2.2  Limitations

Cyclically-adjusted, or structural fiscal balances are one of the most common summary indicators of the effects of fiscal policy on economic activity, with increases in the structural deficit interpreted as expansionary, and decreases as contractionary (see Blanchard, 1993).

Blanchard (1993) provides an important survey of the limitations to short-term fiscal indicators.[6] First, Blanchard notes the original purpose of the structural, or cyclically adjusted balance (CAB) was to assess what the budget balance would be if the economy were at full employment. Blanchard questions whether the CAB is well suited to the task of assessing the effects of fiscal policy on the economy. For example, fiscal policy operates through two main channels, distortions created by the tax system and the effect of fiscal policy on aggregate demand. He argues that the CAB is only aimed at this latter channel. Second, Blanchard draws a distinction between the impact effect of fiscal policy and the final effect. The latter requires consideration of general equilibrium effects on interest rates, exchange rates and output. In Blanchard’s view an indicator can only measure impact effects and even then he is doubtful about the use of the CAB in this role. For example, a measure of fiscal impact will also depend on assumptions about the future because consumption does not depend only on current income.

More recently, Chalk (2002) investigates two propositions concerning the use of structural measures as indicators of fiscal policy. The first is that the change in the primary (i.e., excluding interest payments) structural balance provides a better indicator of discretionary fiscal policy than the change in the primary balance. The second is that the change in the structural balance is a good indicator of the demand stimulus arising from changes in the fiscal position.

Interest payments are excluded from the first proposition since they are non-discretionary. The primary balance represents the fiscal position excluding the current period effects of past deficits and surpluses. In contrast, because interest payments may have an impact on aggregate demand, Proposition two uses the overall structural balance rather than the primary structural balance. Japan and Germany provide the case studies for assessing the propositions. Proposition one is assessed by comparing changes in the estimated primary structural balance, and the primary balance, with qualitative evidence on the timing of fiscal policy measures and quantitative evidence on their size. Proposition two is assessed by comparing changes in the estimated structural balance with a measure of demand stimulus, where this is a weighted budget balance derived using national accounts data rather than budgetary data. Overall, Chalk concludes that, first; changes in both structural primary balances and primary balances are found to be poor descriptors of changes in discretionary fiscal policy. For Germany the structural primary balance is somewhat better than the primary balance. Second, changes in structural indicators appear to correspond poorly to the size of the demand stimulus generated by fiscal policy.[7] For Japan the structural balance gives a reasonable estimate of the demand impact of fiscal policy. Nonetheless, it is unable to capture the effects of compositional changes in fiscal policy.

Chalk also compares changes in the structural fiscal balance with a measure of fiscal impulse previously used by the International Monetary Fund (see Heller, Haas and Mansur, 1986) and explained in the Appendix of this paper. Chalk finds that for Japan and Germany, and for a broader sample of OECD countries, there is little difference between fiscal impulse derived from the Heller et al. approach and changes in the structural fiscal balance.

Although the structural fiscal balance has its drawbacks, evidence that it may not be a good indicator of aggregate demand impact arises largely when it is extended beyond its original purpose. It might be better to think of the structural balance as an indicator of the underlying fiscal position. An increasing structural balance should therefore be interpreted as a non-cyclical strengthening of the fiscal position, rather than an indication of aggregate demand impact.

Whether the Chalk results hold for New Zealand would require a more detailed qualitative and quantitative identification of discretionary policy changes together with a weighted budget balance measure. As discussed in Section 4, the indicators of fiscal impulse derived in this paper reflect the major discretionary fiscal policy changes of the 1990s. A more detailed analysis along weighted budget balance lines would introduce significantly more judgement. A summary of previous Treasury analysis along weighted budget lines is presented in the Appendix.

