1. 1 Comments on Antonio Fatás Luis Servén The World Bank Workshop on fiscal policy IMF, June 2009

2. 2 Automatic stabilizers Three components of fiscal policy: 1.Automatic 2.Systematic discretionary 3.Purely discretionary (i.e., unsystematic) (1) and (2) hard to separate: formal explicit rules vs implicit ones -- routine responses to economic conditions. Most research has focused on identifying the effects of (3). But it likely accounts for a relatively small fraction of the overall variation in fiscal variables – as implied by high R2 from projecting them on cyclical and other factors. Nice to see (1) get some attention too.

3. Automatic stabilizers: measurement Typical ingredients: –Direct taxes (+ SS contributions) –Indirect taxes –Unemployment benefits Measurement –Using tax codes, unemployment rules etc (hard) –Regression of fiscal outcomes on cycle (easier) Reverse causality – with no obvious instruments Mixes up all systematic policies – not only automatic 3

4. Automatic stabilizers: measurement Different in poor countries: smaller government, conventional stabilizers weak on the revenue side, and virtually absent on the expenditure side. 4 Country group (income tercile) Total Exp/GDP (%) Direct taxes (+SS) / Total revenue (%) Transfers / GDP (%) Low income19.526.06.5 Middle income27.835.611.1 High income32.953.618.4 Source: WDI

5. Source: Suescún 2007 Automatic stabilizers: measurement Latin America vs industrial countries

6. Regressions of fiscal aggregates on cyclical indicators. Lump together all systematic policy (automatic + dicretionary) Hard to interpret due to reverse causality (Rigobón 2004) Typical finding is (more) pro-cyclical policy in poor countries, acyclical / counter-cyclical in rich ones – survives a variety of robustness checks (Ilzetzki and Végh 2008) Why? –Financial frictions: procyclical access to borrowing (Gavin-Perotti 1997; Kaminsky-Reinhart-Végh 2004) –Institutional failures (Tornell-Lane 1999, Talvi-Végh 2005, Alesina-Tabellini 2005, Ilzetzki 2007…) Some empirical support for both explanations – although based on crude measures of institutional quality and access to finance. Automatic stabilizers: measurement

7. GDP growth0.417***0.886***0.469**0.829** GDP growth*LDC0.149**-0.0730.085-0.102 GDP growth * ICRG-0.039**-0.043** GDP growth*credit depth-0.0010.001 IV estimates, 121 countries, annual data (WDI dataset) Dependent variable: public consumption growth Calderón & Schmidt-Hebbel 2008: most of the action seems to come from institutional differences. A closer look at LDC fiscal institutions could be illuminating. Automatic stabilizers: measurement

8. But also: shocks in developing countries may be different. Aguiar-Gopinath 2007: Industrial countries: transitory shocks and stable trend Developing countries: trend shocks (“the trend is the cycle”): a current shock signals an even bigger future change in the same direction If optimal policy is forward-looking, its response to current output changes (the focus of conventional regressions) may well be different in industrial and developing countries. Automatic stabilizers: measurement

9. Effectiveness usually stated in terms of output stability – but consumption stability at least as important. Methodologically, assessing effectiveness of automatic stabilizers is different from evaluating unsystematic policies: it involves evaluating rules – Lucas critique. In principle one would need structural models with policy- invariant behavioral relations (like McCallum 1999 on systematic monetary policy). Not many such exercises (Andrés, Doménech & Fatás 2008 is one) Instead, reduced-form regressions of aggregate volatility on measures of cyclical response of budget – or even government size. Automatic stabilizers: effectiveness

10. Source: Perry, Servén and Suescún 2007 Automatic stabilizers: effectiveness The relation between volatility and government size is different outside rich countries

11. Why does government size work differently in developing countries? -- Nonlinearities: poor countries are below a “minimum government size” for the stabilizing effect to occur (the reverse of Buti et al 2003 for rich countries) -- Composition effect: automatic stabilization is overwhelmed by procyclical discretionary policy -- Shocks are different (as before) Worth a closer look. Automatic stabilizers: effectiveness

12. Automatic stabilizers vs discretionary policy Some hints that the latter may be partly replacing the former since the 1990s (e.g., Debrun et al 2008, Auerbach 2009) – is that a good idea? Not so clear that “automatic stabilizers are more effective” – what is the metric and evidence? They do offer the advantages of speed, predictability and reversibility – especially valuable when fiscal institutions are weak Aside from efficiency issues, the political economy of automatic stabilizers can be hard too: income taxation, tax enforcement etc – still big hurdles for many developing countries. 12 Automatic stabilizers: effectiveness

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14. 14 Source: Auerbach 2009