The Political and Economic Determinants of Budgetary Consolidation in Europe

Carlos Mulas-Granados

 

 

Abstract

 

This paper explores the political and economic determinants of fiscal adjustment strategies in the European Union (EU) between 1970 and 2001. Results confirm the hypotheses that, besides economic conditions, fragmentation of decision-making, ideology of the party in government, and closeness to elections affect fiscal policy in general and adjustment strategies in particular. During the nineties, the ideology of the party in government has become the most powerful predictor of fiscal policies and strategies of adjustment. Evidence shows that in the new context, socialist governments prefer to use balanced budgets to finance supply-side policies of capital formation and to maintain public employment, and are reluctant to cut these expenditures even at the expense of public consumption and transfers.

 

Keywords: Political Economy, European Union (EU), Fiscal Consolidation, Fiscal Adjustment.

 

1. Introduction

The 3%GDP deficit requirement to qualify for the third stage of EMU and the subsequent Stability and Growth Pact have made budget balances across Europe to converge. This, together with the process of economic globalization and the creation of the European Central Bank has served in several debates as an argument to proclaim the end of differences in economic policies in Europe, and the growing impossibility of governments to affect monetary and fiscal policies. 

 

But convergence in budget balances toward the 3% limit does not mean convergence in the size nor in the composition and distribution of public revenues and public expenditures. Fiscal policies in general and adjustment strategies in particular can vary in three dimensions: their timing, their duration, and their composition. In a situation of strong budgetary disequilibria, governments can decide to launch a fiscal adjustment sooner or later, that lasts longer or shorter, and that is revenue-based or expenditure-based. There can be switching and mixed strategies, where governments may decide to wait before cutting politically sensitive items such as transfers and subsidies. And the macroeconomic consequences of these different types of adjustment are not equivalent. 

 

In the last four decades, evidence of these variation in the strategies of fiscal adjustment in Europe is abundant, but in the nineties this variation has become even more relevant. While one could witness in the last decade a convergence in the timing of fiscal adjustments due to a generalized process of convergence toward the 3% boundary to comply with the Maastricht’s rules before 1999, it also became evident that different countries chose different strategies (in terms of duration and composition) to achieve the common objective. Since this variation is very paradoxical in the strict framework of the Maastricht Treaty and the Stability and Growth pact, this article looks at the possible political and economic determinants that can explain it. 

 

However, one must be careful in doing so and must take into account the following considerations. First, fiscal policy is a continuum along time where governments can implement fiscal expansions (that can lead to budget deficits), or fiscal consolidations (that can lead to budget surpluses). An strategy of fiscal adjustment can be defined as the group of measures designed and implemented by any government with the purpose of reducing the budget deficit or improving the budget surplus, that actually succeeds in approaching to each other public revenues and public expenditures as a percentage of GDP. As such, years in which a fiscal adjustment occurs are only a sub-sample of the fiscal policy implemented by any government along time. Therefore, if one is to study properly the economic and political determinants of fiscal adjustment strategies in particular, it is necessary to explore first the determinants of fiscal policy in general, in order to avoid a problem of “selection bias”. Secondly, as mentioned above, whenever any government designs a strategy to consolidate is budget, it has to decide on the timing (when to launch the adjustment), on the duration of the adjustment episode, and on its composition. Since the first two dimensions of any adjustment strategy have been already studied in depth elsewhere , this article focuses specifically on the third dimension (the budget’s composition), and it does so by answering consecutively to the two following questions: 

-What are the political and economic determinants of the budget’s composition in general, during both episodes of fiscal adjustment and episodes of fiscal expansion?

- What are the political and economic determinants that explain that during episodes of fiscal adjustment, different countries follow different strategies of adjustment in terms of budgetary composition? 

 

Although the literature on fiscal policy has covered a wide range of issues2 : To date the only study that has directly addressed the first question is the one by Perotti and Kantopoulus (1998). On a panel of OCDE countries from 1970-1995 they find that both cabinet’s ideology and fragmentation of decision-making affect the composition of the budget, mostly with respect to transfers. Nevertheless, their article bases its conclusions on data until 1995, leaving unexplored the period of strongest fiscal consolidations in the European Union (EU) that led to EMU in 1999. And most importantly, it does not address the question of what determines the choice of a certain type of fiscal adjustment strategy, in countries attempting to balance their budgets. 

 

Therefore, it is the purpose of this article to investigate the political and economic determinants of the strategic choice involved in the decision of the budgetary composition of any fiscal adjustment episode, with an special focus on the fiscal adjustments in the nineties in the European Union (EU). 

 

This is done from a political economy perspective, with reference to the institutional, ideological and electoral approaches that have traditionally tackled this issue. Driven by empirical results, the article pays special attention to the role that the government’s ideology has on fiscal outcomes, because if politics was already defined in the thirties as the decision over “who gets what, when, and how” (Laswell, 1936: 19), it is clear that fiscal policy and the choice of consolidation strategies are precisely so. 

