Presentation - The rleationships between Public finance and Fiscal Policy 24.pptx

Public finance
and
fiscal policy
Petr Wawrosz

Structure of the presentation
 1. Public finance – some basic view
 2. Public finance: some macroeconomic issues
 3. Government debt
 3. Fiscal policy – basic overview
 4. Fiscal policy - some current issues
 5. Fiscal policy – crowding out effect
 6. Fiscal policy – smoothing economic cycle
 7. Fiscal policy – some current issues

Public finance – some basic view

Public finance (PF): some possible
definitions
 Specific financial relationships and operations that are
realized within economic system between the organizations
and other subjects of public sector on the one hand and
other entities on the other (citizens, households,
companies, NGOs,…).
 It is the part of the financial system of a national economy,
that is redistributed by public budgets, they is decided by
public choice and solved by public administration and
public sector and it is subject of public control.

Public finance = financing of
public administrative and sector

The goals of PF(Gruber 2016)
 On the expenditures side of public finance,
we ask:
 What kind of services should the
government provide, if any?
 Why should the government be spending
hundreds of billions of dollars to provide
health insurance to the uninsured (to cite
just one example)?
 More generally, why is the government the
primary provider of goods and services
such as highways, education, and transfers
to the unemployed, while the provision of
goods and services such as clothing,
entertainment, and property insurance is
generally left to the private sector?
 On the revenue side of public
finance, we ask:
 How much should the government
tax its citizens, and how should
that amount be related to the
economic circumstances of those
individuals?
 What kinds of activities should be
taxed or be given tax relief in
difficult times?
 What effect do taxes have on the
functioning of the economy?
The goal of public finance is to understand the
proper role of the government in the economy.

Four questions of PF
 In the simplest terms, public finance
is the study of the role of the
government in the economy. This
study involves answering the four
questions of public finance:
 When should the government
intervene in the economy?
 How might the government intervene?
 What is the effect of those
interventions on economic outcomes?
 Why do governments choose to
intervene in the way that they do?
 When: functions of PF (see next
picture)
 How:
- taxes (revenue) and subsidies
(expenditures)
- Restrict or Mandate Private Sale or
Purchase
- Public Provision: a government
provide the good directly
- Public Financing of Private Provision
 What: direct (costs and revenues) and
indirect effect (how a human behavior
changes)
 Why: normative questions (economics)

Principles and functions of PF
Principles:
Irreversibility
Inequivalence
Involuntary
Functions:
Allocation
(Re)Distribution
Legislative and
regulation
Stabilization

Public finance
– some macroeconomic issues

Public finance: some macroeconomic issues
 Long run public deficit and debt,
economic growth
 Ricardian equivalence
 g and i relationships

Central Government Debt
Percent of GDP (2022)
Source: iMF (2023)
See
https://www.imf.org/external/datamapper/CG_D
EBT_GDP@GDD/CHN/FRA/DEU/ITA/JPN/GBR/U
SA for details

Central Government Debt
Percent of GDP, trend

The relationship between government
debt and economic growth
 Empirical literature usually found negative correlation between public debt
and economic growth in advanced and emerging economies (e.g.Egert 2015;
Calderon & Fuentes 2013; Matiti 2013; Ebernardt & Presbitero 2015;
Favour et al. 2017; Mousa &Shawawreh 2017; Matandare &Tito 2018).
 Other studies find that the results become negative only when
government’s debt reaches a certain threshold (e.g.Pattillo et al. 2011;
Reinhart & Rogoff 2010; Panizza & Presbitero 2012; Dinca & Dinca 2013;
Chirwa & Odhiambo 2017; Pegkas 2018). A large majority of studies on the
debt-growth relationship find a threshold somewhere between 75 and 100
percent of GDP.
 Only limited number of studies (e.g. Al-Zeaud 2014, Owusu-Nantwi and
Erickson 2016) find evidence to suggest that government debt is positively
associated with economic growth.

The negative relationship between government
debt and economic growth
 Rugy and Salmon (2020):
 Large increases in the debt-to-GDP ratio could lead to much higher
taxes, lower future incomes, and intergenerational inequity.
 High public debt can negatively affect capital stock accumulation and
economic growth via heightened long-term interest rates, higher
distortionary tax rates, inflation, and a general constraint on
countercyclical fiscal policies, which may lead to increased volatility and
lower growth rates.
 When the debt-to-GDP ratio reaches elevated levels, the private sector
seems to start dissaving. These findings contradict the Ricardian
equivalence hypothesis, which holds that households are forward
looking and increase their saving in response to increases in
government borrowing.

Summaries of the studies on relationship between
government debt and GDP growth
Source: Rugy and Salmon (2020)

The relationship between government debt and
economic growth – current research
 Pradhan, Rudra P; Arvin, Mak B; Nair, Mahendhiran; Hall, John H
(2022). PUBLIC DEBT, ECONOMIC OPENNESS, AND SUSTAINABLE
ECONOMIC GROWTH IN EUROPE: A DYNAMIC PANEL CAUSAL
ANALYSIS. Journal of Economic Development , 47(1): 167-183.
 This paper examines the short-term and long-term dynamics between public
sector debt, economic openness, and economic growth in European countries
between 1990 and 2018.
 Using the panel vector error correction model, we find that both public debt and
economic openness contribute to long-term economic growth in European
countries.
 The empirical analysis also shows that there are strong endogenous links
between public debt, economic openness and economic growth in Europe in the
short run. These relationships suggest that governments in Europe should give
careful attention to the co-curation of macroeconomic policies pertaining to
public sector spending/taxation, economic openness, and economic growth.

Long run public deficit and debt
 The debt should be investigated from long run perspective. Some effects can lead to
short run deficit but in long run they have no positive or negative effects (see
example).
 Gokhale and Smetters (2003): Suppose that the government offers you the following
deal when you are 20 years old. When you retire, the government will pay you $1 less
in Social Security benefits. In return, the government will reduce the payroll tax that
you pay today to finance the Social Security program by 8.7, the present value of that
$1.22 In terms of the government’s net obligations throughout the future, this policy
has no impact; it is lowering current tax revenues and lowering future expenditures by
the same present discounted value amount.

Long run public deficit and debt
 From today’s perspective, however, this policy increases the deficit because it lowers
current tax revenues but does not lower current expenditures. As a result, the current
deficit will rise, leading to higher national debt for the next 50 years until this payroll
tax reduction is repaid through lower benefits.
 This example is even more striking if we consider the following alternative: the
government offers to pay you $1 less in Social Security benefits, in return for which the
government will reduce your payroll tax today by only half of the present value of that
$1. Yet, from today’s perspective, it is still cutting current taxes and not reducing
current expenditures, so the deficit and the debt are rising.

Factors affecting the future of government
debt and its present value
 Which factors are taken into
consideration (Is e.g. right the
assumption that government policy
remains unchanged?)
 Growth rate of GDP
 Interest rate
 Indirect effects (e.g. improvement of
environment and nature thanks to
present investments causing prevent
debt)
 Even 10 years estimations are usually
wrong (see next picture).

Projected vs. actual surplus/deficit of US
government (federal) budget
Source:
Gruber (2016)
Greenspan (2001): “. . . the continuing unified budget surpluses currently projected
imply a major accumulation of private assets by the federal government. . . . It would be
exceptionally difficult to insulate the government’s investment decisions from political
pressures. Thus, over time, having the federal government
hold significant amounts of private assets would risk suboptimal performance by our
capital markets, diminished economic efficiency, and lower overall standards of living
than would be achieved otherwise.”

Ricardian Equivalence
 Ricardian equivalence is an economic theory that says that financing government spending
out of current taxes or future taxes (and current deficits) will have equivalent reverse effects
on the overall economy.
 This means that attempts to stimulate an economy by increasing debt-financed government
spending will not be effective because investors and consumers understand that the debt will
eventually have to be paid for in the form of future taxes.
 The theory argues that people will save based on their expectation of increased future taxes to
be levied in order to pay off the debt, and that this will offset the increase in aggregate
demand from the increased government spending.
 This also implies that fiscal policy will generally be ineffective at boosting economic output

 Barro (1974) modeled and generalized Ricardian
equivalence, based on the economic theory of
rational expectations and the lifetime income
hypothesis.
 Because investors and consumers adjust their
current spending and saving behaviors based on
rational expectations of future taxation and their
expected lifetime after-tax income, reduced
private consumption and investment spending
will offset any government sending in excess of
current tax revenues.
 The underlying idea is that no matter how a
government chooses to increase spending,
whether through borrowing more or taxing more,
the outcome is the same and aggregate demand
remains unchanged.

