Fiscal Policy, Business Cycles and Economic Stabilisation: Evidence from Industrialised and...

I. Introduction

Using a comprehensive data-set of 94 countries, this paper empirically examines how fiscal policy responds to economic fluctuations and how effectively fiscal policy has reduced them. From responsiveness regressions, we find that the government's current expenditures and subsidies & transfers move counter-cyclically, while taxes and capital expenditures move procyclically. A comparison of the OECD with the non-OECD reveals that government expenditures respond much more counter-cyclically in the OECD than they do in the non-OECD. We also observe that fiscal policy responds asymmetrically over economic fluctuations, thus implying that government debt can grow over business cycles. From effectiveness regressions, we confirm that economic fluctuations are smaller in larger economies with bigger governments. We also find that military expenditures, oil production and economic fluctuations in neighbouring countries are positively associated with economic fluctuations and that the responsiveness of fiscal policy to business cycles is negatively associated with economic fluctuations.

The three main contributions of this paper are as follows. First, in investigating fiscal policy responsiveness to business cycles, we conduct an instrumental variable (IV) estimation to correct the downward bias of OLS regressions, which is associated with the reverse causality effect of fiscal policy on economic fluctuations.1 Lane (2003) also conducted IV estimation, but it was not the main focus of his study.2 As an instrumental variable, we use the weighted average of economic fluctuations in each country's neighbouring economies, weighting by the inverse of the distance between the two countries. The validation of the instrumental variable is based on the fact that a country's economic fluctuations are highly related to those of neighbouring economies but the fluctuations in neighbouring economies are exogenous to the country's fiscal policy. Our IV results indicate that OLS estimates significantly underestimate the responsiveness of fiscal policy to business cycles.

Second, we use a more comprehensive data-set than the existing literature, consisting of both 22 OECD and 72 non-OECD countries. Using a more comprehensive data-set enables us to utilise larger cross-country variations than previous studies and to examine systematically the differences between developed and developing countries. Third, we also examine the effectiveness of fiscal policy and confirm the consistency of empirical results between the responsiveness and effectiveness regressions. In investigating the effectiveness of fiscal policy in reducing economic fluctuations, we mitigate omitted variable bias by adding four notable factors affecting the degree of a country's economic fluctuations - military expenditures, oil production, economic fluctuations in neighbouring countries and the responsiveness of fiscal policy to business cycles. Specifically, the first two factors - military expenditures and oil production - are found to have a very strong explanatory power for economic fluctuations in the non-OECD. We also find that in the OECD, the responsiveness of fiscal policy is even more important in explaining economic fluctuations than the sheer size of the government.

The rest of the paper is organised as follows. Section II reviews previous studies, Section III describes empirical specifications and Section IV explains the data. Note that in Sections II to IV, we discuss literature, specification and data for both the responsiveness and the effectiveness regressions. Section V reports regression results for the responsiveness of fiscal policy to business cycles. Section VI reports regression results for the effectiveness of fiscal policy in stabilising the economy. Section VII concludes the paper with a summary and discussion of policy implications.

II. Literature

There is a large body of empirical work on the relationships between fiscal policy, business cycles and stabilisation.3 Below, we review previous studies on how fiscal policy responds to economic fluctuations and then review previous studies on how effectively fiscal policy has reduced them.

1. Responsiveness of the fiscal position to business cycles

Our regression results on the responsiveness of fiscal policy in the OECD qualitatively confirm the counter-cyclical responsiveness of fiscal policy reported in previous studies (Fiorito, 1997; Sorensen, Wu and Yosha, 2001; Lane, 2003).4,5 However, in terms of magnitude, our IV estimators suggest a much stronger responsiveness of fiscal policy than those obtained from OLS regressions. As for the non-OECD, most previous studies have focused on Latin America, reporting pro-cyclical patterns in fiscal policy (Gavin et al., 1996; Gavin and Perotti, 1997; Stein, Talvi and Grisanti, 1998). However, previous studies using data for other non-OECD countries report a diversity of patterns. For example, while Talvi and Vegh (2000) show a pro-cyclical pattern in a wider sample of developing countries, Agenor, McDermott and Prasad (1999) report a counter-cyclical pattern in some non-OECD countries.6

