THE EFFECT OF LOW INFLATION ON PUBLIC FINANCES

THE EFFECT OF LOW INFLATION ON PUBLIC FINANCES Maria Grazia Ainasi, * Vladimir Borgy, ** Ohman Bouabdallah, *** Crisina Checheria-Wesphal, Maximilian Freier, Georgios Palaiodimos, Doris Prammer, Piero Tommasino and Jochen Zimmer The paper analyses he impac of an unanicipaed disinflaion shock and finds evidence of an adverse impac on fiscal balances given rigidiies in nominal governmen spending, which limi he downward adjusmen o lower inflaion, whereas revenues end o decline much faser. Moreover, he impac on he deb-o-gdp raio ends o be sronger and more persisen given he adverse implicaions of he denominaor effec. Counry specific feaures are found o play an imporan role, whereas second round, hough imporan, effecs coming from he impac of low inflaion on real GDP growh are no fully aken ino accoun given he lack of available evidence for euro-area counries. Given he gradual decline in inflaion raes in he euro area and he weak growh performance in several member counries, his paper aims o analyse he direc ransmission mechanisms of inflaion developmens on public finances by aking ino accoun counry-specific feaures. The paper provides evidence ha an unanicipaed disinflaion shock has an adverse impac on fiscal balances given rigidiies in nominal governmen spending, which limi he downward adjusmen o lower inflaion, whereas revenues end o decline much faser. Moreover, he impac on he deb-o-gdp raio ends o be sronger and more persisen given he adverse implicaions of he denominaor effec. Counry specific feaures are found o play an imporan role, whereas second round, hough imporan, effecs coming from he impac of low inflaion on real GDP growh are no fully aken ino accoun given he lack of available evidence for euro-area counries. This is one of he few papers providing a comprehensive analysis of he fiscal effecs of low inflaion. I focuses on he case of Germany, France, Ialy, Ausria and Greece and looks ino he ransmission channels of low inflaion on he main fiscal aggregaes in wo seps. Firs, by using he fiscal forecas model of each Naional Cenral Bank, he paper presens model based simulaions where counry-specific feaures regarding he dynamics of expendiures and receips are documened in deail and aken ino accoun for a deeper undersanding of how price shock ranslaes o governmen balances in he simulaions displayed. In paricular, he paper finds ha in response o an unexpeced (emporary) disinflaion shock of 1p.p. he primary balance deerioraes on average by 0.15p.p. of GDP in he firs year. This is aribued o he * European Cenral Bank, Direcorae General Economics. E-mail: maria_grazia.ainasi@ecb.in ** *** Banque de France. E-mail: Vladimir.borgy@banque-france.fr European Cenral Bank, Direcorae General Economics. E-mail: ohman.bouabdallah@ecb.in European Cenral Bank, Direcorae General Economics. E-mail: crisina.checheria-wesphal@ecb.in European Cenral Bank, Direcorae General Economics. E-mail: maximilian.freier@ecb.in Bank of Greece. E-mail: GPalaiodimos@bankofgreece.gr Bank of Ausria. E-mail: doris.prammer@oenb.a Bank of Ialy. E-mail: piero.ommasino@bancadialia.i Deusche Bundesbank. E-mail: Jochen.zimmer@bundesbank.de

304 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer finding ha oal nominal revenues decline more han nominal primary expendiures which, a leas iniially, display some rigidiy. The size and duraion of he deerioraion in he primary balance ends o be counry specific. Moreover, if lower inflaion feeds hrough o lower marke ineres raes (i.e., via lower inflaion expecaions), he impac on he headline budge balance would be cushioned by he reducion in ineres paymens on newly issued deb. The effecs end o be sronger in case he growh rae of he GDP deflaor urns negaive. Second, using he findings of he simulaions on he effec on he primary balance, he paper looks a he effecs of an inflaion shock on deb susainabiliy. The effec on he deb-o-gdp raio ends o be more sizeable, due o he denominaor effec. Moreover, he larger he iniial deb-o- GDP raio, he more vulnerable a counry is o unexpeced negaive shocks o inflaion. This deb susainabiliy analysis shows ha a permanen low inflaion shock leads o an average increase in he deb raio of 11p.p. of GDP over en years, which implies heighened deb susainabiliy risks for some counries. The noe finds ha in case inflaion would urn negaive, he adverse impac on he fiscal variables would be larger. 1 Inroducion While i is crucial ha moneary and fiscal policy auhoriies are clearly separaed in erms of objecives and insrumens, i has o be acknowledged ha here are srong inerdependencies beween moneary and fiscal developmens. 1 Indeed, boh moneary and fiscal policy impac similar key macroeconomic variables (e.g., aggregae demand, real ineres raes and risk premia) (Sargen & Wallace 1980, Aiyagari & Gerler 1985, Sims 1988, Walsh 2010). These inerdependencies are paricularly challenging in he curren low inflaion and low growh environmen. Since 2011 inflaion raes across he euro area have fallen gradually on accoun of a number of facors, and remain below he ESCB s medium-erm objecive, while he convenional moneary policy insrumens have reached he zero lower bound. A he same ime, euro-area counries fiscal posiions remain weak following he unsound policies of he pas, bu also he effec of he financial and economic crisis and he sill weak recovery. In mos counries, he need for furher consolidaion remains and here is a risk ha persisenly low or negaive inflaion furher aggravae he weak fiscal posiion of euro area sovereigns. Economic analysis suggess ha, coeeris paribus, a disinflaion shock worsens boh he headline and he primary budge balance and increases he deb-o-gdp raio. The firs effec is modes and shor-lived, bu he second is larger and more persisen. In he presen paper, afer reviewing he main channels hrough which inflaion influences public finances, we will shed more ligh on hese effecs by looking on a subsample of euro-area counries (Germany, France, Ialy, Ausria and Greece). Based on he fiscal forecas models of individual cenral banks, we find ha a 1p.p. emporarily lower inflaion rae worsens he primary balance on average by 0.15p.p. of GDP on impac. Furhermore, o he exen ha lower inflaion passes hrough o marke ineres raes (via lower inflaion expecaions), he ensuing decline in ineres paymens would have a cushioning effec on he headline balance, which, on average, would deeriorae by abou 0.05p.p. of GDP on impac. The effec on he fiscal balances ends o be ransiory and o fade away by he end of he hird year. Counry specific circumsances (e.g., a emporary suspension of indexaion mechanisms) may heighen he sensiiviy of he fiscal balances o inflaion developmens and imply a more persisen deerioraion. A high deb-o-gdp raio is anoher imporan vulnerabiliy 1 The separaion is needed o avoid ha fiscal auhoriies force cenral banks ino accommodaing heir policies while disregarding price sabiliy objecives.

