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CESifo / LBI Conference on Sustainability of Public Debt 22 - 23 October 2004 Evangelische Akademie Tutzing Policy Adjustments and Sustainability of Public Finances in the Netherlands Jan-Egbert Sturm and Jakob de Haan CESifo Poschingerstr. 5, 81679 Munich, Germany Phone: +49 (89) 9224-1410 - Fax: +49 (89) 9224-1409 E-mail: [email protected] Internet: http://www.cesifo.de Policy Adjustments and Sustainability of Public Finances in the Netherlands Jakob de Haana , Jan-Egbert Sturmb and Olaf de Grootc a b University of Groningen, The Netherlands and CESifo, Munich, Germany Thurgau Institute of Economics, Switzerland, University of Konstanz, Germany and CESifo Munich, Germany c University of Groningen, The Netherlands This version, 19 October 2004 Abstract This paper analyses fiscal policy in the Netherlands over the period 1970-2004 from three perspectives. First, we analyse fiscal policy in some detail, examining to what extent the Dutch experience has been in line with policy recommendations coming from the so-called fiscal adjustment literature. We conclude that successful fiscal adjustments in the Netherlands are quite different from successful adjustments in other countries. Second, we draw on the fiscal sustainability literature, which tests whether the intertemporal budget constraint of the public sector would be satisfied had fiscal policy in the sample been pursued indefinitely and were the relevant macro and structural features of the economy stable over time. These tests suggest that fiscal policy in the Netherlands is sustainable. Since, however, the demographic structure will not remain stable, we also discuss recent literature on generational accounting. Key words: fiscal adjustments, sustainability, public finance, Stability and Growth Pact JEL code: Address of corresponding author: Jakob de Haan, Faculty of Economics, University of Groningen. PO Box 800, 9700 AV Groningen, The Netherlands, tel. 31-50-3633706, fax 3150-3633720, email: [email protected]. 1. Introduction Following the oil shocks of the 1970s many OECD countries had large and persistent deficits, which in turn resulted in an unprecedented peacetime rise in the public debt-to-GDP ratio. The Netherlands was no exception. In 1982 the general government budget deficit in the Netherlands amounted to 6.2 per cent of GDP, the highest level since decades. The general government debt-to-GDP ratio increased from a post-war low of 39 per cent in 1976 to 78 per cent in 1993. Various coalition governments – that differed substantially in terms of the parties participating – aimed at reducing the budget deficit in the 1980s and 1990s as fiscal policy at the time was generally perceived as unsustainable. Over time, the financial position of the public sector improved substantially. In 2000 the Dutch government even had a surplus of 2.2 per cent of GDP. However, in more recent years the fiscal situation deteriorated rapidly, even to such an extent that the ECOFIN Council in its meeting of 2 June 2004 decided that the Netherlands had an excessive deficit according to the rules of the Stability and Growth Pact. This paper analyses fiscal policy in the Netherlands over the period 1970-2004 from three perspectives. First, we analyse fiscal policy in some detail, examining to what extent the Dutch experience has been in line with policy recommendations coming from the so-called fiscal adjustment literature. According to this line of research, that started with the seminal paper by Alesina and Perotti (1995), successful fiscal policy adjustments are characterised by spending cuts. Notably spending on government wages and transfers ought to be cut in order to permanently improve the government’s financial position. In contrast, fiscal adjustments which rely primarily on tax increases and cuts in public investment tend not to last. We find that successful fiscal adjustments in the Netherlands were often not in line with these prescriptions. Second, we draw on the fiscal sustainability literature, which tests whether the intertemporal budget constraint of the public sector would be satisfied had fiscal policy in the sample been pursued indefinitely and were the relevant macro and structural features of the economy stable over time. Previous studies come to rather diverging conclusions with respect to the sustainability of fiscal policy in the Netherlands. We perform various tests and find no clear evidence that fiscal policy in the Netherlands is sustainable. A crucial assumption of the sustainability literature is that the structural features will remain the same. Since, however, the demographic structure of the Netherlands will not remain stable, we finally discuss recent literature on ageing and generational accounting. This 2 literature suggests that a sustainable fiscal policy requires that tax revenues have to be permanently increased with 0.7% of GDP. The remainder of this paper is organized as follows. Section 2 outlines fiscal policy in the Netherlands during the period 1970-2004. In section 3 the policy adjustments are analysed in some detail, following the fiscal adjustment literature. In section 4 the sustainability of fiscal policy in the Netherlands is examined. Section 5 reviews recent studies on generational accounting. The final section offers our conclusions. 