Fiscal policies in EMU countries: strategies and empirical evidence

• Published date: 21 March 2016
• DOI: https://doi.org/10.1108/JITLP-10-2015-0031
• Date: 21 March 2016
• Pages: 67-98
• Author: Francesco Forte,Cosimo Magazzino
• Subject Matter: Strategy,International business,International business law,Economics,International economics,International trade

Fiscal policies in EMU countries:

strategies and empirical evidence

Francesco Forte

Department of Economics, Sapienza-University of Rome, Rome, Italy, and

Cosimo Magazzino

Department of Political Sciences, Roma Tre University, Rome, Italy

Abstract

Purpose – The aim of the paper is to evaluate scal adjustments that have occurred in the Economic

and Monetary Union (EMU) countries in the last 35 years, and their consequences on the economic

growth process by using the mean group (MG) estimators.

Design/methodology/approach – Our emphasis is on the effects of different composition of scal

stimuli and consolidations. We compare the effects on the economic growth rate of different

compositions of major scal changes. We use a cyclically adjusted value of the scal variables to leave

aside variations of the scal variables induced by business cycle uctuations.

Findings – Our empirical research of the effects of large changes in scal policy, both in case of a scal

consolidation and of scal stimulus in the 18 EMU countries from 1980 to 2015, shows that adjustments

by cutting current expenditures, rather than by tax increases are more likely to boost economic growth.

It also shows that cuts of investment expenditures may reduce GDP growth. During scal stimulus

episodes, tax cuts and public investments are more likely to increase growth than current public

expenditure.

Originality/value – This is the rst study devoted to the EMU countries. It should be underlined that

the results obtained as for EMU countries are not necessarily applicable to other countries, as the

different government size as well as different market institutions may inuence the results.

Keywords Panel data, Economic growth, Fiscal policy, EMU

Paper type Research articles

1. Introduction

According to Wohlgemuth and Brandi (2007), the actual institutional structure of

European Union (EU) may be described as that of a club composed of two clubs. On

one side, the club of the members states that belong to the European Monetary Union

(EMU) and on the other side the European states that belong to EU but not to the

EMU.

The Eurozone is atypical as an economic union because monetary policy is decided at

the central (European) level, while scal policy is mostly carried out at the sub-central

(member state) level. There is a general consensus that monetary stability in the EMU

requires sustainable public nances of the member states. The idea that persistent scal

laxity would undermine the European Central Bank’s ability to fulll its mandate of

price stability runs through all important documents and decisions marking the

progress toward EMU, from the Delors Report in1989 to the scal convergence criteria

JEL classication – C33, H11, H60, O52

The current issue and full text archive of this journal is available on Emerald Insight at:

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Fiscal policies

in EMU

countries

67

Received 29 October 2015

Revised 7 January 2016

13 February 2016

18 February 2016

Accepted 19 February 2016

Journalof International Trade Law

andPolicy

Vol.15 No. 1, 2016

pp.67-98

©Emerald Group Publishing Limited

1477-0024

DOI 10.1108/JITLP-10-2015-0031

for entry into EMU dened by the Maastricht Treaty, to the Stability and Growth Pact

adopted in Amsterdam.

The global nancial crisis has led to a sharp deterioration of EU countries’ public

nances. Its legacy, together with earlier scal imbalances, has burdened many

EMU governments, with high public debt/GDP ratios, often accompanied by still

signicant structural decits, which call for large consolidation efforts to reduce

debt to more prudent values. National governments were then confronted with a

dilemma: they had to guarantee long-term sustainability of public debt and had to

avoid stiing the nascent recovery. This trade-off between debt reduction and

activity depends critically on the value of the scal multipliers.

For the Organization for economic cooperation and development (OECD) as a

whole, gross government debt is expected to rise to unprecedented levels, having

exceeded 100 per cent of GDP for the rst time in 2011 (Sutherland et al., 2012),

denitely higher in respect of Eurozone (65 per cent). Moreover, the scal decit in

the OECD area was 7.9 per cent of GDP in 2009, while it was 6.6 per cent in the EMU.

