Working paper No.3 Cyclically adjusting the public finances

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1 Working paper No.3 Cyclically adjusing he public finances Thora Helgadoir, Graeme Chamberlin, Pavandeep Dhami, Sephen Farringon and Joe Robins June 2012

2 Crown copyrigh 2012 You may re-use his informaion (no including logos) free of charge in any forma or medium, under he erms of he Open Governmen Licence. To view his licence, visi hp://www.naionalarchives.gov.uk/doc/opengovernmen-licence/ or wrie o he Informaion Policy Team, The Naional Archives, Kew, London TW9 4DU, or Any queries regarding his publicaion should be sen o us a: ISBN PU1342

3 Cyclically adjusing he public finances Thora Helgadoir, Graeme Chamberlin, Pavandeep Dhami, Sephen Farringon and Joe Robins Office for Budge Responsibiliy Absrac The specificaion of he Governmen s fiscal mandae in cyclically-adjused erms requires he OBR o make an assessmen of he effec of he economic cycle on he public finances. These esimaes are generally produced for he main fiscal aggregaes using cyclical adjusmen coefficiens. In his paper we reassess he size of he cyclical adjusmen coefficiens boh by revisiing previous Treasury analysis and by considering a range of oher approaches. Our esimaes sugges a conemporaneous cyclical adjusmen coefficien o he oupu gap for ne borrowing and curren budge of 0.5 and a lagged coefficien of 0.2, which are he same as he coefficiens he OBR has used in is forecass o dae. We use hese coefficiens and he OBR's hisorical oupu gap series o produce an updaed hisorical series for srucural ne borrowing. We also analyse he effec ha flucuaions in asse prices and propery ransacions, which are no relaed o he economic cycle, could have on he public finances using wo differen approaches. We are graeful for commens from colleagues a he Office for Budge Responsibiliy, he OBR s Advisory Panel and colleagues a HMRC and DWP. JEL references: E62, E32 Keywords: Fiscal policy, Cycles

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5 Conens Chaper 1 Inroducion... 1 Chaper 2 Esimaing cyclical adjusmen coefficiens... 5 One-sep approach... 6 Two-sep approach Conclusion Chaper 3 Alernaive approaches o cyclical adjusmen SVAR model Componen mehod (ECB) Conclusion Chaper 4 Asse price adjusmens Adjusing for asse prices and propery ransacions Conclusion Chaper 5 Conclusion Chaper 6 References Annex A Sensiiviy and robusness Annex B The relaionship beween he one-sep and wo-sep approaches Annex C Simulaneous equaion bias and he problem of idenificaion Annex D Srucural VARs and idenificaion... 83

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7 Inroducion 1 Inroducion 1.1 The Office for Budge Responsibiliy (OBR) has been asked wih judging wheher he Governmen has a greaer han 50 per cen probabiliy of achieving he medium-erm fiscal arges ha i has se iself. The Governmen s fiscal mandae is currenly defined as he requiremen o balance he cyclically-adjused curren budge (CACB) by he end of a rolling, five-year period. 1.2 The specificaion of he fiscal mandae in cyclically-adjused erms requires he OBR o make an assessmen of he effecs of he economic cycle on he public finances. This is generally done by adjusing a given fiscal aggregae, such as ne borrowing or he curren budge, for he amoun of spare capaciy in he economy (he oupu gap) using cyclical adjusmen coefficiens. 1.3 To dae, he OBR has adoped he Treasury s approach o cyclical adjusmen as presened in he 2008 Treasury working paper: Public Finances and he cycle. In his paper we reassess he size of he cyclical adjusmen coefficiens. We do his by revisiing he previous Treasury analysis and by considering a range of alernaive approaches o cyclical adjusmen. Esimaing cyclically-adjused fiscal aggregaes 1.4 The cyclical posiion of he economy is likely o have an impac on public secor receips and expendiure. If he economy is operaing below is poenial (i.e., here is a negaive oupu gap ) hen, oher hings equal, here is likely o be higher expendiure on iems such as jobseekers allowance. Similarly, here are likely o be lower receips from sources such as income ax, corporaion ax and VAT, due o lower labour income, corporae profis and consumer spending, respecively. 1.5 This implies ha governmen borrowing will ypically end o be higher when oupu is below is poenial level, and lower when oupu is above is poenial. Adjusing for he impac of he cycle on he public finances provides an esimae of he srucural posiion of he public finances, once he emporary effecs of he economic cycle have been removed. 1.6 The cyclical adjusmen coefficiens used o make his adjusmen are derived by analysing he pas relaionship beween he oupu gap and he fiscal posiion. As explained in he OBR s Economic and fiscal oulooks (EFO), he esimaes of hese coefficiens are highly uncerain for a number of reasons: 1 Cyclically adjusing he public finances

8 Inroducion he oupu gap is no direcly observable, so here is no hisorical fac from which o esimae he coefficiens; he number of observaions on which o base coefficien esimaes is limied; he fiscal posiion is affeced by evens ha do no necessarily move in line wih he cycle, such as one-off fiscal policy adjusmens and movemens in commodiy and asse prices; and insofar as he curren economic cycle differs from he average cycle, he relaionship beween he public finances and he oupu gap over he course of ha cycle will no be capured in he coefficiens. 1.7 In his paper we aemp o address hese uncerainies as far as possible. We compare he resuls from several approaches o esimaing he cyclical adjusmen coefficiens. In our cenral esimaes we make use of he hisorical oupu gap series published in he OBR s Working paper No. 1: Esimaing he UK s hisorical oupu gap, bu we es he sensiiviy of hese resuls o alernaive oupu gap series. We exend our analysis by using he srucural VAR approach o consider he poenial feedback from fiscal policy o he oupu gap. We also analyse he poenial impac on he fiscal posiion from emporary facors ha may no be correlaed wih he economic cycle, in paricular asse prices and ransacions. Main conclusions 1.8 Our esimaes sugges a conemporaneous cyclical adjusmen coefficien of 0.5 and a lagged coefficien on he previous year of 0.2. These are he same coefficiens ha have been used in EFOs o dae. We have used hese coefficiens and he OBR s hisorical oupu gap series o produce an updaed hisorical series for srucural ne borrowing. The change in he oupu gap series means ha srucural borrowing appears somewha higher in he 1990s and in he run up o he 2008 financial crisis han previous Treasury esimaes have implied. Srucure of he paper 1.9 The analysis in his paper is srucured as follows: in Chaper 2 we esimae cyclical adjusmen coefficiens using he previous Treasury approach and he approach used by he Organisaion for Economic Cooperaion and Developmen (OECD). Boh approaches are based on economeric esimaion of he pas relaionship beween he oupu gap and he fiscal posiion; Cyclically adjusing he public finances 2