2. Effectiveness of fiscal policy in stabilising the economy

Our empirical investigation of the effectiveness of fiscal policy in stabilising the economy mitigates the omitted variable bias in previous studies. Several papers have already examined the relationship between government size and output volatility. Notwithstanding the theoretical ambiguity mentioned in Gali (1994) about the effect of government size on output volatility, many studies provide empirical evidence that government size has a negative relationship with output volatility (Gali, 1994; van den Noord, 2000; Fatas and Mihov, 2001a and 2001b).7 Rodrik (1998) takes this stabilisation role of the government sector as given and suggests that more open economies tend to have bigger governments.8

III. Specification

We need two specifications - one for testing the responsiveness of fiscal policy to business cycles and the other for testing the effectiveness of fiscal policy in stabilising the economy.

1. Responsiveness of the fiscal position to business cycles

In measuring the responsiveness of fiscal policy to business cycles, it is important to note that fiscal policy and GDP can both have a time trend. If we do not de-trend fiscal variables and GDP, their overall trend may generate a spurious correlation between them. To extract the cyclical component of the time-series variables, we employ two alternative detrending procedures: (i) Hodrick and Prescott filtering (hereafter, 'HP filtering') and (ii) first-differencing. HP filtering is a widely used way to detrend, but it is not an entirely satisfactory approach to de-trending. Cogley and Nason (1995) show that HP filtering can generate business-cycle dynamics (namely, the 'Slutsky effect') even if none are present in the original data. Furthermore, Ehlgen (1998) reports that not only when the conditions for HP filter optimality are not satisfied, but even when the HP filter is optimal, its application can lead to distortions. Ashley and Verbrugge (2006) also show that the de-trending of stochastically trended data through application of the HP filter yields notably mis-sized hypothesis tests.

We use the log of expenditures, or the log of tax revenues, as a key fiscal position variable. In this log-log specification, α^sub 1^ is the elasticity of the fiscal position to business cycles. Note that we de-trend fiscal variables and GDP by including second-order polynomial functions of time t; thus trends in the fiscal variables and GDP are already controlled for. When α^sub 1^ is greater than 1, the fiscal variable increases more than proportionally in a boom. This implies that the ratio of the fiscal variable to GDP increases in a boom. Our working definition of pro-cyclical fiscal policy is that the ratio of the fiscal variable to GDP increases (decreases) in a boom (recession). To stabilise the economy, taxes need to move pro-cyclically, indicated by α^sub 1^ greater than 1, while government expenditures need to move counter-cyclically, indicated by α^sub 1^ less than I.12

A key issue that has not been addressed sufficiently in the previous empirical literature is the reverse causal relationship of fiscal policy to the business cycle. To address this endogeneity issue, we adopt an IV estimation by using as instruments the weighted average GDP growth rates in neighbouring countries, weighting by the inverse of the distance between the two countries.13 While GDP growth rates of neighbouring countries are not much influenced by the country's fiscal policy, the correlation between GDP growth rates in neighbouring countries and the country's GDP growth rates is remarkably high in the data.14 This suggests that the weighted average of GDP growth rates in neighbouring countries is an exogenous factor affecting the growth rate of a country without much being influenced by the country's fiscal policy, thus satisfying the characteristics of a good instrument. Although using many valid instrumental variables has the potential to improve efficiency, it also makes the usual inference procedures inaccurate (Hansen, Hausman and Newey, 2007). Furthermore, when the instruments are weak, the usual large-sample approximations provide a misleading basis for inference, in the sense that the estimator is biased towards the OLS estimator. Particularly, this occurs in our study. Thus we decided to use this variable as the only IV without adding other weak IVs.

2. Effectiveness of fiscal policy in stabilising the economy

To empirically investigate the effectiveness of fiscal policy in stabilising an economy, we use the standard specification used in the existing literature and simply add four additional factors. As in previous studies, such as Gali (1994) and Fatas and Mihov (2001a and 2001b), we begin by regressing the standard deviation of GDP growth rates on the log of GDP (lGDP), GDP growth rates (ΔlGDP), the log of GDP per capita (lGDPPC), government size (Gov/GDP) and trade openness (Open).