2. Fiscal policy in the Netherlands, 1970-2003 Figure 1 shows the general debt-to-GDP ratio (right-hand side) and the general government financial balance. The decline in national economic performance since the late 1970s and early 1980s triggered a financial crisis of the Dutch welfare state. As follows from figure 1, annual budget deficits were quite high as from 1975, which was reflected in a subsequent upsweep of the debt ratio, which reached a peak in 1993. Afterwards a steep decline of the debt ratio set in, which in more recent years levelled of. Figure 1. Government debt (right-hand side) and government financial balance (left-hand side), 1969-2003 (% GDP) 3 80 2 1 70 0 -1 60 -2 -3 50 -4 -5 40 -6 2003 2001 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977 1975 1973 1971 30 1969 -7 3 After the second oil shock had hit the Netherlands unemployment shot up from 4.1 to 11.2 percent. Since transfers to strongly rising numbers of benefit recipients were at the time fully linked to contractual wages, general government spending was in fact out of control. In 1978, the government presented a blueprint of medium term objectives and policies (‘Blueprint 81’) which aimed at improving competitiveness of the Dutch economy, halting the growth of public sector revenues as a proportion of GDP, and reducing the public sector deficit. The aims of Blueprint 1981 have not been met. Despite improved competitiveness, output and employment growth fell also well short of expectations. Rising interest payments and increasing unemployment put upward pressure on government spending. Despite increasing gas revenues, the general government deficit exceeded policy targets previously set, due to lower tax revenues than envisaged and higher spending levels. The economic programme of the incoming centre-left government aimed at a slight reduction of the general government budget. However, revenues soon turned out to be lower than assumed and various revenue boosting measures were taken; both factors resulted in a public sector borrowing requirement of over percent of GDP. Disaccord on the allocation of unavoidable spending cuts brought the government down in May 1982. The new centre-right government that - after elections - came into office late in 1982 was clearly faced with unsustainable budget conditions. Continuation of public borrowing at prevailing levels would have led to an explosion of government debt and interest payments. The government announced objectives for the reduction of the deficit by the end of its four-year term in office (in 1986). By now, the authorities shared the view that the size of the public sector itself was an impediment to balanced long-term growth. High tax and social security levels were thought to create potential welfare losses, distorting work, saving and spending decisions in the private sector. Various spending cuts were introduced, along with with certain tax increases (e.g. in the 1984 Budget the standard VAT rate was raised by 1 point to 19% and excise taxes were also increased) as well as tax decreases (e.g. the corporate income tax rate was reduced by five percent points, down from 48%). The 1985 Budget also introduced spending cuts (Gld 9.3 billion), including a Gld 2.5 billion cut in social security benefits, while the corporate income tax rate was cut further by one point, to 42%. In 1985 and 1986 the level of minimum wages, social insurance benefits and child allowances was ‘frozen’. In its 1986 Budget, the government concluded that the objectives set in the 1982 programme (i.e. a reduction of the borrowing requirement of central and local government, with no increase in the so-called ‘collective burden’, consisting of total of taxes, social security contributions and certain non-tax revenues of government as a percentage of income) 4 had largely been attained. Indeed, public spending had fallen, while the objective for the central and local government deficit had been broadly achieved. Although in itself this was a remarkable achievement, some critical sounds might be voiced. First, the decline in the deficit is much less impressive once the social security system is taken into account. Second, by 1986 expenditures were substantially higher than foreseen at the start of the plan. Part of this overspending occurred because certain programmes were expanded; part of it was due to slippage in a number of ‘open-ended’ income related programmes. After the 1986 elections the centre-right coalition remained in power until mid 1989. The coalition Agreement for the 1987-1990 period, drawn up around mid-1986, aimed at reducing the central government budget deficit to 5.25 percent of net national income (NNI) by 1990. Deficit reduction was to be accompanied by at least a stabilisation of the ‘collective burden’ and without loss of real net income for families at the minimum income level. It can be concluded that these objectives have been met. Reduction of the deficit was hampered, however, by a marked drop in natural gas revenues accruing to the government. Especially in 1987 gas revenues decreased sharply. As a consequence, the 1987 target for the central government deficit was missed, as the fall in gas revenues could only partly be offset by additional spending cuts and tax increases (one percent point higher VAT rate, higher excise taxes on energy, reduced income