The Effec of Low Inflaion on Public Finances 305 facor. Illusraive simulaions of he effecs of a negaive inflaion shock are also presened for he case of France. Low/negaive inflaion has also implicaions for deb susainabiliy. The DSA presened in secion 5 finds sizeable effecs from low inflaion on he deb-o-gdp raio, especially for counries saring from a high deb-o-gdp raio. The average increase in he deb-o-gdp raio is abou 11p.p. for a permanen low inflaion shock. A disinflaion shock is no a major hindrance o comply wih SGP requiremens. Given he limied effecs of low inflaion on public finances, secion 6 argues ha hese are oo small o obsruc compliance wih SGP requiremens. While here is no specific definiion in he SGP of a severe economic downurn, should ail risks and deflaion maerialise, an applicaion of he general escape clause migh need o be considered. However, if negaive inflaion maerialises in he absence of a severe economic downurn, he general escape clause will likely no apply. The effecs on public finances are likely o be exacerbaed if inflaion urns negaive. On he fiscal side proper, negaive inflaion would possibly lead o a more pronounced impac from he downward rigidiy of some governmen spending (e.g., social paymens and compensaion of employees), hence a sronger deerioraion of he fiscal posiion. However, a full undersanding of he effecs of negaive inflaion on public finances is beyond he scope of his noe given he uncerainy surrounding is macroeconomic effecs. The laer depend, in he firs place, on he naure of he inflaion shock. If negaive inflaion reflecs a supply-side shock (e.g., a posiive echnology shock or cos compeiiveness improvemens) ha is no monearily accommodaed, he effec on public finances is posiive as he decline in he price level is accompanied by an increase in he acual and naural level of oupu (Bordo e al. (2004)). If negaive inflaion originaes from a collapse in aggregae demand, oupu and employmen would decline given he downward rigidiy of nominal inpu prices, including wages, which reduce firms margins. Moreover, o he exen ha he moneary policy is consrained by he zero lower bound, real ineres raes would increase hus furher hiing he real economy. 2 In hese circumsances, negaive cyclical developmens are likely o weigh significanly on public finances. The res of he paper is as follows. In secion 2, we discuss in general erms he impac of inflaion on public finances, reviewing boh he analyics and he available empirical evidence; we highligh hree differen channels of ransmission of he inflaion shock o he deb-o-gdp raio. We hen ry o measure his impac boh separaely for each channel (secion 3) and globally (secion 4) for a subse of European counries. he effecs on deb susainabiliy are also looked a (secion 5). In secion 6 we draw some policy implicaions. Secion 7 concludes. 2 The effecs of inflaion on fiscal policy: an overview According o he empirical lieraure, changes in he price level may have significan effecs on deb dynamics. Aizenman & Marion (2011, 538) find ha an unanicipaed inflaion shock of he order of 6 per cen could reduce he deb/gdp raio by up o 20 per cen wihin 4 years. Invesigaing he impac of inflaion on he public deb in he G7 counries, Akioby e al. (2014) find ha if inflaion were o fall o zero for five years, he average ne deb-o-gdp raio would increase by abou 5 percenage poins over he nex 5 years. 3 Hall & Sargen (2010) decompose 2 In his conex, inflaion expecaions are crucial. If deflaion becomes anicipaed, han he expecaion of a furher decline in prices may reinforce he negaive oupu effecs. This occurs, for example, when in anicipaion of furher declines in prices, firms and households pospone invesmen and consumpion choices respecively, his causing a furher fall in aggregae demand and a prolonged economic slump. This vicious circle riggers a deflaionary spiral, which however, is no explicily considered in his noe. 3 The paper simulaes he effec of inflaion on base money creaion (seigniorage) and he erosion he real value of he deb.

306 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer he pos-war deb reducion in he US ino conribuions from negaive real reurns on governmen bonds, primary surpluses, and growing real income. They find ha higher inflaion accouned for only 20 per cen of he 85 per cen decline in he deb-o-gdp raio achieved over he period 1946-1974. Theoreically, inflaion affecs fiscal oucomes hrough a number of channels (Tanzi e al., 1987; Abbas e al., 2013), in paricular via: (1) he real deb sock; (2) marke ineres raes; (3) primary public expendiures and ax revenues. 4 To illusrae he firs channel, one could sar from he well-known dynamic deb accumulaion equaion: Δb i g = 1+ g b 1 pb where b is he deb-o-gdp raio, i is he average nominal (effecive) ineres rae, g is he nominal GDP growh rae, pb is he primary balance-o-gdp raio a ime. Indeed, equaion (1) can be reformulaed by expressing he oal deb-o-gdp raio as he S sum of b he porion of deb ha is sensiive o inflaion (i.e., shor-erm deb, foreign-currency NS denominaed deb, long-erm variable-ineres or inflaion-indexed deb) and b he porion which includes only domesic-currency denominaed, long-erm, non-indexed deb: 5 where i is he ineres rae on b 1+ i 1+ g * TOT S NS S NS = b + b = b 1 + b 1 S 1+ i 1+ g b, i* is he ineres rae on b NS pb (1) (2) ; g is he growh rae of nominal GDP and pb is he primary balance. 6 Equaion (2) can be furher rearranged and expressed as (see Annex 2): b 1+ r (1 + r )(1 + π * exp TOT S NS = b 1 + b 1 1+ n (1 + n)(1 + π ) ) pb, (3) where n is he real growh rae, r and r* are respecively he real exchange rae required by invesors in period 1 on he b S and he b NS porion of he deb, and π exp is he rae of inflaion in period expeced by invesors in period 1. The firs erm on he righ hand side of equaion (3) capures he conribuion o he deb-o-gdp dynamics of he componen of deb whose cos is inflaion-sensiive. This erm does no depend on inflaion as i is he sum of he deb ousanding from he previous period, which depends negaively on inflaion, and ineres paymens, which depend posiively on inflaion. These wo opposing effecs on he deb-o-gdp raio cancel ou. To he exen ha period inflaion is unexpeced, he second erm in equaion (3), clearly does depend negaively on inflaion. 4 This noe absracs from seignorage revenues. Governmens ypically receive revenues from he operaing profis of he cenral bank. For he euro area, he Proocol on he Saue of he European Cenral Bank saes ha ECB profis are disribued in accordance wih paid-up shares of member counries in European Cenral Bank capial. Operaing profis broadly originae from he change in he moneary base (seigniorage) as well as ineres income (Buier 2007). Governmen seigniorage revenues are hus ofen undersood as an inflaion ax, i.e., he financial loss of value suffered by holders of currency (e.g., Fischer, 1982). However, seigniorage accouns for a very small percenage of governmen revenues in indusrialised counries (Hilscher e al., forhcoming). 5 6 A more deailed version of his equaion is discussed in Akioby e al. (2013). NS For ease of exposiion, we did no ake ino accoun ha he various componens of b migh have differen ineres raes, and we disregard ime sub-indices. The equaion also assumes a full Fisher effec. This will be relaxed below.

The Effec of Low Inflaion on Public Finances 307 Moreover, i is worh noing ha he real ineres rae (r*) may decrease if inflaion increases his is he second channel menioned a he beginning of his secion. Indeed, he sensiiviy of he deb-o-gdp-raio o he inflaion rae is a funcion no only of he size and he srucure of deb, bu also on he pass-hrough from low inflaion o nominal ineres raes. In paricular, when he pass hrough from low inflaion o he nominal ineres rae is 1 (so-called full Fisher effec) he formula for he elasiciy of deb o inflaion is: 7 NS π b ε TOT =. (4) b TOT, π 1+ π b Bu when he pass-hrough is less han one, he elasiciy is: S NS ε π b π b TOT = (1 k) b TOT π TOT + π b 1. (4 ), 1 + π b where we have defined (1+i)=(1+r)(1+kπ ), where k 1 (k=1 in he full Fisher effec). Equaion (4 ) differs from equaion (4) for he firs erms on he righ hand side. The inuiion behind his erm is sraighforward. Wih k=1 inflaion reduces he deb-o-gdp raio only via b. Wih k<1 also b conribues, because he ousanding-deb effec on b S is only parially counerbalanced by he S increased ineres paymens effec. This happens because also he real ineres rae r due on b is reduced by inflaion, as now he nominal ineres rae (i) reacs less han 1-o-1 o π. Empirical evidence sugges ha he pass-hrough could be lower han one. Several sudies (Feldsein & Summers 1978, Ardagna e al. 2007, Laubach 2009) find ha a 1 percenage poin increase in expeced inflaion leads o an increase in bond yields in he range of 0.1 and 0.3 percenage poins. Caporale & Williams (2002), find ha inflaion expecaions play a greaer role for ineres raes in counries wih a hisory of volaile inflaion han in hose wih a hisory of low and sable inflaion. Similarly, Arslanalp and Poghosyan (2014) argue ha for advanced economies he smaller impac of inflaion on ineres raes could be explained by he relaively low and well anchored inflaion expecaions in hese counries hus diminishing heir imporance for long-erm invesors. To assess he degree o which he Fisher effec is valid for oday s Europe, we regressed daily changes in he 10-year overnigh index swap (OIS) on daily changes in inflaion expecaions measured by inflaion swap raes a 10-year mauriy: he esimaed coefficien over he daily period 1 April 2005-25 Augus 2014 amouns o 0.61, is highly saisical significan and raher sable. We also performed a more formal mulivariae analysis, using a panel regression wih counry fixed effecs and conrolling for he level of governmen deb, expeced real GDP growh 1-year ahead, he sovereign bid-ask spread, and a proxy of he redenominaion risk premium (he USD/EUR opion price a 1-year mauriy). We found in his case a pass-hrough from he 10-yr OIS rae o he 10-yr sovereign yield is close o 1 (esimaed for a cross-secion of he larges 10 euro-area counries over he period Oc 2003 o July 2014, monhly frequency; he resuls are suppored by a Pedroni residual coinegraion es, which suggess ha he residuals of he panel regression are saionary). 7 For ease of exposiion we assume here ha he primary balance does no reac o unexpeced inflaion shock. This effec will be discussed in more deail in he following secions. NS S

