2  Definitions, Limitations and Other Approaches

2.1  Definitions

Wells (1995, p.76) notes that 'single-number' measures such as the fiscal balance are often used in policy discussions regarding fiscal policy. He suggests that in an IS-LM model, a definition of fiscal stimulus or contraction is given by the degree to which changes in fiscal instruments shift the IS curve. As a result, it is not the level but the change in the fiscal balance that provides an indicator of fiscal stimulus or contraction.

Wells (1995) sees two drawbacks in using the change in the fiscal balance as an indicator of fiscal policy effects. First, both changes in private-sector demand and fiscal instruments (tax rates and spending plans) can influence changes in the actual fiscal balance. The most common approach to this drawback is to estimate a cyclically adjusted or structural fiscal balance. The structural fiscal balance is an indicator of what the fiscal balance would be if the economy were operating at potential output. Second, because of inherent differences in each of the fiscal instruments, they should be weighted to reflect their initial impact on aggregate demand. This leads to the use of what is sometimes termed the weighted budget balance.

In this paper we focus on changes in discretionary policy that are likely to have an effect on aggregate demand. A focus on changes in discretionary policy implies the use of a structural fiscal balance that excludes cyclical influences. For example, consider the case of unemployment expenditure. Changes in unemployment expenditure occur through changes in unemployment numbers and/or changes in unemployment benefit rates. The effect of cyclical changes in unemployment numbers is considered non-discretionary and would be excluded from the measure of fiscal impulse. The effect of changes in unemployment benefit rates is discretionary.

Isolating discretionary policy changes is not straightforward. For example, an exogenous and non-cyclical increase in the number of hospital patients can require increased spending on healthcare. Although such exogenous factors are largely non-discretionary (for given health policy), a government will need to take them into account when making budget decisions. A government has the discretion over whether to accommodate non-discretionary changes, or to offset them with discretionary changes elsewhere in the budget.

Isolating the non-cyclical or structural component recognises the role of so-called automatic fiscal stabilisers.[5] For example, consider the case where forecasts indicate a significant deterioration in the overall fiscal balance. If this is due in large part to a forecast cyclical downturn, then although the change appears expansionary, it is reflecting the role of automatic stabilisers. The onset of the downturn may result in a fiscal deficit under policies that would otherwise have generated a balance or surplus.

If the cyclical downturn does not eventuate then the extent of automatic fiscal stabilisation will have been less. The change in the actual fiscal balance would ex post appear less expansionary. Since we are interested in the discretionary fiscal policy, rather than the overall fiscal impact, then it is important to distinguish between a fiscal loosening that arises from cyclical effects versus one that arises from discretionary changes.

Overall, the exclusion of cyclical influences means that we draw a distinction between the actual fiscal balance and estimates of the structural fiscal balance. We define the change in the structural fiscal balance as a measure of fiscal impulse. An increase (decrease) in the structural deficit (surplus) represents an expansionary fiscal impulse. Some authors describe the structural fiscal balance as a measure of fiscal stance. We emphasise the change in the structural balance for two reasons. First, given the methodologies typically used, the level of the structural balance has a degree of arbitrariness, whereas changes from year to year provide a reasonable indication of fiscal trends. Second, the change in the structural balance is a measure of whether fiscal policy is adding to, or subtracting from, aggregate demand pressures in the economy. Section 3 discusses the precise definition of which fiscal balance is relevant for the estimation of fiscal impulse indicators, and how the structural balance is derived.