Rules, and their effects on fiscal policy in Sweden Peter Claeys * Summary

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1 SWEDISH ECONOMIC POLICY REVIEW 15 (2008) 7-47 Rules, and heir effecs on fiscal policy in Sweden Peer Claeys * Summary Fiscal rules aim a consraining public deb. In Sweden, a combinaion of procedural and numerical rules was inroduced in response o he severe 1991 fiscal crisis. These rules have been effecive: public deb has come down. The curren fiscal framework does no rule ou fuure fiscal crises, however. Spending is no sufficienly kep under conrol. Taxes are se procyclically, only o keep deb in check. Conrols on deb susainabiliy require igher spending rules, linked o levels of axaion. JEL classificaion: E60, E62, E65. Key words: Fiscal policy, deb, susainabiliy, Markov swiching, Sweden. * Peer Claeys is a Research Fellow a he Universia de Barcelona, Research Group AQR- IREA. 7

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3 SWEDISH ECONOMIC POLICY REVIEW 15 (2008) 7-47 Rules, and heir effecs on fiscal policy in Sweden Peer Claeys * The susained high deficis in mos indusrialised counries in he sevenies and eighies caused some concern abou he susainabiliy of public deb. This has raised an ineres in ways of resraining his defici bias. Fiscal rules ha consrain he abiliy of governmens o use spending and axes a heir discreion have generaed much debae. In conras o he academic discussions on moneary policy, here are many pracical proposals for implemening conrols on fiscal policy. Fiscal rules can ake many forms. An improved design of he budge process, which is ofen accompanied by some insiuional shake up, goes o he core of he poliical problem a he roo of he deb problem. Alernaively, a numerical arge on defici or deb raios has been imposed. These rules seem o have disciplined fiscal policy. Even if he Gramm-Rudman-Hollings Ac never officially applied, he Clinon Adminisraion neverheless governed a subsanial reducion of public deb. The EU governmens enshrined public deb and defici arges in he Treay of Maasrich and srenghened hese provisions wih he Sabiliy and Growh Pac. These arges have been me in differen counries hrough a diversiy of fiscal rules. Some EU counries underook major insiuional reforms; ohers buil poliical agreemen around deb consolidaion; many imposed simple numerical consrains. As in mos oher OECD counries, Sweden also sared o experience fiscal rouble in he lae sevenies. Deb soared by more han 40 per cen of GDP in a couple of years. The brief consolidaion of deb over he eighies occurred wihou any formal changes in he seing of he budge. These informal agreemens on fiscal discipline were no sufficienly srong o preven he mos severe deb crisis of * Peer Claeys acknowledges suppor by a Marie Curie Inra-European Fellowship wihin he 6h European Communiy Framework Programme. Correspondence address: Universia de Barcelona, Facula de Ciències Econòmiques i Empresarials, Grup AQR IREA, Torre IV, Avinguda Diagonal, 690, E Barcelona, Spain. Peer.Claeys@ub.edu el: , fax:

4 Peer Claeys As economic condiions worsened dramaically boh a home (financial crises) and abroad (EMS crisis, Russia), he defici plunged o double digis, and deb soared once more by 40 per cen of GDP in less han a year (Figures 1 and 2). Fiscal rules were adoped in response o his fiscal havoc. Sweden is an exemplary case of a combinaion of boh insiuional and numerical fiscal rules. Iniially, procedural reform pu more cenralised budge procedures in he hands of he finance miniser, srenghened he posiion of he governmen in budge seing and led o some insiuional changes relaed o he budge process (Hallerberg, 2004). Numerical fiscal rules have been pu in place since 1997 and consis of hree pars. The governmen budge should aim a an overall srucural surplus of one percen of GDP. 1 This surplus arge is anchored o an expendiure rule for he cenral governmen, which defines a rolling medium-erm nominal ceiling on spending for he nex hree years. This is no a rigid limi: a buil-in margin allows for some cyclical variaion in spending and gives some flexibiliy in he budge planning process. Finally, local governmens need o run balanced budges, and any deficis have o be offse wihin wo years. 2 Figure 1. Deb raio o GDP This was modified in 2006 from he iniial wo per cen surplus arge as EU regulaions classified some pars of he pension sysem as belonging o he privae secor. 2 In addiion, Sweden also needs o comply wih he provisions of he Sabiliy and Growh Pac. 10

5 Peer Claeys Figure 2. Surplus raio, and oupu gap surplus raio gap Noe: verical bars indicae he roughs of growh cycle recessions (ECRI). Fiscal rules are no a panacea: hey always presen a compromise beween simpliciy and comprehensiveness (Kopis and Symansky, 1998). Rules ofen address pas policy problems o redress he fiscal siuaion, bu do no look forward o possibly new hreas o deb susainabiliy. As rules canno provide clauses for all coningencies, several loopholes are open ha governmens can possibly exploi o run up deficis under some circumsances. Fiscal rules are only as srong as he poliical consensus ha can be gahered in heir favour (Debrun and Kumar, 2007). The violaion of fiscal rules in recen years aess o he ease wih which fiscal rules can be modified. A pessimisic view would be ha rules are mere saemens by he governmen abou curren policy, raher han working as a consrain on fiscal policy. Once deb consolidaion shifs down on he prioriy ladder of governmens, fiscal policy may swich is sance. Poliical and economic circumsances may make i difficul no o give in o renewed calls for spending hikes or ax cus. Wihou sufficienly srong insiuions o guaranee a coninued concern for he susainabiliy of public finances, deb will rise again. In his paper, I characerise hese shifs in fiscal policy beween alernaing periods of deb consolidaion and loose fiscal policies. I analyse he mechanism behind he defici bias by looking in deail a boh spending and axaion decisions of Swedish fiscal policy since I basically es fiscal rules for he susainabiliy of public deb. I ouline 11