tax facilities for enterprises). During the 1987-89 period spending overruns even exceeded those in 1984-86, but buoyant tax revenues ensured that nonetheless deficit targets were met. Using these windfall revenues to finance spending overruns implied that the pace of consolidation was slower than what could have been achieved. In May 1989 the government fell on disagreement over financing the National Environmental Policy Plan. According to the coalition Agreement of the centre-left government that came into office in November 1989 the central government budget deficit would be brought down further by 0.5 percent points of NNI annually in the period 1990-1994, taking it to 3.25 percent, with the ‘collective burden’ not exceeding 53.6 percent. In February 1991 the Government published its Midterm Review, which confirmed that on unchanged policies the budget deficit was likely to exceed its target by a considerable margin as a result of a number of unforeseen developments (shortfall of revenues, rise in interest rate, higher than expected wage increases in the private sector). The Midterm Review contained proposals for additional expenditure cuts and revenue increases amounting to around Gld 17.5 billion in 1994, to keep the budget deficit in line with the medium term target. The proposals include cuts in subsidies (Gld 3.4 billion in 1994), reduction of disability and sickness 5 benefits (Gld 4.8 billion) and the number of public sector workers (Gld 1.1 billion), and cuts in expenditure on defense and social welfare (Gld 3.8 billion). However, at that time a considerable part of the spending cuts was not specified. The 1991 and 1992 Budget presented more detailed proposals on spending cuts as announced in the Midterm Review. Additional spending cuts were announced as well. In most the years of the coalition of social democrats and the left-of-centre and conservative liberals (the so-called Purple Coalition), the Dutch economy experienced economic growth rates which were substantially above the EU average. As a consequence, government’s financial position improved substantially. It is quite interesting that various coalition governments all aimed at reducing budget deficits, independent of their composition. Much of the improvement of the financial position was realised by reducing government spending. Figure 2 shows total government spending as share of GDP, as well as government transfers and government wages. The latter are also shown since the fiscal adjustment literature suggests that especially reductions in these categories of spending are needed for a permanent improvement in the government’s financial position. Figure 2 indicates that indeed the time pattern shows by total government spending and government transfers are much a like (correlation coefficient of 0.96). The degree of concordance between government spending and wages is much less (correlation coefficient of 0.25). 6 Figure 2. Total government spending, government transfers to households and government wages, 1969-2003 (% GDP) 60 50 40 30 20 10 Spending/GDP Transfers/GDP 2003 2001 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977 1975 1973 1971 1969 0 Wages/GDP However, in the more recent period, the general government budget balance deteriorated markedly, from a surplus of 2.2 per cent of GDP in 2000 to an estimated deficit of 3.3 per cent of GDP in 2004. Part of this increase reflected the soaring state of the economy, but structural effects also played a role, amounting to roughly 2 percentage points of GDP (included the 2001 tax reform). Temporary expenditure windfalls were used to fund permanent increases in spending, notably on health care and education. Moreover, after years of running close to balance, the local governments surprisingly recorded a deficit of 0.6 percent of GDP in 2003, contributing to the breach of the 3 percent Maastricht ceiling. 3. Fiscal policy adjustment When a policymaker must redress a fiscally unbalanced position, he can raise taxes and/or cut expenditures. Which should be used in order to permanently improve the fiscal position? And which type of expenditure or tax should be changed? A large literature has addressed the question whether the composition of the fiscal adjustment matters for it to be long lasting. Alesina and Perotti (1995, 1997), McDermot and Wescott (1996), Perotti (1997) and Alesina and Ardegna (1998) find that fiscal adjustments that are concentrated on the spending side, 7 and in particular on public wages and social welfare spending, are more successful than adjustments that rely primarily on tax hikes. In this section we analyse the fiscal adjustment of the Netherlands in some detail to examine whether the Dutch policy experience is in line with the conclusions of the fiscal adjustment literature. An important issue here is, of course, how a successful fiscal adjustment is defined. A fiscal adjustment is generally defined as a period during which government tries to reduce its budget deficit. To take the impact of the business cycle into account, most authors focus on an improvement in some cyclically adjusted deficit measure. We follow Alesina and Perotti (1995) and employ two fiscal impulse indicators: (1) the change in the primary deficit as share of the GDP of the previous year (FSM1), and (2) an indicator suggested by Blanchard (1993), which is an