules Supranational Rules
  5. 5. Fiscal Rules and Compliance Byproduct of this project
  6. 6. Menu 1. Main Research Issues 2. A General Framework (skip) 3. Model 4. Data and Econometrics 5. Empirical Analysis
  7. 7. 1. Main Research Issues
  8. 8. Main Issues 1. Do fiscal rules promote fiscal performance? 2. Does the type of fiscal rule matter? 3. Which other fiscal institutions, political institutions, economic conditions, and development conditions affect fiscal performance? 4. Do fiscal rules interact with other institutional and economic variables in their impact on fiscal performance? 5. Do the effects of fiscal rules depend on country size? (Skip) 6. Are there differences between de jure rules and de facto rules (compliance)?
  9. 9. 2. A General Framework
  10. 10. General Framework • Fiscal performance is linked to fundamental sets of variables: – Fiscal institutions (including fiscal rules) – Political institutions (and distortions) – Economic conditions – Structural conditions • Growing analytical and empirical literature focuses on key links (e.g.: Alesina, Eslava and others on pol-econ determinants of deficits; Végh and others on determinants of fiscal performance measures; Schmidt-Hebbel and Soto on determinants of fiscal rules) • Interrelations between fiscal performance measures and fiscal institutions, political institutions, and economic/structural conditions are complex and go in all ways
  11. 11. Fiscal Outcomes, Institutions, and Economic/Structural Conditions
  12. 12. General Framework (skip) • Fiscal sustainability assessments: – Derived from sustainability models and their specific assumptions on future growth, interest rates, and structural changes – Hence based on judgment and future forecasts – Constructed ad hoc, not systematically available for large country panel, particularly small economies • Available measures of fiscal performance: – Government deficit – Government debt – Government expenditure – Government debt price (spread) – Cyclical measures of deficits, debt, expenditure, revenue
  13. 13. Main modelling issues • The potential impact of rules on fiscal outcomes (balance, debt, and procyclicality) have three defining characteristics: – they tend to display high persistence, thereby requiring the use of dynamic models – countries are highly idiosyncratic vis-à-vis unobservable features in their tax and revenue structures, prompting the existence of individual country effects, – there may be reverse causation and endogeneity, since governments may decide to implement rules as a result of their fiscal stance.
  14. 14. 3. Model
  15. 15. Model Strategy • Performance variables (dependent variables) – Fiscal Balance (% of GDP) – Government Debt (% of GDP) – Cyclicality of Government Expenditures (7 years, centered) – Cyclicality of Fiscal Balance (7 years, centered) • Independent Variables – Fiscal rules – Structural Variables (Development level, Financial development, Dependency ratio, Trade openness, Capital Account Openness) – Political Variables (Democracy, Government Stability, Control of Corruption, Checks and Balances) – Macro Management (Inflation) – Macro Regimes (Exch. Regime, Monetary Union, Inflation Targeting)
  16. 16. Models • Base Models (exclude fiscal rules) • Fiscal Rule Models – Any Fiscal Rule (Supranational, National) – Any National Fiscal Rule – Particular National Fiscal Rules • Government Debt • Budget Balance • Expenditure • Revenues (too few observations)
  17. 17. Fiscal Rules • Fiscal Rules can be seen as a “treatment” • Once and for all change in regime • At a known instant in time
  18. 18. Unconditional Effect of adopting a Fiscal Rule Time Fiscal Outcome Adoption of rule Difference estimator
  19. 19. Conditional Effect of adopting a Fiscal Rule Time Fiscal Outcome Adoption of rule Non adopters Adopters Diff-in-diff estimator
  20. 20. Conditional Effect of adopting a Fiscal Rule Time Fiscal Outcome Adoption of rule Non adopters Adopters Diff-in-diff estimator Adopters were more responsible
  21. 21. Conditional Effect of adopting a Fiscal Rule Time Fiscal Outcome Adoption of rule Non adopters Adopters Diff-in-diff estimator Adopters were partially successful
  22. 22. 4. Data and Econometrics
  23. 23. Data and Econometrics • Panel Data – 1980-2015 – At most 155 countries • Endogeneity of fundamentals – Use lagged values – Contemporaneous correlations not a problem, in general • Endogeneity of Fiscal Rules (next class) – Use predicted probability of having a rule, based on Schmidt-Hebbel and Soto, 2016
  24. 24. Two and three-stage instruments • Need an instrument for the endogeneity of fiscal rules – Correlated with fiscal rules, uncorrelated with (lagged) fundamentals • Instrument 1: – Prediction of Random Effects, Probit panel models of each rule against fundamentals. Consistent instrument. • Instrument 2 – Prediction of a Random Effects, Linear panel model of each rule against fundamentals (no fiscal performance) and instrument 1. Consistent and Efficient Instrument.
