On the Relationship between Fiscal Plans in the European Union: An Empirical Analysis Based on Real-Time Data Massimo Giuliodori & Roel Beetsma (University of Amsterdam)

2 Overview 1.Motivation and related literature 2.Data Description 3.Model Specification 4.Empirical Results Baseline Specification Robustness Estimates based on unadjusted primary deficit Small versus large countries 5.Conclusion

3 1. Motivation Spillover Effects of Fiscal Policy in the Europe They can work indirectly through the economy 1.Economic/indirect spillover of fiscal expansion Debt-financed  long-term interest rate goes up (-) e.g. Ardagna et al (2005) and Faini (2006) Inflation goes up  ECB raises euro-zone short-run interest rate (-) Output increases  foreign exports to domestic country increase (+) e.g. Giuliodori and Beetsma (2004) and Beetsma, Giuliodori, Klaassen (2006)

4 1. Motivation (cont’d) Spillovers can also work directly: 2.“Pure” or “direct” policy spillovers Expenditure side  investment expenditure to attract business from abroad or voters comparing quality and quantity of domestic infrastructures (+) e.g. Case, Rosen and Hines (1993) and Redoano (2003) Revenue side  competition for mobile tax base (+) e.g. Besley and Case (1995), Devereux et al., (2002) and Baicker (2005) Decision process side  meetings of ECOFIN (implicit or tacit interdependence) or ‘peer pressure’ within the current fiscal regime (+)

5 1. Motivation (cont’d) This paper: empirical analysis of the presence of ‘pure’ policy or ‘direct’ spillovers. –Have received much less attention than indirect spillovers via the economy –Better information on spill-over effects promote better alignment of national fiscal policies –How can peer pressure be made to work most efficiently? How can countries be motivated to put pressure on each other to improve quality of public finances and conduct fiscal reforms? Wider implications –How can countries be motivated to positively affect each other even when there are no tangible sanctions (e.g. Lisbon goals)?

6 1. Motivation (cont’d) Two main contributions –Study of the determinants of fiscal plans using real-time information at the time the budget is planned –Extension of ‘traditional determinants’ with external fiscal policy conditions Advantage of using plans –More informative about fiscal behavior: realized fiscal policy is sum of plan plus (often ad hoc) response to unforeseen developments

7 2. Data Description Modeling fiscal plans implies the use of data and information available at the time of decision For monetary rules (Orphanides, 1997, 2001, 2003 etc) this implies conditioning the operating instrument on real-time information e.g. This applies also to fiscal rules, with the difference that also the objective is subject to revisions (Cimadomo, 2006) e.g.

8 2. Data Description We construct a new real-time dataset for the period for 14 EU countries using the OECD Economic Outlook (EO) The EO is published twice a year (June and December) Given that the timing of the fiscal policy process is generally concentrated in the Autumn of each year, we take the real-time information based on the December issue All data from same issue  maximum of consistency For each year t (vintage t), we take the current estimates of fiscal and business cycle stances for year t (E) and the planned or forecast (F) business cycle stances for year t+1

9 2. Data Description For each country i we collect: CAPDF it =cyclically adjusted primary deficit over GDP for year t forecast in December of year t-1 CAPDE i,t-1 =cyclically adjusted primary deficit over GDP for year t-1 estimated in December of year t-1 YGF it =output gap for year t forecast in December of year t-1 DEBTE i,t-1 =Gross Government Debt over GDP at the end of year t-1 estimated in December of year t-1 …and other ‘standard’ real-time control variables

10 3. Model Specification Baseline specification: CAPDF it = c i + CAPDE i,t-1 +  CAPDFWY it +  ’ x it + u it CAPDFWY it = GDP-weighted average cyclically adjusted primary deficit over GDP for year t forecast in December of year t-1 Idea: if partners relax fiscal stance, country i perceives more (political) freedom to do so too x it = vector of other control variables including: YGF it,DEBTE i,t-1, YGFOECD t = forecast of the OECD output gap NONACTIVE it = share of young plus old in the population ELECT it = dummy for election year