 

Once economic conditions are taken into account, results confirm the hypotheses that fragmentation of decision-making, proximity of elections and ideology affect fiscal policy

 

More fragmented governments tend to spend more, to increase transfers and if forced to consolidate the budget, they prefer to follow a revenue-based adjustment strategies. For different reasons, socialist governments prefer bigger budgets in terms of the size that public revenues and expenditures represent as a share of GDP, though they cannot be necessarily associated to unbalanced budgets. They tend to increase transfers, the government wage bill and public investment. This is why during episodes of fiscal adjustment, more leftist governments also prefer revenue-based strategies. Moreover, evidence from the nineties suggest that EMU has forced socialist governments to switch their preferences on the expenditures’ side. In the new context, they prefer to use revenues from direct taxes to achieve balanced budgets that allow them to finance publicly supply-side policies of capital formation and to maintain public employment. When forced to adjust they are reluctant to cut these expenditures even at the expense of public consumption and transfers

 

Next section draws a general picture of fiscal outcomes in the EU during the last decades, and shows that a lot of variability in fiscal policies can be found despite of common trends. Section 3 explores the factors that explain the mentioned variation in fiscal policies and that have affected the composition of public budgets across Europe between 1960-2001. Section 4 defines different strategies of fiscal adjustment and tests whether the same variables that explain composition of the budget during adjustment and non-adjustment years, also determine the strategy of fiscal adjustment and its composition during episodes of fiscal consolidation. Finally, section five summarizes the main findings and presents some conclusions.

 

2. Fiscal Policies in the European Union (EU), 1960-20013

 

When one looks at the overall record of fiscal outcomes in the last decades for the fifteen EU Member States, it is easy to draw a general picture of common fiscal policy developments in the whole European Union (EU). 

 

Fiscal policy during the past thirty years has been characterized by a tremendous increase in public expenditures that rose from 35% of European GDP in 1970 to a peak of 53% in 1993. This was basically due to expansion of public consumption and social transfers, associated to the Welfare State. In 2000 they had declined to about 46% of GDP. But this means that the size of the European public sector is still 13 percentage points of GDP higher than in the US and 20 percentage points of GDP higher than in Japan. 

 

In order to finance the strong growth of public expenditures, public revenues in the EU grew from 35% in 1970 to a peak of 46% in 1999. They were expected to decrease only from 2000 onward. The increase was based on higher taxes on labour. Both direct taxes and social contributions, increased by 3% of GDP. On the contrary, indirect taxes fell by six percentage points during this period. Nevertheless, the increase in public revenues did not run parallel to the increase in public expenditures, and then it was not sufficient to balance the budget. As a consequence, large and persistent deficits arose, that had to be financed issuing debt. 

 

This general development of fiscal policies around Europe made public deficit in the EU to remain above 3% from 1975 on. Public deficit reached its maximum in 1993 after the 1992-93 recession, recording 6% of GDP. These persistent deficits led to a rapidly increasing government debt, which jumped from 30% of GDP in the 1970s to a maximum of 72% in 1996. Public debt in the EU still remains at an average of 64% of GDP (with Belgium, Greece and Italy over 100%). Under such unsustainable path, the Maastricht convergence criteria forced a strong fiscal consolidation in the European Union (EU), which achieved a deficit reduction of 5 percentage points between 1993 and 1999. 

 

Despite the previous general picture of aggregate convergence on budget balances, the structure of those budgets have significantly varied among different Member States. In the last decades, some countries decided to dedicate very large shares of their GDP to public provision of goods and services and the welfare state, while others preferred to limit the presence of the public sector in the economy. Table 1 illustrates very clearly this variation in the structure of fiscal policies and fiscal outcomes in Europe. 

 

The previous variation in fiscal developments among different European countries, has been also translated into remarkable variation in the timing, the duration, and composition of fiscal adjustment episodes. At different moments in time, countries have found that their fiscal imbalances were unsustainable in the medium and long-run, and have decided to correct those imbalances and approximate public revenues and public expenditures. When they have done so, some have chosen to reduce their budget deficit gradually through successive short fiscal consolidations (like Finland or the Netherlands), while others preferred to pursue fewer but longer adjustments (like Greece or Ireland). 

 

3.1 Economic factors

Budget deficits are the result of different economic and political decisions. However, if a government is to consolidate the budget successfully, it has to take into account the previous level of structural deficit, and the cyclical surrounding economic conditions in terms of prices and employment.

 

The most important constraint that governments face when deciding about the composition of the budget and the strategy of fiscal adjustment, is the accumulated level of debt. The higher it is, the higher the share of public expenditures that has to be dedicated to interest payments generated by that debt. This is known as the “snow-ball effect”, and it can seriously diminish the alternatives available to governments.

 

In this respect, if the effect of interest payments on the budget is discounted (because they lay out of the government’s immediate control), the remaining structural balance is also very important to predict the likelihood of fiscal adjustments to start and survive. The higher and the more persistent the structural deficit in a country, the more difficult will be for that country to change this tendency and to generate structural surpluses to avoid defaulting on the debt.

 

The economic cycle also affects the public budget very strongly through automatic stabilizers: when there is a recession, tax revenues decrease, and unemployment benefits push up public expenditures. In very generous welfare systems, the effect of the unemployment rate on the budget is very strong: when the unemployment rate is growing, the increase in the amount of public resources devoted to unemployment benefits makes it more difficult to launch a fiscal adjustment based on spending cuts. In fact, the group of countries that met the Maastricht deficit criteria would have been considerably smaller, if the second half of the nineties would not witnessed a period of remarkable economic growth 

 

Growing prices can be the result of different disequilibria, from excess of demand and wage rigidities in the labor market to malpractice in the way of financing public deficits by printing money. In all cases, tight monetary policy in the form of higher interest rates is the immediate tool that is generally used to control inflation. But fiscal policy is also used with this purpose, since taxes increase prices and public outlays tend to boost economic activity creating temporary excesses of demand. Therefore, when prices are high, the probability of starting a fiscal consolidation increases. But when prices are under control as a result of a tight monetary policy the probability of starting a fiscal consolidation the following year diminishes. 