6 Peer Claeys he argumens for he derivaion of he empirical policy rules in Secion 1. A concise overview of he empirical lieraure on sysemaic fiscal policy shows how we may recas a es for deb susainabiliy à la Bohn (1998) in erms of a fiscal policy rule. I discuss some major problems in he idenificaion of fiscal policy in Secion 2. Then, I follow radiions in he moneary policy lieraure in esimaing fiscal rules in which he surplus is gradually adjused o is arge level. I deail he behaviour of Swedish fiscal policy by decomposing fiscal rules in spending and axes in Secion 3. I furher examine he sabiliy of hese fiscal rules o lay ou he mechanism behind spending and axes ha underlies deb creaion in Secion 4. Then, I compare he experience wih fiscal rules in Sweden o ha of similar open economies. Conclusions follow in Secion Fiscal rules 1.1. Susainabiliy of public deb, and fiscal rules Discussions abou fiscal policy rules have mosly been normaive and limied o pracical policy proposals. These can be roughly divided ino wo differen ypes. A firs group of rules explicily imposes numerical defici or deb arges. Balanced budge rules, a golden rule, deb brakes, ec. all belong o his class. A second class changes he rules of he game. A change in insiuional arrangemens is believed o improve budgeing procedures. Boh ypes of rules aim a correcing he defici bias in fiscal policy. The objecive is a susainable pah for public finances. Susainabiliy means ha he public secor does no leave public asses or liabiliies wih any posiive probabiliy, i.e., he sum of he presen discouned value of expeced fuure primary surpluses suffices o pay off curren deb. The period-by-period dynamics of oal deb b are given by he accumulaion of ineres paymens on pas fiscal imbalances and he curren primary surplus, s, which is he difference beween governmen revenues and governmen spending, g 3 b 1 + r ) b s where s = g. (1) ( 1 3 All fiscal daa are expressed as a raio o oupu here. Spending is inclusive of ineres paymens on public deb. 12

7 Peer Claeys Solving forward (1), one obains he ineremporal budge consrain IGBC (2) n n b lim ( ) ( ) n g + n + n b = E + E (2) n j = + r + j n = j = + r + j The susainabiliy condiion is me when he public secor does no leave any public asses or liabiliies wih a posiive probabiliy. For his o hold, he ransversaliy condiion needs o be saisfied, i.e. when n b + n lim E ( ) = 0. (3) n j = r + j Some equivalen ime series ess for fiscal susainabiliy can hen be derived under various assumpions on his condiion. Coinegraion beween non-saionary governmen expendiures g and revenues can be shown under some weak economic assumpions o be a necessary condiion for he IGBC o hold. Conversely, his coinegraion relaion is also a sufficien condiion under weak assumpions on he daa generaing process of deb, viz. ha i is an I(1) process (Ahmed and Rogers, 1995). I hen follows ha he oal governmen defici series is saionary when spending and revenues or alernaively he primary surplus s and public deb b are coinegraed. 4 Mos of he empirical ess of fiscal susainabiliy have been based on he (co)inegraion implicaions of he ransversaliy condiion. The laer relaion beween he primary surplus and deb can also be rewrien in erms of a reacion funcion (4): s = +. (4) θb µ Bohn (1998) proves ha a sricly posiive reacion of he primary surplus s o public deb in his fiscal rule is a robus sufficien condiion for he susainabiliy of public finances. 5 4 Such bounded susainabiliy implies ha undiscouned public deb is finie in he long run. Wih an unspecified coinegraing vecor, only weak susainabiliy can be said o hold (Quinos, 1995). 5 I.e., rejecion of his null does no mean ha fiscal policies are necessarily unsusainable. 13

8 Peer Claeys Governmens can run higher surpluses and reduce public spending or raise more axes so as o pay off public deb. Bu here are alernaive policies for sabilising public deb. Inflaion erodes he real value of ousanding public deb. Leeper (1991) and Sims (1994) argue ha prices or oupu will adjus o make he IGBC hold, whenever fiscal policy disregards public deb. In ha case, i is no moneary policy bu fiscal policy ha evenually deermines prices. If fiscal policy is no sufficienly reacive o deb, fiscal policy is labelled as acive. In conras, if fiscal policy responds o deb or is passive hen he budge consrain will be saisfied for all price pahs. Moneary policy reains he abiliy o conrol prices in his Ricardian environmen. We may es wheher policy is acive or passive wih a fiscal rule similar o equaion (4). For a passive governmen, θ > 0. The implicaions and he underlying assumpions of his Fiscal Theory of he Price Level have no gone unchallenged, and is validiy is a fiercely debaed issue. 6 A less sanguine view on policy ineracion akes accoun of oher economic effecs on he pah of spending, axaion and public deb. Lower ineres raes or higher inflaion reduce he burden of ineres paymens on ousanding deb. The deb posiion also becomes more susainable in a period of srong economic growh. We can redefine he fiscal rule in erms of he surplus ha would be needed o bring abou he sabilisaion of public deb. We can wrie ou he flow budge consrain (1) o ge: b (1 + q ) = b 1 (1 + k ) s. (5) Apar from he surplus in every period, he increase in deb also depends on real ineres raes q as well as nominal economic growh k. Deb remains sable if he deb-sabilizing surplus s equals b 1( q k )/(1 + k ). If nominal GDP growh exceeds he ineres cos of deb, persisen deficis are sill consisen wih deb sabiliza- 6 Noe ha idenificaion of differen policy regimes wih a fiscal feedback rule sill runs ino idenificaion problems. A passive rule is no uniquely defined from he daa generaing process for surpluses and deb, and is observaionally equivalen o an off-equilibrium behaviour ha is consisen wih acive fiscal policies (Cochrane, 1998). 14