9 Inroducion Chaper 3 considers some exensions o hese approaches. We esimae a srucural vecor auoregressive model (SVAR) which aemps o address he endogeneiy of he oupu gap and fiscal policy. We also look a he approach used by he European Cenral Bank (ECB) which aemps o correc for he impac of changes in he composiion of GDP; Chaper 4 analyses he poenial emporary effecs on he fiscal posiion of flucuaions in asse marke prices and ransacions, which may no be correlaed wih he economic cycle; and Chaper 5 summarises and ses ou our conclusions. 3 Cyclically adjusing he public finances

10 Inroducion Cyclically adjusing he public finances 4

11 Esimaing cyclical adjusmen coefficiens 2 Esimaing cyclical adjusmen coefficiens 2.1 This chaper explains and presens he resuls from wo economeric approaches used o cyclically adjus he public finances. To dae in he OBR s forecass of he public finances i has adoped he approach firs se ou in deail in a Treasury Occasional paper published in 1995, Public finances and he cycle. The resuls have since been updaed by he Treasury on regular occasions mos recenly in 2008 bu he underlying mehodology has remained broadly unchanged. 1 We call his he one-sep approach as i involves regressing public expendiure and receips direcly on he oupu gap. 2.2 We hen consider a more widely-used mehodology developed by he OECD. We label his he wo-sep approach as i involves firs regressing he ax/expendiure economic base (for example, oal labour income as he base for income ax receips) on he oupu gap, and hen esimaing he responsiveness of he ax/expendiure sream o is base. The OECD applies his approach across a number of counries and herefore makes a number of simplifying assumpions o do so. We are able o ailor he approach o he UK using counry-specific models and daa. 2.3 We use boh approaches o esimae cyclical adjusmen coefficiens for he UK using he laes available daases. We hen assess he robusness and he relaive meris of he wo approaches. For our cenral esimaes we have used he oupu gap series published in he OBR s Working paper No. 1: Esimaing he UK s hisorical oupu gap, bu we also consider he sensiiviy of he resuls o alernaive hisorical oupu gap series. 2.4 The approaches produce cyclical adjusmen coefficiens consisen wih adjusing public secor ne borrowing (PSNB) figures. However, since he difference beween PSNB and he curren budge balance is mainly public invesmen, which is small as a share of GDP, he coefficiens can also be used o cyclically adjus he curren budge. 1 HM Treasury (1995), (1999), (2003) and Farringon e al, (2008). 5 Cyclically adjusing he public finances

12 Esimaing cyclical adjusmen coefficiens One-sep approach Overview of mehod 2.5 The underlying mehodology of he one-sep approach is relaively simple. Expendiure and revenue expressed as raios o GDP over he pas 30 years are regressed agains esimaes of conemporaneous and lagged oupu gaps. The coefficiens in he equaions indicae he average responsiveness of he public finances o he economic cycle. 2.6 In is analysis, HM Treasury adjused he resuls of he regression analysis o allow for prior expecaions based on srucural changes in ax and expendiure sysems ha migh no be picked up fully in he regression analysis. The adjused coefficiens were used by HM Treasury, and subsequenly by he OBR, o adjus nominal fiscal aggregaes (expressed as raios o nominal GDP) for he impac of he economy s posiion in he cycle. 2.7 There are a number of heoreical and pracical difficulies wih implemening his sraighforward approach. For example, he use of hisorical daa means ha he esimaes reflec he average effec of changes in he oupu gap on he public finances over previous cycles. If he curren economic cycle differs from he average cycle, he relaionship beween he public finances and he oupu gap over he course of ha cycle will no be capured in he coefficiens. We herefore conduc some sensiiviy analysis of he resuls o he choice of ime period by looking a he resuls for individual cycles and recursive esimaion of he equaions. The resuls are discussed in Annex A. 2.8 Anoher problem wih his approach is ha ideally i is necessary o remove he effecs of discreionary fiscal policy changes on he daa series of governmen expendiure and receips used in he regressions. Oherwise he regression may capure changes in receips and expendiure driven by policy choices. In pracice, as discussed below, adjusing daa for policy effecs is very difficul and is only really feasible for receips, alhough some aemp is made o model policy effecs in he expendiure regressions The following secions discuss, in urn, he approach o modelling he aggregae and individual ax receips effecs, he expendiure effec and how o combine he 2 Noe ha his approach is similar o wha has come o be ermed he narraive approach o he idenificaion of fiscal policy (see for example Romer & Romer (2010)). Indeed he daase of discreionary policy decisions ha we have made available on our websie alongside his paper should prove o be a useful ool for furher research in his area. Cyclically adjusing he public finances 6