Finally, there are issues from theoretical and empirical perspectives as to what the short-term effects of fiscal policy actually are. In a summary of the theoretical literature, Hemming, Mahfouz and Schimmelpfennig (2002) conclude that fiscal multipliers are more likely to be positive and quite large when:

• There is excess capacity, the economy is either closed or it is open and the exchange rate is fixed, and households have limited time horizons or are liquidity constrained.
• Increased government spending does not substitute for private spending, it enhances the productivity of labour and capital, and lower taxes increase labour supply and/or investment.
• Government debt is low and the government does not face financing constraints.
• There is an accompanying monetary expansion with limited inflationary consequences (e.g., because of wage restraint).

Fiscal multipliers are likely to be smaller, and could turn negative, when:

• There is crowding out as interest rates rise and a flexible exchange rate appreciates in response to a fiscal expansion, especially if there are rational expectations and a fiscal expansion is perceived to be permanent.
• Households are Ricardian, in which case a permanent fiscal expansion can reduce consumption, this effect being stronger if households anticipate that distortionary taxes will have to rise in the future.
• There is a debt sustainability problem and risk premia on interest rates are large, in which case a credible fiscal contraction can result in a large fall in interest rates.
• Expansionary fiscal policy increases uncertainty which leads to more cautious saving and investment decisions by households and firms.

Hemming, Mahfouz and Schimmelpfennig list the main conclusions from the empirical literature as:

• Estimates of fiscal multipliers are overwhelmingly positive but small. Short-term multipliers average around 0.5 for taxes and 1 for spending, with only modest variation across countries and models (albeit with some outliers). There are hardly any instances of negative fiscal multipliers, the exception being that they can be generated in some macroeconomic models with strong credibility effects.
• There is nevertheless evidence of non-Keynesian expansionary fiscal contractions. Expansionary fiscal contractions appear to be more likely where a fiscal contraction is large and focuses on cuts in unproductive spending; occurs against a background of high debt, together with large premia on interest rates; is accompanied or preceded by a sizable depreciation and wage restraint, and increases the credibility of fiscal policy.[8]
• There is little evidence of crowding out through interest rates or the exchange rate. Neither full Ricardian equivalence nor a significant partial Ricardian offset gets much support from the evidence.

2.3  Other approaches

Indicators of fiscal impulse will only ever be, at best a guide to the initial impact of fiscal policy. For example, an increase in government spending could add to aggregate demand pressures in the first instance. However, as firms and households react to this increase in government spending, they may change their investment and consumption behaviour. A simple indicator cannot capture these second-round effects. The final effect of fiscal policy changes on aggregate demand needs to take account of the dynamic effects through time. As Blanchard (1993) argues, to make a more complete assessment of the effects of fiscal policy on aggregate demand requires a full-scale macroeconomic model.

There are a number of papers that use macroeconomic models to examine the effect of fiscal policy on the economy. For example, Hall and Rae (1998) examine the effect of a fiscal expansion in New Zealand using the NBNZ-DEMONZ model. They consider how the results are dependent on the financial market response and the monetary policy reaction, and the difference between a fiscal expansion achieved through tax cuts and increased spending. Modelling the effect of fiscal policy using the New Zealand Treasury Model (NZTM) is an area for further work.[9]

As a complement to macroeconomic models, which through their assumptions can pre-determine the effect of fiscal policy (see Blanchard, 2000), Blanchard and Perotti (1999) use a structural vector-autoregression (VAR) approach to estimate the dynamic effect of fiscal policy on US economic activity. This approach takes into account not just the initial impact on the economy, but how the impact changes through time. Blanchard and Perotti use the observation that within a quarter, there is little or no discretionary response of fiscal policy to unexpected movements in economic activity. Combining this with institutional information about the tax and transfer systems as well as the timing of tax collections allows Blanchard and Perotti to construct estimates of the automatic effects of unexpected movements in activity on fiscal variables, and, by implication, obtain estimates of exogenous fiscal policy shocks. Having identified these shocks, they then trace their dynamic effects on output. The results consistently show that positive government spending shocks have a positive effect on output, and positive tax shocks have a negative effect. The multipliers for both spending and tax shocks are typically small, often close to one.