9 Peer Claeys ion as real economic growh and inflaion ougrow he ineres paymens. This presumes ha ineres raes and oher economic variables are exogenously deermined. However, empirical evidence shows ha fiscal policy may have real economic effecs (Blanchard and Peroi, 2002). Boh fiscal and moneary policies reac o and have an effec on curren economic condiions in he shor erm. Some recen DSGE models have revived he ineres in he public finance approach owards he join deerminaion of fiscal and moneary policies. In hese Ramsey ype of models, he governmen s problem is ha of selecing he leas disrupive combinaion of inflaion and axaion ha maximises he represenaive agen s welfare for financing a given level of public spending (Lucas and Sockey, 1983; Chari e al., 1991). 7 This approach has recenly been popularised by marrying i o he growing class of DSGE models wih nominal price rigidiies and imperfec compeiion (Schmi-Grohé and Uribe, 2004). These resuls carry relevan insighs ino he sysemaic seing of boh fiscal and moneary policy o economic condiions. A relevan join decision problem for boh auhoriies arises as boh policies can minimise he cumulaive disorion in oupu ha is caused by disorionary axaion and sicky prices. Boh fiscal and moneary policy makers inend o maximise welfare by sabilising inflaion and he resuling oupu gap. Benigno and Woodford (2003) characerise ime-invarian opimal fiscal and moneary policy argeing rules. Boh policies necessarily respond o inflaion as well as oupu arges. Fiscal policy needs o conribue o he radiional moneary ask of inflaion sabilisaion, as ax raes affec real marginal coss (and hence prices). Moneary policy needs o ake accoun of alernaive price and ineres rae pahs for he governmen budge consrain. I will no analyse such heoreical fiscal rules, bu he argumens call for an analysis of fiscal policy ha includes economic responses of he budge. 7 This supposes a cooperaive social planner. Alernaively, fiscal and moneary policy could be on a conflic course, or caugh in a bad policy mix, as each can exploi is own policy insrumen a is discreion (Nordhaus, 1994). This gives rise o eiher an inflaion or a spending bias (Adam and Billi, 2006). Leadership by one or boh policy makers avoids sraegic moves and he non-cooperaive races ha are associaed wih he Nash equilibrium, whenever here is no agreemen on he policy objecives (Dixi and Lamberini, 2003). 15

10 Peer Claeys 1.2. The idenificaion of fiscal policy rules There is no comprehensive framework for analysing fiscal policy. Hence, i is useful o se some erminology for characerising fiscal policy. The main disincion is beween fiscal policy acions ha can be aribued o discreionary policy decisions on he one hand and auomaic responses of fiscal variables o cyclical economic condiions ( auomaic sabilisers ) on he oher. By definiion, we can decompose any indicaor of fiscal sance f ino a srucural (or cyclically adjused par fˆ ) and a cyclical componen ( α ) as shown in (6), wih α being he elasiciy of he fiscal indicaor wih respec o oupu: y f fˆ + αy. (6) The laer componen includes he reducion of unemploymen benefis and ransfer paymens, or he increase in ax receips in an economic boom. 8 Typically, one would aribue he srucural par o discreionary policy inervenion. Wih a fiscal rule, in conras, I express he indicaor f as a funcion h ( ) of cyclical condiions y and some oher variables colleced in X, for example, poliical variables, elecion cycles, ec.: f = h y, X ) + ε. (7) ( We can associae cyclical reacions of fiscal policy wih auomaic sabilisers. Bu, in addiion, he governmen may wish o seer he economy and implemen supplemenary measures in response o economic condiions. The governmen may wish o furher fuel a boom by lowering axes or increasing spending, or lean agains he wind by raising ax revenues and cuing spending. Any sysemaic cyclical reacions of discreionary policy are also included in he cyclical reacion. The non-sysemaic par is he rue policy shock ε. The esimaion of moneary policy rules has become a rue research indusry. In conras, fiscal rules like (7) are no widely esimaed. There are a number of reasons for his lack of evidence. 8 Figure 2 shows he close correlaion beween boh he surplus and gap series, and he common urning poins a changes in he economic growh cycle. 16

11 Peer Claeys Firs, fiscal policy indicaors are no widely available. Daa consrains limi he analysis: reliable measures of fiscal variables a a quarerly frequency are available for a limied number of counries only (Peroi, 2005). Second, he esimaion of moneary policy rules has been guided by he validiy of he Taylor Principle by which cenral banks should no accommodae changes in he price level (Clarida e al., 2000). There is no similar leimoiv in fiscal rules. Pleny of papers limi he analysis o gauging he cyclical sensiiviy of some fiscal policy indicaor in (7). Oher papers mosly focus on he response of he fiscal surplus o public deb (Bohn, 1998). Sill anoher branch of he lieraure focuses on poliical deerminans of fiscal policy. Consequenly, fiscal rules have hardly carried he normaive policy prescripions of he moneary Taylor rule. Third, he heerogeneiy of fiscal policy boh in is seing (composiion of revenues versus spending) and in is effecs on differen economic agens impedes a sraighforward exension of fiscal rules as i implies several idenificaion problems. The main problem relaes o he auomaic sabilisaion componen in fiscal variables. No only do cyclical flucuaions explain an imporan par of he variaion in fiscal variables because of he workings of he auomaic sabilisers. Excep under he hypohesis of Ricardian equivalence, hese flucuaions may also be deermined by he fiscal variable. If fiscal policy indeed has real effecs on he economy, hen he fiscal policy shock is likely o be correlaed wih he oupu gap in he policy rule. Second, here is a poenial join dependence beween he primary defici and deb ha works via he ineracion of he fiscal rule wih he deb flow equaion (1). Applying OLS leads o biased and inconsisen esimaes and he degree of sabilisaion would consequenly be overesimaed. Boh problems sugges insrumenal esimaion o correc for he endogeneiy of oupu, and correcly label he esimaion of his reacion funcion as a fiscal policy rule. There are only a few papers ha es fiscal rules. Viren (2002) demonsraes how much he cyclical sensiiviy of he budge is reduced for a pool of EU saes. Lane (2003) examines cyclical properies of differen governmen budge componens: cyclicaliy is shown o vary subsanially across budge iems. Ballabriga and Marinez-Mongay (2003) esimae non-linear fiscal policy rules for EU counries. Fiscal policy is found o be only weakly counercyclical. 17