13 Esimaing cyclical adjusmen coefficiens resuls ino a single esimae of cyclical adjusmen coefficiens ha can be applied o ne borrowing and he curren budge. Receips and he cycle 2.10 To esimae he effecs of he economic cycle on ax receips we begin by consrucing a policy-adjused daase for he bulk of ax receips using published cosings of ax policy measures since 1970 (see Box 2.1). In heory, removing he esimaed policy cosings from he individual (and aggregae) receips series leaves us wih a ax series ha should be predominanly driven by movemens in he economic cycle. Char 2.1 shows he resuls of his exercise. 3 Char 2.1: Indexed ax o GDP raios Index 100 = Source: OBR Unadjused Adjused 2.11 The adjused series follows our esimae of he economic cycle a lile more closely, hough he correlaion is no very srong. The difference beween he wo series also appears o be largely relaed o he cyclical posiion of he economy: from o : a gap opens up as he unadjused series falls, while he adjused series increases. This paern is consisen wih a cyclical increase in ax receips ha is more han offse by procyclial discreionary policy loosening; 3 The char sars in 1973 due o he unavailabiliy of more deailed informaion on ax receips prior o his year, which resrics he effecive size of our sample period. 7 Cyclically adjusing he public finances

14 Esimaing cyclical adjusmen coefficiens from o : boh series fall a approximaely he same rae, due o a cyclical fall in ax receips; and from o : he gap closes as (milder) procyclial discreionary policy ighening booss he unadjused series Noe ha his series only encompasses an average of around 85 per cen of oal ax receips and covers he major ax heads: income ax & NICs, VAT, corporaion ax, fuel duy (plus VED), capial axes and excise duies. 4 This is because Budge cosings for he oher principal elemens (e.g. local auhoriy axes) are no available on a consisen basis. We herefore exclude local auhoriy axes and oher receips (mainly ineres dividends, rading surpluses and ren) from his analysis. However, his is a slighly larger wider ax aggregae han used in previous Treasury analyses, which also excluded capial axes. Box 2.1 provides more deail of he mehod we use o produce he policy-adjused series and he uncerainies involved Once he daase has been policy-adjused i is also necessary o adjus for large, one-off, fiscal operaions ha can affec he calculaion of he cyclicallyadjused fiscal balances even hough hey have no, or very lile, implicaions for he fiscal sance. The only example in he UK ha requires a specific adjusmen is he aucioning of hird generaion mobile elephone licenses. The new classificaion reamen of hese receips as a ne capial ransfer will reduce PSNB (bu no ax receips) by a one-off amoun of 22.5bn in an effec which should be removed from he calculaion of cyclically-adjused borrowing. 5 4 The proporion of oal ax receips accouned for by hese ax heads rises hrough he 1980s from 75 per cen o over 90 per cen a he sar of he 1990s. 5 See Treamen of he sale of UK 3G Mobile Phone Licenses in he Naional Accouns - Augus 2011, available a for more deails. Cyclically adjusing he public finances 8

15 Esimaing cyclical adjusmen coefficiens Box 2.1: Consrucing he policy-adjused ax receips daase To compile our policy-adjused ax receips series we have consruced a daabase of all of he larger ax policy measures of he las 42 years. a These policy measures are lised in he ables which se ou he coss of new measures published by he Treasury a Budges and oher fiscal evens since Budge This approach herefore assumes ha hese iniial policy cosings were accurae, alhough here are significan uncerainies around many policy cosings, and heir accuracy is ofen very difficul o assess ex-pos. In he ineress of efficiency, we have ypically only included policy measures ha were cosed in excess of plus or minus 50 million in a leas one year. In some cases, smaller measures were grouped ogeher where i was easy o do so and in laer years smaller measures for he smaller ax heads have also been included. The Budge ables ypically only show cosings for he nex wo years, alhough more recen Budges have shown up o five years. So hese cosings were hen exrapolaed for he whole daa period using he growh rae of nominal GDP. This is anoher weakness of his approach bu here is no obvious beer alernaive. The policy-adjused receips series is hen consruced simply by subracing hese cosings from he relevan daa series of acual receips. Wih he very significan cavea of he uncerainies se ou above, he policy-adjused series is herefore heoreically showing he level of receips ha would have been recorded if no ax policy changes had been made afer Despie he inheren difficulies wih his approach, he headline resuls are reasonably inuiive. Taking he period as a whole, he fac ha he wo lines mee a he end as well as he beginning suggess ha discreionary ax increases and decreases have broadly offse each oher over he period. Discreionary income ax measures have reduced ax receips o couner he effecs of fiscal drag, while indirec ax measures, especially for VAT and fuel duies, have boosed receips. In he case of VAT, his reflecs a general shif in he burden of axaion from direc o indirec axes, while he fuel duy measures have parially offse he effecs of a declining ax base as fuel efficiency has improved. The increase in he ax-o-gdp raio across he sample period largely reflecs he choice of saring poin in , as he raio was a is cyclical low a his poin, following a year of very rapid growh in GDP. a The daabase is available on he OBR s websie a 9 Cyclically adjusing he public finances

16 Esimaing cyclical adjusmen coefficiens 2.14 The policy adjused series is hen included in he following simple regression: ( TR / Y ) ygap ygap Y (1) * Where ( TR / Y ) is policy adjused ax receips as a share of nominal GDP, Y, α * is a consan, ygap is he oupu gap, Y is he level of poenial oupu (in logs) and is an error erm. The regression is esimaed using ordinary leas squares (OLS) over he sample period, financial years, The coefficiens on he oupu gap and he lagged oupu gap are he coefficiens of ineres and indicae he responsiveness of ax receips o he cycle. The lagged oupu gap is included in he specificaion on he basis of prior expecaions ha here are likely o be lags from changes in he oupu gap o changes in receips. This may be due o lags in he economy - for example changes in he labour marke may lag changes in oupu. There are also lags in he ax sysem. For example selfassessmen ax is paid some period afer earnings are received, and hese receips are no accrued back o he earlier period as happens for income ax receips. The poenial oupu variable can be hough of as a proxy for he effecs of real fiscal drag The use of a policy-adjused series ackles one possible source of endogeneiy, bu anoher remains: here migh also be a simulaneous relaionship beween expendiure, receips and he oupu gap. The oupu gap can be affeced by fiscal policy working hrough he level of receips and expendiure. The level of governmen expendiure (he consumpion elemen of which is scored in GDP) is also likely o depend in par on he level of ax receips, and vice versa One possible mehod for addressing his issue is o esimae he equaion using insrumenal variables. Bu in pracice i can ofen be difficul o idenify srong insrumens. This was he approach used in he Treasury s 2008 working paper, using he world oupu gap and world ineres raes as insrumens. This deeced no significan evidence of bias, in line wih he conclusions of Darby and Meliz (2008). An alernaive mehod, discussed in Chaper 3, is o adop a more formal srucural modelling approach and esimae a srucural vecor auoregressive model (SVAR). 6 Fiscal drag is he name given o he endency for ax receips as a percenage of GDP o increase over ime. This is due o he progressive naure of he ax sysem, whereby he average ax rae increases he more income is earned. Nominal fiscal drag occurs when inflaion pushes incomes up; real fiscal drag occurs when wages rise faser han inflaion due o produciviy growh. Cyclically adjusing he public finances 10