 

3.2 Political factors

Cabinets are responsible for both the design and the implementation of fiscal policies and adjustment strategies. These cabinets are made of politicians that belong to different (or the same) political parties; they have different ideologies; and they all depend on electoral results to continue in office. 

 

Traditionally, scholars working on the problem of public deficit reduction have focused on different barriers to successful consolidation. All these studies are related to the idea that fragmentation in decision-making is negative for expenditure control, because each group in a majority can push for an expenditure but it only internalizes a part of the costs and distortions associated to the increase in revenues that is necessary to equilibrate the budget (Weingast, Shepsle and Johnson, 1981; Hallerberg and Von Hagen, 1997; Von Hagen, Hallett and Straucht, 2001). According to these theories, one can expect larger coalitions and larger cabinets to be positively associated to higher expenditures and deficits. 

 

In addition, governments are in hands of politicians affiliated to political parties, and different parties usually have different ideologies regarding the relative roles they assign to the state and the market in the economy. 

 

Following the socialist preference for equality, redistribution, social benefits to the unemployed, and interventionist supply side policies in the form of public provision of human and physical capital, left-wing governments have traditionally promoted a higher degree of public intervention in the economy. To finance all these redistributive expenditures, left-wing governments have tended to tax more and more progressively. Higher public expenditures financed by higher public revenues does not mean that one should expect left-wing governments to run deficits more often than right-wing governments. Stronger presence of the State in the economy does not initially have to be associated with unbalanced budgets. Moreover, according to Keynesianism, demand management of the economy, requires that surpluses are built during periods of economic growth, to be used for consumption smoothing during periods of recession. Also, in order to intervene on the supply side of the economy through public investment in physical and human capital socialist governments have usually preferred to maintain close to balance budgets (Boix, 1996). 

 

By contrast, right-wing governments have traditionally preferred to run balanced and small budgets, because this means lower presence of the State in the economy and more room of maneuver for the market forces to generate economic growth. As a result, right-wing governments have tended to tax less and spend less than socialist governments. Lower levels of expenditures to GDP require lower levels of public revenues, and ideally less distortionary taxes that harm market mechanisms and private incentives. 

 

Finally, politicians depend on the popularity of their policies to remain in office. Under the assumption of fiscal illusion, policy-makers assume that voters overestimate the benefits of current expenditures and underestimate the future tax burden that will be needed to finance current expenditure7 . In addition, it will be difficult for misinformed voters to fully understand the details of public budget’s composition and its long-term impact. Thus politicians will be willing to cut taxes and increase public consumption and transfers before elections. Apart from the immediate effects that these policies may have on voters, these policies will also launch a fiscal expansion that is likely to increase the rate of growth of GDP and the employment level8 . Note that these electorally-driven policies are not supposed to affect only the government that takes these decisions, but also the newly elected government. Moreover, in democracies were alternation is common, fiscal policy can be strategically managed by an outgoing government to return to office in the next election, immediately after the electorate has punished the incoming government for medium-term undesirable fiscal outcomes that were really induced by the outgoing government and not by the incoming one.

 

3.3 Empirical evidence of the effect of economic and political factors during adjustment and non-adjustment years

To test the effect that these political and economic factors have on the composition of the public budget during both adjustment and non-adjustment years, I run the following regression of time-series cross-national data for the period from 1970 to 2001 in the fifteen European Union (EU) Member States. 

 

4. Economic and political determinants of the budget’s composition (Adjustment episodes)

 

Once the political and economic determinants that affect the composition of the budget during adjustment and non-adjustment years have been found, the paper turns now to answer the second question: i.e. What are the political and economic determinants that explain that during episodes of fiscal adjustment, different countries follow different strategies of adjustment in terms of budgetary composition?

 

The first thing that needs to be done before answering to this second question is to select a sub-sample of fiscal adjustment episodes from the general sample of fiscal data used in previous sections of the article. And in order to do this, a criterion for this selection must be also specified.

  

4.1 A criterion for the selection of adjustment episodes

As was mentioned in the introduction to this article, a public deficit exists when total public revenues are insufficient to pay for total public expenditures. This difference is covered annually by borrowing money, and this constitutes the public debt. Therefore, public deficits can be increased or reduced every year. A fiscal adjustment takes place when in any given year the public deficit is reduced. 

 

However, because this section focuses on fiscal adjustment episodes that are politically driven, episodes of fiscal adjustment should be identified attending to annual positive variations of the cyclically adjusted primary deficit. As has been also stated in previous sections, this allows one to focus on discretionary measures taken by politicians, once the economic cycle and debt interest payments have been discounted.