11 3. Model Specification (cont’d) Additionally, following Forni and Momigliano (2004), to control for the external constraints given by the Maastricht criteria and SGP we construct: M i,t-1 = (DE i,t-1 -3%)/(1997- t), if DE i,t-1 >3%, t<1997 (Greece t<1999) and i is currently in the Euro-area = 0, otherwise SGP i,t-1 = (DE i,t-1 -3%)/2, if DE i,t-1 >3%, t  1997 (Greece t  1999) and i is currently in the Euro-area = 0, otherwise where De i,t-1 is the total deficit over GDP of country i for year t-1 estimated in December of year t-1

12 4. Empirical Results – baseline Both OLS and IV estimation, with country fixed effects Instruments for YGF it => YGE i,t-1 and YGEOECD t-1 Instruments for CAPDFWY i,t => CAPDEWY i,t-1 and YGEWY i,t-1 Given that CAPDFWY i,t may be not in the information set, we also look at cases where we substitute it with: CAPDFJWY i,t = GDP-weighted average cyclically adjusted primary deficit over GDP for year t forecast in June of year t-1

13 Table 2: Estimates of baseline fiscal rules

14 4. Empirical Results: robustness Given that CAPDFWY i,t may be not in the information set, we also look at cases where we substitute it with: CAPDFJWY i,t = GDP-weighted average cyclically adjusted primary deficit over GDP for year t forecast in June of year t-1 Alternative weighting scheme: geographical distance between capitals => CAPDFWD it and CAPDFJWD it Normalizing CAPDF i,t, CAPDFWY i,t CAPDFJWY i,t for potential output

15 Table 3: June forecasts and weighting scheme based on distance

16 Table 4: Normalizing by potential output

17 4. Empirical Results: robustness Alternative and additional controls –Improve specification –Check for alternative common driving factors –Capture indirect fiscal spillovers

18 Table 5: Additional controls – improved specification

19 Table 6: Alternative common driving factors

20 Table 7: Controls to capture indirect fiscal spillovers

21 4. Empirical Results: robustness Have we inadvertently excluded time dummies? –Replace CAPDFWY it with time dummies –Strong positive correlation time effects and fiscal interaction term –When jointly included time effects and fiscal interaction term are both insignificant

22 Figure 2: Time effects versus “external” fiscal factors

23 4. Empirical Results: robustness EU versus non-EU countries – idea: –Check for possibility of some common world factor driving all OECD fiscal stances –If existent, group of non-EU countries should show similar results as EU-group –Also EU average stance should drive non-EU countries stances and vice versa

24 Table 8: Split into groups of non-EU and EU countries

25 Table 9: Fiscal behaviour before and after SGP

26 4. Empirical Results: non-adjusted primary deficits Cyclical adjustment may potentially affect results Control for absence of cyclical adjustment by including output gap as regressor Common versus country-specific response Include average of foreign average cyclically adjusted primary deficit – conceptually the correct regressor

27 Table 10: Non-adjusted primary deficits

28 4. Empirical Results: small versus large countries Consensus view: large countries behave differently Large countries are responsible for most violations of the SGP Do large countries react differently to average fiscal stance? Do the groups affect each other?

29 Table 11: Split into large and small countries

30 Table 12: Do groups affect each other?

31 5. Conclusions The paper explores the potential importance of pure cross-border fiscal policy spill-overs in the EU Dataset based on real-time information to model the actual fiscal plans of policy makers Our empirical results indicate that such spill-overs potentially exist and these results are robust to several variations Key question is what is the source of these spill-overs? –Preventive arm of SGP –Tax competition? –Expenditure/investment competition? –Answer is important to judge to what extent countries will press each other to achieve Lisbon goals –We would need forecasts of deficit components

32 5. Conclusions (cont’d) Split of sample into small and large countries suggests that only the small countries, and not large countries, react to average EU movements in the deficit Common over-optimism biases unlikely (otherwise small and large would react similarly) Also large countries do not react to each other  ‘peer pressure’ does not seem to work for large countries Results may help us to infer to what extent countries might press each other to improve quality of finances, conduct fiscal reform and take measures to achieve Lisbon goals