The rationales for including these variables as independent variables are as follows. First, larger countries may experience smaller economic fluctuations because they have a more diverse set of economic activities, including types of industries, consumers and technology. For example, the world economy consisting of the most diverse set of economic activity shows smaller fluctuations than each individual country does. Second, economic fluctuations measured by the standard deviation of GDP growth rates would be larger when the average GDP growth rate is larger. Thus we need to control for average growth rates. Third, an argument could be made about the possibility that richer economies are less volatile - for example, due to more developed financial systems. Fourth, a larger government can be associated with smaller economic fluctuations because the government sector is more stable than the private sector and can conduct fiscal and monetary policy tools to stabilise the economy. The effects of government size on economic stabilisation have been the focus of the literature (for example, Fatas and Mihov (2001a)). Finally, trade openness can increase economic fluctuations because it makes the country more vulnerable to external forces (Rodrik, 1998).

IV. Data and sample

Our data come from the World Bank's World Development Indicators (WDI). The only exception is the ratio of oil production to GDP, which comes from OPECs Annual Statistical Bulletin.16 Our main sample for the responsiveness regressions consists of 1,982 observations covering 94 countries and 27 years from 1972 to 1998. The period is the same for both the OECD and the non-OECD. Each of the countries in our data-set has more than five observations and complete data regarding total tax revenues, total government expenditures and real GDP.

1. Responsiveness of the fiscal position to business cycles

Table 1 reports summary statistics for the responsiveness regressions. The average of the first difference in the log of real GDP, which can also be interpreted as the average GDP growth rate, is 3.49 per cent. The weighted average of GDP growth rates in neighbouring countries, weighting by the reciprocal of bilateral distance, is 3.17 per cent. Compared with the non-OECD countries, the OECD countries have lower growth rates, not only in terms of their own GDP growth rates but also in terms of the GDP growth rates of neighbouring countries. This pattern is due to the fact that OECD members tend to be located close to other members. The averages of the first differences in the log of tax revenues and in the log of expenditures are 4.32 per cent and 4.47 per cent respectively, suggesting that tax revenues and expenditures increase, on average, more rapidly than GDP. The fact that expenditures have higher growth rates than tax revenues indicates deterioration in fiscal positions. Among the major components of expenditures and tax revenues, subsidies & transfers and commodity taxes increase most rapidly.

2. Effectiveness of fiscal policy in stabilising the economy

Summary statistics for the effectiveness regressions are reported in Table 2. Note that, in the effectiveness regressions, we utilise cross-sectional variations of 94 countries. The standard deviation of the GDP growth rates over the sample period is, on average, 4.50, with a much lower figure for the OECD (2.40) than for the non-OECD (5.11). The average tax ratio is slightly less than 20 per cent and the average ratio of total expenditures to GDP is 28 per cent. The estimated average responsiveness of expenditure to economic fluctuations is 0.13. In particular, the responsiveness is estimated to be -0.52 in the OECD and 0.33 in the non-OECD, suggesting that OECD government expenditures move much more counter-cyclically to business cycles than non-OECD government expenditures. In contrast, taxes show cyclical behaviour in response to economic fluctuations, with an estimated average responsiveness of 1.14 (1.09 in the OECD and 1.15 in the non-OECD). The average ratio of trade to GDP is about 70 per cent. The ratio of oil production to GDP is, on average, 5 per cent, with a very large standard deviation, and the ratio of military expenditures to GDP is about 3.5 per cent.

