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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 fiscal consolidation challenge 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 Number of episodes 18 16 14 12 10 8 6 4 2 0 1 2 3 4 5 6 7 8 9 10 11 12 Improvement in underlying budget position during the episode (% of potential GDP) Source: Guichard et al. (2007). 13 Synchronisation and international spillovers imply negative demand effects fiscal consolidation challenge Fiscal consolidation equivalent to 1% of own-country GDP Source of change: United States Japan Euro area OECD Spillover as % of own-country effect Impact of change on: United Euro Japan States area GDP effects, % differences from baseline: 2011 -0.9 -0.2 -0.1 0.0 -0.8 0.0 -0.1 -0.1 -0.8 -1.2 -1.3 -1.1 26% 54% Total OECD -0.5 -0.2 -0.3 -1.1 Of which “own country”1 -0.3 -0.1 -0.2 32% 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. Policy rates have been cut to very low levels fiscal consolidation challenge Per cent Source: US Federal Reserve, Bank of Japan, European Central Bank. 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 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: How to consolidate ₋ Reform pension/health system now ₋ ₋ ₋ Fiscal rules ₋ ₋ ₋ ₋ Little up-front demand impact Had to be done anyway – hence signalling rather than paying for crisis 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 Probability to reach a primary balance that stabilises debt Size of adjustment (percentage point) 100 How to consolidate 4.0 90 3.9 80 70 3.8 60 50 3.7 40 3.6 30 20 3.5 10 0 3.4 average value (14%) 28% Share of primary current expenditure cut in the primary balance adjustment Source: based on Guichard et al. (2007). average value 10% 20% Share of social spending cut in the primary balance adjustment Arguments why the shape of consolidation could matter How to consolidate • 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 practice Saving in teaching staff for unchanged output Per cent How to consolidate 18 16 14 12 10 8 6 4 2 0 Source: Sutherland et al. (2007) How to consolidate? Effect of a drop in the NAIRU by 1 percentage point on financial balance Iceland Hungary Portugal Austria France Belgium Italy Ireland Denmark Greece Australia Spain United Kingdom Poland Netherlands Germany Canada United States Czech Republic Switzerland Japan Luxembourg Korea 0 0.1 0.2 0.3 0.4 0.5 Percentage point of nominal GDP Source: OECD 0.6 0.7 Ranking of tax in terms of their negative effect on long-term growth More distortive How to consolidate 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. Challenges in restoring fiscal sustainability Federal Planning Bureau 27 October 2009 Jørgen Elmeskov Acting Chief Economist Economics Department