estimate of the budget deficit if the unemployment rate had remained the same as in the previous year (FSM2). Following Alesina and Perotti (1995), we regressed transfers as share of GDP on a time trend and the unemployment rate and used the estimated coefficient for the unemployment rate to estimate what transfers would be in period t if unemployment were the same as in the previous year. We define the fiscal policy stance as follows. Let u and σ be the average and the standard deviation of our fiscal stance measure (FSM being either the change in the primary deficit, or the Blanchard impulse measure). In a given year fiscal policy is: - neutral if FSM Є (u – 0.5σ, u + 0.5σ) - loose if FSM Є (u + 0.5σ, u + 1.5σ) - very loose if FSM ≥ u + 1.5σ - tight if FSM Є (u – 1.5σ, u – 0.5σ) - very tight if FSM ≤ u – 1.5σ It is hard to give a precise definition of success, but there is a broad consensus that a reasonable indication might be if the ratio of public debt to GDP starts to decline after the adjustment and continues to do so. We take years with either a tight or very tight fiscal policy according to one of the fiscal stance measures as years of fiscal tightening and follow McDermot and Wescott (1996) and consider a reduction of at least 3 percentage points in the ratio of gross public debt to GDP by the end of the third year after the fiscal tightening began as a workable criterion for judging success.1. Table 1 shows the resulting classification of years.2 Two conclusions can be drawn. First, it is clear that the selection of a particular fiscal stance measure affects the classification of years with fiscal tightening. As a consequence, the 1 2 Alesina and Perotti (1995) use a decline of 5 percentage points over the same three year period. Appendix 1 shows the results of previous studies. 8 choice of the fiscal stance measure also influences the selection of fiscal adjustments that are considered to be successful. In other words, there are years in which the debt ratio three years later has declined by 3 percentage points or more, but that are not years with fiscal adjustment according to the fiscal stance measures used. Table 1. Classification of Fiscal Policy in the Netherlands, 1970-2004 Measure: Very loose Loose Neutral Tight Very tight FSM1 1975, 2001 1978, 1979, 1971, 1972, 1973, 1977, 1991, 1996 1980, 1986, 1974, 1976, 1983, 1985, 1989, 1992, 1981, 1982, 1988, 1993, 1994, 2002, 1984, 1987, 1999, 2000 2003. 1990, 1995, 1997, 1998, 2004 FSM2 1984, 1989, 1985, 1986, 1971, 1982, 1972, 1973, 1995 1987, 1988, 1983, 1991, 1974, 1975, 1990, 1996, 1992, 1994, 1976, 1978, 1997, 1998 1999, 2001, 1979, 1980, 2002, 2003 1981, 1993, 1977 2000 Note: Years with successful fiscal adjustments are indicated in bold Which patterns can be discerned in fiscal policy in the Netherlands? Table 2 shows the results for expenditure, while table 3 shows the outcomes for taxes. The results for expenditure using the change in the primary deficit measure make sense. However, the unemployment adjusted deficit suggests that in years with very loose fiscal policy expenditure declines are even higher than those in years with very tight fiscal policy which is rather counter-intuitive. For taxes, the result is reversed: now the primary deficit measure yields counter-intuitive results. For instance, in years with very loose fiscal policy total tax receipts increase. 9 Table 2. Expenditure (% GDP) change: total and components All years Very loose Loose Neutral Tight Very tight All years Very loose Loose Neutral Tight Very tight Total Investment Tranfers to Wages Non-wage households consumption FSM1 0.20 -0.05 0.18 -0.06 0.08 3.06 0.27 1.06 0.44 0.39 0.37 0.02 0.21 -0.03 0.06 0.26 -0.09 0.28 -0.06 0.05 -0.65 -0.17 -0.11 -0.14 0.07 -0.87 0.08 -0.49 -0.24 0.07 FSM2 0.20 -0.05 0.18 -0.06 0.08 -1.71 0.04 -0.99 -0.49 -0.03 -0.79 -0.05 -0.33 -0.24 0.04 0.59 0.02 0.34 0.05 0.15 1.06 -0.10 0.67 0.08 0.07 -0.56 -0.46 0.28 0.12 0.16 Rest 0.04 0.88 0.11 0.09 -0.30 -0.29 0.04 -0.25 -0.21 0.03 0.33 -0.66 Table 3. Revenue (% GDP) change: total and components All years Very loose Loose Neutral Tight Very tight All years Very loose Loose Neutral Tight Very tight Total Income Soc.sec. Indirect Business Rest taxes premiums taxes taxes FSM1 0.14 -0.06 0.08 0.11 0.03 -0.01 0.60 0.23 -0.63 0.36 -0.04 0.68 -0.78 -0.45 0.04 -0.15 0.04 -0.26 0.11 0.02 -0.07 0.09 0.02 0.05 0.64 -0.02 0.46 0.26 0.04 -0.10 1.62 0.89 0.13 0.26 0.07 0.27 FSM2 0.14 -0.06 0.08 0.11 0.03 -0.01 -2.14 -0.73 -1.32 -0.13 -0.01 0.04 -0.27 0.34 -0.30 0.19 0.01 -0.50 0.18 -0.39 0.49 0.14 0.05 -0.11 0.90 0.16 0.34 -0.02 0.03 0.40 0.73 0.02 -0.07 0.84 0.04 -0.09 Table 4 contrasts successful and unsuccessful adjustments. According to the fiscal adjustment literature, spending on government wages and transfers ought to be cut in order to successfully improve the government’s financial position. It is clear from Table 4 that the Dutch experience is not in accordance with this recommendation. Take, for instance, transfers 10 to households. According to measure FSM1, under both successful and unsuccessful fiscal adjustments transfers were reduced; the reductions are of similar magnitude. Under FSM2 transfers increased in successful and unsuccessful adjustment, albeit that the increase was much higher during unsuccessful adjustments, which gives some weak support to the fiscal