V. Responsiveness regression results

In this section, we report the results of regressions on the responsiveness of fiscal policy to economic fluctuations. Table 3 reports the regression results for total expenditures and tax revenues using two different methods of detrending. Note that in all regressions, we add country and time dummies to control for country fixed effects and worldwide year effects. Simple OLS results without any de-trending are reported in columns 1 and 6, which show that expenditures (tax revenues) move counter-cyclically (pro-cyclically).17 These OLS estimation results without any de-trending may bias fiscal responsiveness toward 1, due to the time trend of the fiscal variables and GDP. As expected, de-trending leads to a stronger cyclical response of fiscal policy. In columns 2 and 7, we report that total expenditures (tax revenues) show a slightly more counter-cyclical (pro-cyclical) response after detrending with the HP filter. De-trending with first-differencing in columns 4 and 9 appears to correct the bias more strongly.

In columns 3, 5, 8 and 10, we report IV estimation results. Note that our instrumental variable - the neighbouring countries' GDP growth rates (ΔlGDP^sub j≠i,t^) - is strongly correlated with the country's GDP growth rate (ΔlGDP^sub it^) with a correlation coefficient of 0.61 (p-value = 0.00), suggesting the validity of our instrumental variable.18 Fiscal variables are estimated to be much more responsive to economic fluctuations in IV estimations than in OLS estimations. In the regressions for government expenditures, the IV estimation coefficient for the HP-filtered log of GDP, 0.60 (0.62 for the firstdifferencing of GDP), is much smaller than the OLS coefficient for the HPfiltered log of GDP, 0.85 (0.72 for the first-differencing of GDP). In the regression for tax revenues, the IV estimation coefficient for the HP-filtered log of GDP, 1.34 (1.39 for the first-differencing of GDP), is much larger than the OLS coefficient for the HP-filtered log of GDP, 1.18 (1.28 for the first-differencing of GDP). Our results indicate that OLS estimates underestimate the responsiveness of fiscal policy since they include the impact of the fiscal variables on economic fluctuations.

Our main results in columns 5 and 10, which are the IV estimation results for the whole sample, imply that total expenditures increase by 0.62 per cent and tax revenues increase by 1.39 per cent when there is a 1 per cent increase in GDP growth rates.19

Table 4 examines the results of the responsiveness regression for subsamples. Columns 2, 6, 10 and 14 report the results for the subsample without the five largest countries: the US, Japan, France, the UK and Italy. The exogeneity of economic fluctuations in other countries, and thus the strength of IV, may be weak for large countries because economic fluctuations in these large countries can significantly affect economic conditions in adjacent countries. However, the estimation results indicate that dropping the five largest countries does not affect the main results. Table 4 also reports the IV estimation results separately for the OECD and the non-OECD. In the regressions for total expenditures, the estimated coefficient for the HP-filtered log of GDP (the first-differenced log of GDP) for the OECD is -0.35 (0.05), which is much smaller than 1, compared with 0.64 (0.64) for the non-OECD. We also estimate the GDP elasticity of government expenditures for each country, as reported in Tables A1 and A2 in the appendix. The country-by-country regression results also confirm that expenditures respond much more counter-cyclically in the OECD than in the non-OECD. Within the OECD, expenditures in European welfare states generally move more counter-cyclically, while expenditures in the US, Japan, Canada and members with lower incomes, such as Portugal, Turkey and Greece, move less counter-cyclically. This finding indicates the importance of social security in the counter-cyclical response of expenditures.

Taxes are found to be more pro-cyclical in the non-OECD than in the OECD. In an attempt to at least partly explain this somewhat puzzling finding, we discuss factors affecting the responsiveness of taxes to the business cycle. This responsiveness can be affected by the progressivity of the tax system, tax-reporting behaviour, institutions, tax composition and the size of the unofficial economy. First, progressive tax systems can lead to a stronger pro-cyclical movement of tax revenues. Members of the OECD generally have more progressive tax systems than non-OECD countries, implying that tax revenues move more pro-cyclically in the OECD. Second, when taxpayers smooth their reported income, tax revenues move less procyclically. Lee (2005) presents a model in which taxpayers smooth their reported income out of fear that a large change in reported income over time could invoke a tax audit. Taxpayers in the OECD may have a stronger incentive to smooth their reported income because of a more advanced tax administration system that can trace over-time changes in reported income. Therefore tax revenues would move less pro-cyclically in the OECD. Third, we conjecture that economies without a strong legal-political-institutional infrastructure may respond to a positive productivity shock by increasing taxes more than proportionally (for example, see Tornell and Lane (1999) for this 'voracity effect'). Therefore taxes move less pro-cyclically in the OECD than in the non-OECD. Taking these factors into account, it is ambiguous whether the OECD or the non-OECD has more pro-cyclical tax revenue.