 Some economists, including Ricardo himself, have argued that Ricardo's theory is
based upon unrealistic assumptions. For instance, it assumes that people will
accurately anticipate a hypothetical future tax increase and that capital markets
function fluidly enough that consumers and taxpayers will be able to easily shift
between present consumption and future consumption (via saving and
investment).
 it is widely understood (e.g. Evans et al. 2013) that Ricardian Equivalence does
not generally hold if agents are not dynamic optimizers
(e.g., if agents choose current consumption
on the basis of current disposable income),
if households are liquidity constrained,
if taxes are distortionary, if government
spending is not exogenous to financing,
or if households effectively have finite horizons.
 Empirical results are ambiguous
(for details see Haug 2017).

Public debt: g and i relationship
 g: averrage growtg rate per year
 i: weight averaage yearly interest rate of government borrowing
 One major determinant of public sector debt sustainability is how the
cost of debt compares to the resources available to service it.
 As long as the nominal average interest rate on government debt (i) is
smaller than the nominal GDP growth rate (g), a country’s government
debt-to-GDP-ratio may remain stable even with a primary budget
deficit.
 This gap is widely known as the “interest-growth (g-i) differential.
 The primary deficit is the difference between the government’s revenues
and expenditures, excluding debt servicing costs.

Public debt: g and i relationship
 Past and projected i-g under different fiscal policy scenarios (percentage
points)(projection solid lines: gradual fiscal consolidation, dashed lines: no fiscal
consolidation)

Does higher debt lead to higher interest
rates?
 One argument we often hear is that
if government borrowing increases –
we can expect higher bond yields.
Investors demand higher yields to
compensate for the risk of
government default.
 However, other economists argue
this is misleading. If inflation is low,
and there is surplus savings in the
economy, higher debt will not cause
rising bond yields. In recent years,
rising government debt has led to a
fall in bond yields.

rates?
 Why might higher debt levels lead to
higher bond yields?
 1. Fear of default. If a government borrows
too much, investors may fear that the
government is at risk of default. If the
government borrows too much, they may
not be able to meet repayments in the
future – meaning bonds will not be repaid
by the government. If investors fear this is
a possibility they will not want to buy
bonds but sell.

rates?
 Why might higher debt levels lead to higher
bond yields?
 2. Inflation. If a government borrows too much,
the government may be tempted to deal with
the debt by increasing the money supply
(printing money) and paying off the debt
through inflation. But, if this happens investors
will lose the real value of their bonds. The bonds
will fall in value because inflation is reducing
their real worth. (This is sometimes known as
default through inflation). If investors fear
inflation, they may sell bonds, causing interest
rates to rise.

rates?
 Why higher debt levels do not lead
to higher bond yields?
 1. Risk of default very minimal. It
is rare for a developed economy to
default on government debt.
Countries like the UK and US
have not suffered an outright debt
default in their history. Japan has
a public sector debt of over 230% of
GDP, but bond yields remain very
low. Investors don’t fear a
Japanese government default and
therefore are willing to keep
buying Japanese bonds.
Risk of country default in 2023

rates?
 Why higher debt levels do not lead to
higher bond yields?
 2. Lender of last resort. For countries
with their own currency (let us ignore
Eurozone economies for the moment), the
Central Bank can always step in and
purchase government debt. If necessary
the Central Bank could create money in
order to purchase government bonds.
This helps avoid any liquidity fears
markets may have.

rates?
 Why higher debt levels do not lead to higher
bond yields?
 3. Debt and economic cycle. During a
recession, government debt tends to rise.
This is due to cyclical factors, such as a fall
in income tax revenue and higher welfare
spending. This leads to higher debt, but in a
recession, the private saving ratio tends to
rise. There is greater demand for buying
government bonds in a recession because
people are looking for a safe haven for their
excess savings. Therefore, bond yields tend
to fall during a recession – because there is
greater demand for buying bonds.
 When the economy recovers, savers start to
look for more profitable uses for their
savings (e.g. stock market, private
investment), therefore as the economy
recovers bonds become less attractive and
interest rates start to rise.

Some terms
 Gross government debt (GGD) consists of the
liabilities owed by general government.
 Data covers the consolidated General government
and its subsectors. The 'general government sector'
consists of all government units, all non-market non-
profit institutions (NPIs) that are controlled by
government units and other non-market producers.
Government units are legal entities established by
political process possessing legislative, judicial or
executive authority over other institutional units
within a given area.
 General government gross debt, is expressed as a
percentage of GDP. The calculation formula is:
(GGDt / GDPt) * 100.
 Net government debt could be broadly defined as the
stock of a specific set of government's liabilities
minus the stock of a specific set of financial assets
held by government.

Government net debt as a share of
gross domestic product (2023)

Some terms
 The primary deficit focuses on the difference
between government revenues and spending,
excluding interest payments.
 Many analysts and economists point out that
when the primary deficit is small and interest
rates are lower than the growth rate of nominal
GDP, the debt-to-GDP ratio will fall.
 US case: the primary is deficit projected to
average 2.1 percent of GDP over the next decade
— and with interest rates at relatively high levels
— debt will continue to grow faster than our
economy. CBO estimates that debt held by the
public will climb to nearly 116 percent of GDP in
2034 — higher than at any point in the nation’s
history.
US primary and total deficit

How to Tackle Soaring Public Debt
 IMF blog
(https://www.imf.org/en/Blogs/Articles/20
23/04/10/how-to-tackle-soaring-public-
debt)
 An adequately tailored fiscal contraction
of about 0.4 percentage point of GDP—
the average size in our sample—lowers
the debt ratio by 0.7 percentage point in
the first year and up to 2.1 percentage
points after five years.

 But the timing of the adjustment can
impact what effect it has.
 The probability of reducing debt ratios
through consolidation improves from the
baseline (average) of about half to three-
quarters when undertaken during a
domestic and global boom or periods
during which financial conditions are
loose and uncertainty is low.

 Design also matters. In advanced economies, spending cuts are more likely to lower
debt ratios than increasing revenues. Odds of success also improve when fiscal
consolidation is reinforced by growth enhancing structural reforms and strong
institutional frameworks.
 This explains why fiscal consolidation hasn't typically reduced debt ratios in the
past—the right conditions and accompanying policies weren’t present.
 There are important factors for why fiscal consolidation alone didn’t reduce the debt
ratio level in about half of the cases:
 first fiscal consolidation tends to slow GDP growth
 Second, exchange rate fluctuations and transfers to state-owned enterprises or
contingent liabilities can offset debt reduction efforts.
 These “below-the-line” operations can increase debt, despite improvements in the
primary balance (which would ordinarily drive down debt). Examples include
unexpected transfers that the government provided to state-owned enterprises in
Mexico (2016), and clearance of payments past due by the government in Greece
(2016), which were all recorded as below the line items in the fiscal account.

 While well-designed fiscal consolidation and growth-friendly structural reforms can
help reduce debt ratios, they may not be sufficient for countries in debt distress or
facing increased rollover risks. In such cases, debt restructuring—a renegotiation
of the terms of a loan—may be necessary.
 Restructuring is typically used as a last resort. It’s a complex process that requires
the agreement of domestic and foreign creditors and involves burden sharing
between different parties (for example, between residents and banks in most
domestic restructurings). It can incur significant economic costs and there are
reputational risks and coordination challenges.
 But when combined with fiscal consolidation, it can significantly reduce debt
ratios—on average, up to 8 percentage points or more after 5 years in emerging
markets and low-income countries.

 Seychelles, for example, had a debt ratio of over
180 percent in 2008, when the global financial
crisis hit. After debt restructurings with both
official Paris Club and private external
creditors that involved a large reduction in face
value of debt, this ratio sharply declined to 84
percent in 2010. Prudent fiscal policy combined
with high GDP growth helped sustain the
reduction in debt ratios.
 It matters how deep the restructuring is. Public
debt in Belize remained elevated despite two
sequential restructurings, suggesting that even
when done early, debt will stay high if the
treatment is not deep enough.
 By contrast, debt ratios in Jamaica were
significantly reduced with early and deep
restructurings that were executed through an
extension of maturity and a reduction in coupon
payments rather than a reduction in the face
value of debt. Notably, the fiscal space created
by the debt service relief from restructuring
was saved, as reflected in its strong fiscal
consolidation.

 For countries that can afford a moderate and
gradual reduction in debt ratios, it’s best to
undertake fiscal consolidation when conditions
are favorable, along with policies that include
structural reforms aimed at promoting growth.
 Having strong institutional frameworks can
prevent "below the line" operations that
undermine debt reduction efforts and ensure
that countries indeed build buffers and reduce
debt during good times.
 Countries facing increased funding pressures
or already in debt distress may have no viable
alternative than a substantial or rapid debt
reduction.
 Fiscal consolidation will likely be needed to
regain market confidence and recover
macroeconomic stability in these countries. In
addition, policymakers should also consider
timely debt restructuring. If pursued, the
restructuring will need to be deep to reduce
debt ratios.

