Considerations for designing a fiscal consolidation strategy

Douglas SutherlandOECD Economics Department

20 June 2011“Fiscal consolidation, policy framework and governance” Policy Workshop IMAD, Ljubljana

• The starting point– What consolidation is already underway

• The end point– Fiscal gaps

• How to get there– Past experience and general principles

2

Third wave of large deficits in OECD

3

-10

-8

-6

-4

-2

0

2

4

6

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

Deficits% of GDP

0

20

40

60

80

100

120

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

% of GDP

Gross financial liabilities

Today’s challenges

Top panel – required change in the primary balance as % of GDP to stabilise debt Bottom panel – gross debt as percent of GDP. OECD Economic Outlook 88

4

0

50

100

150

200

250

0

50

100

150

200

250 2007 2011

Spending and revenues have reached a plateau?

5

0

10

20

30

40

50

60

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

Revenues% of GDP

0

10

20

30

40

50

60

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

Spending%of GDP

Large consolidations already underway

OECD Economic Outlook 2011

6

0

2

4

6

8

10

12

14

0

2

4

6

8

10

12

14

CHE

NZL

DNK

FIN

SWE

DEU

BEL

HUN

CAN

AUT

LUX

USA

KOR

JPN

SVN

ISR

NLD

FRA

ITA

AUS

GBR ES

TSV

KPO

LCZ

EIR

LES

PPR

TIS

LG

RC

Tightening between trough and 2012

% of GDP

Short-run impacts on growth

• Multiplier-type effects– Short-run contractionary impact

• Monetary policy and financial markets• Alone or simultaneous consolidation

• Non-Keynesian effects– Key messages not in dispute

7

Consolidations and growth

Growth before and after fiscal consolidation, based on different definitionsBottom panels when consolidation succeeds in stabilising debt at time t +1 or +3

8

-.02

0.0

2.0

4.0

6

-5 0 5time

Trough highlow

-.02

0.0

2.0

4.0

6

-5 0 5time

Sharp highlow

-.02

0.0

2.0

4.0

6

-5 0 5time

Gradual highlow

-.02

0.0

2.0

4.0

6

-5 0 5time

Sharp + 1 highlow

-.02

0.0

2.0

4.0

6

-5 0 5time

Sharp + 3 highlow

-.02

0.0

2.0

4.0

6

-5 0 5time

Gradual + 3 highlow

Expansionary contractions

Finland – 3 episodes of “expansionary fiscal contractions” 9

-4

-2

0

2

4

6

8

1980 1985 1990 1995 2000 2005 2010

Adjusted Primary Balance

10

20

30

40

50

60

70

1980 1985 1990 1995 2000 2005 2010

Gross Debt

40

45

50

55

1980 1985 1990 1995 2000 2005 2010

Underlying total revenues

40

45

50

55

1980 1985 1990 1995 2000 2005 2010

Underlying spending less interest payments

-.12

-.08

-.04

.00

.04

.08

1980 1985 1990 1995 2000 2005 2010

Real GDP growth

80

100

120

140

160

180

1980 1985 1990 1995 2000 2005 2010

Competitiveness indicator

Difference with past episodes

• Debt reaching unprecedented levels– Not just stabilisation – Prudential debt targets/ceilings

• Allow automatic stabilisers to operate fully • Minimise deadweight losses• Absorb shocks• Respect intergenerational fairness

10

Other spending pressures

• Demographic and other pressures on public spending

– Pensions

– Health and long-term care

– Contingent liabilities

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Fiscal gaps

Simple model structure 12

Population

Budget

Other spending

Demographic spending

GDP

Revenues

Debt Interest

Baseline simulations

13

0

1

2

3

4

5

6

7

8

9

0

1

2

3

4

5

6

7

8

9

KOR

SWE

CH

E

LUX

ITA

DN

K

AUS

PRT

ESP

HU

N

CZE

GR

C

BEL

ND

L

FIN

DEU SV

K

AUT

CAN PO

L

FRA

IRL

NZL

GBR USA JPN

75 50 25 2007

Adding spending pressures

Note: Greece is pre-retirement reform

14

-2

0

2

4

6

8

10

12

14

-2

0

2

4

6

8

10

12

14SW

E

DN

K

ITA

AUS

POL

HU

N

PRT

CH

E

FIN

CZE

AUT

CAN FR

A

DEU

KOR

ND

L

BEL

GBR IR

L

LUX

ESP

USA NZL

JPN

GR

C

Baseline Pension Low health High health

Sensitivity analysis

• Costs of delay or stalled consolidation

• Fiscal shocks and contingent liabilities

• Risk premia

• Higher productivity

• Delayed retirement

15

Sustained consolidation

• Bernanke (6/7/2011)

– …the appropriate response is to move quickly to enact a credible, long-term plan for fiscal consolidation. By taking decisions today that lead to fiscal consolidation over a longer horizon, policymakers can avoid a sudden fiscal contraction that could put the recovery at risk.

16

Large consolidations

Developments before and after the start of large consolidations, based on trough-to-peak of underlying primary balance

17

-.02

0.0

2.0

4.0

6

-5 0 5time

Real GDP growth

highlow

-4-2

02

4

-5 0 5time

Underlying primary balance

highlow20

4060

80

-5 0 5time

Gross debthighlow

3035

4045

5055

-5 0 5time

Underlying revenuehighlow

3035

4045

5055

-5 0 5time

Underlying spending (ex int)

highlow-2

-10

12

3

-5 0 5time

Spread

highlow

Challenges

• Sustained effort needed

– Enhance efficiency to support long-term growth

• More efficient distributional instruments

• Greater spending efficiency

• Less-distortionary taxation/user fees

18

Better distributional policies

Milligan and Wise (2011) 19

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

ITA ESP BEL CAN FRA DEU NLD SWE

Age 45 Age 64Proportion of men collecting disability benefits

More efficient spending

Joumard et al (2011) 20

Less distortionary taxation

21

0

0.5

1

1.5

2

2.5

3

3.5

0

0.5

1

1.5

2

2.5

3

3.5Un

ited

King

dom

Unite

d St

ates

Cana

daIs

rael

Fran

ceJa

pan

New

Zeal

and

Icel

and

Aust

ralia

Denm

ark

Pola

ndKo

rea

Swed

enIre

land

Spai

nPo

rtuga

lM

edia

nIta

lyCh

ileNe

ther

land

sFi

nlan

dG

erm

any

Slov

enia

Belg

ium

Slov

ak R

epub

licNo

rway

Hung

ary

Aust

riaTu

rkey

Mex

icoG

reec

eCz

ech

Repu

blic

Switz

erla

ndLu

xem

bour

g

2008% of GDP

Recurrent tax revenues from immovable property

Supporting consolidation

• Econometric evidence (Molnar)– Growth and interest rates– Spending cuts associated with debt

stabilisation (large consolidations are associated with rises in revenue as well)

– State-level governments can help– Fiscal rules (combinations of spending

rules and budget balance requirements)22

Wider fiscal framework

• Good budgetary practices

• Fiscal rules

• Other fiscal institutions

23

Thank you

Douglas Sutherland@oecd.org

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