  25. 25. Econometrics • Identification of “average treatment” (having a fiscal rule, conditional on changing fundamentals) – Diff. in Diff. Model 𝐹𝑂𝑖𝑡 = 𝛼𝑖 + 𝛿𝐹𝑅𝑖𝑡 + 𝛽𝑋𝑖𝑡 + 𝛾𝐹𝑅𝑖𝑡 𝑋𝑖𝑡 + 𝜀𝑖𝑡
  26. 26. Correlations between fiscal rules Appendix Table 1 AnyBudgetBalance NationalBudgetBalance SupranationalBudget Balance AnyDebtRule NationalDebtRule SupranationalDebtRule AnyExpendituresRule NationalExpendituresRule AnyRevenueRule NationalRevenueRule Any Budget Balance 1 National Budget Balance 0.6834 1 Supranational Budget Balance 0.7654 0.1788 1 Any Debt Rule 0.7841 0.3576 0.8145 1 National Debt Rule 0.3595 0.4234 0.1265 0.5552 1 Supranational Debt Rule 0.7332 0.1662 0.9640 0.8449 0.1172 1 Any Expenditures Rule 0.3951 0.3817 0.3073 0.3109 0.2213 0.2930 1 National Expenditures Rule 0.3951 0.3817 0.3073 0.3109 0.2213 0.2930 1.0000 1 Any Revenue Rule 0.2034 0.1234 0.1818 0.2698 0.2170 0.1738 0.3325 0.3325 1 National Revenue Rule 0.2034 0.1234 0.1818 0.2698 0.2170 0.1738 0.3325 0.3325 1.0000 1 Note: no supranational revenue or expenditures rules
  27. 27. Appendix Table 2 Sample Correlation of Fundamentals EconomicDevelopment Financialdevelopment Inflation BudgetaryUncertainty DependencyRatio TradeOpenness Businesscycle Cap.AccountOpenness FixedExchangeRate MonetaryUnion InflationTargeting PoliticalParticipation CorruptionControl GovernmentStability Economic Development 1.00 Financial development 0.64 1.00 Inflation -0.20 -0.23 1.00 Budgetary Uncertainty -0.31 -0.39 0.22 1.00 Dependency Ratio 0.73 0.57 -0.13 -0.26 1.00 Trade Openness 0.18 0.10 -0.11 0.01 0.26 1.00 Business cycle 0.02 -0.01 -0.04 -0.11 0.02 0.02 1.00 Cap. Account Openness 0.63 0.40 -0.23 -0.26 0.41 0.17 0.01 1.00 Fixed Exchange Rate 0.16 0.04 -0.14 0.03 0.03 0.21 0.01 0.11 1.00 Monetary Union 0.11 0.05 -0.13 0.04 -0.14 0.14 0.00 0.01 0.45 1.00 Inflation Targeting 0.20 0.18 -0.09 -0.20 0.23 -0.07 0.00 0.13 -0.36 -0.14 1.00 Political Participation 0.34 0.33 -0.09 -0.33 0.21 -0.09 0.00 0.30 -0.15 0.07 0.31 1.00 Corruption Control 0.63 0.48 -0.14 -0.28 0.32 0.01 0.01 0.41 0.02 0.07 0.13 0.39 1.00 Government Stability -0.04 -0.10 -0.04 0.06 -0.01 0.10 0.07 -0.06 0.07 0.00 -0.14 -0.31 -0.04 1.00 Correlations between other fundamentals
  28. 28. 5. Results
  29. 29. Econometric Results • Models with Political Variables • Models without Political Variables (skip) • Models – Any rule (skip) – Any National Rule (skip) – Particular National Rules • debt, expenditure, and budget balance
  30. 30. Base Models Results • Models without Fiscal Rules – Tested for fixed and random effects (Hausman test) • Fixed effects estimator is consistent – Tested for poolability • Fixed effects are needed • Most fundamentals significant and “correct” sign
