Challenges in restoring fiscal sustainability

Federal Planning Bureau 27 October 2009

Jørgen ElmeskovActing 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 surgedPer cent of GDP

Source: Economic Outlook 85 database.

Potential output is likely to have fallen

Source: OECD Secretariat.

The distribution of fiscal consolidation episodesby size

Source: Guichard et al. (2007).

Synchronisation and international spilloversimply 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

JapanEuro area

GDP effects, % differences from baseline: 2011

United States -0.9 -0.2 -0.1 -0.5 -0.3Japan 0.0 -0.8 0.0 -0.2 -0.1Euro area  -0.1 -0.1 -0.8 -0.3 -0.2OECD  -1.2 -1.3 -1.1 -1.1Spillover as % of own-country effect 26% 54% 32%    

Policy rates have been cut to very low levels

Source: US Federal Reserve, Bank of Japan, European Central Bank.

Per cent

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 2008. 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.

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

The shape of consolidation affects its outcome

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

Raising public sector efficiency

Potential gains from moving to national best practiceSaving in teaching staff for unchanged output

Source: Sutherland et al. (2007)

Per cent

Effect of a drop in the NAIRU by 1 percentage point on financial balance

Source: OECD

Percentage point of nominal GDP

Ranking of tax in terms of their negative effect on long-term growth

More distortiveCorporate tax

Personal income tax

Consumption tax (and other property tax)

Tax on immovable propertyLess distortive

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.

Challenges in restoring fiscal sustainability

Federal Planning Bureau 27 October 2009

Jørgen ElmeskovActing Chief Economist

Economics Department