Challenges in restoring fiscal sustainability Federal Planning Bureau 27 October 2009 Jørgen Elmeskov Acting Chief Economist Economics Department

Outline 1.The contours of the fiscal consolidation challenge 2.What experience tells us about ways to consolidate

Headline fiscal deficits have surged Per cent of GDP Source: Economic Outlook 85 database. fiscal consolidation challenge

Potential output is likely to have fallen Source: OECD Secretariat. fiscal consolidation challenge

The distribution of fiscal consolidation episodes by size Source: Guichard et al. (2007). fiscal consolidation challenge

Synchronisation and international spillovers imply negative demand effects Fiscal consolidation equivalent to 1% of own-country GDP Note: Own country” effect corresponds to the own country multiplier weighted by the country’s share in OECD GDP. The “spillover“ is calculated as the effect of other OECD countries consolidation on own-country GDP as a share of the total GDP effect on that country when all OECD countries consolidate at the same time Source: OECD Global model. Source of change: Impact of change on: Total OECD Of which “own country” 1 United States Japan Euro area GDP effects, % differences from baseline: 2011 United States Japan Euro area OECD Spillover as % of own-country effect26%54%32% fiscal consolidation challenge

Policy rates have been cut to very low levels Source: US Federal Reserve, Bank of Japan, European Central Bank. Per cent fiscal consolidation challenge

Higher government debt tends to raise long-term interest rates Spread between long-term and short-term interest rates versus gross government debt in % of GDP Note: Bars represent average across all OECD countries for which data are available over the period 1994 to Short-term interest rates are typically rates on 3-month Treasury bills and long-term interest rates those on 10-year government bonds. Source: OECD. fiscal consolidation challenge

Strong signalling of commitment is needed Various commitment devices to raise credibility: ₋ Reform pension/health system now ₋ Little up-front demand impact ₋ Had to be done anyway – hence signalling rather than paying for crisis ₋ Fiscal rules ₋ Empirical evidence: rules are associated with consolidation success ₋ But causality is not so clear ₋ (Re-)establishing credibility after the crisis may be hard ₋ Fiscal transparency How to consolidate

The shape of consolidation affects its outcome How to consolidate Source: based on Guichard et al. (2007). Share of primary current expenditure cut in the primary balance adjustment Size of adjustment (percentage point) Probability to reach a primary balance that stabilises debt Share of social spending cut in the primary balance adjustment

Arguments why the shape of consolidation could matter Why is consolidation more likely to succeed if based on (social) spending cuts? Signal of determination Avoids potentially inflationary tax hikes Allows monetary policy accommodation Empirical evidence: accommodation seems to increase choice of successful consolidation The findings could be spurious How to consolidate

Raising public sector efficiency Potential gains from moving to national best practice Saving in teaching staff for unchanged output How to consolidate Source: Sutherland et al. (2007) Per cent

Effect of a drop in the NAIRU by 1 percentage point on financial balance How to consolidate? Source: OECD Percentage point of nominal GDP

Ranking of tax in terms of their negative effect on long-term growth More distortive Corporate tax Personal income tax Consumption tax (and other property tax) Tax on immovable property Less distortive How to consolidate

A glimmer of hope? Fiscal consolidation is more likely when the fiscal situation is bad. It is also more likely to succeed when initiated in a bad fiscal and economic situation. How to consolidate

Challenges in restoring fiscal sustainability Federal Planning Bureau 27 October 2009 Jørgen Elmeskov Acting Chief Economist Economics Department