  31. 31. Determinants of the Procyclicality of Government Expenditure ------------------------------------------------------------------------------------------------------------------------ Base Model Clean Model BBR Model DR Model ER Model ER SS ER LAC ER SWF (1) (2) (3) (4) (5) (6) (7) (8) ------------------------------------------------------------------------------------------------------------------------ 1st Lag Expenditure 0.639*** 0.665*** 0.659*** 0.664*** 0.652*** 0.637*** 0.652*** 0.677*** Procyclicality (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) 2nd lag Expenditure -0.203*** -0.195*** -0.190*** -0.188*** -0.194*** -0.187*** -0.193*** -0.221*** Procyclicality (0.003) (0.002) (0.003) (0.003) (0.004) (0.005) (0.003) (0.001) Development -0.335** -0.210* -0.208* -0.205* -0.128 -0.132 -0.132 -0.0829 Level (0.028) (0.078) (0.070) (0.067) (0.273) (0.273) (0.248) (0.550) Government -0.0284 -0.0303* -0.0296 -0.0298* -0.0285 -0.0261 -0.0293 -0.0256 Stability (0.110) (0.089) (0.117) (0.096) (0.142) (0.183) (0.128) (0.220) Business Cycles 6.000** 6.800*** 6.860*** 6.910*** 6.593*** 6.358*** 6.568*** 6.074*** (0.010) (0.005) (0.005) (0.004) (0.006) (0.007) (0.007) (0.010) Financial 0.533*** 0.401** 0.406** 0.406** 0.522*** 0.493** 0.534*** 0.565*** Openness (0.002) (0.011) (0.048) (0.022) (0.005) (0.010) (0.003) (0.003) Price 0.812 0.710 0.711 0.730* 0.710 0.697 0.700 0.708 Instability (0.108) (0.102) (0.100) (0.091) (0.111) (0.121) (0.113) (0.101) Revenue 0.912** 0.826** 0.810* 0.808* 0.550 0.509 0.576 0.546 Instability (0.017) (0.046) (0.054) (0.058) (0.188) (0.222) (0.177) (0.196) Exports -0.241 -0.330** -0.325** -0.326** -0.332** -0.332** -0.334** -0.230 Concentration (0.134) (0.031) (0.038) (0.039) (0.035) (0.033) (0.036) (0.157) Workers 0.0470 Remittances (0.151) Fixed Exchange -0.120 Regime (0.225) Resource Rents 0.257 Cycles (0.298) Dependency Ratio 1.124 (0.174) Budget Bal. Rule -0.0537 (0.905) Debt Rule -0.0562 (0.944) Expenditure Rule -1.434** -1.472** -1.362* -1.970** (0.034) (0.031) (0.054) (0.034) Expenditure Rule* 1.469 Small State (0.519) Expenditure Rule* -0.496 LAC (0.694) Sovereign Wealth -0.944* Fund (0.068) Expenditure Rule* 3.634 Sov. Wealth Fund (0.187) Constant -0.115 4.228*** 4.173*** 4.156*** 3.614** 3.649** 3.668** 2.499 (0.973) (0.005) (0.007) (0.006) (0.026) (0.023) (0.025) (0.195) ------------------------------------------------------------------------------------------------------------------------ Observations 408 414 414 414 414 414 414 414 Number of Countries 111 111 111 111 111 111 111 111 Arellano Bond Tests -4.10*** -4.54*** -4.50*** -4.58*** -4.47*** -4.42*** -4.45*** -4.73*** -1.36 -1.59 -1.61 -1.65* -1.37 -1.33 -1.30 -1.27 Sargan Test 20.68 21.55 22.14 22.21 21.84 21.39 21.81 21.07 ------------------------------------------------------------------------------------------------------------------------ Note: Dependent variable is the 10-year rolling correlation of HP-filtered expenditures of general government to HP- filtered GDP. The econometric method used is System Dynamic Panel-data Models with Instrumental Variables. Fiscal rules and Sovereign Wealth Fund are instrumented using the results in section 6. p-values in parentheses. * p<0.1, ** p<0.05, *** p<0.01.
  32. 32. Main Results I • Having fiscal rules: – Improves fiscal balances – Reduces procyclicality of government expenditure – Improves procyclicality of fiscal balance – Unclear results for government debt – Importance of using instruments – Magnitudes of effects are in line with size of fiscal outcomes • Very minor differences in results when including or excluding political controls.