Table 5 disaggregates expenditures and taxes into their main components.20 Current expenditures, especially in the OECD, show a strong counter-cyclical response, while capital expenditures are estimated to be procyclical. Subsidies and transfers are estimated to be slightly more countercyclical than the other parts of expenditure. As shown in Table 5, among the three main components of taxes, income tax revenues are estimated to respond most pro-cyclically.

In the literature on the relationship between fiscal policy and the business cycle, an important issue has been whether or not fiscal policy responds symmetrically over business cycles, since this has attendant implications for the issue of fiscal soundness.21 If the government takes a strong expansionary fiscal position during recessions, while not tightening the fiscal position sufficiently during booms, government debt would grow over business cycles.22

Table 6 reports whether or not government expenditures and taxes respond differently depending on whether GDP growth rates are positive or negative.23 We find that government expenditures show a strongly countercyclical response during recessions, as reported in Alesina and Perotti (1995), but respond pro-cyclically during booms. The hypothesis that the response of expenditures to business cycles is symmetric can be rejected at the 5 per cent, 16 per cent or 6 per cent p-value, respectively, for the whole sample, the OECD and the non-OECD. Expenditures during booms are estimated to increase only proportionally in the OECD, but progressively in the non-OECD, thus indicating that governments in developing countries have a tendency to spend away additional revenues during booms. On the other hand, expenditures during recessions are estimated to increase more strongly in the OECD, suggesting the active role of expenditures (probably for social security) in stabilising OECD economies during recessions. Our results suggest that fiscal policy takes a strong expansionary position during recessions, but does not tighten the fiscal position during booms, which can cause a serious problem for the long-run sustainability of government debt.

VI. Effectiveness regression results

In this section, we analyse the effectiveness of fiscal policy in stabilising the economy. As mentioned earlier, we begin by regressing the standard deviation of GDP growth rates on a set of independent variables used in the previous literature. Then we add four additional variables that were not considered in the previous studies - military expenditures, oil production, economic fluctuations in neighbouring countries and the responsiveness of fiscal policy to business cycles. In analysing the effectiveness of fiscal policy, our paper examines both revenues and expenditures.

Without controlling for our four new variables, column 1 of Table 7 shows that the ratio of total expenditures to GDP is not associated with economic fluctuations.24 This could happen because we use total expenditure while ignoring the possibility that certain components of expenditure, such as military expenditures, destabilise rather than stabilise the economy. When military expenditures, oil production and the standard deviation of GDP growth rates in other countries are included in the estimation, as shown in column 2, the ratio of expenditures to GDP is estimated to be significantly negatively associated with economic fluctuations, with an estimated coefficient of-0.035 (standard error: 0.016), significant at 5 per cent.25

When the estimated responsiveness of taxes to business cycles is included in the specification, government expenditure remains significant. The responsiveness of taxes to business cycles is estimated for each country by running IV regressions using the specification in column 10 of Table 3. For the whole sample of 94 countries, as shown in column 3 of Table 7, the responsiveness takes the expected negative sign but is not statistically significant. When the estimated responsiveness of expenditures to business cycles is included in the specification instead of the estimated responsiveness of taxes (column 4), we observe that the responsiveness takes a positive sign but is not statistically significant. However, in separate regressions for the OECD and the non-OECD, as shown in columns 5 and 6, the responsiveness of expenditures to business cycles becomes statistically significant in the OECD but is insignificant in the non-OECD. This result is not surprising, since the estimated values for the expenditure responsiveness to business cycles in the OECD countries themselves are mostly significant, while those in the non-OECD are not (as shown in Tables A1 and A2 in the appendix). This significance in the responsiveness of fiscal policy indicates that the responsiveness of fiscal policy is as important as the sheer size of the government in explaining economic fluctuations in the OECD.26