Development of US government debt

US interest payments from government debt
relative to GDP

Czech government deficit/surplus

Structure of Czech government budget
revenue

Czech government budget - expenditure

Dynamics of public debt in Russia, billion
rubles

Budgeting at times of high
inflation
March 2023
The Czech Fiscal Council

Inflation in the Czech Republic
 Inflation started to soar at the end of 2021.
 Even before the Russian invasion, inflation in Czechia was close to 10%.
 The central bank’s interest rate was close to zero during COVID-19.
 The central bank began to raise its interest rate in the second half of 2021.
 The interest rate was raised to 7% in July 2022 and has stayed there ever since.
5.8% October 2021
9.9% January 2022
18% September 2022
0
2
4
6
8
10
12
14
16
18
20
Jan-…
Mar-…
May…
Jul-18
Sep-…
Nov…
Jan-…
Mar-…
May…
Jul-19
Sep-…
Nov…
Jan-…
Mar-…
May…
Jul-20
Sep-…
Nov…
Jan-…
Mar-…
May…
Jul-21
Sep-…
Nov…
Jan-…
Mar-…
May…
Jul-22
Sep-…
Nov…
Jan-…
CPI in Czechia (2018–2022)
0.75% August 2021
7% June 2022
0
1
2
3
4
5
6
7
8
Jan-18
Mar-18
May-18
Jul-18
Sep-18
Nov-18
Jan-19
Mar-19
May-19
Jul-19
Sep-19
Nov-19
Jan-20
Mar-20
May-20
Jul-20
Sep-20
Nov-20
Jan-21
Mar-21
May-21
Jul-21
Sep-21
Nov-21
Jan-22
Mar-22
May-22
Jul-22
Sep-22
Nov-22
Jan-23
Central bank main interest rate (monthly average)

Public finances in Czechia before the energy crisis and high
inflation
65
 Even before the energy crisis, Czechia had been living through a period of
fiscal expansion and fiscal imbalances.
 The central government budget has recently been ending in huge deficits:
2020: CZK 367 billion (6.5% of GDP)
 The deficits are not predominantly due to one-off Covid-19 measures but to
measures influencing the structural balance.
For example, the 2020 personal income tax cut means CZK 100 billion less in
revenue.

How does inflation affect public finances?
66
Public revenues
Both positive and negative effects can appear.
 Value added tax is influenced by both effects.
 Higher prices mean higher tax and therefore higher revenue.
 Higher prices mean a decrease in consumption and therefore lower revenue.
 In 4Q 2022, real household consumption expenditure dropped by 5.5% (y/y).
 Personal income tax and social security contributions
 The increase in these revenues depends on the dynamics of wages, in other words, how
much wages keep pace with inflation.
 In 2022, the average wage grew by 6.5% (CPI 15.1%).

67
Public expenditures
Expenditure indexation
 The increase in expenditure depends on how strong the indexation of
pensions, social benefits and public sector salaries is.
Energy prices
 Increase in expenditure due to capping of prices of electricity and gas for
households and companies + aid for firms in energy-intensive industries.
 Increase in expenditure because of purchase of natural gas for state
material reserves + more expensive intermediate consumption.

68
Government debt
 Higher inflation lowers the ratio of government debt
to nominal GDP.
 Not so much if there is a big difference between
the GDP deflator and CPI.
Czechia in 2022:
 GDP deflator: 8%, versus CPI: 15.1%
𝑃𝑢𝑏𝑙𝑖𝑐 𝑑𝑒𝑏𝑡 1
𝐺𝐷𝑃1
=
𝑃𝑢𝑏𝑙𝑖𝑐 𝑑𝑒𝑏𝑡 0
𝐺𝐷𝑃0
(
1+𝑟
1+𝑔
) +
𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝑏𝑎𝑙𝑎𝑛𝑐𝑒1
𝐺𝐷𝑃 1
r = average interest rate on debt
r = 2.3%
g = GDP growth
The primary balance is the
fiscal balance excluding net
interest payments on public
debt. That is, the primary
balance is the difference
between the amount of
revenue a government
collects and the amount it
spends on providing public
goods and services.

69
Pensions
 Pensions are valorised according to the following formula:
Valorisation of pensions = CPI (whole) + ½ of growth of real wages
 The law also imposes extraordinary valorisation if CPI exceeds 5 percentage
points in the year-on-year index since the last valorisation (typically in June).
 The average pension increased by 17% between 2021 and 2022 and by 24.7%
between 2020 and 2022.
Anti-inflation government bonds
 Starting in 2019, individuals were able to buy anti-inflation government bonds.
 This programme was stopped at the end of 2021. But interest costs obviously
remain…

Discretionary measures adopted by the Czech government
in 2022–2023
70
 Cancellation of road tax (CZK 5 billion yearly): 0.07% of GDP
 Reduction of excise duty on fuel (CZK 10 billion yearly): 0.15% of GDP
 One-off child allowance (CZK 7 billion): 0.1% of GDP
 One-off household electricity allowance (CZK 17 billion): 0.25% of GDP
 Waiver of payment for renewables (CZK 23 billion): 0.34% of GDP
 Capping of electricity and gas prices (CZK 100 billion): 1.47% of GDP
 Aid for firms in energy-intensive industries (CZK 30 billion): 0.44% of GDP
 Windfall tax + levies on excess income in energy sector (CZK 100 billion): 1.47%
of GDP

71
Social
benefits
Salaries (excluding education and healthcare)
Payment to health insurance companies
Education
CZK 2,223 billion
CZK 1,928 billion
CZK -295 billion (4% of
GDP)
Energy price cap + aid for firms
Intermediate consumption
Interest payments
Social security
contributions
Corporate income
tax
Personal income tax
Excise duty
Value added tax
Windfall tax + levies on excess
profits
Indexation to CPI
Promise of 130% of
average wage for all
teachers
Pressure to increase due to
inflation
Indexation to CPI
Expensive services and energy
Higher due to higher CB rates
Structure of the state budget in 2023

Unexpected effects of high inflation on the indexation of social benefits
72
Due to this formula:
Valorisation of pensions = CPI (whole) + ½ of growth of real wages
 Real wages are only accounted for if their growth is positive. If it is negative,
they are not accounted for and pensions are valorised by the whole CPI.
 In the current period of high inflation (15.1%) and a huge decrease in real
wages, the replacement rate is soaring. The gap between the average wage
and the average pension is closing…
 There is an ongoing discussion about a new pension valorisation formula.

73
Average pension (left scale) and replacement rate (right
scale)

Zvýšení důchodů v červnu 2023
 67ca
 (1) Při zvýšení důchodů v mimořádném termínu v červnu 2023 se nepoužije §
67 odst. 10 a 16; při tomto zvýšení se procentní výměry vyplácených důchodů
zvýší tak, že procentní výměra důchodu se zvyšuje
 a) o 2,3 % procentní výměry důchodu, která náleží ke dni, od něhož se
procentní výměra zvyšuje, a
 b) o 400 Kč; jsou-li splněny podmínky nároku na výplatu více důchodů, zvyšuje
se o tuto částku ten důchod, který se vyplácí v plné výši (§ 4 odst. 2 věta první).
 V záasdě se nezvyšovalo o reálnou mzdu.

Inflation and public debt
 imf.org/en/Blogs/Articles/2023/04/03/fiscal-policy-can-help-tame-inflation-and-
protect-the-most-vulnerable
 unexpected inflation—such as in the recent episode—erodes the real value of
government debt at the expense of bondholders. For countries with debt
exceeding 50 percent of GDP, each percentage point of unexpected (“surprise”)
increase in inflation reduces public debt by 0.6 percentage points of GDP, with
the effect lasting for several years.
 As inflation becomes persistent and better anticipated, however, it stops
contributing to declining debt ratios.
 Likewise, deficit-to-GDP ratios initially decline as spending fails to keep pace
with the rise in the monetary value of the economy’s output. But such effects
fade even quicker.

 Fiscal policy can support monetary policy in dealing with inflation because it also affects aggregate
demand. Our statistical evidence suggests that fiscal policy’s impact on inflation has changed over
the decades. For advanced economies we find that, since 1985, reducing public expenditure by 1
percentage point of GDP lowers inflation by half a percentage point.

 The economic model incorporates inequality in incomes, consumption, and
asset holdings. It shows that when central banks act alone—without the
support of fiscal policy—they need to hike interest rates substantially to fight
inflation. Fiscal tightening makes it possible to increase interest rates by less
to contain inflation.
 But to safeguard the poor—who benefit more from public services—tax hikes
or cuts in lower-priority spending must be combined with larger transfers. This
strategy results, by design, in no drop in consumption for the poor, but also in a
lower decline in overall consumption.