 

The existing literature on fiscal consolidations follows the trend started by Alesina and Perotti (1995), and define episodes of fiscal consolidations as those in which the cyclically adjusted primary budget balance increased by at least 1.25% of GDP in two consecutive years, or if the change in the cyclically adjusted budget balance exceeded 1.5% of GDP in one year and was less than 1.25% of GDP in the following or the precedent year. To be consistent with this literature and to make the findings of this section comparable to other studies, the same criteria is adopted here to select all fiscal adjustment episodes from the general sample. The only innovation that has been introduced is that if for example an episode of fiscal adjustment lasts for 4 years and there is a change in the government’s ideology in the middle, the case is separated into two cases. This facilitates the comparison between leftist and rightist strategies of adjustment; a comparison that deserves in this restricted analysis of adjustment episodes an special attention, in order to test if ideology maintains the predictive power that it showed in the analysis for both adjustment and non-adjustment years 

 

4.2 Partisan strategies of fiscal adjustment and the composition of the budget

In cases of unbalanced budgets, the public budget deficit can be reduced by increasing revenues in order to allow the government to pay for the same level of public expenditures (revenue-based strategy), or by reducing public expenditures while public revenues are maintained or even reduced (expenditure-based strategy). More specifically, the range of possible strategies that are available to any government willing to start a fiscal consolidation are: 

-Type 1 Strategy (S1): To increase revenues more than what it increases expenditures; (∆∆R;∆E )

-Type 2 Strategy (S2): To increase revenues and freeze expenditures; ( ∆R;= E ) -Type 3 Strategy (S3): To increase revenues and reduce expenditures; (∆R;∇E )

-Type 4 Strategy (S4): To freeze revenues and reduce expenditures; ( = R;∇E )

-Type 5 Strategy (S5): To reduce revenues less than what it reduces expenditures. (∇R;∇∇E ). 

 

Following the main hypotheses presented in section 3.2, left-wing governments should be associated to revenue-based strategies of fiscal adjustment (S1>S2>S3>S4>S5), because their preference for equality and for bigger presence of the public sector in the economy increases public expenditures, and this calls for higher revenues in order to keep the budget balanced. Deepening in leftist preferences with respect to the composition of the budget during fiscal adjustment periods, one should expect those preferences to be the same than their preferences during non-adjustment years: if forced to freeze or reduce expenditures leftist governments are expected to maintain the government wage bill, transfers payments and public investment. 

 

Thus, all left-wing governments undertaking a fiscal adjustment should place themselves to the right of the 45° line, when the FEL (Fiscal Expansion Line) becomes the FAL (Fiscal Adjustment Line). And at each level (levels defined by the degree of the adjustment), leftist governments should be expected to choose those strategies that imply both higher levels of public revenues and public expenditures (to the right of FAL). Similarly, preference for a weaker public sector should place right-wing governments making a fiscal adjustment below the Fiscal Adjustment Line (FAL). 

 

4.3 Empirical evidence for the effect of economic and political factors during adjustment episodes

In order to test the previous hypotheses, 53 episodes of fiscal adjustment are selected in the European Union (EU) from 1960-2000, according to the definition provided in section 4.1. Simple plotting of these 53 episodes of adjustment, labeled by the ideology of the party in government that undertook the adjustment, gives an idea of how well the data fits the partisanship hypothesis presented in section 4.2. 

 

Basically, both left-wing and right-wing governments followed the predicted consolidation strategies. Nevertheless, it looks like between 1960-91 some rightist governments followed leftist strategies of fiscal adjustment, increasing revenues substantially to finance increases in expenditures. This basically reflects the Welfare State consensus of the 60s and 70s in Europe, that developed the Welfare State in all European countries independently of the party in government.

 

The picture is less clear during the fiscal adjustment episodes that preceded EMU, even though the partisanship hypothesis still fits very well. As can be seen in figure 6, in the nineties the strongest fiscal adjustments were taken by leftist governments. This makes the comparison more difficult, since the number of adjustments held by leftist governments doubles the number of adjustments held by rightist ones.

 

More confusion of strategies appear in the nineties, with some rightist governments following revenue-based strategies of adjustment like France in 1995-96 or Portugal 1992-93, and some leftist governments following expenditure-based adjustment such as Denmark 1996-99 and Sweden 1995-98.

 

These illustrative results stress the importance of looking at the composition of the adjustment strategies. That is, when the effect of politics fades away in aggregate magnitudes, it is necessary to look at minor components before arriving at definitive conclusions. To study the effect that political and economic factors have had on strategies of fiscal adjustments and the composition of the budget during episodes of fiscal consolidation, I run the same regressions than in section 3.3., but now only for the 53 cases selected as fiscal adjustment episodes. 

 

The technique used now is OLS with robust standard errors, with country dummies and no year dummies, because the panel is markedly unbalanced, and the environment was assumed to be common for every EU country in the nineties20. Given the fact that now observations are episodes of fiscal adjustment that normally last longer than one year, the values in levels and in first differences of the dependent and independent variables are averages of the levels and variations of the whole period of adjustment. A new dependent variable is created, “Strategy Type”, which is the sum of the average variation of cyclically adjusted revenues and cyclically adjusted primary expenditures. The higher the value of “Strategy Type” in a fiscal adjustment episode, the more expansionary of the public sector was the strategy followed by the corresponding government. Results for the aggregate measures of the adjustment composition are presented in the table below. 

 

Most importantly, results show that ideology of the party in government is the most important political variable affecting the evolution of different items of the budget during episodes of fiscal consolidation. Leftist governments followed strategies of adjustment that increased revenues (mostly from direct taxes) to finance maintenance or even increase of expenditures, especially, public consumption, the government wage bill and public investments. The rest of public expenditures were also positively affected by leftist governments, though they were not statistically significant. 

 

These results are very important, since according to prominent studies mentioned in previous sections, consolidations that rely on increases in revenues and do not cut the government wage bill and public transfers are unlikely to be successful22. Nevertheless, in relation to the EMU process, it should be recalled at this point that evidence from section 3.3 showed already that since 1995 all governments started to reduce slowly social transfers, and that the effect of a more vigilant and stronger European Commission could slowly change leftist strategies at the aggregate level. 

