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World
World
Economic
Economic
Outlook
Outlook
Fall 2010
Will It Hurt? Macroeconomic Effects of
Fiscal Consolidation
Daniel Leigh, Pete Devries, Charles Freedman,
Jaime Guajardo, Douglas Laxton, and Andrea
Pescatori
with support from Murad Omoev,
Min Song and Jessie Yang.
Setting the Scene



Advanced economies face challenge of fiscal consolidation.
What are the macro effects of tax hikes and spending cuts?
Role of monetary policy, international trade, tax-spending
composition, perceived sovereign risk.
Fiscal Balance/GDP
0
Government Debt/GDP
110
-1
-2
1 00
-3
-4
90
-5
-6
80
-7
-8
70
-9
-10
2005
10
15
60
2005
10
Source: IMF World Economic Outlook database. Note: Advanced economy weighted average. General government.
15
Main Results

Fiscal consolidations are contractionary : GDP falls,
unemployment rate rises in the short term.

Monetary easing (ER↓, R↓) + NX boom = key cushioning role.

Contractionary for both spending cuts and tax hikes but more for
tax hikes. Key: R↓ more for spending cuts.

Contractionary for both high sovereign default risk and low risk
but more for low risk.

Long-term gains.
Roadmap

Looking at History (Empirical Analysis)
New approach for identifying episodes.
 Fresh evidence: short-term effects.


Model Simulations: GIMF
Zero lower bound, synchronized adjustment.
 Long-term effects.
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Identifying Fiscal Consolidation
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Conventional approach: outcome-based (CAPB).
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Sample selection bias  expansionary effects.
Alesina and Ardagna (2010), many others.

Action-based definition: historical accounts and records
(OECD Economic Surveys, IMF documents, budgets).

15 OECD countries 1980-2009: 173 cases of fiscal consol


G7, AUS, BEL, DNK, FIN, IRL, PRT, ESP, SWE.
Mean size of 173 cases: 1% of GDP.
Example: Fiscal Consolidation in Japan in 1997

Fiscal consolidation totals 1.8 % of GDP.

Tax hikes: of 1.2 % of GDP, spending cuts of 0.6 % of GDP.

Part of medium-term strategy of fiscal consolidation (Fiscal
Structural Reform Act) in response to large structural fiscal
deficit and future demographic pressures.

Sources: 1997 IMF Staff Report for Japan.
Macroeconomic Effects

Estimation approach: Romer-Romer-style.
g: growth rate of real GDP.
 FC: action-based consolidation in % of GDP.
 Cumulate responses to estimate GDP level.

2
2
j 1
s 0
git      j gi ,t  j   s FCi ,t s uit
uit  i  t  vit
Robustness: different lag lengths (up to 4), no lags of growth. Similar results.
Fiscal Consolidation is Contractionary


Impact of 1% of GDP fiscal consolidation.
GDP down ½ percent. Unemployment rate up ⅓ point.
Note: Consolidation in year t=1. Point estimates and one standard error bands.
Usually: Monetary Mitigation

Monetary conditions ease in response to fiscal consol.


Interest rates fall.
Currency looses value (both real and nominal).
Interest Rate
(Basis points)
Exchange Rate
(Percent)
Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands.
Transmission Channel: Net Exports


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NX increase plays key offsetting role. Contribution ↑ 0.5%.
Domestic demand ↓ 1%.
Exports rise 1%, imports fall 1%.
Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands.
Does Composition Matter?


Tax-based vs. spending-based consolidation.
Both are contractionary, but spending-based less so.
Unemployment Rate
GDP
Tax-based
Spending-based
Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands.
Does Composition Matter? (Cont.)
Domestic Demand
Tax-based
Spending-based
Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands.
Composition and Monetary Policy

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Spending-based: interest rate cuts, currency loses value.
Tax-based: interest rate hikes.
Policy Rate
(Basis points)
Real Effective Exchange Rate
(Percent)
Tax-based
Spending-based
Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands.
Role of Perceived Sovereign Default Risk
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Low perceived risk  “Keynesian” contraction.
High risk  milder contraction.
Denmark/Ireland = outliers.
Denmark (1983) and Ireland (1987)
High risk
Low risk
Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands.
Contrast with the Literature
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Our sample using AA (2010) episodes  expansionary effects.
Interpretation: sample selection bias.
Action-based approach (large > 1.5%)
Standard approach (∆CAPB/GDP > 1.5%)
GDP
Unemployment Rate
Note: Impact of additional 1% of GDP consolidation in year t=1. Point estimates and one standard error bands.
GIMF: Zero Interest Rate Floor
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Canada and Rest of the World.
With zero interest rate floor  contractionary effect doubles.
ZIRF + synchronized adjustment  effect doubles again.
Impact of Fiscal Consolidation of 1% of GDP on GDP
With zero interest rate floor
Without zero interest rate floor
Canada-only fiscal consolidation
Global fiscal consolidation
GIMF: Long-term Effects
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G3 debt/GDP ↓ 10pp  interest rate ↓ 30 bps.
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Interest payments ↓  taxes ↓ (or spending ↑)
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GDP ↑ range of outcomes:
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Minimum: 0.5% (savings used to raise general transfers)
Maximum: 1.5% (savings used to cut capital income taxes)
Rest of world benefits (lower interest rate).
Lessons for Today

Fiscal consolidations are contractionary in short-term.

Monetary easing (ER↓, R↓) + NX boom = key
cushioning role. But less today (zero R, synchronized).

Less contractionary for high risk than for low risk.

Reforms needed: retirement age, entitlement programs.

Long-term gains. Lower interest rates, lower taxes.
Appendix
Episodes of Fiscal Consolidation:
Action-based vs. Standard Approach
JPN 1999
FIN 2000
JPN 2006
BEL 1984
FIN 1993
IRL 1982 ITA 1993
FIN 1992
IRL 2009
Action-based approach
Standard approach
(change in cyclically adjusted primary balance)
DEU 1996
Tax vs. Spending: Additional Results
Tax-based
GDP
Domestic Demand Contribution
Spending-based
Unemployment Rate
Net Exports Contribution
Note: Impact of 1% of GDP consolidation in year t=1. Point estimates and one standard error bands.
Composition and Monetary Policy (cont.)
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Why do monetary conditions ease less for tax-based?
Central banks view spending cuts favorably (signal discipline)?
Inflation impact of (indirect) tax hikes.
Policy Rate
(Basis points)
Tax-based (indirect)
Tax-based (direct)
Spending-based
GDP
(Percent)
Note: Impact of 1% of GDP consolidation in year t=1.
Spending Composition

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Transfers cuts more benign than cuts to government
consumption or investment.
Confidence effects? Results only suggestive.
Cuts to government transfers
Cuts to public consumption
Cuts to public investment
Note: Impact of 1% of GDP consolidation in year t=1.
Long-Term Effects (GIMF)