adjustment hypothesis. However, government wages, which should decline according to the fiscal adjustment hypothesis to lead to a permanent decline of the debt ratio, did not decline in successful adjustments according to both fiscal stance measures. In contrast, in unsuccessful years this category of spending did decline. According to the fiscal adjustment literature, unsuccessful fiscal adjustments often rely on tax increases. As Table 4 shows, this is confirmed for fiscal policy stance measure FSM2. However, according to FSM1 both successful and unsuccessful adjustments were characterised by lower total tax revenues, although income taxes were reduced in successful adjustments in contrast to unsuccessful ones. In conclusion, the experience of the Netherlands is only to a very limited extent in line with the conclusions of the fiscal adjustment literature. Although we have followed a similar approach, our findings do not yield a strong confirmation of the findings of Alesina and Perotti (1995) and McDermot and Wescott (1996). As our results are highly dependent on the fiscal policy stance measure chosen, we decided to use an alternative definition of a successful adjustment, which is independent of the characterisation of fiscal policy being stringent. We only require for a year to be registered as one with a successful fiscal adjustment that the debt ratio three years later has been reduced by three percentage points. In the bottom of Table 4 we show the results using this alternative definition of successful adjustments. Again, the Dutch experience is not in line with the policy prescriptions of the fiscal adjustment literature. 11 Table 4. Successful vs. unsuccessful adjustments # Obs. Total Investment Successful Unsuccessful 7 3 -0.14 0.15 0.43 -0.12 Total Income Nobs taxes Successful 7 -1.05 -0.74 Unsuccessful 3 -0.56 0.55 # Obs. Total Investment Successful Unsuccessful 7 5 2.60 -0.14 4.10 -0.19 Total Income Nobs taxes Successful 7 1.27 -0.33 Unsuccessful 5 1.77 -0.94 FSM1 Tranfers to Wages households -0.07 0.00 -0.10 -0.63 Soc.sec. Indirect premiums taxes -0.64 0.27 -0.20 0.20 Non-wage Rest consumption 0.26 -0.48 0.28 1.00 Business Rest taxes 0.01 0.05 0.18 -1.29 FSM2 Tranfers to Wages households 1.54 0.43 2.15 -0.55 Soc.sec. Indirect premiums taxes 0.21 0.49 1.75 -0.46 Non-wage Rest consumption 0.39 0.38 0.56 2.13 Business Rest taxes -0.02 0.92 0.34 1.08 Alternative definition of successful adjustment # Obs. Total Investment Tranfers to Wages Non-wage Rest households consumption Successful 19 0.02 -0.07 0.13 0.05 0.22 -0.31 Unsuccessful 11 0.71 -0.19 0.52 -0.81 0.36 0.84 Total Income Soc.sec. Indirect Business Rest Nobs taxes premiums taxes taxes Successful 19 0.32 -0.24 -0.09 0.47 0.02 0.16 Unsuccessful 11 -0.13 -0.24 0.34 -0.09 0.22 -0.36 4. Sustainability of fiscal policy Assuming that government issues debt with a single-period maturity, the period-by-period government budget constraint can be written as: (1) ∆Bt = rBt −1 + Gt − Tt where Bt denotes the real value of government debt at the end of the period, r is the interest payable on that debt, Gt is real government expenditures exclusive of debt interest payments, and Tt denotes real tax revenues. Reformulating eq. (1) and performing recursive substitution for all future debt yields: 12 (2) n [ ] Bt = ∑ 1 / (1 + r ) S t + j + 1 / (1 + r ) Bt + n j =1 j n where S (the primary deficit) is defined as: (3) S t = Tt − Gt If the second term in eq. (2) converges to zero as n becomes large, the outstanding stock of government debt equals the present value of future government surpluses. (4) Lim n→∞ 1 / (1 + r ) Bt + n = 0 n In that case the government budget is intertemporally balanced. If the limit term is higher than zero, the government is “bubble-financing” its expenditures. It is important to point out that the solvency constraint can be satisfied by an infinite series of conventional budget deficits. The appropriate sustainability test is to see whether the historical process that generates fiscal data is likely to result in the intertemporal budget constraint being violated. If so, fiscal policy will have to be changed; something has to give in, be it spending, taxes, or both. Various tests have been proposed in the literature to examine sustainability.3 Hamilton and Flavin (1986), who were – as far as we know the first to examine this issue – assume that the real interest rate is constant and that the deviation of the debt from the sum of discounted future surpluses growth at rate r. In that can case, one can write: ∞ (5) Bt = c(1 + r ) t + ∑ (1 + r ) − s Et S t + s s =1 where Et denotes the expectation operator conditional on information at time t. The intertemporal budget constrain would only be satisfied if c = 0. If both the debt and the sum of discounted surpluses are stationary, c = 0. Hamilton and Flavin examined the order of integration of Bt and St using annual data for the US and found that they cannot reject stationarity. Various studies have employed similar tests (see appendix 2 for a summary of studies that include the Netherlands). 3 This part heavily draws upon Artis and Marcellino (2000). 