 

Nevertheless, these results present very clear evidence that, even under the strongest pressures for further convergence on general budget balances, European governments have still found ways to formulate differentiated fiscal policies at the level of the individual items of the budget’s composition. 

 

 Very important in this respect is the evidence that leftist governments still tried to affect the supply-side of the economy investing relatively more than rightist governments. This preference is so strong that was maintained even during episodes of fiscal adjustment, when typically public investment is either frozen or reduced. The fact is that under a general trend of decreasing public provision of physical capital since the 1970s, in the last decade socialist governments seem to have been successful in maintaining or even increasing the share of the GDP dedicated to public investment. 

 

5. Conclusion

 

This article has answered the following two questions: what determines the composition of the budget in general, and what explains that different countries follow different strategies of adjustment during episodes of fiscal consolidation.

 

Results have confirmed that even under the strict provisions of the Maastricht criteria and the Stability and Growth Pact, domestic economic and political variables are still very important determinants of the budget’s composition in general, but also during adjustment episodes in particular.

 

With respect to the impact of political variables, and once economic conditions are taken into account, bigger coalitions, bigger cabinets, more leftist governments and closeness of elections affected positively the increase in public expenditures, specially social transfers, between 1970-94. Nevertheless, this influence was reversed during the second half of the nineties. Interestingly, evidence shows that ideology was the strongest determinant of the composition of the budget during this period, when leftist governments reoriented their policies, and decided to use increasing revenues from direct taxes to balance the budget and to maintain or increase the government wage bill (public employment and wages) and public investment (to affect the economy in the supply side), even at the expense of reductions in subsidies, consumption and social transfers. The importance of these political variables, and specially the role of the cabinet’s ideology, is confirmed when adjustment episodes are studied in isolation.

 

Because the composition of fiscal adjustment is related to its likelihood of success, apparently decisions such as those taken by some European countries in the nineties that followed a revenue-based adjustment to quickly qualify for EMU, should have never been adopted because they were not economically optimal in the medium run. In fact, some of these countries are showing difficulties to keep their budgets balanced during the current economic slowdown.

 

By pointing out the influence that political factors have of fiscal policy, this article is important to understand why those decisions were made, and why those adjustment strategies were chosen. 

 

Acknowledgements

 

This paper was written during my period at Columbia University. I wish to thank the European Commission, Cabinet Solbes, and the DG ECFIN for access to their economic databases, and Roberto Perotti for sharing with me the data on “coalition size” and “cabinet size”. I also thank the Juan March Institute (Madrid), La Caixa Foundation (Barcelona), and the Social Science Research Council Program in Applied Economics (New York) for their financial support during this period. I am specially grateful for their important insights on the final draft to Adam Przeworski, Carles Boix, Roberto Perotti, Alex Segura-Ubiergo, Michael Gilligan, Carlos Martínez-Mongay, Marco Buti, José Manuel González-Páramo, Andrew Richards, and José María Maravall. 

 

Appendix:

 

Definition of Variables and Sources of Data The set of variables used in all regressions of this article are defined as follows: 

 

1. Economic variables:

- Annual variation of cyclically Adjusted primary budget balance; Lagged budget balance; and all Budget components.

 

Data for primary budget balance, total revenues, and total primary expenditures, was cyclically adjusted according to the European Commsission´s method. The DG ECFIN method involves three main steps. In the first step, the output gap is computed as the difference between the actual output and an estimated output trend, applying the Hodrick-Prescott (HP) filter. In the second step, the budget sensitivity to the output gap is computed. This allows to compute the cyclical component of the budget. Finally, the cyclically adjusted budget balance is obtained by deducting the cyclical component from the actual government budget balance.

 

Budget components at more disaggregate levels were not cyclically adjusted.

 

- Annual variation of the Unemployment rate (Var. Unemployment).

 

- Annual variation of Consumer Price Index (Var. Prices)

 

SOURCE: AMECO-Macroeconomic database of the European Commission. DGECFIN. Brussels. Update January 2001.

 

2. Political Variables:

 

- Socialist Control of the Cabinet (Government-Left).

 

Social-democratic and other left parties in percentage of total cabinet posts, weighted by days. This variable runs continuously from 0 to 100.

 

SOURCE: Armingeon, Beyele and Menegale (2000).

 

- Number of Parties in the Coalition (Coalition Size)

 

Borrowed from Prof. Roberto Perotti.

 

SOURCE: Woldendorp, Keman and Budge (1993) and Europa Yearbook for Greece, Portugal and Spain (the whole period), and all countries from 1995-2000.

 

- Number of Spending Ministers (Cabinet Size)

 

Borrowed from Prof. Roberto Perotti.

 

This variable is the sum of the following ministers: 1) Industry or Trade and/or ministers with related and/or subdivided competences like Foreign Trade, Commerce, and State Industries (if not attributed to Public Workssee next); 2) Public Works and/or Infrastructure and/or ministers with related and/or subdivided competences like (Public) Transportation, Energy, Post, Telecommunications, Merchant Marine, Civil Aviation, National Resources, Construction (if not specifically attributed to Housing-see below), Urban Development, etc; 3) Defense, 4)Justice; 5) Labour; 6) Education; 7) Health; 8) Housing; 9) Agriculture. Also all ministers with economic portfolio are added to this group: 10) Finance and/or ministers with related and/or subdivided competences like First Lord of the Treasury, Budget, Taxation, etc.; 11) Economic Affairs and/or ministers with related and/or subdivided competences like (Regional) Economic Planning or Development, Small Businesses.