17 Esimaing cyclical adjusmen coefficiens Resuls for ax receips and he cycle Aggregae axes 2.18 The resuls of esimaing he aggregae ax receips equaion are shown in Table 2.1, and presened alongside hose of he previous Treasury analysis o faciliae comparison. The updaed esimaes migh be expeced o differ from he Treasury resuls due o he use of a longer sample period, which now includes movemens in he oupu gap caused by he recen recession, and he use of he OBR esimae of he oupu gap, as opposed o he Treasury s consrucion of his variable. 7 Table 2.1: Aggregae ax receips (per cen of GDP) Consan Oupu gap Oupu gap Sandard Trend GDP R squared (-1) error (0.6) (2.9) (-0.0) OBR (-1.9) (1.0) (4.5) T-saisics in brackes 2.19 However, while he resuls differ in a few respecs from he previous Treasury esimae, he coefficiens on he key variable he oupu gap are of a similar magniude. The resuls coninue o indicae no significan relaionship wih he curren oupu gap wih a slighly smaller coefficien on he lagged oupu gap. The divergen esimaes of he coefficien on poenial oupu appear o be due o an anomalous resul in he Treasury s 2008 analysis, as he previous analyses published in 1999 and 2003 boh repored coefficiens closer in magniude o our updaed esimaes. The size of he coefficien implies ha real fiscal drag increases he ax o GDP raio by around 0.1 per cen a year The fall in he R-squared saisic a measure of he explanaory power of he regression is likely o be due o he exension of he end of he sample period from 2006 o Tha he equaion does no fi very well over he recen recession suggess ha he responsiveness indicaed by he regression coefficiens may no be a good guide o he curren responsiveness of ax receips o he economic cycle In is 2008 paper he Treasury judged ha, despie he resuls of he regression analysis, i is reasonable o allow for some conemporaneous effec beween he cycle and ax receips. For example, he Treasury suggesed ha he inroducion 7 Se ou in Pybus (2011), Esimaing he UK s hisorical oupu gap, OBR Working paper No Cyclically adjusing he public finances

18 Esimaing cyclical adjusmen coefficiens of quarerly insalmen paymens (QIPs) of corporaion ax for large companies from 1999 migh have led o more imely responsiveness of receips o he cycle. The Treasury herefore adjused he regression resuls and placed a coefficien of 0.1 on he conemporaneous oupu gap, and a coefficien of 0.1 on he lagged oupu gap. This is broadly equivalen o bringing forward half he impac associaed wih he esimaed regression coefficien on he lagged oupu gap This is a conclusion shared by oher analyses of cyclical adjusmen. For example, he OECD s implemenaion of he wo-sep approach (Girouard and Andre (2005)) commens ha exac lag srucures for UK corporae and personal income ax are no known, and hey may vary significanly over ime. On he basis of judgemen, however, he OECD also assumes a wo year adjusmen period, wih equal weigh on he conemporaneous and lagged effec. Individual axes 2.23 To complemen he op-down regression analysis, and o gain furher insigh ino he cyclicaliy of ax receips, we carry ou similar regression analysis for each of he individual componens of he aggregae ax receips series. The responsiveness o he oupu gap could differ across he ax base, and individual componen regressions (as are also used in he wo-sep approach), can provide useful addiional informaion on he relaionship beween he cycle and aggregae receips. The resuls are shown in Tables 2.2 o 2.8. Table 2.2: Income ax and NICs receips (per cen of GDP) Consan Oupu gap Oupu gap Sandard Trend GDP R squared (-1) error (-7.5) (-2.7) (2.9) (8.5) OBR (-9.2) (-2.4) (11.0) Table 2.3: Non-oil corporaion ax receips (per cen of GDP) Consan Oupu gap Oupu gap Sandard Trend GDP R squared (-1) error (1.1) (2.0) (3.9) (-0.9) OBR (31.0) (3.7) Cyclically adjusing he public finances 12

19 Esimaing cyclical adjusmen coefficiens Table 2.4: VAT receips (per cen of GDP) Consan Oupu gap Oupu gap Sandard Trend GDP R squared (-1) error (3.8) (3.3) OBR (34.4) (-0.89) Table 2.5: Excise moor 8 ax receips (per cen of GDP) Consan Oupu gap Oupu gap Sandard Trend GDP R squared (-1) error (2.5) (-0.3) (-2.4) OBR (11.1) (3.4) (-11.0) Table 2.6: Oher excise 9 ax receips (per cen of GDP) Consan Oupu gap Oupu gap Sandard Trend GDP R squared (-1) error (19.3) (-18.7) OBR (16.4) (2.7) (-16.3) Table 2.7: Capial axes (per cen of GDP) Consan Oupu gap Oupu gap Sandard Trend GDP R squared (-1) error OBR (-10.0) (3.0) (10.8) Table 2.8: Sum of oupu gap coefficiens 10 (per cen of GDP) Oupu gap Oupu gap (-1) OBR Fuel duy and vehicle excise duy. 9 Tobacco, alcohol and being duies. 10 Where saisically significan i.e. excluding he VAT coefficien in he OBR equaion. 13 Cyclically adjusing he public finances