308 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer All in all, our resuls 8 sugges ha he shor-erm pass-hrough from long-erm expeced inflaion o long-erm nominal sovereign yields is quie high, and he Fisher hypohesis can be considered a monhly frequencies a good approximaion of realiy Concerning he hird channel (primary balance), he overall negaive effec on he primary balance can be considered limied and ransiory. On he spending side, a decrease in he prices of goods and services reduces nominal inermediae consumpion and governmen invesmen. I also reduces spending on compensaion of public employees, pensions and oher ransfers, as long as hose paymens are indexed o price developmens. Barro (1979) and Dwyer (1982) argue ha in order o mainain he same anicipaed real amoun of spending, governmens adjus heir defici o unanicipaed inflaion rae changes. However, in pracice public expendiures are unlikely o adjus o inflaion auomaically. Expendiures, including discreionary spending, are decided in a discreionary manner every year by governmen eniies in he conex of he budgeary process. Public wages and ransfers are usually fixed for even longer periods, and indexaion rules may apply wih a lag. Unanicipaed lower inflaion may hus cause expendiures o increase as a raio o GDP, a leas in he shor erm. Inflaion can affec ax revenues on accoun of (nominal) fiscal drag (Kremer, 2006; Creedy and Gemmell, 2007; Lee, 2011). Progressive income axes imply ha increases in wages in line wih inflaion increase governmen real ax revenues by pushing nominal incomes ino higher ax brackes ( bracke creep ). A deceleraion in he rae of inflaion miigaes his effec. Negaive inflaion can lead o a reversal of he fiscal drag and may where nominal wages sar falling imply a fall in real ax revenues. Heinemann (2001, 543) finds ha in many OECD counries wih srongly progressive ax sysems, inflaion is helpful in increasing revenues from individual income axes and social securiy conribuions on accoun of he fiscal drag. Immervoll (2005) in a sudy of he ax sysems in Germany, he Neherlands and he U.K. finds ha he bracke creep has a subsanial effec on individual ax burdens in he absence of auomaic inflaion adjusmen mechanisms. A he same ime, inflaion has a negaive effec on real revenues for axes wih a significan collecion lag. Inflaion auomaically reduces real revenues for axes wih a considerable lag beween he axable even and he momen he ax is acually paid (Escolano 2010). 3 Public finances in a low (negaive) inflaion environmen: a look a seleced euro-aurea counries The effec of an unexpeced disinflaion shock on public finances depends on he srucure of governmen spending, he ax sysem and he srucure/size of governmen deb. This secion focuses on seleced euro-area counries (Germany, France, Ialy, Ausria and Greece) for which deailed informaion on key fiscal aggregaes (i.e., primary expendiures, revenues, ineres paymens and he deb sock) and how hey are likely affeced by inflaion developmens is available. 9 Afer summarising he key ransmission channels, a model-based simulaion of he impac of low inflaion on public finances is obained using he fiscal forecas models of he NCBs. Finally, an illusraive quanificaion of he effecs of negaive inflaion for he case of France is provided. 10 8 Resuls are available from he auhors upon reques. 9 This informaion has been colleced by he working eam on he basis of a deailed quesionnaire prepared and filled in by he NCBs expers paricipaing in he working eam. 10 The model based analysis presened in his secion, however, is a parial analysis as i is no based on a fully consisen macroeconomic scenario.

The Effec of Low Inflaion on Public Finances 309 3.1 The Primary balance channel (1): primary expendiure Indexaion of governmen spending is common o all counries under consideraion and CPI inflaion is he mos commonly used index (see Table 1). The share of oal spending which is indexed ranges from 29 per cen (13.3 per cen of GDP) in Germany, o 60.8 per cen (31.9 per cen of GDP) in Ialy. In Germany, however, less han 5 per cen of oal spending is direcly indexed o inflaion. Since 2009-2010, however, indexaion mechanisms have been suspended eiher enirely or parly in boh Ialy and France in he conex of he ongoing consolidaion effors of he respecive governmens. As a resul, he effecive indexaion is smaller (for Ialy i falls o 21 per cen of GDP). In Greece all indexaion mechanisms operaing before he counry enered he economic adjusmen programme have been suspended. Discreionary spending, (e.g., inermediae consumpion and public invesmen) is usually budgeed in nominal erms a he beginning of he budgeary process. Budgeing is done in a op-down manner (i.e., spending envelopes across eniies are decided cenrally by he Miniser of Finance) in France, Ialy and Germany, and boom-up (i.e., based on consulaion wih various eniies) in Ausria and Greece. Spending envelopes are usually se in nominal erms and in France, Germany and [Ialy], hey are based on expeced inflaion developmens, whereas in Ausria a medium-erm pah is se for he period +4 which, however, is no linked o inflaion developmens. Unexpeced changes in inflaion usually ransmi o his ype of spending wih a ime lag, because mos of hese expendiures are conrolled by lower levels of governmen. They usually adjus heir spending behaviour only in he medium-erm, while relying on budge-deficis in he shor-erm. 3.2 The Primary balance channel (2): Tax revenues Personal income axes are levied progressively in all counries under consideraion, hough only France legally indexes he ax brackes of is personal income ax o inflaion (of year 1) hus limiing he fiscal drag o real componen (see Table 2). However, such indexaion has been suspended for 2012 and 2013 for consolidaion reasons, whereas for he remaining counries in our sample, boh a nominal and real fiscal drag effec is a work. The overall fiscal drag ypically amouns o revenues of up o 0.2 per cen of GDP annually over he las 15 years. Corporae income axes are progressive only in Greece and France bu no bracke indexaion is foreseen. For hese wo counries he nominal fiscal drag has been small over he recen pas. This is due o he limied number of ax brackes foreseen by law in boh counries(wo). Inflaion plays a role in corporae axaion even if corporae profis are axed proporionally. In all counries considered here, depreciaion allowances are based on hisoric coss; hus inflaion reduces he real value of depreciaion allowances and increases he effecive ax rae on corporaions indirecly. Social securiy conribuions, which share he same ax bases as personal income axes, are ypically levied proporionally. Wih he excepion of Greece, in all counries here are caps on he maximum amoun of social securiy conribuions o be paid. As inflaion would push more and more people over he cap limis, i.e., exemping hem from conribuions, all counries in our sample legally index he caps o inflaion developmens. 11 These adjusmens allow for sabiliy of real social securiy conribuions. Indirec axes, such as VAT, are usually levied proporionally on prices (ad valorem mehod of axaion). Excise duies, are levied proporionally on quaniies (excep for obacco axes which 11 While Germany and Ausria adjus he caps (and also minimum conribuion levels) o wage increases in 2, France adjuss according o wage increase in 1 and Ialy akes price increases in 1 ino accoun. Hence, Ialy implicily spares real wages from higher social securiy conribuions.

