Perotti examines economic impact of fiscal policy, weighs elements of successful adjustment

• Author: Hamid Faruqee
• Position: IMF Research Department
• Pages: 190-191

Page 190

The impact of fiscal policy has garnered considerably less attention in academic circles than that of monetary policy, according to Roberto Perotti, Professor of Economics at Columbia University. Speaking at an IMF Institute seminar on April 2, Perotti reviewed recent empirical studies and highlighted several key findings. He noted that the composition of fiscal adjustment-whether pursued primarily through taxes or expenditures- was often a critical determinant of the plan's longevity and ultimate success. In particular, a reliance on expenditure cuts was more likely to sustain the adjustment effort and reduce the government's budget deficit. He also pointed out that, contrary to conventional wisdom, fiscal tightening is not always recessionary. It can have strong positive effects on private investment- in part because of an often-overlooked transmission channel of fiscal policy: the labor market.

Irish experience

Perotti cited the Irish experience of the 1980s as a quintessential example of fiscal adjustment. Ireland had been an economy in trouble, saddled with high levels of government debt and mired in low economic growth. On previous occasions, the authorities had attempted to reduce the public deficit largely through tax increases, only to abandon their efforts later and see the deficit balloon again. In 1986-87, however, the government broke from the "European approach" to consolidation and embarked upon an ambitious plan of reducing primary expenditures and cutting spending dramatically over the next two years-to 35 percent from 40 percent of GDP. Tax revenues (as a ratio to GDP) remained virtually unchanged during this period, though tax rates were eventually lowered in later years. Conventional or "Keynesian" logic would suggest that such a large withdrawal of fiscal stimulus should be contractionary, Perotti said. But in Ireland, growth revived, led by a boom in private consumption and investment. Unemployment initially increased but soon declined. And, interestingly, unit labor costs decelerated sharply during the adjustment period, as public sector layoffs and the avoidance of income tax increases helped moderate wage demands.

Composition matters

Could broader lessons be drawn from Ireland's experience? Searching for a more systematic relationship, Perotti and Alberto Alesina of Harvard University...