 

SOURCE: Woldendorp, Keman and Budge (1993) and Europa Yearbook for Greece, Portugal and Spain (the whole period), and all countries from 1995-2000.

 

- Months to Next Election (Months-Election).

 

This variable takes values: 0, 12, 24, 36 and 48 depending on the distance between the current year, and the year in which the next general election will be celebrated.

 

SOURCE: Election dates are from Armingeon, K. et al. 2000. “Comparative Political Data Set”. University of Berne. 

 

CARLOS MULAS

What makes fiscal consolidations last? A survival analysis of budget cuts in Europe (1960–2004)

Reyes Maroto Illera · Carlos Mulas-Granados

 

Abstract This article examines the political and economic determinants of the relative duration of fiscal consolidations in Europe. The study focuses on the fifteen Member States that formed the EU between 1960 and 2004, and applies survival analysis techniques to their fiscal data. We find evidence that the probability of ending a period of fiscal consolidation depends on the debt level, the magnitude of the adjustment, the relative contribution of spending cuts, and the degree of cabinet fragmentation. Most importantly we also find that under a stricter definition of fiscal consolidation, political variables, such as coalition size and election year, gain importance with respect to economic variables as predictors of the probability of ending an episode of fiscal consolidation. This relative importance of political variables weakened in the run-up to EMU, probably because countries had to consolidate irrespective of their political constraints.

 

Keywords Public finance · Duration analysis · Fiscal consolidation · Fiscal adjustment JEL

 

Classification C41 · H30

 

1 Introduction

 

Between 1992 and 1998, the fulfillment of the Maastricht convergence criteria depended mainly on the relative ability of different EU Member States to reduce their public deficits below the 3% GDP target. From 1999 on, remaining within the limits imposed by the Stability and Growth Pact depends on the ability of these countries to maintain the fiscal consolidation they started some years ago.

 

The process of European Monetary Union (EMU) launched a wave of fiscal adjustments around Europe. This drew the attention of some prominent scholars, who begun to study aspects of the process, such as the type of fiscal adjustments, the quality of these adjustments and the factors behind successful consolidations.

 

Nevertheless, it remains to be investigated why some consolidation experiences last longer than others. Only Strauch (1999) and Von Hagen et al. (2001) have approached this issue somewhat systematically before, but they used a smaller sample and they did not focus on both the economic and political factors behind the observed differences in the duration of fiscal consolidations.

 

Therefore, in this paper we try to answer two related questions: what makes consolidations last? And what are the economic and political factors that explain the duration of fiscal adjustments?

 

For that purpose, we analyze the time spells between two consecutive years of fiscal expansion, or in other words, the number of years between the beginning and the end of a fiscal consolidation. We do this using the methodology of duration models, applying it to data for the fifteen EU Member States between 1960 and 2004.

 

The article proceeds as follows. In Sect. 2, we explain our criteria to select periods of fiscal consolidation and we present our data. In Sect. 3, we briefly describe the main aspects of duration models and we present the empirical results of the non-parametric and the parametric estimations of our model. In Sect. 4, we check for the robustness of our results when we control for the temporal heterogeneity of our sample (to control for the ‘Maastricht effect’), and when we use a stronger definition of fiscal consolidation. The final considerations in Sect. 5 recapitulate the main findings of this article.

 

2 Duration of fiscal consolidations in the EU:

Data and variables In this study we use annual data between 1960 and 2004 for the fifteen EU Members States at the time: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden and the United Kingdom. To define our dependent variable we use data on cyclically adjusted budget balances. This variable expresses the budget balances (Total Public Revenues minus Total Public Expenditures)adjusted by the economic cycle,4 as a percentage of the Gross Domestic Product of each country. Based on this data, we generate a dummy variable called “Failure”, which takes value zero when the annual variation of the cyclically adjusted budget balance is bigger than zero (years of fiscal consolidation), and changes to value one, when the annual variation is zero or lower than zero (years of fiscal expansion). Using the dates in which a failure event occurs, we build a new variable called “Duration” that counts the intervening years between two consecutive failures, that is, the time span that the fiscal consolidation lasts. In our sample, the minimum number of years that a consolidation lasts is one year, and the maximum is ten years.

 

3 Duration analysis:

Estimation results Typically, duration analysis involves two steps, first a non-parametric analysis in which the dependence of duration of fiscal adjustments on time is analyzed. And secondly, a parametric analysis in which other factors, apart from time dependency, are included as possibly accounting for the observed variation in duration of adjustment episodes.

 

3.1 Non-parametric estimation:

The time dependency of duration This section proceeds very briefly with the non-parametric analysis.5 What this analysis tries to disentangle is the positive or negative dependence of fiscal consolidations on their accumulated duration. This is typically done by estimating the two following functions: (a) The survivor function, which is defined as:

S(t) = Pr(T ≥ t) = 1 − F(t)

and gives the probability that the duration of the fiscal consolidation (T ) is greater than or equal to t. (b) The hazard function, which is defined as: h(t) = Pr(T = t/T ≥ t)and gives, for each duration, the probability of ending a consolidation episode, conditioned on the duration of the consolidation through that moment.