Fiscal policy – basic overview

Fiscal policy
 Fiscal policy refers to the use of government spending and tax policies to influence
(macro)economic conditions, including aggregate demand for goods and services,
employment, inflation, level of GDP and economic growth.
 Fiscal policy is largely based on ideas from John Maynard Keynes, who argued
governments could stabilize the business cycle and regulate economic output.
 In Keynesian economics, aggregate demand is what drives the performance and
growth of the economy. According to Keynesian economists, the private sector
components of aggregate demand (C, I, NX) are too variable and too dependent on
psychological and emotional factors to maintain sustained growth in the economy.
 Pessimism, fear, and uncertainty among consumers and businesses can lead to
economic recessions and depressions, and excessive exuberance during good times
can lead to an overheated economy and inflation. However, according to Keynesians,
government taxation and spending can be managed rationally and used to counteract
the excesses and deficiencies of private sector consumption and investment spending
in order to stabilize the economy.

Fiscal policy
 Keynes:
 Higher YD => higher probability that
YD > C => ↑ S (savings)
 Saving must be somehow used
 The „first possibility“: investment
 However: animal spirit, state of
confidence
 If they are low => low investment (lower
than saving) => unused resources

Investment
 Expenditures of companies on capital goods + change in inventories.
 In AE: Ip includes renewal (Ir) and net investments (In) + planned
inventory change (Ivp).
 Ip = Ir + In + Ivp
 The value of investments (Ir + In) determines the value of capital goods
(K).

Investment and their dependences
 The investment must be paid for.
 1. The invested amount (RC) must be
reimbursed.
 2. The firm must obtain a return at least if it
invests elsewhere (OPC).
 When investing, companies compare what the
additional investment will give them (the
yield from the investment, MRPK) to the
investment cost (MCK).
 MCK consists of RC and OPC.
On the horizontal axis: the
amount of capital good, on
the vertical axis yields
(revenues) from and costs
for the amount.

 MCK from the point of view of the company
independent, therefore horizontal.
 MRPK declining, the law of diminishing
marginal yields applies.
 Firms will invest (renew a capital good or buy
a new one) till MRPK = MCK.
If MRPK < MCK than the yield generating
from the investment (a capital good creating
by investment) does not cover costs
connecting with investment.
 Optimal level of capital gods (K*): the value
for MRPK = MCK.

 If something changes, the MRPK or the MCK changes. Also, the optimal level of capital (K*)
changes (it increases or decreases). Companies then invest more or less (their net
investment is positive or negative), and they have more or less capital goods.

 Technological progress
 Marginal product change
 Change in income from the marginal product due to a change in prices
 GDP development
 How OPC changes
 Political, legal and other stability.
 The future, uncertainty. Most factors cannot be influenced.

Fiscal policy
 Keynes: If investment are lower than saving and the economy suffer from
unused resources, the government can use the source for expansionary fiscal
policy and so achieve the level of potential GDP.

Expansionary or Contractionary fiscal policy
 Expansionary Policies
 Recession.
 The government might issue tax stimulus rebates to
increase aggregate demand and fuel economic
growth.
 When people pay lower taxes, they have more money
to spend or invest, which fuels higher demand. That
demand leads firms to hire more, decreasing
unemployment, and to compete more fiercely for
labor. In turn, this serves to raise wages and provide
consumers with more income to spend and invest.
It's a virtuous cycle, or positive feedback loop.
 Rather than lowering taxes, the government may
seek economic expansion through increases in
spending (without corresponding tax increases). By
building more highways, for example, it could
increase employment, pushing up demand and
growth.
 Expansionary fiscal policy is usually characterized
 Contractionary Policies
 Economy is above protentional GDP,
high inflation and other expansionary
symptoms,
 Increasing taxes, reducing public
spending, and cutting public-sector
pay or jobs.
 Where expansionary fiscal policy
involves deficits, contractionary fiscal
policy is characterized by budget
surpluses.
 This policy is rarely used, however, as
it is hugely unpopular politically.
Public policy makers thus face a major
asymmetry in their incentives to
engage in expansionary or
contractionary fiscal policy.

The cyclical behaviour of fiscal policy: A meta-analysis (2023)
 https://www-sciencedirect-
com.infozdroje.czu.cz/science/article/pii/S0264999323000718?via%3Dihub
 Whether fiscal policy exacerbates or counteracts fluctuations in the economy is a
key policy issue, because it contributes to growth and inflation outcomes.
However, existing literature provides partly contradictory findings.
 Therefore, we provide the first quantitative synthesis by applying meta-
regression methods to a novel data set with 3536 cyclicality estimates from 154
studies.
 Our main findings are: on average, fiscal policy in advanced countries is
countercyclical, but developing countries lean towards procyclicality.
 Furthermore, government spending policies exacerbate business cycle
fluctuations more than tax policies.
 Finally, fiscal policy plans are more countercyclical than policy outcomes.
Results are robust to tackling endogeneity between the business cycle and fiscal
policy.

Fiscal policy in AS and AD model

Logic of fiscal policy: multiplier
 Expenditure multiplier:
 ∆𝐘 = 𝛂𝟒𝒔 ∗ ∆𝐀,
𝛂𝟒𝒔 = 1/(1 – c *(1-t) + im)
 ∆𝐀 = ∆𝐆 𝐨𝐫 𝐜 ∗ ∆𝐓𝐑
 Tax multiplier:
 ∆𝐘 = 𝛂𝟒𝑻𝒔 ∗ ∆𝐀,
 𝛂𝟒𝑻𝒔 = c/ /(1 – c *(1-t) + im
Some possible situations:
It is expected that
value of multipliers
is higher than 1.

The value of multiplier
 Cottareli,Gerson and Senhadji (2014): there is no unique value of any multiplier
(MPL). They depend:
 Automatic stabilizers: their presence ↑ value of MPL
 Share of import: higher share ↓ value of MPL
 Public debt: higher value ↓ value of MPL
 Development of financial sector: no clear relationship
 The value of GDP per capita (a developed or underdeveloped economy): higher share
↑ value of MPL
 Relationship between GDP (Y) and potential GDP (Y*) : if Y is closely below or
somewhere above Y*↓ value of MPL
 Ramsey (2011, 2018): expenditure multiplier 0,5-2 (2011), respective 0,6-1 (2018)
 Difference between expansionary multiplier and contractionary multiplier:
Barnichon and Matthes (2018) expansionary below 1, contractionary above 1.
 Ag et al. (2012) fiscal multiplier in a period of expansion is between 0 and 0.5, and
ranges from 1.5 to 2.0 in a period of recession.

The value of multiplier
- Jerow & Wolff (2022)
- government spending multipliers are smaller in episodes characterized by high
macroeconomic uncertainty. This state dependence is found to be statistically and
economically significant and robust to several alternative specifications.
- In simulations, we find significant volatility in multipliers as well as co-movements
that qualitatively match our empirical results.
- We find that these results are generated by a reallocation away from risky assets
following the government spending shock which triggers a financial accelerator
mechanism in our model; we then show that this channel is also active in the data.
- We conclude that uncertainty plays a significant role in determining the effectiveness
of fiscal policy and that business cycle models which abstract from uncertainty can
produce misleading policy recommendations.

Box: financial accelerator
 The financial accelerator in macroeconomics is the process by
which adverse shocks to the economy may be amplified by
worsening financial market conditions. More broadly, adverse
conditions in the real economy and in financial markets
propagate the financial and macroeconomic downturn.
 The link between the real economy and financial markets
stems from firms’ need for external finance to engage in
physical investment opportunities.
 Firms’ ability to borrow depends essentially on the market
value of their net worth. The reason for this is asymmetric
information between lenders and borrowers.
 Lenders are likely to have little information about the
reliability of any given borrower. As such, they usually
require borrowers to set forth their ability to repay, often in
the form of collateralized assets.
 Afall in asset prices deteriorates the balance sheets of the
firms and their net worth. The resulting deterioration of their
ability to borrow has a negative impact on their investment.
 Decreased economic activity further cuts the asset prices
down, which leads to a feedback cycle of falling asset prices,
deteriorating balance sheets, tightening financing conditions
and declining economic activity. This vicious cycle is called a
financial accelerator.
 It is a financial feedback loop or a loan/credit cycle, which,
starting from a small change in financial markets, is, in
principle, able to produce a large change in economic

Examples of (small) positive impact
of fiscal policy
 Raifu, Isiaka Akande; Aminu, Alarudeen (2023). The effect of military spending
on economic growth in MENA: evidence from method of moments quantile
regression. Future Business Journal, 9(1): 7. DOI:10.1186/s43093-023-00181-9
 MENA, an acronym in the English language, refers to a grouping of countries
situated in and around the Middle East and North Africa.
 This study adopted a novel quantile regression via moments to explore the
effects of military spending on the distribution of economic growth of 14 MENA
countries over the period from 1981 to 2019.
 An increase in military expenditure and military burden by 1% would raise
economic growth (real GDP) by 0.040%.

