7 Policy issues
This section discusses some of the issues surrounding the interpretation of the fiscal gap that might influence its presentation and use as a long-term fiscal indicator. Applications of the fiscal gap have tended to emphasise its role as a “fiscal indicator”. For example, solutions to a long-term fiscal imbalance require adjustments in specific taxes and/or expenditure programmes. But a necessary first step is to understand the size of the imbalance and how large the adjustments must be in the aggregate (Auerbach, 1997). Further, the fiscal gap is an illustrative device for measuring the magnitude of long-term budgetary imbalances, not a prescription for policy (CBO, 1998). However, the uncertainty around fiscal gap calculations needs to be considered when assessing policy changes.
7.1 Uncertainty
Auerbach (1994) notes the natural response of policymakers to downplay long-term projections of the fiscal gap type because they involve considerable uncertainty. He argues that this uncertainty could be more explicitly recognised through the calculation of confidence intervals based on making explicit the stochastic nature of the projections (see for example Lee and Skinner, 1999; Lee and Edwards, 2001; CBO, 2001).
Furthermore, Auerbach suggests that even with unbiased projections, the prospect that things are just as likely to be “worse” than forecast as they are to be “better” should in the face of risk aversion generate more immediate action. Auerbach and Hassett (1999) provide a more explicit model of fiscal policy under uncertainty. They suggest that the consequences of relatively “bad” long-term fiscal outcomes argues for accelerated action, with some precautionary saving in addition to whatever changes are needed to respond to expected fiscal imbalances.
7.2 Policy adjustment
Auerbach (1994, 1997) makes two important points about policy adjustments. First, permanent time horizon fiscal gaps calculated at a particular date t indicate the size of the permanent change in the primary balance-to-GDP (Δ) needed for currently projected fiscal settings to satisfy the government’s IBC. This change will satisfy the IBC if the projections at date t prove to be accurate. But a trajectory for primary balances based on Δ may not satisfy the IBC in year t + 1 once projections are revised. If the revisions to variables such as growth rates and other economic variables are assumed to be unpredictable, the process for Δt, Δt+1, Δt+2,… will follow a random walk.
With perfect foresight, the strict tax-smoothing mode of Barro (1979) implies constant tax rates. But in the presence of uncertainty, new information leads to a revision of tax rates and tax-smoothing implies that tax rates would follow a random walk. This might suggest a policy of implementing each period’s Δ immediately and as a consequence letting the tax rate follow a random walk. Tax rates would be revised on the basis of the new information affecting the fiscal gap. This will ensure that only small changes (spread over time) are needed, thereby minimising deadweight losses. This might be tempered by the infeasibility or undesirability of frequent changes in tax rates because of short-term macroeconomic considerations.
The CBO calculations of the fiscal gap suggest that Δ is influenced by revisions to projections (as illustrated in Table 1 above). Note that large expected events like population ageing are already incorporated into the projections of the primary balance. Auerbach argues that the fact that the fiscal gap will change does not alter the fact that it is an optimal forecast at date t.
Changes in the fiscal gap resulting from projection updates will capture a range of factors. These will include “forecasting changes”, such as those around the levels of taxes and spending to GDP. However, changes in the starting point will also reflect structural policy decisions. For example, a decision to lower taxes will, without a corresponding change in spending, increase the fiscal gap (as the tax change will be modelled as permanent). Presentation of fiscal gap calculations through time should ideally decompose changes into their key sources.
Secondly, although uncertainty might suggest that governments deal with future fiscal problems closer to when they occur, Auerbach (1997) argues that the problem already has occurred. In this view, short-term fiscal surpluses are a misleading indicator because they exist only because accounting methods ignore the accruing liabilities of future entitlement benefits. Delaying policy adjustment until measured deficits increase will require even larger adjustments to policy settings that are less desirable on both efficiency and equity grounds.