Pensions Expendiure Iems Share in Toal Expendiures (2013 daa, percen) Indexaion Srucure of Main Governmen Spending (percen) (percen of 2013 GDP) Indexaion Mechanism (Y/N) Index Used for Indexaion Germany 24.4 11.2 Y Per capia wage increase in 1 Table 1 Is Mechanism Working a Presen? France 24 14.1 Y Forecased CPI excl. obacco Basic pensions frozen in 2015; supplemenary pensions progress less han inflaion Ialy 35 18.3 Y Forecased CPI excl. obacco Parial indexaion for pensions > 3000 EUR/monh Ausria 28 14.7 Y Realised CPI Greece 26 15.2 Y Forecased CPI Suspended since 2009 Social benefis Germany 4.6 2.1 Y Privae secor wage growh and pas CPI France 11 6.5 Y Forecased CPI (excl. obacco) Ialy 5.3 2.8 Y Wages and CPI Ausria 2.8 1.5 Y Wages, CPI Greece 2.00 1.18 Y Forecased CPI Suspended since 2009 Compensaion of employees Germany 17.5 8.0 N France 23 13.5 Y Index poin no auomaically relaed o inflaion Ialy 20.5 10.7 Y Governmen CPI inflaion arge Ausria 18.3 9.6 N Yes, unil 2017 will be frozen Yes, unil 2015 will be frozen Greece 20.4 11.9 Y Forecased CPI Suspended since 2009 Source: auhors elaboraion based on ESA1995 daa. Noe: figures in bold represen hose iems which are direcly indexed o inflaion. 310 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer

The Effec of Low Inflaion on Public Finances 311 Table 2 Main Taxes and Indexaion of Tax Brackes in Seleced Euro-area Counries Type of Taxes and Indexaion of Tax Brakes PIT Corporae SSC Excise duy EL progressive /NO progressive/no proporional proporional on quaniy DE progressive /NO proporional/no proporional/indexaion of caps proporional on quaniy FR progressive/yes progressive/no proporional (progressive)/indexaion of caps proporional on quaniy IT progressive /NO proporional/no proporional/indexaion of caps proporional on quaniy AT progressive /NO proporional/no proporional/indexaion of caps proporional on quaniy Source: auhors elaboraion. incorporae also a price componen). Thus, assuming no behavioral changes, price developmens should no affec nominal excise ax revenues. In real erms, however, and in percen of GDP hese ax revenues are gradually eroding over ime wihou any discreionary adjusmen. For he counries in he sample, hese represen approximaely 5 per cen of overall ax revenues, which are no legally linked o any price developmens. Moreover, he same phenomenon concerns recurring real esae axaion, in insances where i is based on cadasral values, as opposed o marke values. This is he case for Ialy, Ausria, France and Germany. Table 3 quanifies he nominal fiscal drag for he wage ax and excise duies 12 and shows ha for 2013 i is overall very limied. For he purpose of his analysis, he focus is only on he nominal revenue effecs of fiscal drag on wage ax for 2013 13 and on excise duies. The underlying mehod used o calculae he nominal fiscal drag is deailed in he Annex 2 14 and he reference price index used is he privae consumpion deflaor. The nominal fiscal drag from he wage ax in 2013 was posiive for all counries ha experienced an increase in he price deflaor and was comprised beween 0.07 and 0.14 per cen of GDP, whereas i was negaive, hough small in Greece owing o he fall in he price deflaor. Differences in he change in he price deflaor, largely explain he observed cross counry differences in he fiscal drag. The fiscal drag from excise axes was small across counries bu he sign of he fiscal drag goes in opposie direcion o he change in he price deflaor. Since excise axes are levied on quaniies, he calculaion of he nominal fiscal drag assumes ha he ax base is linked o real privae consumpion and no o nominal privae consumpion. The elasiciy of revenues from excise axes o changes in real privae consumpion is assumed o be smaller han 1. As a resul, in 12 13 14 The WGPF provides informaion on fiscal drag using he disaggregaed approach for income ax. However, his source only allows quanifying he combined effec of real and nominal changes on fiscal drag. If, however, he aim is o examine he impac of low inflaion on public finances, quanifying he general fiscal drag is a relaively ineffecive approach. This analysis akes no accoun of a furher imporan effec of inflaion on he size of he real ax burden, for where axaion is deermined in line wih nominal invesmen income, higher inflaion generally resuls in he ax levied on he real reurn being well above he nominal ax rae. In his regard, he degree of divergence beween he nominal rae and he effecive real ax burden depends on he raio of he nominal ineres rae o he real ineres rae, alhough oher facors (in paricular, depreciaion allowances) also exer an influence. The following example illusraes he effec in quesion: If, say, he ax rae is 50 per cen, he nominal ineres rae is 2 per cen and inflaion sands a 0 per cen, his leaves a nominal and real reurn afer ax of 1 per cen while ax revenue also amouns o 1 per cen. By conras, if he nominal ineres rae is se a 5 per cen, wih inflaion a 3 per cen (he real ineres rae remaining unchanged a 2 per cen), he nominal reurn afer ax amouns o 2.5 per cen whereas he real reurn afer ax is 0.5 per cen and ax receips sand a 2.5 per cen. This effec, which impacs on he progressive ax regime bu also on proporional ax raes, can be quie considerable. Moreover, i can lead o severe disorions in he economy ha are a drag on poenial growh. However, i is no aken ino consideraion here when calculaing fiscal drag. The calculaion of he fiscal drag is based on he implici assumpion ha a change in inflaion induces an equally large percenage change in nominal wages. In addiion, he relaive significance of he price effec for income ax (relaive o a proporional ax regime) depends on he choice of price index.

312 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer Fiscal Drag ha Is Due o Changes in he GDP Deflaor (2013) Table 3 Fiscal Drag on Wage Tax Fiscal Drag on Excise Taxes Overall Fiscal Drag Change in Pric Deflaor Counry bn EUR %GDP Source: auhors elaboraion. Sensiiviy o 1p.p. change in deflaor bn EUR %GDP Sensiiviy o 1p.p. change in deflaor bn EUR %GDP Sensiiviy o 1p.p. change in deflaor % AT 0.42 0.14 0.06-0.15-0.05-0.02 0.27 0.09 0.04 2.20 DE 1.93 0.07 0.06-0.86-0.03-0.02 1.07 0.04 0.03 1.25 FR GR -0.10-0.05 0.03 0.1 0.05-0.03 0 0 0.00-1.5 IT 1.63 0.10 0.08-0.58-0.04-0.03 1.05 0.07 0.05 1.32 2013, he fiscal drag from excise axes due o a change in he deflaor was negaive in all counries, excep Greece where he fiscal drag was posiive due o a fall in he deflaor. 15 3.3 The deb raio and he ineres-rae channels As illusraed in secion 2, an unexpeced increase in inflaion reduces he deb-o-gdp raio via he impac on he ousanding sock of deb and he cos of servicing his deb in addiion o is effec via he primary balance (see equaion 1, Secion 2). 16 The share of he deb which is no sensiive o inflaion developmens differs significanly across counries (see Annex 2 and Table 8 for more deails) hus leading o differen degree of sensiiviy of he deb raio o inflaion shocks. Table 4 below illusraes he resuls of applying he formula derived in secion 2 o individual counries. Ialy is he counry wih he larges sensiiviy o changes in inflaion (0.9p.p. of GDP), owing o he high deb raio. Greece, on he oher hand, records he lowes impac on he deb raio (0.3p.p.) owing o he very low elasiciy, which in urn depends on he very low share of deb which is no sensiive o he inflaion rae. For he oher counries he effec is in beween hese wo exremes (Table 5). This sensiiviy becomes larger under he assumpion of a parial pass-hrough from inflaion o ineres raes. Applying he formula in (4 ) and assuming a value for k=0.6 (see secion 2) we obain he new values for he elasiciy and he impac of lower inflaion on he deb raio. As expeced, he sensiiviy of he deb-o-gdp raio o he same decline in inflaion is larger han in he k=1 case. However, i urns ou ha he effecs are no quaniaively very differen. The debo-gdp raio increases by 1.1 percenage poins of GDP in Ialy, 0.8p.p. in France, 0.6p.p. in Ausria and 0.6p.p. in Germany. The only excepion is Greece, where he increase in deb is now 0.9 percenage poins (as opposed o 0.3 percenage poins in he full-fisher scenario). This is due o he fac ha Greece is he only counry in which b is much bigger han b. S NS 15 Finally, he so-called Tanzi effec (Tanzi 1977), which refers o he inflaion-induced reducion in real ax income due o collecion lags is likely o be no significan in ESA erms. In mos counries ax-prepaymens should avoid collecion lags and moreover boh ESA 95 and ESA 2010 follow he accrual principle. 16 As in he res of he paper, we do no consider here he seigniorage channel.