12 Peer Claeys Finally, he heerogeneiy of fiscal policy also reflecs he poliical naure of spending and ax decisions. Srucural breaks in fiscal policy have no been so well documened. A range of eligible breakdaes has been suggesed in he lieraure, mosly based on ad hoc argumens. Narraive sudies on he effecs of fiscal policy use major US defence spending increases such as he Korean, Vienam or he Cold War o idenify fiscal shocks (Ramey and Shapiro, 1998). A common urning poin for European fiscal policy is supposed o be he consolidaion sared under he Treay of Maasrich (Wyplosz, 2005; Galí and Peroi, 2003). For Sweden, Ohlsson and Vredin (1996) relae fiscal oucomes direcly o changes in governmen ideology. The long-erm orienaion of fiscal policy probably undergoes more gradual ransformaions. Hence, fiscal rules are bes undersood by relaing hem o differen regimes. A few papers explicily model coninuous regime changes in US fiscal policy (Davig and Leeper, 2005; Favero and Monacelli, 2005). 2. Mehodology Fiscal daa for Sweden are available a a quarerly frequency since 1970, and cover a broad range of spending and ax iems. I can hus characerise fiscal policy behaviour over a reasonably long sample and over a period wih relevan policy shifs. The budge daa give sufficien deails o look a he policy conduc of governmens. In order o characerise fiscal policy behaviour, I ake as he baseline arge rule of he governmen a reacion funcion of a surplus objecive s ha is se a some long-erm level s *, 9 bu also varies in response o cyclical condiions and public deb, s * e = s + γ ( y y ) + θ( b b ). (8) The surplus arge flucuaes in response o expeced deviaions of e oupu y from he desired arge oupu level y. The oupu response γ does no only capure he auomaic sabilisaion responses of some spending and revenue caegories; i also includes he sysemaic discreionary inervenion of he governmen o cyclical condi- 9 This could, for example, correspond o a golden rule defici which allows producive invesmen spending o be financed by issuing deb. 18

13 Peer Claeys ions. If he governmen jus les he auomaic sabilisers work over he cycle, hen γ=α. The governmen also aaches some direc weigh on deb by keeping under conrol deviaions of deb b from a seady sae long-erm level for deb b *. We can filer he surplus arge by applying he definiion equaion (6) o (8). Under he assumpion ha he long-erm surplus and oupu level arges of he governmen are consisen, I obain an expression for he cyclically adjused insrumen * sˆ ŝ of he fiscal auhoriy e = sˆ + ( γ α )( y y ) + θ( b b ). (9) The argeed cyclically adjused surplus is in par srucural, bu is also deermined by any bias in oupu or deb sabilisaion he governmen may have. Fiscal policy is more ypically characerized by implemenaion lags han is moneary policy. Governmens pu in pracice elecoral promises and he budge process involves lenghy parliamenary processes. Sunk decisions of previous governmen are no easily unwound. Hence, he anicipaed (endogenous) componen of fiscal policy should be adequaely represened by simple feedback rules. I assume ha he fiscal insrumen only gradually adjuss o is arge level: 10 s = ρ s + (1 ρ ) s + υ. (10) 1 This gives he following non-linear relaion beween he surplus and public deb, and is he baseline empirical specificaion of he fiscal rule: s [ ω + γx + θb ] = ρ s 1 + (1 ρ ) + υ (11) where he oupu gap is given by x = y y. In his rule, ω equals sˆ* γ ( y y) θ( b b ) and represens he long-erm fiscal indicaor adjused for he deviaion beween he governmen s oupu (deb) arge and long-erm oupu (deb). The residual erm υ capures dis- 10 Alernaively, he governmen may implemen a policy ha gradually converges o some deb level. 19

14 Peer Claeys creionary exogenous deviaions from he rule (which is inerpreable as a fiscal policy shock). I es (11) as he baseline fiscal policy rule. Le us assume ha he fiscal insrumen is he primary surplus raio o GDP. The key ineres usually focuses on he sysemaic cyclical properies of fiscal policy. I ake as he oupu measure he gap calculaed by OECD. 11 If auomaic sabilisers are allowed o work, hen γ = α and he srucural surplus ŝ is consan a is long-erm level ŝ ceeris paribus. A posiive coefficien γ > α indicaes addiional discreionary inervenion, while γ < α procyclically magnifies he oupu gap. General governmen deb is consolidaed across differen governmen levels, and expressed as a raio o GDP. Deb susainabiliy has commonly been inferred from a posiive coefficien, θ. 12 The magniude of his response is of minor imporance: as long as a sabilising response o public deb comes abou on average, his is sufficien for susainabiliy (Canzoneri e al., 2001). Tesing a fiscal policy rule as in (11) suffers from simulaneiy because of he dependence beween he surplus and deb, and he economic effecs of fiscal policy. I herefore use a Generalised Mehod of Momens (GMM) procedure o idenify he equilibrium responses of he reacion coefficiens in he fiscal rule. In he se of insrumenal variables, I include lags of he oupu gap and deb. In addiion, I consider uni labour coss, growh in labour produciviy and he NAIRU as domesic supply side facors. A broad money aggregae akes accoun of domesic moneary policy. Oher insrumens model inernaional moneary condiions (a synheic ineres rae of he Euro Area, oil price index, he SEK/DEM exchange rae). I es overidenifying resricions wih he J-es (Hansen, 1982); and I addiionally compue he F-es on he firs sage regression for each of he endogenous righ-hand side variables o es for weak idenificaion. 11 Auomaic sabilisers respond o real ime changes in he economy. I choose he conemporaneous oupu gap. In case he governmen gives addiional fiscal impulses o he economy, i bases his decision on curren oupu condiions available a he ime of planning governmen spending, raher han on daa ex pos. Unforunaely, real ime daa on he oupu gap in Sweden are available since 2000 only. 12 In FTPL erminology, a similar condiion implies ha fiscal policy is passive (see Secion 2). 20