Examples of (small) positive impact of fiscal policy
 AlMarzoqi, Raja; Sarra Ben Slimane; Altamimi, Saud (2023). Nonlinear Fiscal
Multipliers in Saudi Arabia. Economies, 11(1): 11. DOI:10.3390/economies11010011
 Government spending multipliers ranged between 0.09 and 0.19 in the short term and
between 0.31 and 0.38 in the long term.
 Assenova, Kamelia (2023). SMALL OR BIG IS FISCAL MULTIPLIER? Economic and
Social Development: Book of Proceedings, Varazdin.
 Fiscal multiplier for this period is 0.21. It is with small value, but is statically significant.
Compare with such multiplier calculated for the first decade after the transition, it has
increased. There are the differences between the impact of public spending on GDP in
first and last quarters of every year and second and third. The most effective are the
public spending in last quarter.

Examples of impact of fiscal policy
 Klyvienė, Violeta; Jakaitienė, Audronė (2022). Fiscal adjustments: lessons from and for
the Baltic states. Baltic Journal of Economics, 22(1): 1-27.
DOI:10.1080/1406099X.2021.2020985
 In 2009, Estonia, Latvia and Lithuania experienced a sudden stop of capital inflow with
the banks abruptly cutting down on lending, which caused a sharp drop in domestic
demand. This consequently led to notable fiscal consolidation in order to adjust to the
different economic reality.
 Previously, the economies of the Baltic states had already been challenged by the Russian
financial crisis of 1998.
 During these two crisis periods all three countries reacted in a similar way, i.e. by
implementing procyclical fiscal consolidation. Expenditure cuts, mostly to wages and
public investment, were the immediate policy choice, especially during the global
financial crisis. In addition, the Baltic states also increased taxes, primarily in 2009 and
2010.

 The impact of an increase in direct taxes on GDP in Latvia is relative sluggish reaching a
maximum value of 0.7% in the tenth quarter. However, this is significant only in the first
period.
 The impulse response values in Lithuania are very similar to the Latvian ones, but are
more persistent and significant over the estimation horizon. The impulse response
coefficient is initially 0.04% and increases to 0.5% in the fourth quarter, peaking at 0.8%
in the sixth quarter.
 The effect of direct taxes on GDP in Estonia is negative, although not statistically
insignificant except the first quarter.

 The effect of indirect taxes on GDP is less consistent across the region and remains small
and unstable throughout the estimation horizon.
 For example, in Lithuania, it is positive and significant only in the first quarter and then
turns negative and insignificant.
 In Estonia, it remains positive but small for the entire impulse response horizon, reaching
a maximum value of 0.2% in the fourth quarter before gradually converging to 0.
 In the case of Latvia, it starts as negative in the first quarter to then also gradually
converge to 0.
 Weak and unstable coefficients for indirect taxes could be explained by relatively inelastic
private consumption patterns in the Baltic countries.
 Output responses to increases in government consumption in Latvia are negative for their
entire analysis period; however, it is significant only in the first period.
 In Lithuania, the impulse response coefficients are positive and increase substantially from
0.3 in the first quarter to 1.0 in the sixth quarter, showing a high persistence of government
consumption shocks on GDP.

The Baltic Countries at the Eve of the Crisis, 2007 (Percent of GDP,
unless otherwise noted)

Baltic states: situations before crisis
 As they joined the EU, the Baltics entered a new boom phase. Their economies
quickly bounced back after the 1998–99 Russian crisis, supported by closer
integration with the Nordic countries. Private sector confidence was further boosted
by the adoption of the acquis communitaire and the prospect of imminent euro
adoption following entry into the EU’s exchange rate mechanism (ERM2) in 2005.
 The key drivers of this boom were bank lending and a corresponding acceleration of
domestic demand.
 Credit demand was fueled by high permanent income expectations and very low real
borrowing rates on eurodenominated loans, which quickly became the predominant
form of borrowing.
 On the supply side, banks’ lending was in large part funded by borrowing from their
Nordic foreign parents who were eager to gain market share in these rapidly
growing markets. But even domestically-owned banks in Latvia and Lithuania had
little difficulties to attract funding through non-resident private deposits or to
borrow on the global wholesale market. Credit growth and capital inflows (as a
share of GDP) to the Baltics exceeded those to most other CEE countries and
reflecting the role of parent-bank funding their loan-to-deposit ratios rose sharply.

Baltic states: crisis start
 Growth started slowing in early 2008, before the onset of the global financial and real
crises. The two main Swedish banks active in the region, recognizing the
vulnerabilities associated with their rapidly expanded Baltic exposures, sought to
engineer a controlled deceleration of credit growth from 40–60 percent per annum in
2005–07 to a targeted 20-25 percent.
 Confidence was also dented by S&P’s change in the rating outlook and a short-lived
currency run in Latvia (February 2007), political tensions between Estonia and Russia
(May 2007) and first global financial market jitters (August 2007).
 Led by deflating equity and real estate bubbles, real activity started to decelerate in
the first half of 2008, especially in Latvia and Estonia.
 Meanwhile, inflation remained high (partly due to the global commodity price boom,
convergence and increases in indirect tax rates and regulated prices, but more so to
excessive domestic demand), and wage growth continued unabated.

Baltic states: crisis start
 The Lehman’s bankruptcy dramatically accelerated the downturn in all the countries
and threatened to unhinge financial stability.
 Foreign-owned banks experienced varying degrees of loss of depositor confidence
across the Baltics reflecting the freeze-up of global financial flows and concerns about
the health of parent banks. But the drying up of global wholesale markets also
impacted domestically-owned banks. T
 he prime victim in the Baltics was Parex Banka, with a market share of 20 percent,
Latvia’s second largest bank: outflows of non-resident deposits, which had already
started after the Russian-Georgian war in the summer of 2008, turned into a deposit
run; moreover, large syndicated loans were falling due. In view of its systemic
importance, the Latvian government in October 2008 took a 51 percent stake in the
bank (later extended to 85 percent) and imposed partial deposit withdrawal
restrictions. The Bank of Latvia also lowered reserve requirements and the policy rate
in an effort to provide liquidity to the financial system.

Baltic states: fiscal situation before and in crisis
 At first glance, the Baltics entered the crisis
with comparatively favorable fiscal positions
only to see their deficits and debt rise
considerably.
 Why did the crisis impact fiscal positions so
dramatically?
 In large part the answer lies in the past
policies. While deficits appeared low in an
international perspective and in line
Maastricht deficit criterion, underlying
imbalances were in fact growing in
cyclically-adjusted terms and had reached
between 5-7 percent of GDP by end-2008 in
all three countries-

Fiscal situation of Baltic states
before and during crisis
 The spending overhang. On the back of rising
tax receipts, expenditure had risen rapidly
the boom years, primarily on items that are
typically more difficult to reverse.
 The growth of public sector salaries and
social benefits far outpaced inflation. In
Lithuania, for example, social benefit outlays
rose in real terms by 44 percent between
2006–08, driven by a more than 60 percent
increase in sickness pay, a near 40 percent
increase in pension spending, and a doubling
of spending on maternity benefits.
 Similar patterns were seen in Latvia and in
Estonia through mid-2008.
 Consequently, when the crisis hit and GDP
and tax receipts fell back to 2006 levels,
spending remained at 2008 peaks.

Fiscal situation of Baltic states
before and during crisis
 The fiscal deficit risked to balloon, threatening financing and confidence. Under
unchanged policies, the 2009 deficit would have been around 16–18 percent of
GDP in Latvia and Lithuania and exceeded 10 percent in Estonia.
 Financing such large fiscal gaps would have been extremely challenging given the
extreme stress in international financial markets and the limited capacity of
domestic debt markets. Even more importantly, deficits of such magnitude would
have undermined confidence and called into question the longer-term
compatibility of fiscal policies with the exchange rate pegs and eventual euro
adoption.

Fiscal consolidation in Baltic states after 2008
 The Baltics therefore had little alternative but
to implement sizeable fiscal consolidation that
was unprecedented by historical and
international standards.
 Including the original and subsequent
supplementary budgets in 2009, the net fiscal
adjustment was by far the largest in Latvia,
comprising just over 11 percent of GDP on a
net basis in just a single year. As a result, the
headline deficit ended 2009 at a substantially
better than expected 7 percent of GDP on a
cash basis (9 percent of GDP in ESA 95 terms).
 However, only in Estonia did the adjustment
prove sufficient to more than offset the
structural and automatic effects discussed
above, allowing it to keep its fiscal deficit well
below the 3 percent of GDP Maastricht level
and thus paving the way to euro adoption in
2011.

 The adjustment strategies were expenditure-led. As Table 3shows, expenditure
savings comprised a large part of the adjustment effort in 2009, ranging from
about half of the total in Estonia and Latvia to more than three-quarters in
Lithuania.
 The focus on the expenditure side was appropriate given the increase in
spending that occurred over the boom that is no longer in-line with new
revenue outlook. It is also in line with international experience that shows
large scale fiscal adjustments are most successful when driven by spending
measures. The composition of adjustment also reflected a long held-preference,
shared by all three Baltics, to maintain low levels of taxation.

