Public Choice 105: 103124, 2000. 2000 Kluwer Academic Publishers. Printed in the Netherlands.

103

Success and failure of scal consolidation in the OECD: A multivariate analysis

FREDDY HEYLEN & GERDIE EVERAERT
Social Economics Research Group, University of Ghent, Hoveniersberg 4, B-9000 Ghent, Belgium Accepted 30 October 1998 Abstract. This paper tests ve hypotheses explaining the success and failure of scal consolidation in a multivariate regression framework. These hypotheses concern (i) the composition of the consolidation programme, (ii) its size and persistence, (iii) the gravity of the debt situation, (iv) the inuence of the international macroeconomic environment and (v) the contribution of a preceding devaluation. To test for composition effects we use cyclically-adjusted data. Although many conclusions of the existing empirical literature are conrmed, some do not survive. A popular hypothesis that to succeed, consolidation should rely on cutting the government wage bill is rejected. A new empirical result is that the contribution of a devaluation to the success of scal consolidation depends on the composition of the consolidation programme.

1. Introduction The reduction of government debt and decits has been high on the political agenda in many OECD countries in the 1980s and, even more, the 1990s. In the US it has been a major goal of the Clinton administration. In Europe the ght against government debt and decits has been the absolute priority of macroeconomic policy since the signing of the Maastricht Treaty in 1992. Various reasons explain the perceived need for lower debt ratios (see e.g. Ball and Mankiw, 1995; IMF, 1996). First, there is the widespread belief that the massive buildup of government debt since the 1970s has resulted in signicantly higher global real interest rates and lower capital stocks. Second, many countries do not just face high debts today, but also upward pressure on debts in the future caused by growing pension costs. On current policies, future public debt paths may be unsustainable in these countries. Without scal consolidation today, much harder choices will have to be made in the
We want to thank Rudi Vander Vennet, Koen Vermeylen and participants at the Conference on Public Decits and Monetary Union (59th International Conference of the Applied Econometrics Association, Rome, November 1997) for useful suggestions and comments to an earlier version of this paper. Tanja Termote provided excellent research assistance. Any remaining errors are ours.

104 future. Especially in Europe scal consolidation is considered necessary to safeguard the welfare state. A third reason is that high government debts and decits can be inationary. If the public believes that government debt is unsustainable and that the central bank may have to monetize it in the future, ination expectations will rise and so may actual ination, whatever the stance of current monetary policy (Sargent and Wallace, 1981). This perspective may further raise real interest rates. Moreover, it shows that high debt levels are a threat to central bank independence, which right or wrong many have begun to consider absolutely necessary on the road to prosperity. Fourth, high debt ratios affect the distribution of income. To the extent that high government debt raises real interest rates and undermines the capital stock, it implies lower living standards not only for future generations, but also for current workers. A lower capital stock reduces the productivity of labour and thus real wages. It raises the productivity of capital and thus the income of capital owners. Quite striking is that in Europe, where debt levels in percent of GDP have never been higher since the 1960s than today, the share of labour in national income has never been lower than today (European Commission, 1998, p. 281). Given the priority attached to scal consolidation in many countries in recent years, it is not surprising that the effects of consolidation have become an important research topic in the 1990s. Particular attention has been paid to investigating the conditions for successful consolidation, i.e. consolidation that brings about a signicant reduction in the government debt ratio. Five hypotheses have guided the discussion. These concern (i) the composition of the consolidation programme, (ii) its size and persistence, (iii) the gravity of the debt situation, (iv) the inuence of the international macroeconomic environment and (v) the contribution of a preceding devaluation. In Section 3 of this paper we review these hypotheses and discuss the results of related empirical studies. In Section 4 we present the results of our own empirical work. Our aim is to explain the change in the gross government debt ratio in a sample of 39 episodes of scal consolidation in 18 OECD countries since the mid-1970s. We present these episodes in Section 2. As we shall see, in only a small minority consolidation was successful and led to a substantial reduction in the debt ratio. Our empirical approach differs in several respects from what has usually been done in the literature. A rst contribution of this paper is that we opt for a multivariate regression analysis. This allows us to test the main hypotheses from the literature simultaneously. Second, by relying on cyclically-adjusted data, we avoid problems of endogeneity that may have affected the results in some of the existing empirical literature. Our ndings enable us to verify

105 these results. Many of them are conrmed, others are rejected, however. Section 5 summarizes our conclusions.