13 Trehan and Walsh (1988) argue that if debt and deficits are integrated, and if interest rates are constant, then a necessary and sufficient condition for sustainability is that debt and primary balances are cointegrated. This can easily be seen by writing eq (1) as: Bt +1 − Bt = rBt + S t (1a) If Bt is integrated of order one, then Bt-1 – Bt is stationary by definition, which, in turn, implies that the overall balance D = rBt + St is stationary, and that, if the interest rate r is constant, Bt and St are cointegrated with a cointegrating vector (1,r). Trehan and Walsh (1991) show that an alternative way to examine sustainability is to test whether the deficit inclusive of interest payments (Dt) is stationary. The attractive feature of this test is that its derivation is not depending on the assumption of a constant interest rate. Alternatively, one can test whether expenditures including interest payments are cointegrated with tax revenues (Trehan and Walsh, 1991; Hakkio and Rush, 1991). If the series Gt, Tt, and rBt-1 are I(1) variables, the deficit inclusive of interest payments is a zero mean stationary process if and only if (6) Tt − Gt − rt Bt −1 is a cointegration relationship. Ahmed and Rogers (1995) test this for the US and the UK and accept it, as do Trehan and Walsh (1991), but Hakkio and Rush (1991) reject cointegration. The latter two tests are performed in the present paper, using the fiscal variables concerned expressed as percentage of GDP (see also De Haan and Siermann, 1993). Table 5 shows the results. 14 ADF-statistic incl.constant -2.28 -1.94 no constant -0.99 -1.89 Crit.values 1% 5% 10% incl. constant -3.64 -2.95 -2.61 no constant -2.63 -1.95 -1.62 (T-G-rB)/GDP T-G-rB Def./GDP Deficit Table 5. Sustainability tests E-G coint. -2.10 -3.59 statistic 1% 5% 10% -4.24 -3.52 -3.17 It follows from Table 5 that there is no convincing evidence that fiscal policy in the Netherlands is sustainable during the period under consideration. However, this evidence is weak due to the low power of the unit root tests. Appendix 2 offers a summary of all papers that we are aware of that perform some kind of sustainability test of fiscal policy in the Netherlands. It follows that also other previous studies conclude that Dutch fiscal policy has not been on a sustainable path. A crucial assumption of the sustainability tests as applied in this line of literature assume that the present conditions remain in the future. However, it is well-known that the Netherlands, like many other OECD countries, faces an ageing problem. The next section therefore discusses the implications of ageing for fiscal policy. 5. Ageing in the Netherlands Statistics Netherlands (CBS) publishes its forecasts concerning population growth once every two years. The most recent forecast was published in 2003 (De Jong, 2003), and refined in 2004 (De Jong and Hilderink, 2004). Using four different scenarios4, De Jong and Hilderink 4 The different scenarios are built upon two dimensions. The first dimension concerns responsibilities and ranges from private responsibilities to public responsibilities. The other dimension concerns the degree of co-operation internationally, and makes a split between international co-operation and national sovereignty. Using these two dimensions, De Jong and Hilderink develop four different scenarios. The first scenario is called Strong Europe, in which the European governments are able to co-operate well and public institutions are able to optimise economic efficiency, leading to a prosperous future in Europe. The second scenario is referred to as the Transatlantic Market, in which private responsibilities are given a large role, and public institutions, such as the European Union, fail repeatedly. The European nations will shift their focus towards the United States, which will boost international trade, but due to the limited feeling of responsibility towards others, welfare will be very unequally distributed. In the Regional Communities scenario, the European governments are unable to reform their Social Security systems and are also unable to stop the expansion of their own bureaucracies. Multilateral 15 construct different population forecasts, as shown in Table 6. Population size ranges from around fifteen million people in 2050 in the Regional Communities scenario to over twenty million in the Global Economy scenario (2002: 16.1 million). Additionally, the table also shows the predicted dependency ratio, which will reach its maximum around 2040, at a level of between 42.7% and 46.2% (2002: 22.1%) Table 6. Population forecasts under different scenarios, 2002-2050 Global Economy 2002 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 Strong Europe Transatlantic Market Regional Communities Population Elderly Population Elderly Population Elderly Population Elderly dependency dependency dependency dependency x 1000 % x 1000 % x 1000 % x 1000 % 16105 22.1 16105 22.1 16105 22.1 16105 22.1 16374 22.8 16372 22.8 16351 22.8 16321 22.8 16830 24.4 16760 24.5 16596 24.5 16459 24.7 17354 28.2 17171 28.6 16802 28.8 16509 28.8 17884 31.3 17574 31.7 16961 32.1 16500 32.4 18405 34.5 17968 35.3 17087 35.8 16447 35.9 18890 38.3 18325 39.4 17165 40.1 16334 40.3 19316 41.6 18622 42.9 17174 44.0 16137 44.5 19677 42.7 18852 44.2 17104 45.7 15846 46.2 20005 41.4 19044 43.0 16980 44.3 15488 45.0 20335 40.0 19234 41.4 16836 42.8 15107 43.3 Source: De Jong and Hilderink (2004) In the study Ageing in the Netherlands, the Netherlands Bureau for Economic Policy Analysis (CPB) compares ageing in the Netherlands with