20 Esimaing cyclical adjusmen coefficiens 2.24 Our resuls are again broadly similar o hose of he 2008 Treasury paper. A negaive sign on he conemporaneous oupu gap in he income ax equaion is no immediaely inuiive, bu probably reflecs cyclicaliy in he labour share of income, alhough here is no longer a parial counerbalance by he finding of a saisically significan posiive relaionship for he lagged oupu gap. The coefficien on rend GDP is consisen wih fiscal drag of around 0.2 per cen a year The corporae ax equaion now shows a bigger conemporaneous effec han previously, which lends some suppor o he adjusmen made by he Treasury for he inroducion of QIPs, discussed in paragraph The excise equaions poin o a larger effec from he lagged oupu gap, which offse he loss of significance in he income ax equaion. The negaive coefficiens on rend GDP reflec he downward rend in he share of GDP of hese axes. The VAT equaion performs exremely poorly, wih a complee absence of saisical significance and explanaory power. Overall, he resul is ha he sum of he individual esimaes shown in Table 2.8 is now smaller han in he 2008 analysis, bu consisen wih he resuls of he aggregae equaion On he basis of hese updaed regression resuls, here seems o be lile evidence poining srongly o a differen conclusion from he Treasury s 2008 analysis of he cyclicaliy of receips. However, he insabiliy of he individual equaion esimaes raises quesions abou he robusness of he one-sep approach. Expendiure and he cycle 2.27 Frequen changes in he coverage and srucure of expendiure programmes mean ha i is no possible o adjus he public expendiure series for policy effecs in he same way as we did for receips. For example, aside from rae changes, he basic srucures of income ax and VAT have remained largely unchanged, whereas i is no possible o rack a consisen series hrough ime for programmes such as ax credis, which are responsible for a large share of expendiure, bu are a relaive recen innovaion in heir curren form. I is herefore necessary o ry o capure some of he possible expendiure policy effecs in he modelling approach. The Treasury s choice of expendiure regression herefore has a slighly differen specificaion o he receips regression: TME Y 1 TME Y TME Y ygap T T 02 (2) ( / ) ( / ) 1 2 ( / ) Where ( TME / Y ) is Toal Managed Expendiure (TME) as a share of nominal GDP, Y, α is a consan, ygap is he oupu gap, T75 and T02 are ime rends saring in and respecively, and is an error erm. The Cyclically adjusing he public finances 14

21 Esimaing cyclical adjusmen coefficiens regression is esimaed using ordinary leas squares (OLS) over he sample period, financial years, The inclusion of lagged dependen variables is designed o capure endogenous policy responses. For example, policymakers may decide o increase social securiy expendiure, over and above he auomaic increase in unemploymen relaed benefis, once i becomes clear he economy is in a downurn. Bu noe ha under hese assumpions (i.e. ha he policy response is counercyclical and responds wih a lag) he long-run response of spending o he economic cycle implied by he regression is likely o be an overesimae The inclusion of a number of ime rends again follows he previous Treasury approach and is designed o capure poenially more long-lasing srucural policy effecs. For example, he inclusion of a rend from 2002 is inended o accoun for a discreionary decision o increase he level of expendiure over subsequen years, announced in Budge The choice of dependen variable in he expendiure regression is oal spending, also known as Toal Managed Expendiure (TME), which he Treasury spli ou ino Annually Managed Expendiure (AME) and Deparmenal Expendiure Limis (DEL). DEL is mainly composed of expendiure on he provision of public services such as educaion and healh, which has ypically been fixed in cash erms in muli-year plans and is herefore no direcly linked o he economic cycle. AME will ypically follow he economic cycle more closely as i conains elemens such as social securiy expendiure which are direcly linked o he level of unemploymen and earnings. However, hese elemens are generally quie small relaive o he res of public expendiure Therefore, wih much of expendiure broadly fixed in nominal erms we migh expec ha, when measured as a raio o GDP, expendiure will be sensiive o he cycle principally hrough a denominaor effec. In oher words, movemens in GDP will be he main driver of he conemporaneous effec of he cycle on he public finances. For example, a fall in GDP will auomaically increase he share of TME o GDP if he level of TME is broadly sable in nominal erms The raio of TME o GDP has averaged 43 per cen across he sample period, which implies ha a one per cen increase in oupu relaive o rend would reduce he share of TME as a percenage of GDP by around 0.4 percenage 11 Calculaed as 1 ). 1 /( In paricular, Budge 2002 announced significan increases in healh spending o an average annual growh rae of 7.5 per cen over he five years o 2007/ Cyclically adjusing he public finances

22 Esimaing cyclical adjusmen coefficiens poins in he firs year. The regression resuls repored in Table 2.9 provide empirical suppor for his conclusion. Table 2.9: Toal managed expendiure (per cen of GDP) Consan TME(-1) TME(-2) Oupu gap T75 T02 R-squared Sandard error (9.0) (6.3) (-4.3) (-4.7) (-7.9) (1.8) OBR (5.8) (3.9) (-2.1) (-3.0) (-5.0) (4.8) Table 2.10: Dynamic response of he TME o GDP raio o a 1 per cen increase in he oupu gap T T+1 Long run OBR The relaionship beween he oupu gap and TME appears o be relaively sable as he esimaed coefficiens are similar o previous Treasury analysis. The increase in he coefficien on he oupu gap is likely o be due o he exension of he sample period o cover he recen recession. This would be he case if he increase in spending in response o recen cyclical weakness has been larger han he hisorical average, perhaps due o counercyclical discreionary policy decisions for which we are unable o adjus. The resuls imply ha a one per cen rise in GDP, relaive o poenial oupu, reduces he TME o GDP raio by 0.44 percenage poins in he firs year. This is in-line wih he prior expecaion of a coefficien of around 0.4 due o he denominaor effec However, he equaion also includes dynamic effecs and he esimaed lagged and long-run responses are shown in Table The expendiure response rises o 0.7 per cen in he second year and remains around ha level over he longer erm. This is above he 0.5 adjusmen for expendiure in he Treasury s 2008 paper, alhough as discussed earlier, he coefficien may be subjec o some upward bias if he endogenous policy response capured by he lagged erms is counercyclical (i.e. spending is increased when GDP falls). Cyclical social securiy 2.36 As discussed above some elemens of AME expendiure in paricular Jobseeker s Allowance and oher income relaed elemens of he social securiy sysem are likely o be closely linked o movemens in he cycle. A separae regression is herefore esimaed o es for he effec of cyclical social securiy expendiure, which we define as all DWP income-relaed benefis and ax credis Cyclically adjusing he public finances 16