 Estonia

Units 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Gross domestic
product, constant
prices Percent change 9.766 7.579
-
5.132
-
14.62
9 2.444 7.263 3.228 1.458 3.011 1.853 3.155 5.792 3.784 3.740
Gross domestic
product per capita,
constant prices
Purchasing power
parity; 2017
international dollar
28,88
4.094
31,21
5.352
29,69
2.895
25,39
7.992
26,07
8.191
28,05
7.354
29,06
6.947
29,59
6.009
30,54
8.735
31,11
3.334
32,08
5.781
33,90
3.126
35,06
3.859
36,24
0.227
Output gap in percent
of potential GDP
Percent of potential
GDP 9.035
11.82
9 3.618
-
10.99
4
-
8.285
-
2.740
-
1.589
-
2.334
-
1.683
-
2.072
-
1.409 1.090 1.685 1.390
Total investment Percent of GDP
39.83
2
40.00
8
31.63
4
21.01
0
21.58
9
25.56
7
29.35
6
27.22
8
27.15
1
25.09
4
25.20
3
26.46
3
28.02
9
26.05
5
Unemployment rate
Percent of total labor
force 5.912 4.592 5.455
13.54
9
16.70
7
12.32
5
10.02
3 8.628 7.351 6.185 6.758 5.763 5.371 4.448
Population Persons (milions) 1.347 1.341 1.337 1.335 1.331 1.327 1.323 1.318 1.315 1.315 1.316 1.317 1.322 1.327

 Latvia

Subject
Descriptor Units 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Gross
domestic
product,
constant
prices
Percent
change 11.965 9.943 -3.243 -14.248 -4.471 2.564 7.037 2.011 1.900 3.885 2.368 3.313 3.989 2.484
Gross
domestic
product
per capita,
constant
prices
Purchasing
power
parity; 2017
internation
al dollar 22,890.212 25,383.047 24,750.752 21,508.541 20,957.069 21,970.045 23,858.767 24,590.907 25,338.065 26,526.187 27,390.591 28,571.465 29,953.032
30,927.
571
Output
gap in
percent of
potential
GDP
Percent of
potential
GDP
Total
investmen
t
Percent of
GDP 39.848 41.586 35.295 22.473 20.373 25.735 27.488 24.318 23.879 23.740 21.176 22.009 23.255 23.245
Unemploy
ment rate
Percent of
total labor
force 7.033 6.075 7.750 17.550 19.475 16.208 15.048 11.868 10.847 9.875 9.642 8.715 7.415 6.311
Populatio
n
Persons
(millions) 2.228 2.209 2.192 2.163 2.121 2.075 2.045 2.024 2.001 1.986 1.969 1.950 1.934 1.920
Decline in population (2006-2019):
about 300 thousands of inhabitants

 Lithuania
Subject Descriptor Units 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Gross domestic product, constant prices Percent change 7.414 11.107 2.615 -14.839 1.652 6.039 3.844 3.550 3.537 2.024 2.519 4.282 3.993 4.574
Gross domestic product per capita,
constant prices
Purchasing power parity;
2017 international dollar
23,021.9
93
25,884.8
32
26,836.2
03
23,109.1
28
23,988.6
10
26,018.3
58
27,383.2
04
28,643.7
70
29,913.0
18
30,807.0
17
31,987.0
68
33,826.6
12
35,514.6
17
37,237.4
57
Output gap in percent of potential GDP Percent of potential GDP
Total investment Percent of GDP 26.947 32.309 28.124 12.657 18.126 21.962 19.760 19.526 19.623 21.270 19.208 19.181 20.353 17.565
Unemployment rate Percent of total labor force 5.778 4.248 5.827 13.787 17.814 15.390 13.366 11.770 10.699 9.119 7.861 7.073 6.146 6.254
Population Persons (millions) 3.270 3.231 3.198 3.163 3.097 3.028 2.988 2.958 2.932 2.905 2.868 2.828 2.802 2.794
Decline in population (2006-2019):
almost 500 thousands of inhabitants

Fiscal policy – crowding out effect

Logic of fiscal policy: IS-LM model, crowding out effect
 IS-LM model takes into account the role
of interest rate (i).
 Fiscal expansion (shift IS to the right)
increases i , that reduces C and I.
 Crowding out effect can be expressed as
the difference between expenditure
multiplier and fiscal policy multiplier.
 CGE = (𝛂𝟒𝒔 - γ) * ∗ ∆𝐀
 Fiscal policy multiplier:
 𝛄 =
𝛂
1+
𝛂∗𝐛∗𝐤
𝐡
 We expect following equations for IS and
LM curve:
 IS: 𝐘 = 𝛂𝟒𝒔 ∗ (𝐀𝐘𝐈 − 𝐛 ∗ 𝐢 + 𝛎 ∗ 𝐑𝐄𝐑)
 LM: 𝐢 =
1
𝐡
∗ (𝐤 ∗ 𝐘 − 𝐌𝐒)).
 Equation of money demand:
MD = k * Y – h * i

Crowding out effect: possible situation in IS-LM model
Classical situation, demand for money does
not depend on i. People want to realize fixed
number of transactions.
Absolute crowding out effect.
Liquidity trap: i is too low, the belief
in future negative events.
No crowding out effect.

Crowding out effect: possible situation in
Mundell-Fleming (MF) model
Flexible exchange rate: no change of Y.
Absolute crowding out effect.
Fix exchange rate: no change of i.
No crowding out effect.
MF model does not take into account factors affecting the value of i (e.g. country risk) and
capital flow need not be perfect especially in time of crisis.

Crowding out effect
Violet values: GDP after fiscal expansion without crowding out effect
The crowding out effect is affected by relationship between Y and Y*.
if Y is closely below or somewhere above Y* ↑ crowding out effect.

Limitation of crowding out effect
 Thanks to technological progress
supply can Y* shift to the right, but
demand (for instance due to
stickiness) does not sufficiently
respond to the shift.
 Y is thus below (new) Y*.
 Expansionary fiscal policy can
smooth the production gap,
1
2
Year (source: IMF) 2002 2003 2004 2005 2006 2007 2011 2012 2013 2014 2015 2016 2017 2018 2019
GDP (% change) 1.742 2.861 3.799 3.513 2.855 1.876 1.551 2.249 1.842 2.526 3.076 1.711 2.333 2.997 2.161
Output gap (% of
potential GDP)
-
2.081
-
2.287
-
1.422
-
0.641
-
0.269
-
0.682
-
6.874
-
6.030
-
5.384
-
4.085
-
2.310
-
1.872
-
0.962 0.444 0.967
General government net
lending/borrowing ‚(% of
GD)P
-
3.812
-
4.764
-
4.238
-
3.069
-
2.029
-
2.910
-
9.703
-
8.028
-
4.564
-
4.058
-
3.556
-
4.364
-
4.591
-
5.786
-
6.349
US development

Crowding out effect: a current research
 Picarelli, Vanlaer, Marneffe (2019): study concerns public investment of 26 EU countries
(not Luxembourg and Malta) for 1995-2015 period
 Their results:
 1% increase in public debt in the EU brings about a reduction in public investment of
0.03%.
 The results are mainly driven by high-debt countries.
 The negative impact of debt on investment is slightly smaller in the Eurozone than in the
entire EU;
 Both the stock and flow of public debt play a role in reducing public investment with the
impact of the latter that is found to be more profound.
 They do not find no significant difference during and after the crisis (2009-2015).

 Demirel, Erdem and Eroğlu (2019)
 Used data for the 2000–2015 period for 14 countries in the Eurozone
(Germany, Austria, Belgium, Finland, France, Holland, Spain, Italy,
Luxemburg, Greece, Malta, Slovakia, Slovenia, and Cyprus)
 They found
- statistically negative correlations between government debt and GDP
growth, and between interest rate (IR) and private investments (PINV),
- statistically significant and negative relationship between budget deficit
(BD) and PINV. An increase in BD causes a rise in IR. Finding of a positive
relationship between BD and IR supports this conclusion.

 Moretti, Steinwender & Van Reenen (2020):
 The study explores one particular segment of federal spending — defense research
and development — and its effects on private sector R&D expenditure. OECD
countries, 1987.
 Main conclusion: Elasticity for the OECD data set is 0.434 . . . suggesting that a 10%
increase in government subsidies in the given year is expected to result in a 4%
increase in private sector R&D the following year. This implies that $1 of additional
public funds for R&D translates into $5 of extra R&D funded by the private sector.

 Three reasons as to why this “crowding-in effect” may not be taking the place.
 First, is that frontier technology projects have extremely high fixed costs — whether
in the form of equipment or labor — so by letting the public sector fund the research,
it allows the private sector to realize higher profits.
 Second is “spillover effects”, where new technologies (e.g. GPD) find different
applications in the private sector. GPS, for instance, was first developed to help
missiles find their targets.
 Third are credit constraints on the private sector, where a project is difficult to fund
without government support due to, say, an economic downturn.

Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Total
investment (%
of GDP) 22.177 21.708 21.742 22.659 23.381 23.539 22.592 21.119 17.805 18.743
General
government net
lending/borrow
ing '% of GDP) -0.537 -3.812 -4.764 -4.238 -3.069 -2.029 -2.910 -6.630 -13.197 -11.024
General
government
gross debt (% of
GDP) 53.146 55.504 58.615 66.119 65.467 64.197 64.665 73.706 86.752 95.487
2011 2012 2013 2014 2015 2016 2017 2018 2019
Total
investment (%
of GDP) 19.104 20.021 20.414 20.806 21.163 20.415 20.547 21.040 21.014
General
government
net
lending/borro
wing '% of
GDP) -9.703 -8.028 -4.564 -4.058 -3.556 -4.364 -4.591 -5.786 -6.349
General
government
gross debt (%
of GDP) 99.833 103.324 104.852 104.508 104.643 106.604 105.746 106.890 108.679
Stable share of investments on GDP in the USA => no clear crowding out effect

Fiscal policy – smoothing economic cycle

Automatic stabilization or discretionary stabilization
 Automatic stabilization occurs through
policies that automatically cut taxes or
increase spending when the economy is in a
downturn in order to offset recession-
induced declines in household consumption
levels. Such automatic stabilization is
provided by, for example, the unemployment
insurance program, which pays benefits to
unemployed workers to offset their income
losses.
 The aim: to smooth economic cycle,
especially due to consumption
 Discretionary stabilization occurs
through policy actions undertaken
by the government to offset a
particular instance of an
underperforming or overperforming
economy, for example, a tax cut
legislated during a recession.

Consumption smoothing
 Consumption smoothing is made by many ways e.g. pension systems,
unemployment insurance, health system, ….
 The primary aim is usually not to smooth consumption, although usual
primary aim (to help to maintain sufficient standard of living) is
connected with consumption smoothing.
 Is consumption smoothing always beneficial? Does not a program
reduce private savings?
 Condition from a person point of view (at least one must be satisfied):
 Unexpected random event.
 Insufficient wealth (impossibility to save due to low income)
 Bounded rationality (insufficient strong will to save for covering future
situation.)

Do automatic stabilizers (especially pension
system) reduce private savings?
 Yes. For instance:
 Vaillancourt (2015): study concerns Canada - increases in the compulsory CPP
contribution rate were followed by decreases in the private savings rate. This
drop in private savings is after accounting for changing interest rates and
shifts in demographics such as age, income, and home ownership. The results
associate a 0.895 percentage point drop in the private savings rate of the
average Canadian household with each percentage point increase in the total
CPP contribution rate, holding other factors constant.
 Rob (2020): study concerns Netherlands. Their mandatory pension system
consists of two parts: a public pay-as-you-go part that provides a minimum
income to all Dutch inhabitants over age 64; and an occupation-specific capital-
funded part that provides supplementary retirement income.
Occupational pensions have a significant negative impact on savings motives
with respect to old age. This can be explained by the fact that individuals take
their pension rights into account when they answer such questions.
Ambiguous results

Do automatic stabilizers (especially pension
system) reduce private savings?
 No. For instance:
 Ertugrul and Gebesoglu (2019): study concerns Turkish private pension system
- that is designed as a voluntary based third pillar pension scheme supported
by tax deduction. Their conclusion: Private pension system in Turkey has
contributed to raising national savings.
 Unclear. For instance:
 Addido, Roger, Savignac (2020): Study concerns on some European countries
(Belgium, France, Germany, Greece, Italy, Luxembourg, Portugal). Their
results point to a large heterogeneity across European countries with respect
to the pension-savings offset, which partly explains cross-country differences in
saving behaviors. The pattern of the pension-savings offset along the non-
pension wealth distribution varies from country to country.
 Other factors: pension scheme (pay as you go, fund), retirement age,
demographic structure, political stability, inflation,….
Ambiguous results

Fiscal policy – some current issues

Public finance and fiscal policy
 Gruber (2016) There are a number of interesting questions about the
stabilization role of the government. These questions have not, however, been
the focus of the field of public finance for more than two decades. This lack of
attention perhaps reflects the conclusion in the 1970s that the tax and
spending tools of the government are not well equipped to fight recessions,
given the long and variable lags between when changes are proposed and when
laws become effective.
 Government failures.
 Time lags.

Some current research: fiscal policy after
Great recession (Šehovic 2015)
 The economic crisis restored the central role of fiscal policy right after the recognition
that monetary policy has reached its limit.
 The precondition for using fiscal stimulators and for the success of the abovementioned
stabilization fiscal policy depends on fiscal space: IMF defined it as the difference
between the current and the maximal level of demand which the state can afford
without endangering its solvency.
 The sharpest decline in the economic activity in the crisis years (2008-2012) is noted in
those states that have not in a quality way managed fiscal space prior the crisis.
 The world economic crisis resulted in the need for better automatic stabilizers because
such measures of fiscal policy, which automatically react to changes in economic policy
without a direct state influence, revitalize negative consequences of changes in demand
or supply. It becomes clear that discretional measures of fiscal policy, aimed at economy
stabilization, are faced with time delays which noticeably reduce their efficiency and
timeliness, and they affect an increase of budget deficit

Some current issues: fiscal policy and banking
crisis
 Fetai (2017) investigates the efficiency of fiscal policy as the respond to banking
crisis.
 It concerns 101 episodes of banking crisis in transition and emerging countries
during the period 1980 to 2013.
 Main conclusion:
 Fiscal expansion has significant effect on shortening the duration of the crisis by
more than three-quarters.
 The only factor that does not have any impact on the duration of the crisis but could
make longer the length of the crisis (by more than three months), is government
intervention in the financial sector. Moreover, government intervention in the
financial system by recapitalizing stressed banks and enabling them to lend again
during the financial crisis is likely to worsen the crisis rather than restore the
economic growth.

Some current issues: fiscal policy and banking
crisis
 Fetai (2017) investigates the efficiency of fiscal policy as the respond to banking
crisis.
 Result also suggests that the income tax cuts are a more effective tool than
government consumption, public investment and goods and service taxes in
shortening the length of the crisis. A decrease in the income tax by 1% would
shorten the length of the crisis by around two months, which is not case with public
consumption, public investment and goods and service taxes.
 Fiscal expansion does not have a statistically significant effect on economic growth
after the crisis. An increase in the public investment by 1% will generate a positive
effect on real GDP by 0.14% in the medium term, while if income tax cuts are
reduced by 1% it will have a positive effect on real GDP by 0.014%.

Some current issues: unconventional fiscal policy
 D'Acunto, Hoang, and Weber (2019) based on Correia et al. (2013) define unconventional
fiscal policies as those policies that generate an increasing path of consumption taxes that
result in households‘ higher inflation expectations and negative real interest rates.
(Nominal interest rates are still positive but close to zero).
 Negative real interest rates can stimulate household consumption, and result in increased
spending, and ultimately higher growth. Thus, the main objective of unconventional fiscal
policies is to increase households‘ inflation expectations even when conventional monetary
policy is constrained.
 D'Acunto, Hoang, and Weber (2019) investigated announcement of Polish government in
July 2010 to increase the general VAT from 22% to 23% and the reduced rate to 8% from
January 2011. They use confidential micro data from the market research firm GfK (1000
Polish household). The research reveal highest willingness to buy durable goods before
increase.
 See next slide.
 General conclusion: Pre-announced VAT increases combined with lower income taxes
including tax credits -would result in a predictable increase in inflation without inducing
uncertainty. They would increase consumer spending and hence growth, but would not lead
to higher budget deficits, without affecting the total tax burden of households.

Polish expected increase in inflation and
average readiness to spend on durables
Source: D'Acunto, Hoang, and Weber (2019)

Czech experience with tax increase
Period Basic VAT rate
Reduced VAT
rate
Second
reduced
VAT rate
1. 1. 1993 – 31.
12. 1994
23 % 5 % –
1. 1. 1995 – 30.
4. 2004
22 % 5 % –
1. 5. 2004 – 31.
12. 2007
19 % 5 % –
1. 1. 2008 – 31.
12. 2009
19 % 9 % –
1. 1. 2010 – 31.
12. 2011
20 % 10 % –
1. 1. 2012 – 31.
12. 2012
20 % 14 % –
1. 1. 2013 – 31.
12. 2014
21 % 15 % –
1. 1. 2015 –
present
21 % 15 % 10 %*
Year 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
GDP (%
change) 5.570 2.686 -4.657 2.435 1.760 -0.785 -0.046 2.262 5.388 2.537
C (%change) 3,1 2,5 0,5 1,2 -0,8 -1,3 1,3 1,3 3,3 3,4
I (% change) 14,3 0,9 -17,7 4,2 1,8 -4,2 -4,2 7,1 13,1 -4,0
Inflation (%
change) 2.873 6.318 1.029 1.473 1.917 3.279 1.439 0.352 0.326 0.667
Growth of Czech VAT rate in 2008, 2010, 2012,
2013 negatively contributes to Czech GDP
growth, consumption and investment
development and it did not resulted in higher
inflation rate in long run.