other countries in Europe. As follows from Table 7, the elderly dependency ratio in the EU-15 is predicted to be around 53% in 2050, compared to 27% in 2000. However, it should be noted that this value is influenced strongly by the very high ratios expected in France and Spain. relations are strongly limited and most countries will be looking inwards. Finally, the Global Economy scenario assumes a great success in the international co-operation with respect to trade liberalisation. The private sector is one of the major driving forces towards liberalisation in this scenario, whereas the public sector’s responsibilities become limited to the supply of pure public goods. The downside of this scenario is an absolute failure of international co-operation with respect to environmental policy and an ever widening income gap. 16 Table 7. Expected elder dependency ratios (%) in different European countries Belgium Denmark Germany Greece Spain France Ireland 2000 28 24 26 28 27 27 19 2050 50 42 53 59 66 51 44 29 67 Italy Luxembourg Netherlands Austria Portugal Finland Sweden United Kingdom EU-15 2000 23 22 25 25 24 30 26 2050 42 40 55 49 48 46 46 27 53 Source:(CPB ( 2000) In the remainder of this section, we summarize the findings based on generational accounting for the Netherlands. The foundation for generational accounting was laid by Auerbach, Gokhale and Kotlikoff (1991) who were the first to present generational accounting as an instrument for policy analysis. Generational accounting is used as a way to compute the present value of current government policies for different age cohorts. In summary, governments are limited to this simple constraint: A + B = C + D, where C is the present value of all future government purchases and D is net government debt. These total liabilities have to be paid by A, the present value of net contributions of currently living generations and B, which is the present value of the bill left for future generations (Kotlikoff and Raffelhüschen, 1999). Generational accounting may shed some light on fiscal policy sustainability. In line with the discussion in the previous section, CPB (2000) defines the sustainability by being able to keep to the solvency condition. The solvency condition implies that the present value (PV) of all income should be equal or larger than the PV of all future obligations. This is basically the same solvency condition suggested by Auerbach, Gokhale and Kotlikoff (1991), who pose that the PV of net payments of the current generation plus the PV of net payments of all future generations plus net government wealth should be equal to the PV of government consumption. Fiscal policy is considered to be sustainable if the solvency condition would be adhered to when current policies would be continued indefinitely. Obviously, this is not realistic, but it does deliver a clear message concerning the need for policy adjustments. According to the CPB (2000), current fiscal policies would certainly lead to disaster. During the first decades of the twenty-first century, the Netherlands is expected to have a 17 budget surplus. From 2016, however, the Netherlands is projected to have a budget deficit due to the ageing of the population, rising to 3.4% of GDP in 2040 and, due to pressing interest payments, 9.0% in 2080. The major contributors to the escalating budget balance are the increased expenditures in healthcare, which are expected to rise from 7.0% of GDP in 2001 to 10.6% of GDP in 2040, and Social Security outlays, where an increase from 10.9% to 15.9% of GDP is expected over the same period. At the same time, government debt would initially decrease from 54% of GDP in 2001 to 28% of GDP in 2020, but subsequently increase to 157% in 2080. There is no doubt about it that these numbers show that current fiscal policy is unsustainable. Especially when it is taken into account that the CPB recently published a memo updating the numbers from their 2000 study (CPB, 2003). In the original study, the government was expected to have a budget surplus of 1.8% of GDP in 2007, but now the CPB expects the government to have a 1.7% deficit instead. To achieve a sustainable policy, tax revenues would have to be permanently increased with 0.7% of GDP. This coincides with the conclusions from previous fiscal sustainability studies, in particularly with Ter Rele (1998), who adds that a policy change has to be implemented quickly, as the necessary change becomes larger when waiting longer. Generational accounting also sheds light on the generational distribution of financial obligations. To be able to evaluate the generational distribution of fiscal policy effects, the generational accounts of newborns have to be compared to those of future generations, as it refers to benefits over the entire lifetime that way. As can be seen in Table 8, the CPB (2000) concludes that with the fiscal policies in place, future generations have a net benefit that is significantly lower than the net benefit of the newly born generation. However, as described earlier, this policy was deemed unsustainable anyway, and when the proposed measure of raising tax revenues with 0.7% of GDP would have been taken immediately, a situation would have occurred in which generational balance would almost be achieved. 