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Proposal of Fiscal Adjustment

In: Business and Management

Submitted By xuetian227
Words 1343
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1 Introduction
After the financial crisis of 2007 almost the entire European countries now has to deal with a great debt crisis. Governments of countries in the west have to use fiscal adjustments in order to get their public finances straight. In this paper we want to establish which lessons can be learned from the past when it comes to conducting successful fiscal adjustments. While not looking at the factors which contribute to the appearance of a fiscal adjustment, we will focus on the factors which influence the success of the adjustment. Examples of these factors are revenue increases, cuts in government spending, the debt-to-GDP ratio and some political variables. In general, each factor accounts for one hypothesis. The paper which comes closest to ours is the one of Alesina et al. (1998). It deals with the success of fiscal adjustments. The authors found that expenditure cuts are more effective than an increase in government revenues. Papers as for example the one of McDermott and Wescott (1996) also focus on this aspect and investigate the question whether fiscal adjustments result in periods of small or even negative economic growth. However, the prevailing research has only been focusing on one type of fiscal adjustments. We think that the distinction between rapid and gradual fiscal adjustments can be of important use to prove existing research findings or even indicate new insights in the topic of the fiscal economy. De Haan et al. (2007) took the aspect of gradual adjustments into account, by concentrating on the impact of factors on the appearance of rapid and gradual fiscal adjustments. In this research, we use the same two definitions of whether fiscal adjustments take place. Successful adjustments are defined as in the paper of Alesina et al. (1998). Their definition is based on reductions in debt-to-GDP ratios and deficit-to-GDP ratios. To test our hypotheses, pooled data of 20 OECD-countries from 1970 to 2003 is used to perform a mean analysis of the factors contributing to the success of the adjustments. The economic data is mainly collected from the OECD database. Data on political variables is taken from the database previously used by De Haan et al. (2007). Our main findings are that rapid and gradual adjustments are mainly influenced by the same factors. As already stated by Alesina et al. (1998), we find that expenditure cuts contribute more to the success of adjustments than increases in tax revenues. It is also shown, that fiscal adjustments seem to be more efficient, if initial debt levels are high. We find that the political variables do not show strong results. The remainder of this paper is structured as follows: in the second part, the hypotheses and associated literature are introduced. Part three is dealing with the model, definitions of fiscal adjustments and the data set. In the fourth part, the results are stated. We conclude in the fifth and final part.
2 Literature review and Hypotheses
In their research of the fiscal economy, Alesina et al. (1998) found that cuts in government spending, as cuts in government wages or a change in the number of people employed in the public sector, appear to be used intensively in successful adjustments. When adjustments were unsuccessful, expenditures only accounted for a small change of the consolidation plans. Also, Alesina et al. (1998) state that the increase in revenues is higher during unsuccessful adjustments relative to expenditure cuts. Unsuccessful adjustments were dominated by taxes on labor, whereas the taxes of successful adjustments mostly did not. The reasoning behind this is that a decrease in public consumption will increase private consumption, when taxes are unchanged. It is worth mentioning that increases in tax rates can still be effective in consolidation plans, but in general, expenditure cuts seem to be a more efficient method for fiscal adjustments, than increases in revenues. We will show in our model that this is also the case for gradual adjustments. From this, the first hypothesis can be formulated:
1) A cut in government spending has a larger effect on the success of rapid and gradual fiscal adjustment schemes than an increase in tax revenues.
It is also shown by Alesina et al. (1998) that countries experiencing successful fiscal adjustments seemed to initially have high debt-to-GDP ratios. One can argue that countries dealing with high debt-to-GDP ratios face relatively high interest rates, because of default risk. When a consolidation plan, targeting lower ratios, is announced, the expectations and trust of investors could grow. Hence, interest rates would fall and investment rises, which could result in a “boom” (Alesina et al., 1998). This leads to the following hypothesis:
2) Rapid and gradual fiscal adjustments are effective, if the initial debt-to-GDP ratio is high.
The effect of political variables is difficult to measure empirically. De Haan et al. (20010) argue that governments facing high support in the parliament have better opportunity to implement fiscal policies. However, the results were not statistically significant. Still, we agree with the argument, because the decisive power gives the government the ability to react faster to shocks in the economy and its implications for the adjustment scheme. Therefore, one could argue that single party governments are more successful in implementing successful consolidation plans, than coalitions. Alesina et al. (1998) found significant results on the relation between single party governments and successful rapid adjustments. The third hypothesis is as follows:
3) One party governments have higher success rates in implementing successful fiscal adjustments.
If a cabinet change occurs after a fiscal adjustment is implemented, ideology might change. Tavares (2004) showed that left-wing parties rely more in tax regulation, while right-wing parties favor spending cuts. Still, he concluded, that the size of the adjustments and its constitution has larger impact on economic variables, than ideology itself. We do not test the aspect of ideology, but the effect of persistence in the government is still an important aspect to us. The measure for testing persistence in this research is changes in government, resulting in the following hypothesis:
4) Changes in the government reduce the probability of a success, when fiscal adjustments were implemented.
A method to reduce debt in nominal terms is to let the currency depreciate. Alesina et al. (2010) found that both, successful and unsuccessful adjustments are accompanied with exchange rate drops. They also found, that the changes in exchange rates are higher when adjustments are successful. We test this aspect and show, that it also holds for gradual adjustments. Therefore, our final hypothesis is as follows:
5) Currency depreciation has a positive effect on the success of political adjustments.
2 Data
3 Models
4 Results
5 Conclusions
This paper investigates which factors determine whether a fiscal adjustment succeeds or not. What sets our research apart from previous research on this topic, like Alesina et al. (1998) and McDermott and Wescott (19xx), is that we make a distinction between rapid and gradual adjustments. Two definitions, proposed by de Haan et al. (2007), are used to capture the difference between rapid and gradual adjustments. The success of a fiscal adjustment is defined using definitions proposed by Alesina et al. (1998), which account for the persistence of the deficit reduction. In order to get results we compared means of explanatory variables for four different groups of observations, each defined as one of the four types of fiscal adjustments we recognize.
Our paper confirms results from earlier research, which led to the conclusion that the success of fiscal adjustments is mainly determined by the initial budgetary position. Also, we found that the composition of the fiscal adjustment matters more than the size of the deficit reduction. Successful adjustments tend to rely more on cuts in spending than on increased revenues. Again, this confirms results found in previous research. Furthermore, the data showed that one party cabinets have a higher success ratio when conducting rapid fiscal adjustments in comparison to coalition governments. Other than that, we found no difference between the determinants of successful rapid and gradual adjustments.

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