2. Episodes of scal consolidation in the OECD, 197595 A look at scal policy developments in the OECD countries during the last decades reveals ample episodes of consolidation. These episodes have been traced by several authors relying on similar though not always the same criteria. In general, scal consolidation is dened as a signicant discretionary (i.e. cyclically-adjusted) rise in the general government nancial balance. Although it must be acknowledged that this approach has also been criticized,1 it seems to be the only one that is applicable in a multi-country analysis (see e.g. Alesina and Perotti, 1995; Alesina and Perotti, 1996; McDermott and Wescott, 1996; IMF, 1996; OECD, 1996a; Cour et al., 1997). For the purpose of this paper we have looked at 19 OECD countries in 1975 95 and have selected all periods of at least two consecutive years when the cyclically-adjusted primary balance expressed as a percentage of potential GDP (further CAPB) improved by at least 2 percentage points. Further, it was required that in the rst year of the consolidation period the CAPB improved by at least 0.25 percentage points, whereas in all other years its change was positive. Table 1 shows these consolidation periods as well as the related change in the CAPB. In total there are 39 episodes spread over 18 countries. Figure 1 relates the change of the CAPB in each of these periods to the change in the ratio of gross government debt to GDP ( GD). The latter is considered between the years ts and tf+2 , with ts indicating the rst year of the scal consolidation period and tf the nal year (see also Table 1). As can be seen, the success of scal consolidation is not obvious. Only a minority of countries have succeeded in bringing down debt ratios substantially. Most countries have failed. The rst group contains the well-known success stories of Denmark (198386) and Ireland (198689). Figure 1 also shows a number of consolidation failures like Germany (198085), Belgium (198287), Ireland (198284), Italy (several episodes) and Greece (several episodes).2

3. Output growth and the outcome of scal consolidation Sections 3 and 4 of this paper investigate the reasons for success or failure of scal adjustment. In Section 3.1. we highlight the crucial role of real output growth in the consolidation period. In Section 3.2. we review the theoretical effects of tight scal policy on real growth and discuss ve hypotheses that

106
Table 1. Episodes of scal consolidation in the OECD (197595) Country Code Period (ts -tf ) Austria at1 at2 at3 Belgium be1 be2 Canada ca1 ca2 ca3 Denmark de Finland 1 2 France fr1 fr2 Germany ge1 ge2 ge3 Greece gr1 gr2 gr3 197778 198081 198485 198287 199294 197981 198690 199495 198386 197576 198889 197980 198387 197677 198085 199294 198283 198687 199094 CAPB GD Country Code Period (ts -tf ) 198284 198689 199194 197677 198283 199193 198087 198183 198586 199395 198486 198687 199295 197576 198384 198687 199495 197982 197679 199395 CAPB GD

2.09 2.28 2.60 9.58 3.09 3.22 3.15 2.89 12.34 3.64 2.24 2.51 3.29 2.08 5.49 2.75 3.19 4.27 12.52

7.41 8.59 10.50 26.70 2.30 11.75 19.33 0.81 9.68 4.66 5.67 2.83 5.29 3.14 12.29 19.10 18.04 18.20 22.48

ir1 ir2 ir3 Italy it1 it2 it3 Japan ja Netherlands nl Norway no1 no2 Portugal po Spain sp1 sp2 Sweden sw1 sw2 sw3 sw4 U.K. uk U.S. us1 us2

Ireland

5.70 7.16 2.69 4.23 3.38 4.90 7.67 2.53 2.68 5.48 8.13 2.02 3.12 2.65 2.80 5.52 4.18 5.37 2.35 2.25

33.08 19.58 20.67 4.27 17.03 15.89 14.96 20.60 2.05 4.57 11.21 3.00 19.85 5.01 0.56 17.77 2.57 6.03 3.78 1.76

Note: CAPB: change in the cyclically-adjusted primary government balance as a percentage of potential GDP (change between ts1 and tf ); GD: change in the gross debt ratio as a percentage of GDP (change between ts and tf+2 ). Due to lack of data for the evolution of the debt ratio, two episodes of scal consolidation in Australia (198082 and 198588) have not been included in our data set. Data source: OECD (1997b)

explain why growth is strong in some consolidation episodes and weak in others. Each of these hypotheses refers to the characteristics of the consolidation programme or to the circumstances in which it takes place. We empirically test these hypotheses in Section 4. 3.1. The role of real output growth High real GDP growth is of crucial importance for the success of consolidation efforts. Equations (1) and (2) illustrate this. Equation (1) is the