The last two columns of Table 7 use the tax ratio instead of the ratio of expenditures to GDP. Unlike expenditures, the tax ratio is significant even when military expenditures are not controlled for. This is not surprising once we recognise that military expenditures are often financed by non-tax methods, such as government bonds or seigniorage. When military expenditures, oil production, economic fluctuations in other countries and the responsiveness of the fiscal position to business cycles are added, the estimated coefficient of the tax ratio, -0.042, has a similar value to that of expenditures, -0.035. The resulting significant tax effect itself does not necessarily imply that taxes alone are very effective in stabilising the economy. Rather, the tax ratio works as a proxy for the degree to which government responds to business cycles and stabilises the economy, through means such as the development of progressive tax systems and flexible social welfare systems.

Among other determinants of economic fluctuations, we find that larger economies in terms of (log of) GDP have smaller economic fluctuations. However, in the OECD, the sheer size of the country turns out to be insignificant. We also find that economic fluctuations in other countries take a positive sign, as predicted, in the OECD. Countries with larger oil production and military expenditures are found to have larger economic fluctuations. Separate regressions for the OECD and the non-OECD in columns 5 and 6 indicate that oil production significantly increases economic fluctuations in the non-OECD while decreasing them in the OECD. This suggests that the non-OECD fails to utilise unstable oil revenues for reducing economic fluctuations, while the OECD succeeds in doing so. Military expenditures significantly increase economic fluctuations, particularly in the non-OECD.

Table 8 reports regression results for each component of taxes and expenditures. Row 1 confirms the tendency that OECD countries, with larger government expenditures, experience less variation in GDP growth rates. Row 2 uses the ratio of total expenditures minus military expenditures to show that the expenditures net of military expenditures are negatively associated with economic fluctuations. Rows 3 and 5 show that countries with larger current expenditures and subsidies & transfers tend to have less variation in their GDP growth rate, which is consistent with the finding in Section V that current expenditures and subsidies & transfers move more counter-cyclically than capital expenditures and other expenditures. Rows 7 to 11 report the results for the tax revenue side. We find that income taxes show a negative, but not statistically significant, relationship with economic fluctuations. Commodity taxes are significantly negatively correlated with economic fluctuations in the total sample and in the OECD. Social security taxes in the OECD are also significantly negatively associated with economic fluctuations, suggesting again that social welfare systems may work as stabilisers in the OECD. When we examine the results of both the revenue and expenditure sides in the effectiveness regression, this indicates the importance of expenditures, such as social security and current expenditures, in responding to business cycles and stabilising the economy.

VII. Conclusion

Using a comprehensive data-set of 22 members of the OECD and 72 nonOECD countries, and instrumental variable (IV) estimation, we show that current expenditures and subsidies & transfers move counter-cyclically while taxes and capital expenditures move pro-cyclically. We also find that ordinary least squares (OLS) estimates understate the responsiveness of fiscal policy to economic fluctuations. Fiscal policy is found to respond asymmetrically over economic fluctuations, casting concern that government debts increase over business cycles.

By investigating the effectiveness of fiscal policy in stabilising the economy, we find that the government works as a stabiliser of economic fluctuations. This paper extends the previous literature on the effects of government size on output volatility by using a larger set of countries and by adding four previously omitted variables. We find that military expenditures and oil production turn out to have very strong explanatory power for economic fluctuations in the non-OECD. We also demonstrate the importance of expenditures, especially social security and current expenditures, in reducing economic fluctuations.

We can draw two main policy implications from our empirical analysis. First, current expenditures and social security expenditures are the key components of fiscal policy in reducing economic fluctuations. These expenditure components are found to respond most counter-cyclically to business cycles and to be negatively associated with economic fluctuations. From these findings, we expect economic fluctuations to decrease as social security systems become more developed.

Second, we find that fiscal policy moves asymmetrically over business cycles, thereby implying that budget deficits or government size can grow over business cycles. The asymmetric response of fiscal policy has attendant implications for the issue of fiscal soundness.