Globalization and budget financing: Looking towards International Markets? Luiz de Mello Economics Department, OECD 19 September 2005

Globalisation and public finances: Size and scope of government 1 The efficiency hypothesis: constraints globalisation imposes on the ability of the government to raise revenue. “Fiscal termites hypothesis” (Tanzi, 2001, 2002); Shift in the composition of government revenue in OECD countries (Bretschger and Hettich, 2002); “Tax reaction function” (Devereux et al., 2002); “Tax handle” hypothesis (Tanzi, 1967, 1973; Musgrave, 1969; Cameron, 1978; Katzenstein, 1985).

Globalisation and public finances: Size and scope of government 2 The compensation hypothesis: greater risk arising from globalisation- induced job losses. Higher government spending on education (Avelino et al. (2005), for Latin America); Federalism: mismatches in expenditure-revenue assignments (Sáez, 2001). Does globalisation exacerbate volatility and therefore increases risk? Labour market risk, deindustrialisation and demands for social protection (Iversen and Cusack, 2000); Role of trade unions and partisan composition of government (Garrett, 1998; Garrett and Mitchell, 2001; Kittel and Winner, 2005).

Globalisation and public finances: Size and scope of government 3 The shock absorber hypothesis: social insurance against terms-of- trade volatility and its effect on income and consumption Rodrik (1997, 1998). Question marks: Tanzi and Schuknecht (2000), Obstfeld and Taylor (2002), Tanzi and de Mello (2005); Related literature: Political integration (Wei, 1991; Alesina and Spolaore, 1997; Bolton and Roland, 1997; Panizza, 1999; Alesina, Spolaore, and Wacziarg, 1997); Federalism and risk pooling (Persson and Tabellini, 1996a, 1996b; Garret and Rodden, 2002).

Globalisation and public finances: Fiscal outcomes Background The literature has focused primarily on testing the efficiency and compensation/shock absorber hypotheses. Compensation/shock absorber hypotheses make the implicit assumption that globalisation is, or should be, deficit-neutral; Efficiency hypothesis overlooks the fact that international competitiveness also depends on the government’s ability to maintain a stable macroeconomy, which implies sound public finances. Hypothesis Trade and financial openness places a higher premium on fiscal discipline at all levels of government (de Mello, 2005): Openness facilitates access to alternative sources of budget financing but also increases market scrutiny over public finances.

Globalisation and public finances (PBF, Spring 2005) Does openness constrain sub-national budget imbalances? Fiscal data: GFS middle-tier budget balance and debt, some discussion on data quality; Globalisation: trade, financial (AREARS, FDI, foreign bank ownership), telecom traffic, black-market premium. Testable hypothesis: access vs. discipline

Cross-sectional evidence 1

Cross-sectional evidence 2

Cross-sectional evidence 3

Empirical findings Openness is associated with lower budget deficits Strong correlation between globalisation indicators and central government fiscal stance, controlling for debt and growth; Reasonably robust to different estimators (FE, 2SLS, GMM). Non-linear effect: higher deficit and then lower deficit as globalisation deepens Effect of market discipline overtakes that of market access.

Globalisation and fiscal outcomes: Panel data evidence

Globalisation and budget financing Controls: ratio of M2 to GDP and the ICRG corruption index. Country selection: GDP per capita > USD (1995 USD) in 2000 in WDI database. => at most 774 observations for 57 countries during , excluding top and bottom deciles of domestic budget financing and top decile of trade openness.

Baseline results Association between changes in the budget balance and in domestic financing is less than one-to-one; no financial autarky. Trade openness is associated with lower domestic financing. Negative sign of the M2-to-GDP ratio: financial crowding-out? ICRG is positive but insignificant. Robustness: M3, credit to private sector and liquid bank reserves instead of M2. Average import tariff instead of trade-to-GDP ratio. S&P/IFS investment index and the sovereign risk premium instead of ICRG index. Inclusion of per capita PPP income, changes in real effective exchange rate and the terms of trade, government consumption, and interest spread.

Threshold effects? 3 levels of openness: low, intermediate and high. Raising openness from: Low to intermediate level reduces the sensitivity of domestic financing in RE model; Intermediate to high level increases the sensitivity of domestic financing in both AB and RE models. Possible explanations: Timing of trade and financial liberalisation? Threshold effects persist in the “financially closed” sample (ratio of private capital flows to GDP is less than sample median), but not in the “financially open” sample.

Fiscal contractions and expansions Fiscal policy as a signalling device, lower borrowing costs in retrenchment. Binary indicator for change in budget balance relative to previous period. Empirical finding: Sensitivity of domestic financing is lower in fiscal retrenchment than expansions, but only in FE model. Caveats: duration of retrenchment, tax smoothing, etc.

Policy reaction function Regional spillovers: Competition for foreign financing, Financial contagion and regional “benchmarking”, Changes in sovereign credit ratings and effect on bond yield spreads (Kaminsky and Schmukler, 2001), Gravity considerations (Portes and Rey, 2000). Empirical finding: Fiscal tightening in regional peers reduces the sensitivity of domestic financing, controlling for fiscal stance, etc.

Looking ahead Areas for future research: Interactions between trade integration and financial liberalisation. Domestic financing responds to changes in the budget balance, but not on a one-to-one basis: cross-border budget financing is not frictionless. Incorporate portfolio preferences and institutional restrictions. Policy implications: Future of fiscal rules: can governments continue to impose restrictions on foreign budget financing as economies become more commercially integrated?.