 

3.2 Parametric estimation.

The economic and political determinants of duration The non-parametric analysis that was presented in the previous section is well suited for describing the actual duration of fiscal adjustment episodes and analyzing the dependence of those consolidations on their accumulated duration. Nevertheless, non-parametric analysis has limitations; it does not allow one to analyze other factor that may explain the probability of ending fiscal consolidations. To address this issue, this section will perform a parametric analysis of duration. This will be done estimating a Model of Proportional Hazard (PH), which is the duration model that has usually been used to characterize the hazard function, and it assumes that the hazard function can be split as follows:

h(t,X) = h0(t) · g(X),

where h0(t) is the baseline hazard function that captures the dependency of data to duration, and g(x)is a function of individual variables. This function of explanatory variables is a negative function usually defined as g(x) = exp(X β). Note that in this proportional specification, regressors intervene re-escalating the conditional probability of abandoning the period of fiscal consolidation, not its own duration. This model can be estimated initially without imposing any specific functional form on the baseline hazard function, following the Cox Model (1972)

h(t,X) = h0(t) · exp(Xβ).

Or an alternative estimation can be done, by imposing one specific parametric form to the function h0(t). In this case, the models most commonly used are the Weibull Model and the Exponential Model. In the first one, h0(t) = ptp−1, where p is a parameter that has to be estimated. When p = 1, the Weibull Model is equal to the Exponential Model, where there exists no dependency on duration. On the other hand, when the parameter p > 1, there exists a positive dependency on duration, and a negative dependency when p < 1. Therefore, by estimating p, it is possible to test the hypothesis of duration dependency of fiscal consolidations.

 

In the vector of explanatory variables we include a set of economic and political variables that are expected to be related to different lengths of fiscal consolidation. We therefore test the role of the following variables:

 

(1) Number of failures: this variable simply controls for the accumulated number of failures (ends of fiscal consolidations) that have taken place in each country before the current consolidation.

 

(2) Debt-to-GDP ratio: this is a continuous variable that measures the public debt with respect to Gross Domestic Product for each country. We expect that higher Debt/GDP ratios will be associated with longer periods of fiscal consolidation, and thus associated with lower probabilities of ending the consolidation. 

 

(2) Strength of consolidation: this continuous variable is the result in absolute terms of subtracting the annual variation of the cyclically adjusted budget balance to the chosen threshold that determines when a fiscal consolidation takes place.

 

(3) Quality of the adjustment: this variable measures the contribution of primary expenditures to the total deficit reduction achieved in each consolidation year. Let Contribution = (Xt − X0)/(St − S0), be the contribution of primary expenditures X to the adjustment in the surplus S, achieved between the first year of the consolidation episode 0, and the year under consideration t. 8

 

(4) Coalition size: this variable measures the number of political parties in government for each country and each year of our sample.

 

(5) Cabinet size: this variable measures the number of spending ministers in the cabinet for each year and each country. The inclusion of both cabinet size and coalition size is related to the idea that fragmentation in decision-making is negative for expenditure control (Weingast et al. 1981; Roubini and Sachs 1989).9

 

(6) Election year: this is a dummy variable, with value 1 when there was a general election in year t in country i. And it is zero when there is no election.

 

We have estimated the functional forms discussed in the previous sections by maximum likelihood, using 501 observations and 245 failures. Table 3 contains the parameter estimates for these alternative hazard function models. Recall that a positive parameter indicates an increase in the hazard rate, that is, an increase in the probability that the consolidation will end in period t + 1, given that it lasted through period t.

 

 The p parameter in the Weibull estimation is statistically significant, positive and bigger than one, which means that the hazard function grows with time (recall Fig. 3). Given that we have several possible parametric models, how can we discriminate among those we have estimated? When parametric models are nested, the likelihood-ratios or the Wald tests can be used to discriminate between them. This can certainly be done in the case of the Weibull versus Exponential models. But when models are not nested, these tests are unsuitable and the task of discriminating between models becomes difficult. A common approach to this problem is to use the Akaike Information Criterion (AIC). Akaike (1974) proposed penalizing each log likelihood to reflect the number of parameters being estimated in a particular model and then comparing them. For this purpose, the AIC can be defined as:

AIC = −2 · (log likelihood) + 2(c + q + 1),

where c is the number of model covariates (explanatory variables) and q is the number of model-specific auxiliary parameters. Although the best-fitting model is the one with the largest log likelihood, the preferred model is the one with the smallest AIC value. According to the AIC criteria, the Weibull estimation is the parametric model that best fits our data. Finally, there exists an additional method to test the power of each model, through graphic analysis of the Cox–Snell (1968) residuals. These residuals are defined as follows:

eˆ = −log S(t/x).

If the model fits the data, then the plot of the cumulative hazard versus eˆ should be a straight line with slope equal to unity and beginning at the origin. The Weibull plot clearly satisfies the exponential requirement for most of the time, except for larger residuals, where the slope appears to exceed unity. This confirms that the Weibull model should be our preferred model.

 

4 Robustness of our results

 

4.1 Controlling for sample heterogeneity:

The ‘Maastricht effect’ The previous results are subject to a possible criticism, related to the likely bias of our estimations due to the presence of the ‘Maastricht effect’. The Maastricht Treaty and the possibility of entering into EMU if the fiscal criteria were fulfilled arguably was one of the most successful factors driving fiscal consolidations in Europe in the second half of the 1990s. If this was the case, ‘traditional’ factors such as fragmentation of governments could have been less important during the 1990s than in other periods, because the external constraint imposed by the Maastricht criteria implied that governments (whatever their composition) simply had to consolidate. A similar argument could also be made in relation to the degree of indebtedness. Those countries with unsustainable levels of debt may have been forced to consolidate despite the effect of ‘traditional factors’ or the Maastricht criteria. In fact, when we perform Cox regression-based tests for equality of survival curves by countries and by period, we can see that our sample shows temporal heterogeneity, but no spatial heterogeneity. Therefore we need to introduce controls for the temporal heterogeneity. There are two ways to do this: to include dummies that control for time effects or to split the sample into the period before and after the Maastricht Treaty. We do both.