Some current issues: problems of fiscal policy
 Kenneth Rogoff (2020):
 Fiscal policy inevitably involves messy, hard-fought compromises – often
overturned by future elections anyway – that most countries have turned to central
banks for short-term stabilization policy.
 The modern, independent, technocratic central bank is arguably the greatest
innovation in macroeconomics since John Maynard Keynes pioneered demand
management. Governments can and should make the big decisions about the long-
term direction of policy, but anyone who thinks that legislatures can consistently
make fine-tuned decisions is living in an alternative reality.

 The fact is that in most countries today, economic policy is highly polarized, with
decisions being made by razor-thin majorities.
 In the United States, for example, fiscal policy for Democrats largely means an
opportunity to engage in more spending and transfers. For Republicans, it means
cutting taxes in order to downsize government.
 Such differences are a recipe for seesaw policy. As a short-run stabilization tool,
fiscal policy will inevitably be difficult to time and calibrate in the same way that
central banks have succeeded in doing with monetary policy.

 Especially over the past 20 years, central bankers have increasingly recognized
that consistent, stable, and predictable policies are just as important as any short-
term decision-making. Indeed, at conference after conference, central bankers can
be heard weighing the nuances of slight changes in messaging and their effects on
expectations.
 But in West Wing-style academic papers, fiscal-policy functions – government
spending and tax policy – are assumed to be totally stable and predictable. All
problems concerning credibility and consistency are assumed away.

Covid 19 and fiscal policy
 For country details see:
 Fiscal policy in specific country: International Monetary Fund:
https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19
 Some data and figures: https://www.imf.org/en/Topics/imf-and-covid19/Fiscal-
Policies-Database-in-Response-to-COVID-19

Covid 19 and fiscal policy
Fiscal policy reduced the
impact of the COVID-19
crisis on poverty, but less so
on poorer economies

Fiscal Policy in a Time of High Inflation
 The Committee for a Responsible Federal Budget (2022):
 Monetary policy fights inflation through two channels – by reducing
demand and by re-anchoring future inflation expectations.
Expansionary fiscal policy can undermine both effects, while
contractionary fiscal policy can reinforce them.
 Specifically, spending increases and tax cuts work to boost demand in
the near term, while high levels of projected deficits and debt can boost
inflation expectations. This is especially true if markets believe the
government will attempt to inflate away a portion of its debt.

 The Committee for a Responsible Federal Budget (2022):
 By enacting inflation-reducing fiscal adjustments, policymakers can ensure all parts
of government are working to temper inflation and signal that both fiscal and
monetary policy are taking the inflation threat seriously. Enacting deficit reduction
during a period of high inflation can also help to reassure markets that elected
officials are committed to responsible policy and won’t attempt to undermine
Federal Reserve tightening in the future should inflation persist.
 Some fiscal (and regulatory) policy changes can even avoid pain associated with
inflation reduction by boosting the supply of goods, services, and labor in the
economy. For example, budget-neutral improvements to work incentives would
help ease tightness of the labor market, reducing inflationary pressures by bringing
supply up toward demand rather than the reverse.

 What should be done:
 Temper Demand. One key way to reduce inflationary pressures is by
lowering demand for goods and services. In layman’s terms, this means
discouraging excessive spending in the economy. Fiscal policy is well
equipped to achieve this goal and can do so through higher taxes, lower
transfer payments, or reductions in direct government spending. For
example, limiting tax deductions would reduce take-home pay and thus
household spending.
 Boost Supply. Boosting the supply of labor, capital, and natural
resources can also help to right inflation. In other words, policymakers
should pursue policies that increase the number of workers and hours
worked, support investment, reduce barriers to production and trade,
and expand extraction or production of energy and other resources.
These policies should also avoid increasing demand in the process. For
example, removing work disincentives in the Social Security program
can help to increase labor force participation and increase the
economy’s productive capacity, thus helping to limit inflation.

 What should be done:
 Lower Prices. Federal policy can sometimes use its micro-economic
tools to directly lower the costs of specific goods or services,
particularly when the government is already setting the price. They
can also reform existing tax, spending, and regulatory policies that
currently drive up prices, such as over-subsidizing some activities or
creating barriers to competition. These policy changes should focus on
reducing overall prices, not just shifting costs onto the government. For
example, selectively reducing Medicare provider payments would lower
health care prices and thus inflation.

Budget rigidities will constrain fiscal policy for years to
come
 https://blogs.worldbank.org/developmenttalk/budget-rigidities-will-constrain-fiscal-
policy-years-come
 Budget rigidities are institutional, legal,
contractual, or other constraints
that limit the ability of governments to
change the size and composition
of the public budget, at least in the
short term. They originate, among
other things, from demographic
factors such as an aging population and
rules that predetermine the level of certain
types of expenditure.

Budget rigidities will constrain fiscal policy
for years to come
 Countries with higher budget rigidity tend to spend more and have higher tax
rates. Budget rigidity is also associated with lower efficiency of public spending and
reduced fiscal space.
 If budget rigidities are perceived to prevent the government from reducing budget
deficits, financial markets will downgrade the government’s quality rating as a
borrower, which would increase a government’s financing costs.
 COVID-19, along with the war in Ukraine, is likely to lead to higher budget rigidity
amid higher debt levels and increased spending. Higher debt and debt-servicing
costs have already constrained the COVID-19 fiscal responses of developing
countries, where tax cuts and spending increases have been relatively modest . The
ratio of public debt to GDP, which increased sharply in 2020 because of the crisis,
has stabilized in 2021, but in the coming years it is expected to remain persistently
higher than the levels projected before the pandemic, constraining governments’
ability to consolidate fiscal deficits and stabilize debts.

for years to come

for years to come
 Reducing budget rigidities would help policy makers address fiscal
imbalances and make fiscal policy more effective. An effective strategy
would involve:
 Increasing the retirement age and facilitating private sector
participation in the pension funds sector.
 Ensuring that medium-term fiscal planning incorporates the costs of
any wage increases or any support required to buffer future pension
payments.

for years to come
 Delegating decisions on long-term budget composition to technical fiscal
councils, such as the wage bill or allowance for early pension withdrawals
(which were ubiquitous during the COVID crisis).
 Increasing budget transparency to reduce the need for spending floors or
spending rules and ensure allocation of resources to the most cost-effective
activities.
 Reducing budget fragmentation, given that the complete picture of public-
resource allocation and distribution allows for a more expedient budget
approval process as circumstances evolve.
 Limiting earmarking and introducing exit clauses to existing constitutional
spending mandates.

Fiscal policy and income inequality The
role of taxes and social spending
 Hazel Granger, Laura Abramovsky and Jessica Pudussery (September 2022)
 https://odi.org/en/publications/fiscal-policy-and-income-inequality-the-role-of-
taxes-and-social-spending/
 Fiscal policy can reduce within-country income inequality by up to 40%. The
greatest impact on inequality has been in high-income countries (HICs) and
upper-middle-income countries (UMICs), where fiscal capacity is high and
there is a broad tax base. Fiscal policy in low-income countries (LICs) achieves
only a 3% reduction in inequality on average.
 In richer countries, social safety nets and flexible tax policy played a key role
in enabling a quicker recovery to the Covid-19 pandemic, and in some cases
partially mitigated further poverty and inequality. This experience highlighted
the need for fiscal systems to both be redistributive over the lifecycle, as well to
build resilience during shocks.

Fiscal policy and income inequality The
role of taxes and social spending
 Revenue mobilisation does not need to preclude more equitable policy choices since
some revenue reforms can be both efficient at raising revenue and equalising, especially
when combined with high-quality equitable social transfers.
 Lower income inequality before and after fiscal intervention can also be beneficial for
economic growth and, in turn, for revenue mobilisation as the tax base expands.
 Opportunities for equitable economic growth include increasing progressivity of income
tax, improving efficiency of consumption taxes, removing inefficient subsidies and tax
exemptions to help finance enhanced social insurance and a mix of complementary in-
kind transfers and targeted equitable cash transfers.
 The design and quality of cash transfers and in-kind transfers, through the delivery of
health and education public services, are paramount to ensure positive net returns to
fiscal intervention.

Equity or efficiency? Possible relationships
All figures:
Horizontal axis: equity
Vertical axis: efficiency
Point of intersection of the axis:
efficiency = equity = 0

GC = A/(A + B)
GC = Gini coeffcient
Tedy:

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