23 Esimaing cyclical adjusmen coefficiens adminisered by HMRC. 13 Cosings for some policy measures relaed o hese benefis are available, bu we have no aemped o adjus he series for he subse of measures ha are available as he oupu would only be a pariallyadjused series. The resuls are shown in Table Table 2.11: Cyclical social securiy (per cen of GDP) Consan Oupu gap (-1) Time R squared Sandard error (4.8) (-3.0) OBR (14.3) (-4.9) (9.7) 2.37 The resuls indicae a sronger relaionship han in he previous Treasury analysis, or a coefficien of 0.18, which is likely o be due o he wider definiion of cyclical social securiy used in our analysis. 14 If we use he narrower measure of unemploymen relaed benefis as he dependen variable, hen we find ha he coefficien on he oupu gap drops back o 0.1. The slighly larger coefficien is also consisen wih he rise in he cyclical response of oal expendiure in he +1 period, given by he dynamic erms in he TME regression. The inclusion of a ime rend, which accouns for he seady increase in his measure of he level of social securiy expendiure hrough he sample period, improves he fi of he regression Unlike he individual ax receips exercise, simply adding he coefficiens from he TME and cyclical social securiy regressions would likely lead o some doublecouning, as his social securiy expendiure is already included in he TME measure. This was confirmed by repeaing he TME regression in Table 2.9, bu subsiuing a TME excluding cyclical social securiy measure as he dependen variable. In his case he coefficien on he oupu gap drops from 0.43 o 0.40, as shown in Table Table 2.12: TME excluding cyclical social securiy (per cen of GDP) Consan TMEx (-1) TMEx (-2) Oupu gap T75 T02 R-squared Sandard error OBR (5.7) (3.2) (-2.1) (-2.8) (-5.3) (5.3) 13 We also include conribuory jobseekers and employmen and suppor allowances. The relevan hisorical series can be found here: hp://research.dwp.gov.uk/asd/asd4/index.php?page=medium_erm. We scale hese figures up o produce UK aggregaes. 14 Due o a ypographical error, he resuls in he 2008 working paper show a relaionship wih he curren oupu gap in fac, his should be he lagged oupu gap. 17 Cyclically adjusing he public finances

24 Esimaing cyclical adjusmen coefficiens 2.39 The Treasury analysis also invesigaed he possibiliy of deb ineres paymens being cyclical. However, he coefficien on he oupu gap in he deb ineres regression was no saisically significan in eiher he Treasury s 2003 or 2008 analysis. We found he same resul so we have chosen no o repor he deail here. This may be because if economic growh is above rend hen ineres raes will end o rise (increasing deb ineres paymens) bu borrowing will end o fall (reducing deb ineres paymens). A large proporion of deb ineres coss will also reflec paymens on he hisorical sock of deb. Any cyclical influence would only affec he deb ha is being refinanced a he ime. Therefore, cyclical effecs on deb ineres paymens are likely o be small bu persisen. Updaed esimaes of he cyclical adjusmen coefficiens 2.40 The main resuls of all he regression equaions are summarised in Tables 2.13 o Table 2.13 shows he unadjused resuls of he economeric esimaes in he Treasury s 2008 analysis, and he adjusmens made by he Treasury o produce he cyclical adjusmen coefficiens is given in Table Finally Table 2.15 shows he resuls of our updaed analysis The resuls of our regressions are broadly similar o hose in he Treasury s 2008 paper. Our esimaes produce slighly higher coefficiens on boh he conemporaneous oupu gap and he lagged oupu gap. However, if he same ses of adjusmens are made o our resuls as were made in he Treasury paper hen a very similar se of cyclical adjusmen coefficiens would be produced. As we have discussed above, he argumens ha he Treasury cied o jusify hese adjusmens on he expeced size of he expendiure denominaor effec and he expeced conemporaneous effec of he oupu gap on ax coninue o have some suppor in he empirical resuls However here are a number of limiaions wih his approach. Policy adjusmen is only feasible on he revenue side and relies on a number of srong assumpions (see Box 2.1). The resuls of he regression analysis are no very robus in a number of cases, and our sensiiviy ess in Annex A indicae ha he resuls are also no very robus o he choice of sample period. In paricular, his means ha we may only be capuring (imprecisely) he average effec of he cycle on he public finances when we are really ineresed in he marginal effec a he curren juncure. The OECD or wo-sep approach discussed in he nex secion seems beer suied o capure his effec. Cyclically adjusing he public finances 18