15 Peer Claeys 3. Fiscal rules, and heir effecs 3.1. The baseline fiscal rule Le us firs consider a baseline fiscal rule, in which he governmen sabilises deb wih he primary surplus. Table 1 repors he GMM esimaes of he fiscal rule (11). The main finding is ha he governmen does no sufficienly raise he primary surplus o pay off ousanding deb. The response o deb of he primary surplus is no significan. The negaive sign raher indicaes ha deficis have been growing in he wake of rising deb. The implicaion is ha deb in Sweden is no on a susainable pah. Time series ess for susainabiliy on he surplus and deb series give a similar resul. 13 Fiscal policy is no very sluggish. The budge surplus is less persisen han wha i seems a firs sigh: afer one year, abou half of he budge decision has already been reconsidered. This is much faser han revisions of moneary policy, for example. These findings are in line wih he resuls of Ballabriga and Marinez-Mongay (2003) or Galí and Peroi (2003) for Sweden. The budge is remarkably responsive o he cycle: a 1 per cen improvemen in he oupu gap srenghens he budge posiion by abou 1.40 per cen. This srong procyclical effec is known as in oher Scandinavian counries o largely be he effec of he exensive welfare sae and large auomaic sabilisers buil ino he unemploymen sysem. Bu he response is much sronger han he compued elasiciy of he oal balance. Recen OECD sudies show how he oupu elasiciy of he oal budge balance is abou 0.79 in Sweden. The reform of he welfare sae and he ax sysem has subsanially brough down he sensiiviy of he budge o cyclical variaions. The elasiciy shrunk o abou Boh he (primary) surplus and deb raio are inegraed of order one. In case one conrols for poenial breaks in he ime series, boh he Zivo Andrews and he Perron es indicae ha he deb raio is I(2). Furher indicaion of unsusainable fiscal policies is given by ineres paymens, which also behave as an I(2) process. Coinegraion ess insead show ha boh spending and revenues expand as a raio o GDP, bu ha axes offse he increases in primary spending and ineres paymens. Similarly, he primary surplus and deb are coinegraed. 21

16 Peer Claeys Table 1. Fiscal surplus rule (1970:1-2006:4) Primary surplus Primary surplus raio Surplus raio raio o poenial GDP ρ γ : : :1 θ (0.76) 1995: (0.12) 1995: (0.49) 1995:4 R F dw J (0.44) (0.79) (0.90) F 1 γ F 1 θ AQ break 1995:1 [1994:1;1996:1] Bai Perron 1975 : : : : : : : :4 1993:4 [1992:2;1995:2] 1975 : : : : : : : :4 1993:4 [1992:2;1995:2] 1975 : : : : : : : :4 Noes: coefficiens of (11) are repored ogeher wih p-values in brackes; daes below coefficien esimaes are he significan Andrews Ploberger breakdae for ha coefficien; dw is Durbin Wason es; J he p-value for he Hansen es of over idenificaion; F 1 he p-value for he F-es on he significance of insrumenal variables in he firs sage regression (es for weak insrumens); AQ he supremum Andrews Quand break es on all coefficiens, and is confidence inerval; Bai Perron is a es for muliple breaks for all coefficiens. Even if one accouns for he uncerainy surrounding he assumpions on he oupu elasiciies of differen ax bases, a rise in he oupu gap of one per cen will sill no lead o an improvemen in he budge sance of more han 0.47 o 0.62 per cen (Girouard and André, 2005). The saisically significan difference o he acual budge response lies wih a counercyclical policy ha gives addiional fiscal impulse o he economy in a recession, and reins in deficis in 22

17 Peer Claeys economic booms. This finding also holds for he oal surplus. This should no come as a surprise, given ha ineres coss on deb may vary over he cycle, owing o changes in he ineres rae and inflaion. The resul also coninues o hold if we accoun for cyclical flucuaions using filered daa. I scale he daa by poenial GDP o remove shor-erm cyclical reacions in he nominaor: he cyclical response remains as large. The finding of an acive fiscal policy ignoring deb is confirmed for all alernaive definiions of he surplus. Fiscal policy is a consequence of poliical bickering and is longerm orienaions are hence likely o vary over ime. The large deficis in he early eighies and nineies ha creaed he firs and second big boom in public deb have been alernaing wih periods of a igher fiscal sance (Figures 1 and 2). This insabiliy could explain he finding of unsusainable fiscal policies in Sweden. I es he parameers in he fiscal rule for srucural breaks in hree differen ways. Firs, I search endogenously for a join break in all coefficiens and esimae his breakdae by leas squares, esing is significance wih he supremum Quand LR es on he cenral 70 per cen of he sample. I modify he es o accoun for subsample variabiliy by condiioning he break es on a poenial change in he residual variance before and afer he breakdae in he coefficiens. Accordingly, he modified es scales down periods of greaer urbulence and magnifies relaively small policy shifs in less urbulen periods. The confidence inerval around his break indicaes how precisely we can locae a change in he parameer (Bai, 1997). A major break in he fiscal rule occurs in 1993:4, and heralds he gradual reducion of he record per cen defici o a 5 per cen surplus in 2000:3. This swich in fiscal policy is quie precisely esimaed o fall beween 1993 and Consolidaion could be he effec of fiscal resrain, bu could as well be due o favourable economic condiions. Figure 2 shows ha he Swedish economy coninued o grow over he nineies, and boomed paricularly srongly a he urn of he cenury. I es he oupu and deb reacion coefficien of he fiscal rule separaely for a poenial break wih he same Quand es. A change from a negaive o a posiive response o deb occurs in This shif o a susainable fiscal policy is also visible from Figure 1. Bu we canno exclude ha economic growh maers for consolidaion a he same ime. The link beween he surplus and oupu seems o have become subsanially weaker afer This furher confirms ha ax reform has reduced he reacion of he budge o he cycle (Girouard and André, 2005). 23

18 Peer Claeys Given he volailiy of fiscal policy in Sweden, locaing a single break seems raher peculiar. A plo of he breakpoin es saisics insead indicaes several candidaes for srucural breaks (Figure 3). Insabiliy in fiscal policy is spread ou over he eighies and nineies. I herefore run he Bai Perron es ha selecs he n bes breakpoins for he fiscal rule (Table 1). Fiscal policy seems o be raher erraic a he end of he sevenies: here are no less han four breaks beween 1975 and I is probably no surprise ha his period also consiues he sar of he deb problem in Sweden. Only four oher breaks have occurred since hen. The 1986 break indicaes a swich o fiscal resrain in he mid eighies. In 1991, he larges fiscal crisis in Sweden occurred. Deb sared o be pu under conrol in Fiscal policy once more shifed en years afer he 1991 crisis. However, somehing has changed in he fiscal policy seing. In conras o he previous loosening of he fiscal sance, his did no lead o an increase in deb in Figure 3. Recursive Andrews Quand LR es saisics for sabiliy of fiscal rule (11) es saisics exponenial es average es 3.2. Spending and ax rules Wha kind of spending or ax policies (or a combinaion of boh) did Swedish governmens pursue ha led o fiscal havoc? Does he fiscal policy sraegy o consolidae deb differ from policies ha creae i? Figure 4 shows ha dramaic spending hikes in 1980, and once more in 1991, have been far from offse by commensurae ax increases. The ax burden hovers beween 60 o 65 per cen of GDP, bu he variaion in spending is much more pronounced. Public spending has 24

