Fiscal Rules, Inertia and Discretionary Fiscal Policy

23 Pages Posted: 14 Oct 2008 Last revised: 17 Oct 2008

See all articles by Martin Larch

Martin Larch

European Fiscal Board

Matteo Salto

Directorate-General COMP, European Commission

Date Written: October 1, 2003

Abstract

In current practice, changes in the cyclically-adjusted budget balance (CAB) are interpreted as reflecting the effort of discretionary fiscal policy. This paper shows that such an interpretation is not a sufficiently accurate description of the behaviour of fiscal policy, as, in some cases, it may conceal an important deficit bias. Specifically, as growth projections are an important building block of budgetary plans, systematic optimism in forecasting growth, coupled with pervasive lags and inertia in the implementation phase of the budget, will result in a fiscal expansion compared to plans, even in the absence of discretionary measures. In order to track down this kind of passive behaviour in the light of growth surprises or sanguine growth assumptions the traditional reading of the CAB needs to be adjusted. This is achieved by relaxing the benchmark assumption according to which, under unchanged fiscal policy, the deficit-to-GDP ratio is invariant to growth. An empirical application to public finance data of four large EU countries shows that passive behaviour is an important element in practice, as forecast errors are significant in explaining changes in the CAB. Moreover, in some cases official growth forecasts appear to have a clear upward bias.

Keywords: Fiscal Policy, Cyclically-Adjusted Budget Balance, Potential Output, Forecast Accuracy, Policy Inaction

JEL Classification: E61, H3, H6

Suggested Citation

Larch, Martin and Salto, Matteo, Fiscal Rules, Inertia and Discretionary Fiscal Policy (October 1, 2003). Applied Economics, Vol. 37, No. 10, 2005, Available at SSRN: https://ssrn.com/abstract=1284404

Martin Larch (Contact Author)

European Fiscal Board ( email )

Belgium
0032 2 2969244 (Phone)

Matteo Salto

Directorate-General COMP, European Commission ( email )

Rue de la Loi 200
Brussels, B-1049
Belgium

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