The Effec of Low Inflaion on Public Finances 313 Effecs of a Decrease of EA Inflaion from 1.3 o 0.3 per cen Table 4 FULL FISHER EFFECT (k=1) GERMANY FRANCE ITALY AUSTRIA GREECE Deb-o-GDP raio (%) (d o ) 78.4 93.5 132.6 74.0 175.1 share of long-erm, non-mauring deb (b NS /b TOT ) 0.66 0.75 0.68 0.88 0.19 Inflaion in 2015 1.3% 1.3% 1.3% 1.3% 1.3% Elasiciy -0.008-0.010-0.009-0.011-0.002 Deb-o-GDP raio wih 1p.p. lower inflaion 78.9 94.2 133.5 74.6 175.4 Change in deb 0.5 0.7 0.9 0.6 0.3 PARTIAL FISHER EFFECT (k=0.6) share of shor-erm, variable ineres rae deb (b S /b TOT ) 0.34 0.25 0.32 0.12 0.81 second elasiciy -0.002-0.001-0.002-0.001-0.004 Elasiciy -0.010-0.011-0.010-0.012-0.007 Deb o GDP raio 79.0 94.3 133.7 74.7 176.0 Change in deb 0.6 0.8 1.1 0.7 0.9 4 Counry specific simulaions on The effec of inflaion on he primary balance This secion aims a providing a sylised assessmen of he ransmission mechanisms from inflaion o revenues and expendiures using he fiscal forecas models of individual cenral banks. Firs, he resuls for a low inflaion shock are presened, (i.e., 1p.p. lower inflaion vs. baseline). Second, he analysis looks a he effecs on public finances in he case of a negaive inflaion rae (i.e., GDP deflaor growh rae of 1 per cen). The main assumpions hese simulaions are in Annex 4. 4.1 A disinflaionary shock The effecs of a 1p.p. emporary shock o he GDP deflaor on he primary balance and he headline balance are illusraed in Table 5. This corresponds o a permanen shock o he level of he deflaor, whereas i is assumed ha he growh rae revers o he baseline already in year +1. The main ransmission channels of he low inflaion shock are counry specific depending on he assumpions on he ransmission of he shock o wages and salaries, he iming of indexaion and he possibiliy ha in some counries exising indexaion mechanisms are emporarily frozen as discussed in secion 4.1. The average deerioraion in he primary balance is 0.15p.p. of GDP on impac hough here are imporan differences across counries (i.e., 0.3p.p. in Ialy vs. 0.1 per cen of GDP in Germany and Greece). These effecs are in line wih he findings from a panel regression for a sample of EU counries based on he fiscal reacion funcion lieraure (see Box 3). The deerioraion is due o oal revenues declining, in nominal erms, more han nominal primary expendiures. Boh discreionary and non-discreionary spending adjus wih a lag o he lower inflaion environmen, hus causing he primary expendiure-o-gdp raio o increase on impac. The reducion in primary spending in he firs year is influenced by assumpions regarding he pass-hrough of inflaion developmens o public and privae wages. In Ausria, for example, boh privae and public secor wages adjus wih a lag o lower inflaion, as wages are usually agreed in year 1 for he following period. In France, Ialy and Greece, public wages do no adjus o lower inflaion as exising indexaion mechanisms are currenly suspended. This inroduces an elemen of downward rigidiy,

314 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer whereby a lower realised inflaion rae resuls in lower realised budgeary savings compared o a baseline scenario wih higher expeced inflaion raes, hence higher savings hanks o he wage freeze. Oher spending caegories also adjus wih a lag, hough by differen degrees. In Germany, Ialy and Greece he pass-hrough from lower inflaion o inermediae consumpion is higher han in Ausria and France. On he revenue side, direc axes end o decline in line wih GDP in Germany and Ausria, and more han in oher counries, whereas he reacion of indirec axes is more subdued. In he case of Ausria his reflecs he fac ha indirec axes depend only parially from privae consumpion. In Ialy, France and Greece indirec axes decline more in line wih GDP. Finally, social securiy conribuions are relaively less affeced by lower inflaion in he firs year in all counries reflecing he parial pass-hrough from low inflaion o oal wages. In Germany and Ausria he primary balance reurns o he pre-shock baseline by he end of he hree-year simulaion horizon. In Ialy he gap o he baseline declines progressively, whereas i akes longer o converge in France and Greece. In Ausria boh revenues and primary expendiures fully adjus downward by he end of he horizon. In Germany, revenues and primary spending in nominal erms decline in proporion by a similar amoun, so ha he impac on he primary balance is almos zero. In Ialy, he primary balance in he firs year deerioraes more han in he oher counries, owing mosly o he fac ha pension expendiures 17 adjus wih a lag o lower inflaion. The gap o he baseline shrinks in he second year and widens slighly by he end of he projecion horizon due o a more pronounced decline in direc axes and social securiy conribuions. In Greece and France, he end of period deerioraion in he primary balance is higher han he one recorded on impac (0.2p.p. of GDP and 0.1p.p. of GDP respecively). This owes o a more rigid srucure of primary spending given ha in addiion o wages and salaries, also social ransfers are assumed no o reac o he low inflaion shock. As a resul, he freezing of he indexaion mechanisms inroduced in he conex of he recen consolidaion effors, inroduces an elemen of downward rigidiy in governmen spending (a unchanged policy), which has persisen effecs on he primary balance in presence of a disinflaion shock. If lower inflaion feeds hrough ino lower ineres raes on newly issued deb, i has a cushioning effec on he headline budge balance, which deerioraes on impac by 0.05p.p. on impac. If lower inflaion passes-hrough o lower ineres raes, via lower inflaion expecaions, his will reduce he cos of newly issued deb, hus cushioning he adverse effecs of lower inflaion on he primary balance. This beneficial effec depends on he degree of pass-hrough from low inflaion o ineres raes (higher in he case of full pass-hrough) and he mauriy srucure of deb. In he case of Germany, he savings relaed o lower ineres paymens more han offse he deerioraion in he primary balance, hus leading o an improvemen of he budge balance of 0.1p.p. In he ouer years, his effec fades away since ineres raes go back o he pre-shock level given he emporary naure of he inflaion shock. For he oher counries, he offseing effec is less srong, bu sill posiive. Overall he dynamics of he headline budge balance are similar o wha described above for individual counries. However, i has o be noed, ha o he exen ha he shock o inflaion is only emporary and inflaion expecaions are no affeced, his beneficial impac from lower ineres paymens is likely no o maerialise, or o maerialise o a smaller exen. 4.2 A negaive inflaion shock A negaive inflaion shock has more adverse consequences for public finances essenially via he negaive effec on economic growh and a higher rigidiy in governmen spending. Simulaing 17 In 2013 pension expendiures in Ialy amouned o 35 per cen of oal spending.