19 Peer Claeys fallen from is 1993 peak of 75 per cen of GDP o abou 55 per cen oday. Figure 4. Spending, and revenue raio o GDP spending revenues Noe: verical bars indicae he roughs of growh cycle recessions (ECRI). I esimae a fiscal spending rule by subsiuing for he spending raio o GDP in (11), and esimae his non-linear rule by GMM. I is hen eviden ha spending increases have grealy conribued o he explosion of deb (Table 2). Only afer 1993 does spending resrain conribue o he gradual consolidaion of deb. 25

20 Peer Claeys Table 2. Fiscal spending rule (1970:1-2006:4) Toal spending γ :3 θ 0.06 (0.04) 1993:1 Curren Consumpion Wages Invesmen Subsidies spending Ineres Transfers : : (0.11) 2001: : (0.21) 2001: :1 R dw J (0.20) (0.21) (0.15) (0.35) (0.07) (0.38) (0.16) (0.23) : : : : : (0.01) 1995: : :4 AQ break 1993:1 [-;-] 1993:1 [1992:3; 1993:3] 1986:4 (0.20) :3 (0.25) :4 [1992:2; 1993:2] 1989:4 [1989:2; 1990:2] 1992:4 [1992:2; 1993:2] 1978:4 (0.09) - Bai Perron 1977:4 1979:4 1991:4 1995:4 1991:4 1973:3 1977:4 1983:1 1995:3 1983:1 1986:1 2001:3 2005:2 2006:1 2005:2 1978:4 1992:3 1997:4 2001:3 1997:4 1977:4 1980:2 1987:4 1994:3 1987:4 1972:4 1975:4 1989:4 1996:2 1989:4 1975:2 1987:4 1989:4 1996:2 1989:4 1973:3 1977:4 1985:1 1996:2 Noes: see Table 1. 26

21 Peer Claeys I look in somewha more deail a differen spending iems. This gives some ineresing insighs ino he way deb was iniially creaed, and consolidaion has been achieved aferwards. Figure 5 plos he composiion of oal governmen spending over ime. Over he sevenies, social ransfers as well as public wages gradually absorbed an increasingly large share of he budge. This rise was only briefly inerruped by he 1979 spending cu. The spending boom of 1981 le he share of ransfers and spending on public wages grow o no less han wo hirds of oal spending. The 1991 defici plunge once more financed a srong increase in social ransfers, as well as public consumpion. The rising burden of ineres paymens gradually sared o crowd ou various oher spending caegories. Public employmen did no increase much furher afer The conracion mainly came a he expense of governmen invesmen, as well as subsidies. 100 Figure 5. Composiion of governmen spending (per cen of oal) consumpion subsidies wages ineres invesmen ransfers The esimaion of a spending rule for every budge iem confirms ha he growing burden of ineres paymens has reduced he budgeary room for oher spending iems. This conracion has been especially pronounced for governmen invesmen. Break ess show ha governmen invesmen was he firs budge iem o suffer cus due o he fiscal rouble in he sevenies. Likewise, subsidies have been reduced in he wake of higher deb. The significan cu in public wage spending has by far been he mos imporan way o fiscal resrain afer In erms of economic size, public wages nowadays absorb 27

22 Peer Claeys abou 15 per cen of GDP, bu have come down from 23 per cen of GDP in The main culpri of he deb problem is he coninued rises in public consumpion and social ransfers. Afer he 1991 deb crisis, lile effor has been made o ackle eiher of hese major spending iems. The endency o expand public consumpion has only been reversed since Public consumpion has no been kep under conrol for long, hough. The Bai Perron es indicaes ha already in 2001, public consumpion was on he rise again. Likewise, a srong increase in social ransfers began in 1978, and his endency has no ever been reversed since. Table 3. Fiscal ax rule (1970:1-2006:4) Toal revenues Tax revenues γ (0.34) 1980: (0.13) 1980:2 θ : (0.01) 1976:2 R dw J (0.11) (0.11) AQ break 1998:1 (0.30) - Bai Perron 1975:3 1985:3 1996:1 2001:3 Noes: see Table :1 (0.21) :3 1985:3 1994:4 2001:3 Viewed from his perspecive, he fiscal rules inroduced in 1997 do no seem o have been very efficien. The major consolidaion effor had already aken place before Hence, he spending cap has no direcly imposed a consrain on he budge decisions of he governmen. The spending cap raher refleced pracices of he las consolidaion. The reversal of spending behaviour in 2001 shows ha he rule is no binding enough. The nominal spending arge is se wihou a clear reference o some basic level. The budgeary margin has been compleely used for addiional spending in nearly all years (IMF, 2005). 28

23 Peer Claeys The immediae measure for balancing budges has insead been o increase ax revenues (Table 3). 14 In response o rising deb, ax rises have been used o finance growing spending. Higher ax levels have caugh up wih spending booms since he mid sevenies. Bu he ax burden has no noiceably come down in periods of spending cus. There are no significan breaks in he ax rule. The Bai Perron es noneheless indicaes a break in boh 1996:3 and 2001:3, and poins o he ax reforms underaken in more recen years. Table 4. Fiscal spending and ax rule, GMM sysem esimaes (1970:1-2006:4) Spending ρ 0.88 γ (0.04) 1980:2 θ 0.20 (0.03) 1976:2 Revenues ) (0.37) 1980: (0.06) 1976:2 R dw J (0.61) Correlaion 0.77 Noes: see Table 1. If he governmen were o minimise economic disorions and keep ax raes consan, ax revenues would vary wih he economic condiions. Insead, oal revenues are no responsive o he cycle. Hence, auomaic ax sabilisers are no allowed o work over he cycle. This is mos likely he consequence of decisions o raise axes o conain he budge defici, regardless of he curren economic sance. Spending is quie counercyclical, however. In conras o spending policies in oher OECD counries (Lane, 2003), spending is considerably reduced during economic upurns. Hence, here does no seem o be a relevan rade-off beween deb and oupu sabilisaion on he spending side. Spending hikes ha are decided upon in good economic imes do no ge locked in. The procyclical budge surplus is 14 I separaely esimae a ax rule. As budge decisions concern boh ax bases and ax raes, he analysis of differen ax iems is less insighful. Therefore, I limi he analysis of ax rules o oal revenues. 29