18 Table 8. Predicted generational accounts Age in 1998 unborn 0 20 40 60 80 Net lifetime benefit with current policies (Thousands of euros) 44.2 58.8 -121.9 -73.5 102.7 128.9 Net benefit with adjusted policies (Thousands of euros) 52.5 53.6 -128.8 -78.2 101 128.4 Source: CPB (2000) 6. Conclusions 19 References Afonso, A. (2004), “Fiscal sustainability: the unpleasant European case”, Cass Business School conference paper Ahmed, S. and J.H. Rogers (1995), Government budget deficits and trade deficits. Are present value constraints satisfied in long-term data?, Journal of Monetary Economics, 36, 351-374. Alesina, A.F. and R. Perotti (1995), Fiscal Expansion and Fiscal Adjustments in OECD Countries, Economic Policy, 21, 205-248. Alesina, A.F. and R. Perotti (1997), Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects, IMF Staff Papers, 44, (2), 210-248. Artis, M. and M. Marcellino (2000), The solvency of government finances in Europe, in: Banca d’Italia, Fiscal sustainability, pp. 209-241. Alesina, A., Perotti, R. and Tavares, J. 1998, The Political Economy of Fiscal Adjustments, The Brookings Papers on Economic Activity, ….. Auerbach, A.J., J. Gokhale and L.J. Kotlikoff (1991), Generational Accounts – A Meaningful Alternative to Deficit Accounting, NBER Working Paper, No. 3589. Bravo, A. and Silvestre, A. (2002). “Intertemporal sustainability of fiscal policies: some tests for European countries,” European Journal of Political Economy, 18 (3), 517-528 CPB (2000), Ageing in the Netherlands, CPB, The Hague. CPB (2003), CPB Notitie: vergrijzing en schuldreductie – een indicatieve update, CPB, The Hague. De Haan, J. and C.L.J. Siermann (1993), The intertemporal government budget constraint: An application to the Netherlands, Public Finance, 48 (2), 243-249. De Jong, A. (2003), Bevolkingsprognose 2002-2050: Anderhalf miljoen inwoners erbij, Bevolkingstrends, 1st quarter, pp. 21-26. De Jong, A. and H. Hilderink, (2004), Bevolkingsscenario’s voor Nederland, Bevolkingstrends, 1st quarter, pp. 66-76. Grilli, V. (1989), Seigniorage in Europe, in: M. de Cecco and A. Giovannini (eds.), A European Central Bank?, Cambridge: Cambridge University Press, pp. 53-79. Hakkio, C. and M. Rush (1991), Is the budget deficit too large?, Economic Inquiry, 59, 429445. Hamilton, J. and M. Flavin (1986), On the limitations of government borrowing: A framework for empirical testing, American Economic Review, 76, 808-819. Kotlikoff, L.J. and B. Raffelhüschen (1999), Generational accounting around the globe, American Economic Review, 89 (2), 161-166. Mc Dermott, C. and John Wescott, R.F. (1996), An Empirical Analysis of Fiscal Adjustments, IMF Staff Papers, 43 (4), 725-753. OECD (2004), Economic Survey - Netherlands 2004: Fiscal policy. Ter Rele, H.J.M. (1998), Generational accounts for the Netherlands, De Economist, 146, 555584. Trehan, B. and C. Walsh (1988), Common trends, intertemporal budget balance, and revenue smoothing, Journal of Economic Dynamics and Control, 12, 425-444. Trehan, B. and C. Walsh (1991), Testing intertemporal budget constraints: Theory and applications to US federal budget and current account deficits, Journal of Money, Credit, and Banking, 23, 206-223. Uctum, M. and M. Wickens (1997), Debt and deficit ceilings, and sustainabality of fiscal policies: An intertemporal analysis, CEPR discussion paper, No. 1612. Vanhoebeek, F. and van Rompuy, P. (1995), “Sovency and sustainability of fiscal policies in the EU,” De Economist, 143 (4), 457-473 20 Wilcox, D. (1989), The sustainability of government deficits: Implications of the present value borrowing constraint, Journal of Money, Credit, and Banking, 21, 291-306. 21 Appendix 1: Episodes of Fiscal Consolidation in the Netherlands after 1970 according to previous studies Alesina and Perotti (1995) 1985, 1991 McDermott and Alesina and Wescott (1997) Ardegna (1998) 1982, 1983, 1988 Appendix 2. Summary of research on sustainability of fiscal policy (only studies that include the Netherlands) Study: Grilli (1991) Period and countries: 1950-86, 10 EU countries Corsetti and Roubini (1991) 1960-89 18 OECD countries De Haan and Siermann (1993) 1900-88 The Netherlands Caporale (1995) 1960-91 EU countries Uctum and Wickens (2000) 1965-1994 11 EU countries and the US Early 1970s-1994 EU countries minus Greece and Luxembourg Artis and Marcelino (2000) Afonso (2004) 1970-2003 EU countries Bravo and Silvestre (2002) 1960-2000 11 EU countries Test performed: Sustainable? Stationarity of deficit incl. Interest payments Non-stationarity only rejected for the UK, and, at a lower confidence level, Germany and possibly Denmark Problems present in some countries, incl. The Netherlands Yes Stationarity of deficit incl. Interest payments and cointegration of expenditures and revenues Stationarity of deficit and debt Not in Italy, Greece, Denmark, and Germany Stationarity test Sustainable in (public debt) Denmark, Ireland and the Netherlands Stationarity test Mixed evidence, (public debt) depending on particular assumptions, incl. the Netherlands Fiscal policy is Unit root and codeemed unsustainable integration tests of with possible revenues and exception of Germany expenditures and the Netherlands Co-integration tests of Sustainable in Austria, France, expenditures and Germany, the revenues Netherlands and the UK 22 Vanhorebeek and Van 1970-1994 Rompuy (1995) 8 EU countries 1870-1993 Belgium Stationarity test No, except for France and Germany 23