25 Esimaing cyclical adjusmen coefficiens Table 2.13: Previous HM Treasury 2008 economeric resuls Fiscal aggregae Oupu gap Lagged oupu gap CA expendiure = TME CA receips = PSCR CAPSNB = PSNB Table 2.14: HM Treasury 2008 cyclical-adjusmen coefficiens afer adjusmen Fiscal aggregae Oupu gap Lagged oupu gap CA expendiure = TME CA receips = PSCR CAPSNB = PSNB Table 2.15: Updaed OBR economeric resuls and adjusmens Fiscal aggregae Oupu gap Lagged oupu gap CA expendiure = TME CA receips = PSCR Unadjused CAPSNB = PSNB Adjused CAPSNB a = PSNB a Same adjusmens as in Table 2.14 are applied Two-sep approach 2.43 This secion looks a he approach developed and used by he OECD o cyclically adjus he fiscal aggregaes of is member counries. 15 The mehod esimaes cyclical adjusmen parameers for individual revenue and expendiure caegories in wo seps. The firs sep is o esimae how he economic base (e.g. consumpion and profis) of he ax/expendiure iem responds o he oupu gap and he second sep is o esimae how ax receips and expendiure move wih he relevan base. Those esimaes are hen combined o produce a single elasiciy which ells us how much ax receips and expendiure move wih he oupu gap. These ax and expendiure esimaes are aggregaed o produce a 15 See Van den Noord (2000) and Girouard and Andre (2005). 19 Cyclically adjusing he public finances

26 Esimaing cyclical adjusmen coefficiens single se of cyclical adjusmen coefficien for he fiscal aggregaes, which are comparable o he coefficiens derived in he one-sep approach see Figure 2.1. Figure 2.1: Flow diagram of he OECD mehod Elasiciy of ax/spending base o he oupu gap Elasiciy of ax receips and spending o relevan ax/spending base Aggregaed elasiciy of ax receips and spending o he oupu gap The raio of ax and spending o GDP Semi-elasiciy of ne borrowing 2.44 We make use of HMRC and DWP forecas models o esimae he elasiciies of ax and expendiure o heir relevan bases. They represen he marginal change in ax and expendiure consisen wih curren fiscal policy and are herefore invarian o he effecs of hisorical discreionary policy measures. This is a major benefi compared o he one-sep approach, given he difficulies of adjusing he revenue and expendiure series for he effecs of policy However, hese elasiciies may hemselves be cyclical. For example, effecive ax raes may differ over he economic cycle due o movemens in ax evasion, he composiion of consumer spending, he use of losses in corporaion ax and he greaer use of par-ime workers. These issues are discussed in Box This approach can also only be used where we can clearly idenify boh a base and he sensiiviy of he paricular ax or expendiure caegory o i. For example, his is he reason he OECD only akes accoun of unemploymen relaed expendiure. The mehod could herefore underesimae cyclicaliy if oher areas of social securiy expendiure ha are no included in he analysis are also relaed o he cycle. In similar fashion o he one-sep approach, he wo-sep approach is also vulnerable o he possibiliy ha he endogeneiy of fiscal policy may be biasing he resuls. This issue is addressed in Chaper 3. Cyclically adjusing he public finances 20

27 Esimaing cyclical adjusmen coefficiens Box 2.2: Effecive ax raes and he cycle A poenial disadvanage wih he wo-sep approach is ha, unlike he one-sep approach, i does no ake ino accoun oher cyclical facors ha migh affec receips bu no he ax base. Possible examples would be cyclical movemens in ax evasion (or speed of compliance), consumpion paerns and he use of losses in corporaion ax which could amplify he responsiveness of axes o he cycle. A recen IMF sudy suggess ha ax revenue efficiency does indeed move wih he business cycle. a In paricular a worsening of VAT efficiency is found o be driven by shifs in consumpion paerns, a decrease in he share of sandard rae consumpion, and changes in ax evasion during conracions. b The sudy also finds a correlaion beween personal income ax and social securiy ax efficiency and he oupu gap. There is some evidence o sugges ha oher cyclical facors have affeced receips in he UK in he recen downurn. In paricular: he VAT gap, he difference beween he heoreical oal VAT liabiliy and acual cash receips, increased in as he economy moved ino recession. The VAT gap can indicae he degree of ax compliance. The VAT gap increased primarily because of a rise in unauhorised VAT deb and he use of he governmen s ime-o-pay scheme o spread ax paymens over a longer ime period. However, he VAT gap fell back o pre-recession levels in and There was also a fall in he share of sandard raed consumpion in and ; he effecive ax rae on corporae profis was lowered by firms being able o carry back losses agains recenly paid ax relaed o previous years liabiliies and carrying forward losses o be used when he firm reurns o profiabiliy. The carrying back of losses boosed repaymens in , while rading losses carried forward are expeced o be remain higher han prior o he downurn for a prolonged period, paricularly in he financial secor; and he effecive ax rae on labour income was affeced by he shif owards par-ime work. Par-ime workers generally face a lower marginal ax rae. In addiion, high-paying secors such as he financial secor end o be more cyclical han oher secors, reducing he ax ake from workers wih high marginal ax raes. a Sancak, C. e al. (2010). b Tax efficiency: he share of ax revenues in he ax base, normalised by he sandard ax rae. 21 Cyclically adjusing he public finances

28 Esimaing cyclical adjusmen coefficiens Overview of mehod 2.47 Cyclically-adjused ne borrowing b*, as a share of poenial oupu 16, can be defined as cyclically adjused governmen expendiure (G*) minus cyclically adjused receips (T*) minus. 17 b * n * * * [ G ( T i )]/ Y (3) i The cyclically-adjused receips and expendiure erms in equaion (3) can be esimaed using he elasiciies of ax receips ) and expendiure ) wih respec o he oupu gap: (, ygap ( g, ygap T * i, ygap i ( Y * / Y ) T i (4) G ( Y / Y ) * * g, ygap G (5) 2.49 The elasiciies are calculaed using a wo-sep approach. On he revenue side he firs sep is o calculae he elasiciy of revenue wih respec o he relevan ax base ( b ) and hen o calculae he elasiciy of he ax base o he oupu gap. The produc of hose elasiciies gives he oupu elasiciy of each ax caegory (i): (6) i, ygap i, b i bi, ygap 2.50 Similarly on he expendiure side he elasiciy of expendiure can be spli ino wo componens: he elasiciy of expendiure wih respec o is base (unemploymen) and ha of he base wih respec o he oupu gap: (7) g, ygap g, UU, ygap 16 Noe ha his definiion uses poenial oupu as he denominaor for he cyclically-adjused budge balance; whereas he one-sep approach uses acual oupu as he denominaor. To compare he resuls of he wo approaches herefore requires a lile algebraic manipulaion. The relaionship beween he wo mehods is discussed in more deail in Annex B. 17 Here G* is cyclically-adjused governmen expendiure (he cyclical elemen is assumed o be dependen on unemploymen); Ti* is cyclical adjused ax caegory i; and Y* is he level of poenial oupu. Cyclically adjusing he public finances 22