24 Peer Claeys mainly due o shifs in spending. The join esimaion of a spending and ax rule wih sysem GMM does no aler hese conclusions. The signs of he cyclical and deb coefficiens are idenical, and of a similar size (Table 4). 4. Fiscal policy regimes Fiscal policy may swich is sance due o poliical and economic circumsances. Even perfecly reasonable policy makers may find i jusified o give in o renewed calls for spending hikes or ax cus. Bu policies coningen on hese circumsances may urn ou o be flawed when condiions change. I deail he changes in fiscal behaviour over ime by esimaing a Markov swiching model in which he probabiliy of each regime can vary endogenously. A priori, here should probably be wo differen regimes in fiscal policy: spending or axes are eiher passively adjused o keep deb under conrol, or fiscal policy acively disregards deficis Regime swiching deb The difference beween an acive or a passive regime for he surplus shows up in he behaviour of he deb raio over ime. I follow Davig (2004) in classifying deb behaviour in differen saes over ime. In paricular, I assume he regime generaing process o be a wo-sae Markov chain. This Markov swiching model for deb (12) is hen esimaed by maximum likelihood, using he EM algorihm. I assume he deb raio o be a simple AR(4)-model. I allow he inercep of his model o shif beween wo differen values, coningen on some laen sae m b = ω m ) + ΛL b + ξ. ( 4 m acive = passive. (12) Moreover, he persisence of fiscal series may reasonably be modelled wih auoregressive parameers ha are he same under boh regimes. I is quie plausible ha afer a change in regimes, he deb raio quickly shoos up bu smoohly converges o a differen level aferwards. I ake accoun of higher variabiliy of deb wih regime varying heeroskedasiciy All compuaions were done in MSVAR for Ox (Krolzig, 1998). 30

25 Peer Claeys Figure 6 plos he ime varying esimaed probabiliies associaed wih each regime. The filered probabiliies (indicaed by he bars) only use he esimaes of he MS model up o ha poin; smoohed probabiliies are based on he full sample esimaes. In order o more easily relae he regimes o he variaions in he deb raio, I also plo he deb raio and he mean deb raio laen in he differen saes of he MS-model. I migh no be surprising ha here is a disincion beween he periods of deb explosion and deb consolidaion. A he end of he sevenies, here is a shif from a low deb regime o a period of higher deb raios. The labelling of each regime wih low or high deb is perhaps no enirely adequae. The laen deb raio of he low deb regime differs by less han 1 per cen of GDP as compared o he mean high deb raio. This is he resul of he uni roo in he deb raio: convergence o a differen level of deb is very slow under boh regimes. 16 Figure 6. Deb raio, Markov swiching, AR(1) model, 2 regimes 75 deb raio mean deb raio probabiliies of regime probabiliies of regime filered smoohed Anoher consequence of he persisence in fiscal series is ha aking conrol of deb is a much more gradual process. A every consolidaion of public deb, he low deb regime gains somewha in probabiliy. Bu even he consolidaion afer he 1991 crisis did no creae 16 As a consequence, regimes are very persisen and he ransiion from one regime o anoher is raher improbable. 31

26 Peer Claeys a real gain in probabiliy of he low deb regime. I was no unil afer six years of coninuous falls in he deb raio ha he regime once more swiched o low deb. Small reversals of fiscal policy, as for example in 2005, migh easily push he deb raio back ino he high deb regime. The inroducion of fiscal rules in 1997 had no immediae consequences on fiscal discipline Fiscal policy swiching Deb is he oucome of changes in policy conduc. I herefore esimae he baseline surplus rule by similar Markov swiching echniques. In he fiscal rule (13), I es for changes in all coefficiens of he fiscal rule. I allow for changes in he reacion coefficiens of fiscal policy, as well as he persisence of he surplus. I also allow for a change in he variance of he underlying shocks in each regime s [ ω( m ) + γ ( m ) x + θ( m ) b ] υ. = ρ ( m ) s 1 + (1 ρ( m )) + (13) Coefficiens may change sochasically over ime, indicaed by he sae m. The regime generaing process is again assumed o be a wosae Markov chain. There is no crierion for selecing he opimal number of regimes in a Markov swiching model. The classificaion in wo regimes of sysemaic policy behaviour corresponds o he acive and passive regime in fiscal policy. Under an acive regime, fiscal policy disregards he pah of public deb. A passive fiscal policy insead consolidaes deb by cuing spending or raising axes. A wo-regime model classifies hese regimes surprisingly well. As a robusness check, I also presen resuls for a hree-regime classificaion, bu his does no subsanially aler he main resuls. 32

27 Peer Claeys Table 5. Regimes in he deb raio, Markov swiching model (1970:1-2006:4) p ii Duraion Obs. ρ ϖ σ Label Regime *** 52.86* 0.28 low deb Regime *** 53.89* 1.24 high deb Noes: p ii is he probabiliy of saying in one regime; *** / ** / * indicaes significance a 1/5/10%. Table 6. Fiscal surplus rule, Markov swiching model, 2 regimes (1970:1-2006:4) p ii Duraion Obs ρ γ θ σ Label Regime *** 0.09*** 0.01*** 0.37 passive Regime *** acive Noes: see Table 5. 33