 

First we repeat the parametric analysis of Sect. 3.2, but now we include dummy variables for each period except the final period. After controlling for periods, where all control variables were statistically significant, the only explanatory variable that has lost statistical significance is the Cabinet Size, while Debt/GDP, Number of failures and Quality of adjustment, remained as strong predictors of the probability of ending the fiscal consolidations. Again, the AIC statistics show that the Weibull estimation is the best model for our data. The analysis of the Cox–Snell residuals also confirms this statement.

 

To be sure of these results, we now split the sample in two periods: pre-Maastricht period (1960–1992) and post-Maastricht period (1993–2000). And we estimate the baseline model (from Sect. 3.2), using the Weibull procedure (which has demonstrated to be the most adequate one) for both periods. Results in Table 5 show that important predictors of duration such as Quality of the Adjustment, Coalition Size, Cabinet Size and Elections lose statistical significance during the 1990s. Only the Debt/GDP and the accumulated Number of Failures remain as strong predictors in both periods. In fact, after splitting the sample, we observe that some variables (Elections and Cabinet Size) which were surprisingly insignificant in the original estimation of Sect. 3.2, regain their expected explanatory power for the period previous to the Maastricht Treaty. These results, confirm the existence of the ‘Maastricht effect’ whereby countries were forced to consolidate regardless of external constraints and government characteristics in the run up to EMU.

 

4.2 Changing the definition of fiscal adjustments

To conclude the robustness analysis, in this last section we replicate the parametric estimation of Sect. 3.2, but with a change in the definition of fiscal consolidation. Now we consider that a fiscal consolidation takes place in a given year if the cyclically adjusted budget balance with respect to GDP in that year increased by 1% or more from the previous year. By changing the threshold from 0% to 1% we want to test the sensitivity of our results to different definitions of fiscal adjustment. We can say that the 0% threshold is the minimum threshold that one can impose to differentiate fiscal consolidation years from fiscal expansion ones. The 1% threshold is the most common in the literature on fiscal adjustments,12 because it discriminates in favor of strong consolidation experiences, where the political commitment to reduce the public deficit is strong and cannot be attributed to unintended outcomes. 

 

Finally, we estimate the same model that we estimated with the initial threshold, but now under the new definition of fiscal consolidation. We expect the coefficients of all explanatory variables to maintain their signs and their statistical significance.

 

5 Concluding

 

remarks In this article we have examined the duration of fiscal consolidations in the European Union. To do this we have applied the methodology of duration models to annual data on cyclically adjusted budget balances for the 15 EU Member States between 1960 and 2004. We have studied the time spells between two fiscal expansions, or in other words, the number of years between the beginning and the end of fiscal consolidation episodes, calculating the hazard and the survivor functions for those consolidations.

 

First, we have done a non-parametric analysis where we have only taken into account time, in order to assess the impact of duration on the probability of maintaining a fiscal consolidation. Results suggest that this probability decreases rapidly after the first year and decreases less dramatically for longer durations.

 

Second, we have performed a parametric analysis, in order to include more variables that could influence the probability of ending fiscal consolidations. We have found that the level of debt, the fragmentation of the cabinet (measured by the number of parties in government and the number of spending ministers), the strength of the adjustment, and the quality of the adjustment (measured by the contribution of primary expenditures to the total amelioration of the budget balance), helped to explain the probability of ending the fiscal consolidations.

 

Interestingly, these results vary when we split the sample and we change the criteria to select episodes of fiscal adjustment. On the one hand, the explanatory power of economic variables was robust to different alternative estimations that tried to control for time heterogeneity but political variables lost their relevance. The fact that cabinet fragmentation and elections became insignificant when we split the sample and estimate our model for the postMaastricht period, indicates that in the run-up to EMU countries simply had to consolidate, regardless of electoral constraints and the government’s composition. On the other hand, we also showed that under a Stronger definition of fiscal adjustments, political variables gained importance with respect to economic variables as predictors of the probability of ending fiscal consolidations.

 

We consider this study the first attempt to analyze systematically the determinants of duration of fiscal consolidations episodes in the European Union. Our results are very relevant to better understand the determinants of longer or shorter experiences of fiscal adjustment. For example, the process of pro-cyclical fiscal policies denounced by the European Commission after the completion of EMU (European Commission 2001), and the subsequent ending of most fiscal consolidation episodes originally launched in the mid 1990s to qualify for the third stage of EMU, can be more easily interpreted from the new perspective that our results provide. It certainly seems that once every country had qualified for the third stage of EMU, the combined effect of accumulated duration, economic slowdown, forthcoming elections and relaxed political commitment towards adjustment, definitively drove many of those fiscal consolidations to an end.

 

Acknowledgements The authors wish to thank Simón Sosvilla (FEDEA) for his comments on the project design, Roberto Perotti for providing the data on coalition and cabinet size, and DG ECFIN (European Commission) for granting us access to their economic database. We also thank all researchers at FEDEA, and the European Economy Group/Complutense University for their useful comments. The views expressed are solely those of the authors and thus do not necessarily represent those of the institutions with which they are affiliated. A first version of this paper was published as a FEDEA-Working Paper (DT10-01) and a second version was published as EEG-Working Paper, No. 18-02.

 

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