29 Esimaing cyclical adjusmen coefficiens The relevan ax and expendiure caegories 2.51 The saring poin for his approach is o idenify which ax and expendiure caegories are likely o have a cyclical elemen. The OECD idenifies corporae ax, personal income ax, indirec ax and social securiy conribuions on he receips side, and unemploymen benefis on he spending side. The economic bases ha correspond o hese ax caegories are wages and salaries, corporae profis and consumer expendiure and he main economic base for unemploymen benefis is he level of unemploymen To provide a comparable and consisen esimae of cyclically-adjused fiscal aggregaes he OECD uses he same ax and spending caegories and bases across all he counries ha i covers. We are able o develop his approach by allowing for he paricular srucure of he UK ax and expendiure sysem We herefore idenify income ax, naional insurance conribuions, non-oil and non-financial corporaion ax, financial secor corporaion ax, business raes, VAT, fuel duy, excise duies and capial axes as poenially cyclical elemens of receips in he UK. On he expendiure side we idenify Jobseeker s Allowance and oher DWP income-relaed benefis paid o jobseekers (such as housing and council ax benefis) as direcly relaed o unemploymen and herefore cyclical. The relevan economic bases for hese iems are se ou in Table Table 2.16: Tax and expendiure caegories and bases Tax /expendiure caegory Income ax Naional insurance conribuions Non-oil, non-financial corporaion ax Financial corporaion ax Business raes VAT Fuel duies Excise duies Capial axes Unemploymen relaed expendiure Tax /expendiure base Wages and salaries Wages and salaries Non-oil, non-financial corporae profis Financial corporae profis Oupu Consumer expendiure Consumer expendiure Consumer expendiure Equiy and house prices and propery ransacions Unemploymen Elasiciies of ax and expendiure bases wih respec o he cycle 2.54 The sensiiviy of each of he bases wih respec o he oupu gap is esimaed economerically using he funcional form in equaion (8). This equaion relaes changes in a ax base, X, (e.g. wages and salaries) o changes in he conemporaneous and lagged oupu gap. 23 Cyclically adjusing he public finances

30 Esimaing cyclical adjusmen coefficiens 2.55 The variables wages and salaries, consumpion and profis are expressed in erms of heir raio o poenial oupu. The level of unemploymen is expressed as he rae of unemploymen consisen wih poenial oupu. 18 For equiy prices, house prices and propery ransacions we use esimaes of heir gap from equilibrium discussed in more deail in Chaper The series are inended o represen a deviaion from an esimaed long run rend As before he oupu gap series used in his paper is aken from he OBR Working paper No. 1: Esimaing he UK s hisorical oupu gap as se ou in Box 2.3. All he esimaes are based on robus sandard errors. log( X ) n * 1log( Y i / Y i ) i0 (8) 2.57 This regression is esimaed for each of he nine differen bases idenified in Table The resuls are collaed in Table The coefficiens on he oupu gap can be inerpreed direcly as he shor-run elasiciies of each ax and expendiure economic base wih respec o he oupu gap. A coefficien greaer han 1 (in absolue value) implies ha swings in he economic cycle lead o he base moving by more han acual oupu. 18 The variable is he log(1-u/1-u*), where U* is he rae of unemploymen consisen wih poenial oupu or NAIRU. For our esimaes we use he OECD esimae of he NAIRU. 19 We use he so-called benchmark series for equiy prices and he OECD house price gap series. 20 We use fiscal year daa from o for he variables wages and salaries, consumpion and non- oil, non-financial corporae profi. For financial company profis daa is only available from 1982 and for he propery ransacions gap from The equiy and house price gaps daa is available from Cyclically adjusing he public finances 24

31 Esimaing cyclical adjusmen coefficiens Table 2.17: Elasiciies of ax and expendiure bases wih respec o he cycle Tax base Oupu gap Oupu gap (-1) R Squared MSE Wages and salaries 0.73*** (0.20) 1 Consumer expendiure 1.14*** (0.12) Non-oil, non-financial profis 4.16*** (0.60) Financial profis 1.18* (0.64) Equiy prices (gap) (2.60) House prices (gap) 3.48* (1.77) Propery ransacions (gap) 5.40* (3.00) Unemploymen -3.77*** -3.34*** (0.74) (0.62) 1 Robus sandard errors in brackes *** Significan a 1 per cen, ** Significan a 5 per cen, *Significan a 10 per cen. The equiy price gap equaion is significan a 20 per cen, if we exclude he las wo years from he sample he variable becomes significan a 5 per cen, see Annex A The resuls in he able show he average response of each base o he cycle using he whole daa sample. To check he robusness of he resuls we have also produced rolling window esimaes which can be found in Annex A. The esimaes indicae some variaion in coefficiens over ime, especially during he economic cycle Profi elasiciy 2.59 The elasiciy of profis o he cycle in Table 2.17 looks high compared o he coefficien on wages and salaries, alhough i is no inconsisen wih wha we would expec considering he curren composiion of profis and wages and salaries in oupu. 21 However he resuling semi-elasiciy of CT o he oupu gap, which is comparable o he one-sep approach, is 0.1 slighly lower han he 21 A 1 per cen increase in nominal GDP in is higher, equivalen, han he combined increase in profis and wages and salaries suggesed by he coefficien in Table This is because he variables used in he economeric esimaes, wages and salaries and profis, only accoun for around 65 per cen of GDP. 25 Cyclically adjusing he public finances

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