107

Figure 1. Fiscal adjustment and evolution of the gross government debt ratio. Data source: OECD (1997b)

well-known equation for the dynamics of the government debt ratio. Equation (2) follows from (1) after some minor rearrangements. GD = PB + (r g)GD1 GD = CAPB.Y/Y CCPB + (r g)GD1 with : PB = CAPB.Y/Y + CCPB (1) (2)

In these equations GD is the government debt ratio, PB the primary government balance in percent of GDP (PB is the primary government decit), r the real interest rate on outstanding debt, g the real GDP growth rate, CAPB the cyclically-adjusted primary balance in percent of potential GDP, CCPB the cyclical component of the primary balance in percent of GDP and Y /Y the ratio of potential to actual real GDP. Equation (2) reveals two channels of inuence of real output growth on the change of the debt ratio. First, a higher g reduces the debt burden, (r g)GD1 . Second, by raising tax receipts and reducing unemployment benet expenditures, higher real output growth raises the cyclical component of the primary balance, CCPB. Both contribute to debt reduction ( GD < 0). The

108 main other determinants of the rate of debt reduction are the size of scal consolidation reected by changes in the CAPB and the real interest rate (r). Figure 2 demonstrates the crucial role of real economic growth. It relates the change in the gross debt ratio between ts and tf+2 to the change in the output gap between ts1 and tf+1 . The latter change indicates the cumulated difference between actual real GDP growth and potential real growth in the years ts to tf+1 . A clear negative relationship shows up. If we compare this result to the absence of a relationship between CAPB and the change in the debt ratio in Figure 1, one may conclude that in Equation (2) output growth is the dominating factor. Fiscal consolidation tends to bring about reductions in debt ratios only if economic growth is strong and the output gap increases. If the output gap falls, consolidation tends to fail. Only Belgium (199294) and, especially, Ireland (199194) have been able to reduce the debt ratio in a climate of low economic growth and falling output gaps. Note though that strong economic growth does not guarantee that consolidation succeeds. In six countries rising output gaps went along with rising debt ratios.

Figure 2. Output gap evolution and evolution of the gross government debt ratio. Data source: OECD (1997b)

109 3.2. Consolidation and growth: ve hypotheses about success and failure Given the dominant role of the evolution of economic growth, it is not surprising that several authors have concentrated on the determinants of growth during and after consolidation. Major contributions have been made by, among others, Giavazzi and Pagano (1990 and 1995) and Alesina and Perotti (1995 and 1996). Alesina and Perotti (1996) and Perotti (1996) present interesting surveys of the literature. Theoretically, the net effect of tight scal policy on growth is uncertain. For decades economists have paid attention mainly to its negative Keynesian effects. The Keynesian view predicts that scal consolidation undermines economic growth because it leads to a reduction of aggregate demand. The fall in demand occurs either directly when the government reduces its consumption or investment, or indirectly when households reduce their consumption because higher taxes or lower transfers affect their disposable income. The multiplier mechanism implies that consumption and investment cuts are more contractionary than tax rises or transfer reductions. Moreover, the fall in aggregate demand may be reinforced when private investment responds negatively to the (expected) fall in output caused by lower private consumption or government spending. This is the well-known accelerator mechanism discussed in many macroeconomics textbooks. In the 1990s, however, this view has been heavily criticized.3 Several authors have emphasized that scal consolidation also induces positive demand effects. In addition to standard crowding-in effects on private investment and wealth effects on consumption, caused by falling real interest rates that result from lower government decits, attention has been paid to favourable expectation effects and credibility effects, among others. Moreover, it has been argued that consolidation also generates a number of supply effects, which might be positive as well. Whether these positive effects are strong enough to overrule the negative Keynesian effects is uncertain, however. In this respect the literature points at the crucial role of the characteristics of the consolidation programme and at the circumstances in which consolidation takes place. Five important hypotheses have been put forward. In the remaining part of this section we review these ve hypotheses as well as related empirical evidence. 3.2.1. Composition The importance of the composition of scal consolidation has been emphasized mainly by Alesina and Perotti (1995, 1996), Lane and Perotti (1996) and McDermott and Wescott (1996). Their view is that scal adjustment programmes that rely mainly on cutting government consumption, especially the wage bill, and transfers have a high probability of success, i.e. a high