28 Peer Claeys Table 6 and Figure 7 summarise he behaviour of fiscal policy under he wo regimes. A he same ime as he budge responds o public deb, he surplus also moves procyclically over he cycle (regime 1). In conras, if fiscal policy does no respond o deb in he acive regime, i does no reac o he cycle eiher (regime 2). Only he pas surplus is hen significan in he seing of fiscal policy. Policy seing in he acive regime seems raher erraic. 17 When fiscal policy behaves as a random walk, he variance of policy shocks is hree imes higher han under he passive regime. A period of deb build-up is very much proraced: he creaion of deb only akes wo and a half years, which is half he ime for consolidaing i again. A plo of he regime probabiliies corroboraes he previous finding of quie some insabiliy in fiscal policy from he mid sevenies o he mid eighies. Fiscal policy only inermienly pays aenion o public deb, bu more ofen enirely disregards is evoluion. The governmen adoped a sop and go approach o he consolidaion of public deb in his period. In he 1991 crisis, fiscal policy swiched back quie suddenly o a loose deb sance. Tha approach o fiscal policy has no disappeared a all. Even afer he fiscal consolidaion of 1995, and afer he adopion of he se of fiscal rules, here is a period (2000:4-2002:3) in which he Swedish governmen acively uses fiscal policy. Figure 7. Markov swiching fiscal surplus rule, 2 regimes, probabiliies 1.00 probabiliies of passive regime probabiliies of acive regime filered smoohed 17 There is no imporan difference in he persisence of fiscal policy in each regime. 34

29 Peer Claeys Bu for wha aim do governmens use fiscal policy in an acive regime? Periods in which he governmen willingly uses he budge o reinforce auomaic sabilisers are also periods in which deb is of lesser concern. These periods are usually followed by periods of srong growh in deb. Fiscal impulses ha were inended o respond o economic circumsances were no reversed aferwards. There is a grea deal of evidence of his procyclical behaviour in bad economic imes, and a consequen bad fiscal policy in good economic imes, also in oher European counries. The effec of he se of rules inroduced in 1997 did no preven a similar policy reacion in Windfall revenues due o buoyan economic growh pushed up he surplus (and pushed deb down). The favourable fiscal sance led o a gradual apering off of furher effors in consolidaing deb in he following years. Forunaely, as his was a posiive shock o he surplus, deb did no explode. Fiscal rules were no srong enough o conrol he behaviour of he governmen which had been so ypical for he deb crises of he eighies and nineies Deb, economic growh and moneary policy Governmens do no need o cu spending or raise axes o sabilise deb. Inflaion and economic growh boh erode public deb. The surplus ha he governmen effecively needs o achieve o bring abou he sabilisaion of public deb depends on he evoluion of real ineres raes q as well as nominal economic growh k. Following (5), deb remains sable if he deb sabilizing surplus s equals b 1 ( q k ) (1 + k ). If nominal GDP growh exceeds he ineres cos of deb, persisen deficis are sill consisen wih deb sabilizaion as real economic growh and inflaion ougrow he accumulaed ineres paymens. 18 Figure 8 plos he ime pah of his implici deb sabilising surplus. Persisen deficis were consisen wih a sable deb o GDP raio unil This was he consequence of raher high inflaion exceeding ineres raes. As in mos oher indusrialised counries, he warding off of inflaion and a shif o less accommodaive moneary policy have made real ineres raes persisenly posiive in Sweden since As a consequence, only in periods of srong 18 Sricly speaking, his only holds under he assumpion ha fiscal policy has no real effecs on he economy. 35

30 Peer Claeys economic growh has i been possible o run deficis. This has only been he case in hree years (1987 ill 1990). The recen decline in his surplus is a combinaion of hisorically low real ineres raes, and srong economic growh. Figure 8. Deb sabilising surplus (1970:1-2006:4) I hen subsiue deb b for his deb sabilizing surplus s in he fiscal rule (13). Wih his non-linear specificaion, we can es he relaion beween s and s whaever he effec of nominal GDP growh and ineres raes on fiscal variables (Favero and Monacelli, 2005). In his way, he fiscal rule implicily conrols for variaions in deb ha are no under direc conrol of he governmen iself. Fiscal policy is passive when s eners significanly wih a coefficien ha is no saisically differen from one. In addiion, he consan erm ω should no be saisically differen from zero Given ha an exogenous componen in he surplus would indicae an acive policy. For spending or axes, we may drop his resricion. 36

31 Peer Claeys Table 7. Fiscal rules, deb sabilising surplus, Markov swiching model, 2 regimes (1970:1-2006:4) p ii Duraion Obs ϖ γ θ σ Label Surplus Regime Passive Regime *** -2.62** 1.11 Acive Spending Regime *** -1.03** 38.33*** 5.67 Acive Regime *** -2.17*** 6.02*** 2.25 Acive Tax Regime *** *** 4.73 Passive Regime *** -0.22** 3.24*** 1.42 Passive Noes: see Table 5. 37

32 Peer Claeys The reacion coefficiens of he baseline surplus rule nealy correspond o an acive and passive regime (Table 7). Moreover, he governmen chooses o sabilise deb or smooh he cycle, bu canno do boh. Under he passive regime, deb consolidaion comes a he expense of cyclical sabilisaion. In he periods in which I locae he acive regime ( , and ), here is insead a srong procyclical response of he surplus. 20 This also makes he surplus abou hree imes as variable in he acive regime as under deb consolidaion. Swiches in fiscal policy are no sudden. The creaion and sabilisaion of public deb each akes hree o four years on average. The shif in real ineres raes and economic growh plays some role in explaining some paricular episodes. A he beginning of he eighies, he deb sabilising surplus swiches because of volaile real ineres raes. Fiscal policy has noneheless coninued o be lax since As long as cyclical consideraions prevailed, fiscal policy inenionally disregarded public deb in ha period. I is also much clearer ha in he mid eighies, no all opporuniies were aken o consolidae deb wih buoyan economic growh. Figure 9. Fiscal spending rule, deb sabilising surplus, 2 acive regimes 1.0 probabiliies of acive regime (1) probabiliies of acive regime (2) filered smoohed 20 The plo of regime probabiliies is similar o Figure 7. 38