Effecs of 1p.p. Lower Inflaion on Main Fiscal Variables Table 5 Deviaions from baseline Germany France Ialy Ausria Greece +1 +2 +1 +2 +1 +2 +1 +2 +1 +2 p.p. of GDP Budge balance 0.08 0.02 0.02-0.04-0.13-0.15-0.11-0.02-0.11-0.14-0.10-0.03-0.05-0.17-0.16 Primary balance -0.05-0.02-0.02-0.15-0.17-0.19-0.27-0.13-0.16-0.17-0.14-0.06-0.08-0.12-0.11 Toal expendiures 0.14 0.18 0.16 0.31 0.32 0.31 0.22 0.05 0.10 0.39 0.11 0.00 0.27 0.32 0.31 Primary expendiures 0.27 0.23 0.20 0.41 0.36 0.36 0.38 0.16 0.15 0.42 0.15 0.03 0.30 0.27 0.26 Toal receips 0.22 0.20 0.18 0.26 0.19 0.16 0.11 0.03-0.01 0.25 0.01-0.03 0.22 0.16 0.15 % deviaions from baseline level Toal receips -0.62-0.65-0.71-0.50-0.64-0.69-0.76-0.94-1.00-0.50-0.98-1.06-0.53-0.65-0.66 o.w.: Direc axes -1.09-1.04-1.08-0.27-0.80-0.90-0.20-0.56-0.65-1.01-1.47-1.61-0.14-0.59-0.64 Indirec axes -0.71-0.75-0.77-0.98-0.97-0.97-0.98-0.97-0.97-0.54-0.74-0.78-1.00-1.00-1.00 Social conribuions -0.13-0.23-0.35-0.30-0.36-0.42-0.26-0.33-0.39 0.00-0.90-1.03 0.00 0.00 0.00 Toal expendiures -0.68-0.59-0.65-0.46-0.43-0.44-0.60-0.90-0.78-0.24-0.78-1.00-0.43-0.30-0.31 o.w.: Compensaion of employ -0.13-0.24-0.37-0.01-0.01-0.01 0.00 0.00 0.00 0.00-0.80-1.00 0.00 0.00 0.00 Inermediae consumpio -0.75-1.00-1.00-0.50-1.00-1.00-1.00-1.00-0.99-0.50-1.00-1.00-1.04-1.06-1.06 Social ransfers in kind -0.42-0.49-0.58 0.00 0.00 0.00-0.50-0.50-0.50-0.30-0.80-1.00 0.00 0.00 0.00 Social benefis -0.43-0.47-0.53-0.11-0.11-0.11 0.00-1.00-1.00 0.00-0.44-0.89-0.27-0.27-0.27 Ineres paymens -5.63-1.20-1.30-5.53-2.87-3.11-4.20-3.20-2.00-2.41-2.48-2.19-1.60 0.00 0.00 Public Invesmen -0.50-1.00-1.00-0.50-1.03-1.06-0.40-1.00-1.00-0.50-1.00-1.00-0.43-1.12-1.04 Nominal GDP growh -1.00 0.00 0.00-1.00 0.00 0.00-1.00 0.00 0.00-1.00 0.00 0.00-1.00 0.00 0.00 Nominal GDP -1.00-1.00-1.00-1.00-1.00-1.00-1.00-1.00-1.00-1.00-1.00-1.00-1.01-1.01-1.01 Source: auhors elaboraion. The Effec of Low Inflaion on Public Finances 315

316 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer he effecs on public finances when he GDP deflaor growh rae urns negaive is paricularly challenging given he uncerainy surrounding he macroeconomic effecs of negaive inflaion and he possibiliy ha hreshold effecs governing he reacion of he main macroeconomic variables operae. Noneheless, some enaive assumpions can be made in order o illusrae how a negaive inflaion rae would ransmi o public finances. When inflaion urns negaive for a proraced period, real economic aciviy is adversely affeced owing o he (likely) downward rigidiy of inpu prices and he (likely) decline in real privae consumpion. These facors would lead o a decline in firms gross operaing surplus, hence he major ax bases. In presence of negaive inflaion, i is plausible o assume ha privae secor wages are downward rigid and ha he negaive inflaion does no pass-hrough o nominal ineres raes, 18 hus causing an increase in he real ineres rae. Moreover, i is also plausible o assume ha real privae consumpion falls in response o negaive inflaion essenially because consumers observing negaive inflaion pospone heir consumpion choices o he fuure. The rigidiy of inpu prices, he fall in privae consumpion and he conracion in economic aciviy ha follows leads o a decline in firms gross operaing surplus. As a resul, he main ax bases sar o conrac wih negaive consequences for ax revenues. Moreover, spending for compensaion of employees and oher social spending, including unemploymen benefis, are also unlikely o fall in line wih negaive inflaion, hus leading o a furher worsening of he budge balance. Nominal ineres paymens are unchanged as here is no effec on nominal ineres rae, including hose on inflaion indexed bonds (he paymens on he reurns is no diminished when inflaion realizaions are negaive; inflaion indexed bonds are se in a way ha preven bonds holder s agains he risk of deflaion). Agains his background, his secion presens some illusraive simulaions for he case of France aking as a saring poin he low inflaion scenario discussed above. I is assumed ha an addiional shock of 1p.p. o he GDP deflaor growh rae occurs, such ha he growh rae of he GDP deflaor is 1 per cen (as he GDP deflaor growh in he pre-low inflaion shock (i.e., baseline was 1 per cen). The simulaions presened in his secion aim a illusraing he ransmission mechanisms of negaive inflaion o public finances. For his purpose i is assumed ha he macroeconomic effecs of negaive inflaion are as described above, hough i may be argued ha in presence of a emporary shock such effecs could be less pronounced. Table 6 illusraes he resuls of he incremenal effec on he fiscal balances (compared o he low shock scenario discussed above) when he growh rae of he GDP deflaor urns negaive. In his scenario, revenues will decrease as he resul of he lower ax bases due o fall in prices bu also o he conracion of economic aciviy. Indeed, unlike in he low inflaion scenario, in his case i is assumed ha negaive inflaion has consequences for he real economy via a fall in privae consumpion will of 0.2 per cen, which ranslaes ino a decline in real GDP of 0.1 per cen. The fall in direc axes reflecs essenially he decrease of corporaes axes, due o he fall of heir profis. In year +2, he primary balance (as percen of GDP) will be lower by 0.22pp compared o low inflaion shock as a resul of lower revenues (compared o low inflaion, primary expendiures will be slighly affeced by an increase of unemploymen saring in year +1). The decrease of social securiy conribuions is limied due o he assumed downward rigidiy of wages. The budge balance deerioraes more han in he case of low inflaion as ineres paymens are no affeced by he decline in he rae of inflaion and he addiional financing needs relaed o he higher budge defici as well as he mauring deb are financed a unchanged ineres raes. 18 On he oher hand, i could be assumed ha wages could be lowered via cuing exra paymens and allowances and by increasing working ime. Regarding ineres raes, i he real ineres rae is sufficienly posiive, nominal ineres rae could sill be reduced even if inflaion is negaive. Boh hese facors would miigae he negaive effec on he fiscal balances. However, hese effecs are no explicily aken ino consideraion in his noe.

The Effec of Low Inflaion on Public Finances 317 Table 6 Addiional Impac on he Budge Balance when GDP Deflaor Growh Rae is 1 per cen Deviaion from Low Inflaion Scenario FRANCE T T+1 T+2 Budge balance (p.p. of GDP) * 0.17 0.24 0.25 Primary balance (p.p. of GDP) 0.15 0.21 0.22 Toal expendiures (p.p. of GDP)* 0.53 0.50 0.50 Primary expendiures (p.p. of GDP) 0.51 0.48 0.47 Toal receips (p.p. of GDP)* 0.36 0.26 0.25 Toal receips (percenage change from low inflaion level) 0.52% 0.70% 0.72% Of which: Direc axes 0.29% 0.94% 1.00% Indirec axes 1.17% 1.16% 1.15% Social conribuions 0.15% 0.25% 0.25% Toal expendiures (percenage change from low inflaion level) 0.26% 0.30% 0.30% Primary expendiures 0.27% 0.32% 0.32% Of which: Compensaion of employees 0.01% 0.00% 0.00% Inermediae consumpion 0.50% 1.00% 1.00% Social ransfers in kind 0.00% 0.00% 0.00% Social benefis 0.11% 0.02% 0.02% Ineres paymens 0.00% 0.14% 0.35% Public Invesmen 0.50% 1.03% 1.06% Nominal GDP growh 1.10% 0.00% 0.00% Nominal GDP 1.10% 1.10% 1.10% Overall, a negaive growh rae of he GDP deflaor is likely o induce an addiional deerioraion of abou 0.2p.p. of GDP of boh he headline and he primary balance a end-period. If aken ogeher wih he low inflaion scenario, he decline in he GDP deflaor by 2p.p. and he nonlineariies associaed o he fac ha is growh rae urns negaive, would cause a deerioraion of he budge balance of abou 0.4p.p. of GDP by he end of he hird year compared o he baseline, wih a similar ime profile as discussed previously. 5 Deb susainabiliy analysis The DSA simulaions ake as a saring poin he benchmark scenario as per he 2014 Public Finance Repor and quanify he deb impac of hree ypes of inflaion shocks:

318 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer 1) A permanen shock of 1p.p. lower GDP deflaor growh (compared o he pah embedded in he benchmark) over he enire simulaion horizon saring wih 2015. The inflaion shock is considered o fully surprise economic agens and governmens he firs years (unanicipaed shocks). Thereafer, i is gradually, over a period of hree years, feeding-hrough expecaions. 2) A emporary shock of 1p.p. lower GDP deflaor growh for 3 years (2015-2017), followed by gradual linear convergence over 5 years (2018-2022) o he pah in he benchmark (reaching he GDP deflaor growh of he benchmark in 2022). 3) A deflaionary shock: counry-specific shocks calibraed o obain a negaive GDP deflaor growh of 1 per cen for 3 years (2015-2017), hereafer convergence o he benchmark pah in 5 years. In all he above scenarios, he price level is permanenly lower. I is assumed ha fiscal auhoriies do no implemen any discreionary policy measures in reacion o he adverse environmen. This allows isolaing he impac of inflaion shocks on he deb dynamics. The resuls are derived aking ino accoun a parial reacion of fiscal, macro and financial variables o he inflaion shocks in line wih he findings of he curren noe. In his respec, hree main channels 19 are capured: Firs, a drop in he rae of inflaion increases he real value of governmen deb direcly by reducing nominal GDP (he so-called denominaor effec, i.e., he deb-o-gdp raio increases ceeris paribus). Second, he slowdown in inflaion may adversely affec he primary balance o he exen ha nominal governmen spending is downwardly rigid and via lower fiscal drag (i.e., nominal revenues increase as higher inflaion pushes incomes ino higher ax brackes). For he purpose of he curren simulaions, he resuls of he empirical analysis, i.e., an adverse impac of lower inflaion on primary balance of 0.1p.p. per year (see Box 3) is considered as a saring poin. Third, he slowdown in inflaion is likely o be refleced in a gradual adjusmen of nominal ineres raes beyond wha implied by he credi risk premia. For a given level of spreads beween governmen bond yields, a reducion in nominal ineres raes is more likely o occur if he low inflaion shocks occur hroughou he euro area, as his is likely o be associaed wih he expecaion of a lower pah of curren and fuure cenral bank ineres raes. The assumpions for he pass-hrough of an inflaion shock o he marginal ineres rae (for new governmen deb) are in line wih he empirical finding of Box 2. For he curren simulaions and in line wih he pracise in he PFR, he deerioraion in fiscal fundamenals resuling from a lower inflaion environmen is ranslaed ino higher sovereign bond spreads (25 bp, and respecively 4 b.p. for every 1p.p. increase in he defici and he deb-o-gdp raios). For he hree DSA shock scenarios, he assumpions above are ranslaed as follows: 1) Permanen shock scenario: Primary balance-o-gdp: deerioraes hrough he srucural componen (exogenous variable) by 0.1p.p. per year for hree years (period during which he shock is unanicipaed). Thereafer, no reacion is considered beyond he denominaor effec. 19 The slowdown in inflaion may also affec poenial oupu growh, wih he sign of his effec being, however, unclear a priori and hus no aken ino accoun in he simulaions. Hence, on he one hand, a slowdown in inflaion may lead o an increase in oupu growh in counries undergoing rebalancing hrough an improvemen in compeiiveness (rebalancing effec). Moreover, oher hings equal, lower inflaion reduces he allocaive disorions caused by (nominal) axaion of ineres income. Therefore, savings, he capial sock and poenial growh could be higher. On he oher hand, in presence of low inflaion, downward rigidiies (especially in wages) can become binding, reducing employmen and real aciviy, which hrough hyseresis could be ransmied o poenial GDP. Moreover, a euro-area wide low inflaion environmen would make more difficul for counries wih exernal imbalances o regain price and wage compeiiveness, especially in he presence of downward rigidiies.

The Effec of Low Inflaion on Public Finances 319 Marginal Ineres raes: A pass-hrough o ineres rae of 0.6p.p. is considered for he firs year of he shock (2015) across he whole yield curve (an alernaive is o have differen pass-hrough effecs, i.e., saring a 1 for very shor-erm deb and converging o 0.6 for 10-year mauriies and above). Thereafer, a full pass-hrough is ensured by he end of he simulaion period (2024) hrough a gradual linear convergence. Marginal ineres raes remain somewha above he benchmark a he end of he simulaion horizon due o he higher risk premia. 2) Temporary shock scenario: Primary balance-o-gdp: deerioraes hrough he srucural componen (exogenous variable) by 0.1p.p. per year for hree years (2015-2017). Thereafer, a symmeric improvemen of he srucural balance is ensured over he nex 3 years (2018-2020). Marginal Ineres raes: A pass-hrough o ineres rae of 0.6p.p. is considered for he firs year of he shock (2015) across he whole yield curve. Thereafer, a full pass-hrough is ensured by he end of he simulaion period (2024) hrough a gradual linear convergence. Marginal ineres raes remain somewha above he benchmark a he end of he simulaion horizon due o he higher risk premia. 3) Deflaionary shock: Primary balance-o-gdp: Given he likely higher pressure from downward expendiure rigidiies, he primary balance-o-gdp deerioraes hrough he srucural componen (exogenous variable) by he specific share of expendiure subjec o inflaion indexaion (wage bill and social ransfers). As above, he impac is mainained only for a period of 3 years. Marginal Ineres raes: A pass-hrough o ineres rae of 0.6p.p. is considered for he firs year of he shock (2015) across he whole yield curve and hen i gradually converges unil he marginal ineres raes hi he lower bound. Marginal ineres raes remain more significanly above he benchmark a he end of he simulaion horizon due o he higher risk premia. Table 7 illusraes he DSA simulaions for he five counries considered in his noe. The effecs on he deb-o-gdp raio o he 2024 horizon are sizeable especially for he counries ha sar wih a high deb-o-gdp raio. In all scenarios, in he absence of discreionary measures in response o he shock, he average headline budge balance deerioraes somewha over he simulaion horizon compared o he baseline. In he lower inflaion shock, he decline in he deb servicing coss is no sufficien o compensae for he assumed deerioraion of he primary balance, as he permanen decline in he marginal ineres raes is offse, a leas parly, by he increase in he sock of deb which feeds ino higher risk premia. For he emporary shock he deerioraion in he headline budge balance is larger han for he permanen shock. This owes essenially o he fac ha ineres paymens savings on accoun of permanenly lower inflaion do no maerialise, whereas he increase in he deb sock weighs on deb servicing coss. In he case of Greece, he deb service coss increase due o confidence effecs relaed o he relaively higherhan-benchmark deb level. Though he size of shocks is no comparable, in relaive erms, he deb increasing effec is he larges in he case of a deflaionary shock due mainly o he size of he shock bu also o he assumed rigidiies on he expendiure side in line wih wha described in he previous secion. 20 20 In all counries he size of he shock is larger in he negaive inflaion scenario: ranging beween 2.5 pp in 2015 and 2.8 pp in 2017 for AT, 2.8 and 3.3 for DE, 2.3 and 2.5 for FR, 1.3 and 2.0 for GR and 2.5 and 2.7 for IT. In Greece, which is currenly in deflaion (bu expeced o rever o posiive inflaion in he projecions), he size of he shock is smaller compared o he oher counries. Moreover, being emporary, he negaive inflaion shock implies a much faser recovery of he GDP deflaor in posiive erriory over he long erm.