The existing literature on scal consolidations provides a number of indications

regarding the determinants of successful scal consolidations, in particular,

regarding their composition, nature, the role played by anking policies and the

inuence of macroeconomic conditions, which are of direct relevance to guide scal

policy making in the present situation. In past decades, evidence of the variation in

the strategies of scal adjustment in Europe is abundant, but, in the last 20 years,

this variation has become even more relevant. Recent research on the quality of

scal adjustments has stressed the importance of achieving budgetary

consolidations on the proper side of the budget. There is ample empirical evidence

showing that budgetary consolidations relying too heavily on raising taxes rather

than cutting down on expenditure are less likely to last and be successful. There is

a growing consensus among economists and policymakers that the success of

efforts to consolidate the government budget depends importantly on the quality of

the budgetary adjustments undertaken. In this context, the “quality” of scal

adjustments refers to the relative contribution of different budgetary items to the

adjustment effort (von Hagen et al., 2001). After the global nancial crisis,

peripheral countries in the EMU started to adjust their imbalances, driven mainly by

consolidation policies imposed by the EC. Alongside the development of imbalances,

a mostly overlooked phenomenon is that trade ows among the rst 12 countries

belonging to the EMU have grown at a less than average rate since the early 1990s,

leading to a continuous reduction in the share of intra-area trade.

The aim of the paper is to evaluate scal adjustments occurred in EMU countries

in the last 35 years and their consequences on the economic growth process using

the mean group (MG) estimators. To our knowledge, this is the rst paper that

applies these relatively new estimators to these data. This paper adds to the existing

literature new denitions of scal consolidation and stimulus to the EMU-18

countries, over the period 1980-2015, using consistent public nance data from

one single source, the European Commission annual macro-economic (AMECO)

database.

The rest of the paper, therefore, is organized as follows. Section 2 shows the

empirical studies of the literature on the performance of the different scal

adjustment policies. Section 3 illustrates the data, the methodology and the

JITLP

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denitions of scal consolidation and stimulus episodes, regarding the scal policy

measures adopted. Section 4 describes the model proposed through and discusses

the results obtained. Finally, Section 5 provides conclusions and policy implications.

2. Survey of the literature

On the theme of the scal rules and scal policy, with which we are here dealing, in the

recent years, there has been an important debate in the international literature, mainly

focusing on scal consolidations and scal stimuli and GDP.

Fiscal policy changes entail effects on economic agents and, at the same time, can be

inuenced by them as described in Giavazzi and Pagano (1990). It has been argued that

a scal adjustment can be expansionary if the economic agents trust its size,

effectiveness and not-repetitiveness in the immediate future. It has been shown that an

increase of both public expenditure and taxes implies negative effects on private

investments (Alesina et al., 2002). Moreover, an increase of public expenditure does not

involve an increase of private consumption (Mountford and Uhlig, 2008). Alesina and

Ardagna (2009) focused on large changes of scal policy through an analysis of the

effects generated from scal adjustments and stimuli on GDP growth.

Hsieh and Lai (1994) examined the interactions between the growth rate in per capita

real GDP, the share of government spending and the ratio of private investment of GDP

for seven countries (Canada, France, Germany, Italy, Japan, UK and the USA). They

found that the government does not have any effect in growth.

Alesina et al. (1998) showed that in successful adjustments, more than half of the

spending cut derives from cuts in transfers and government wages, while in unsuccessful

adjustments these two components are virtually untouched. In addition, during and

immediately after a successful adjustment, a country experiences an investment “boom”,

which is much larger than in an unsuccessful adjustment. Alesina and Perotti (1996) showed

that scal adjustments which rely primarily on spending cuts in transfers and the

government wage bill have a better chance of being successful and are expansionary. On the

contrary, scal adjustments which rely primarily on tax increases and cuts in public

investment tend not to last and are contractionary. Alesina and Perotti (1995) found that on

average, scal expansions are the results of increases in the expenditures, particularly of

transfers programs, while contractions are basically due to tax increases. Successful scal

adjustment do not seem to have recessionary consequences.

von Hagen and Strauch (2001) found that the cyclical positions of the domestic and

international economy, the initial debt level and the stance of scal policy in the OECD

are all important determinants of the likelihood of scal consolidations. They also affect

the government’s choice of consolidation strategy, making them important

determinants of the success of scal consolidations. In contrast, the monetary policy

stance plays only a negligible role for scal consolidations. Hjelm (2002), using data for

19 OECD countries over the period 1970-1997, illustrated that contractions associated

with a favorable macroeconomic outcome have been preceded by signicantly higher

real depreciations; on the other hand, contractions preceded by real depreciations

improve expectations about future income and generate higher private consumption

growth. Tavares (2004) found that spending cuts by the left and tax increases by the

right are associated with persistent adjustments for OECD countries, because these

actions signal commitment to undertake the adjustment in ways that are not favored by

their constituencies. Using data covering 24 OECD countries, Ahrend et al. (2006) found

69

Fiscal policies

in EMU

countries