  33. 33. Table 10 Summary of Results Fiscal Outcomes Budget Balance Rule Debt Rule Expenditures Rule de jure de facto de jure de facto de jure de facto Procyclicality of government expenditures  Is there any effect on procyclicality? No No No No Reduced Reduced  Small states are more/less procyclical? No No No No No No  LAC countries are more/less procyclical? No No No No No No Procyclicality of fiscal balances  Is there any effect on procyclicality? No No No No No No  Small states are more/less procyclical? More No No No No No  LAC countries are more/less procyclical? No No No No Less No Fiscal Balance  Do fiscal balances improve? Yes Yes Yes Yes Yes No  Small states have higher/lower balances? No No Lower No No No  LAC countries have higher/lower balances? No No No No No No Government debt  Is debt reduced? No No No No No No  Small states have higher/lower debt? Lower No No No No No  LAC countries have higher/lower? No No No No No Higher
  34. 34. Table 10 Summary of Results Fiscal Outcomes Budget Balance Rule Debt Rule Expenditures Rule de jure de facto de jure de facto de jure de facto Procyclicality of government expenditures  Is there any effect on procyclicality? No No No No Reduced Reduced  Small states are more/less procyclical? No No No No No No  LAC countries are more/less procyclical? No No No No No No Procyclicality of fiscal balances  Is there any effect on procyclicality? No No No No No No  Small states are more/less procyclical? More No No No No No  LAC countries are more/less procyclical? No No No No Less No Fiscal Balance  Do fiscal balances improve? Yes Yes Yes Yes Yes No  Small states have higher/lower balances? No No Lower No No No  LAC countries have higher/lower balances? No No No No No No Government debt  Is debt reduced? No No No No No No  Small states have higher/lower debt? Lower No No No No No  LAC countries have higher/lower? No No No No No Higher
  35. 35. Table 10 Summary of Results Fiscal Outcomes Budget Balance Rule Debt Rule Expenditures Rule de jure de facto de jure de facto de jure de facto Procyclicality of government expenditures  Is there any effect on procyclicality? No No No No Reduced Reduced  Small states are more/less procyclical? No No No No No No  LAC countries are more/less procyclical? No No No No No No Procyclicality of fiscal balances  Is there any effect on procyclicality? No No No No No No  Small states are more/less procyclical? More No No No No No  LAC countries are more/less procyclical? No No No No Less No Fiscal Balance  Do fiscal balances improve? Yes Yes Yes Yes Yes No  Small states have higher/lower balances? No No Lower No No No  LAC countries have higher/lower balances? No No No No No No Government debt  Is debt reduced? No No No No No No  Small states have higher/lower debt? Lower No No No No No  LAC countries have higher/lower? No No No No No Higher
  36. 36. Table 10 Summary of Results Fiscal Outcomes Budget Balance Rule Debt Rule Expenditures Rule de jure de facto de jure de facto de jure de facto Procyclicality of government expenditures  Is there any effect on procyclicality? No No No No Reduced Reduced  Small states are more/less procyclical? No No No No No No  LAC countries are more/less procyclical? No No No No No No Procyclicality of fiscal balances  Is there any effect on procyclicality? No No No No No No  Small states are more/less procyclical? More No No No No No  LAC countries are more/less procyclical? No No No No Less No Fiscal Balance  Do fiscal balances improve? Yes Yes Yes Yes Yes No  Small states have higher/lower balances? No No Lower No No No  LAC countries have higher/lower balances? No No No No No No Government debt  Is debt reduced? No No No No No No  Small states have higher/lower debt? Lower No No No No No  LAC countries have higher/lower? No No No No No Higher
  37. 37. Table 10 Summary of Results Fiscal Outcomes Budget Balance Rule Debt Rule Expenditures Rule de jure de facto de jure de facto de jure de facto Procyclicality of government expenditures  Is there any effect on procyclicality? No No No No Reduced Reduced  Small states are more/less procyclical? No No No No No No  LAC countries are more/less procyclical? No No No No No No Procyclicality of fiscal balances  Is there any effect on procyclicality? No No No No No No  Small states are more/less procyclical? More No No No No No  LAC countries are more/less procyclical? No No No No Less No Fiscal Balance  Do fiscal balances improve? Yes Yes Yes Yes Yes No  Small states have higher/lower balances? No No Lower No No No  LAC countries have higher/lower balances? No No No No No No Government debt  Is debt reduced? No No No No No No  Small states have higher/lower debt? Lower No No No No No  LAC countries have higher/lower? No No No No No Higher
  38. 38. APPENDIX
  39. 39. Data Issues • Full model with political variables (122 countries): – Too few observations of small countries (only 12) – Not many “interesting countries” for LAC (BHR, BWA, CYP, EST, GAB, GMB, GNB, LUX, NAM, QAT, SUR, TTO) • Models excluding political variables – Around 45 small economies – Potential Misspecification • Omitted variables: democracy & gov. stability low correlation • Control of corruption, high correlation (development levels)

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