320 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer Impac of Adverse Inflaion Shocks on he Deb-o-GDP Raio in 2024 and on he Average Budge Balance Over 2014-24 (percen of GDP, deviaion from baseline) Table 7 Permanen Shock Low Inflaion Shock Temporary Shock Counry-Specific Negaive Inflaion Shock* Deb Effec (2024) Average Impac on Budge Balance (2014-24) Deb Effec (2024) Average Impac on Budge Balance (2014-24) Deb Effec (2024) Average Impac on Budge balance (2014-24) Ausria 8.1% 0.2% [0.0] 5.7% 0.3% 11.3% 0.3% Germany 6.6% 0.1% [ 0.1] 4.9% 0.2% 11.4% 0.2% France 8.7% 0.1% [ 0.2] 5.8% 0.2% 13.4% 0.4% Greece 18.6% 0.5% [0.3] 11.8% 0.6% 15.5% 0.3% Ialy 11.5% 0.1% [ 0.1] 7.9% 0.3% 23.2% 0.9% Average 10.7% 0.2% [0.0] 7.2% 0.3% 15.0% 0.4% Sources: auhors elaboraion. * The size of he shock is counry specific and as a resul, he resuling effecs on he deb sock are no direcly comparable across counries. For he permanen shock scenario, he value in square brackes illusraes he average deviaion of effecive ineres raes compared o he baseline. 6 Policy implicaions The adverse impac of unfavourable inflaion developmens on public finances raises he issue of wheher his may hinder compliance wih he requiremens under he SGP. To briefly recap, he main indicaors for he assessmen of compliance wih he SGP (boh under is prevenive and he correcive arm) are he nominal budge balance and he srucural budge balance. Under he correcive arm, he so-called effecive acion procedure foresees ha if a counry fails o comply wih eiher he nominal balance or he srucural effor arges, a careful analysis is underaken. The careful analysis relies on he adjused srucural balance (i.e., correced for revenue windfalls and changes in poenial growh) and he so-called (boom-up) fiscal effor. The laer sums up he budgeary impac of individual measures on he revenue side; on he expendiure side i assesses measures as improvemens compared o he nominal expendiure pah as included in he EDP recommendaion. Finally, he six-pack reform has operaionalised he deb rule. 21 For he counries ha in November 2011 were under an EDP, a hree-year ransiion period has been inroduced. During he ransiion period a counry needs o make sufficien progress wih is srucural adjusmen o ensure ha i complies wih he deb rule afer he end of he ransiion period. Sufficien progress is measured wih reference o he minimum linear srucural adjusmen (MLSA) which is he leas sringen adjusmen in he srucural balance required for compliance wih one of he hree specificaions of he deb rule (backward looking, forward looking and adjused for he cycle). 21 This rule requires counries whose deb-o-gdp raio is in excess of 60 per cen, o reduce i by 1/20 of he excess over 60 per cen in each year.

The Effec of Low Inflaion on Public Finances 321 Inflaion may hen affec he assessmen of counries compliance wih he SGP requiremens as i affecs he nominal and he srucural budge balances, heir change and he fiscal effor. As shown in his noe, a 1p.p. unanicipaed decline in he rae of inflaion (or GDP deflaor) would ranslae ino a deerioraion of he budge balance ranging from abou 0.04p.p. of GDP on impac in he case of France and Greece o 0.11p.p. of GDP for Ialy and Ausria. Depending on he counry specific circumsances, he effec can become sronger over ime (e.g., France) or fade progressively away (e.g., Ausria) or be very limied alogeher (e.g., Germany). Therefore, a deceleraion in he growh rae of inflaion could cause boh he nominal balance and he srucural balance 22 o deeriorae o differen degrees across counries. As regards he impac of inflaion on he size of he (boom-up) fiscal effor, he implicaions of lower han expeced inflaion crucially depend on he behaviour of expendiures. If spending adjuss downwards in line wih inflaion developmens, han lower inflaion leads o an increase of he expendiure savings vis-à-vis he benchmark of he nominal expendiure pah included in he EDP recommendaion. Inflaion effecs on he spending side herefore could make compliance wih he fiscal effor recommendaion under he EDP easier. However, in case spending does no adjus, as seen in secion 4, hen compliance wih he fiscal effor would be hindered. The implicaions of lower inflaion are more significan in he case of he deb rule. The size of he MLSA, which is defined in erms of a requesed improvemen of he srucural balance, is affeced, among oher facors, by he gap beween he deb-o-gdp raio and he 60 per cen reference value. As shown in secion 4.2, for a very high deb-o-gdp raio a 1p.p. lower inflaion leads o an almos equivalen increase in he deb raio. Moreover, he DSA has shown ha a persisen shock o inflaion deermines an increase in he deb raio of up o 19p.p. in he case of Greece, hus jeopardizing deb susainabiliy. Therefore, unexpecedly lower inflaion has negaive effecs on counries capaciy o comply wih he deb rule via boh he negaive impac on he deb raio (i.e., leading o a widening of he gap vs. he 60 per cen) and via a lowering of he realised srucural adjusmen vis-à-vis he requiremen under he MLSA. Finally, as we have seen, he implicaions for compliance wih he SGP rules end o be more severe in he case of a negaive inflaion shock. Noneheless, and as sressed various imes in his noe, o he exen ha lower inflaion ranslaes ino lower ineres paymens via lower inflaion expecaions, he resuling savings in ineres paymens, alhough iniially limied, would parially offse he negaive impac of inflaion on budge balance. This parially counerbalancing effec would no, however, maerialize in he curren circumsances, given ha he euro area economy is a he zero lower bound. The SGP does no include specific reference o adverse inflaion developmens among he circumsances under which derogaion o he rules can be graned. Under he recenly amended mehod o assess effecive acion under he correcive arm of he Pac, i was conjecured ha he impac of inflaion may be considered in he careful analysis in cases in which he change in he adjused srucural effor and he boom-up fiscal effor poin in differen direcions. This has so far no been applied. A he same ime, under he correcive arm of he Pac, a so-called general escape clause exiss, which refers o periods of a severe economic downurn for he euro area or he Union as a whole. I provides for revisions in EDP recommendaions if his does no endanger fiscal susainabiliy. While here is no specific definiion in he SGP of a severe economic downurn, in case ail risks of negaive growh and deflaion maerialise, an applicaion of such a clause migh need o be considered. The case for doing so would be sronger if deflaion affecs core componens of HICP and GDP deflaor as risks for he economy and public finances are more severe. However, 22 We assume ha a deerioraion in he headline balance, which is due o lower inflaion, is enirely of a srucural naure as he cyclical componen, which is based on he oupu gap, is no affeced.

322 M.G. Ainasi, V. Borgy, O. Bouabdallah, C. Checheria-Wesphal, M. Freier, G. Palaiodimos, D. Prammer, P. Tommasino and J. Zimmer i needs o be recalled ha if deflaion maerialises in he absence of a severe economic downurn (i.e., in he presence of posiive or mildly negaive real oupu growh and oupu gap), hen he general escape clause will likely no apply. In he conex of he deb rule here is no specific provision for low or negaive inflaion developmens as a facor jusifying lack of compliance wih he rule. In paricular, in case a significan deviaion from he MLSA is diagnosed, which riggers he preparaion of a repor under Ar.126(3) TFEU, he Commission in deciding wheher an excessive defici exiss in he sense of he deb rule shall ake ino accoun all relevan facors as indicaed in aricle 2(3/4) of regulaion 1467/2011. Such facors include consideraion of: i) developmens in he medium-erm economic posiion 23 ii) he developmens in he medium-erm budgeary posiions; 24 iii) he developmens in he medium-erm governmen deb posiion. 25 Moreover, he Commission shall give due and express consideraion o any oher facors which, in he opinion of he Member Sae concerned, are relevan in order o comprehensively assess compliance wih defici and deb crieria and which he Member Sae has pu forward o he Council and he Commission. Alhough also in he case of he deb rule adverse inflaion developmens are no explicily menioned as a facor jusifying a deviaion from he rules, a counry can sill ask he Commission o consider adverse inflaion developmens among he oher facors relevan for he assessmen of compliance wih he deb rule. 26 23 This includes poenial growh, including he various conribuions provided by labour, capial accumulaion and oal facor produciviy, cyclical developmens, and he privae secor ne savings posiion. 24 25 26 This includes, in paricular, he record of adjusmen owards he medium-erm budgeary objecive, he level of he primary balance and developmens in primary expendiure, boh curren and capial, he implemenaion of policies in he conex of he prevenion and correcion of excessive macroeconomic imbalances, he implemenaion of policies in he conex of he common growh sraegy of he Union, and he overall qualiy of public finances, in paricular he effeciveness of naional budgeary frameworks. This includes deb dynamics and susainabiliy, including, in paricular, risk facors including he mauriy srucure and currency denominaion of he deb, sock-flow adjusmen and is composiion, accumulaed reserves and oher financial asses, guaranees, in paricular hose linked o he financial secor, and any implici liabiliies relaed o ageing and privae deb, o he exen ha i may represen a coningen implici liabiliy for he governmen. However, inernal ECB analysis for he case of Ialy shows ha even aking ino accoun currenly low inflaion as a relevan facor, compliance wih he MLSA would no be ensured and he size of deviaion from he required adjusmen would remain significan in he sense of he deb rule in boh 2014 and 2015 in he absence of addiional measures.