110 probability of generating strong economic growth and reducing the debt ratio. Programmes that rely mainly on tax rises and government investment cuts, on the other hand, are expected to fail. This is our rst hypothesis. Alesina and Perotti justify this hypothesis on several grounds. They argue that government wage bill and transfer cuts, in contrast to tax rises and investment cuts, benet from favourable credibility and expectation effects on demand as well as from favourable supply effects. As for credibility effects, Alesina and Perotti (1996) argue that governments that tackle the politically more delicate components of the budget (e.g. public employment, social security) signal that they are really serious about scal adjustment. This raises their credibility and, as a consequence, reduces the risk premium (default risk, ination risk) on government debt. This effect reinforces the above mentioned fall in real interest rates and thus the crowding-in of private investment. The stronger fall in interest rates may also cause an additional rise of asset prices and the market value of private wealth, which will further encourage private consumption (see e.g. Giavazzi and Pagano, 1990). Tax increases and investment cuts, on the other hand, will be considered the easy way out, and therefore much less credible. A second reason for higher credibility of government wage bill and transfer cuts is that the root of the budget problem in most OECD countries is on the side of current expenditures, especially transfers (IMF, 1996). As for expectation effects, cuts of public employment and transfers are more sustainable than investment cuts. Although their impact may be the same, one cannot postpone investment (e.g. the maintance of public infrastructure) forever (Alesina and Perotti, 1996). Further, given the experience of the past that tax increases tend to elicit higher spending, these provide the least convincing signal of a permanent change in scal policy. Therefore, the probability that the public considers scal consolidation to be long lasting will be higher when it relies mainly on government wage bill and transfer cuts. This composition offers good prospects of a permanent reduction in taxes on households and rms in the future. It implies a rise in everyones permanent income, which will stimulate private spending and economic growth (see also Feldstein, 1982; Giavazzi and Pagano, 1990; Bertola and Drazen, 1993). The supply effects of government consumption and transfer cuts are also believed to be more favourable. If tax rises or cuts in government investment dominate, supply effects will be negative. Higher taxes will especially in the short-run and in unionized economies cause higher labour costs, either directly (due to a rise of employer contributions to social security) or indirectly (when workers ask higher gross wages to compensate for their decreased after tax income). A cut in government investment will, ceteris paribus, reduce the capital stock in the economy. Some authors (see e.g. Ashauer, 1989; Munnell,

111 1990) expect this to cause negative effects on private investment also, leading to a further reduction of the economys supply potential.4 On the other hand, government wage bill cuts (especially public employment cuts) and transfer cuts may induce positive supply effects. These occur because spending cuts may pave the way for tax cuts and because lower public employment and transfers (e.g. unemployment benets) may change the perspectives of unions and lead to wage moderation in the private sector. Note that in a second round these supply effects may also act upon the demand side of the economy. In general, benecial supply developments will strengthen the favourable credibility and expectation effects of scal consolidation, whereas adverse supply developments will undermine them. Further, and more specically, the evolution of wage costs will inuence the international competitiveness and protability of rms, and thus affect exports and investment. Evidence supporting the composition hypothesis has been provided by Fardmanesh (1991), Alesina and Perotti (1995, 1996) and McDermott and Wescott (1996). Fardmanesh shows that decit-reducing cuts in capital spending are concomitant with lower economic growth, while such cuts in current spending have no net impact on growth. Alesina and Perotti show that successful consolidations, leading to permanent reductions of government debt and decit ratios, mainly rely on cutting the government wage bill and transfers. Successful consolidations typically do not include direct tax increases on households and increases of social security contributions. Increases of taxes on business and indirect tax increases, on the other hand, do not seem to undermine success. Unsuccessful consolidations typically rely on tax increases, spread over all components, and cuts of government investment. A different opinion has been expressed by Hughes Hallett and McAdam (1996). Using the IMFs MULTIMOD to discover the scal corrections necessary for the four largest European countries to meet the 3% decit to GDP ratio imposed by the Maastricht Treaty, Hughes Hallett and McAdam conclude that tax increases are more effective than spending cuts. To explain the relative ineffectiveness of spending cuts, these authors refer to more unfavourable Keynesian multiplier effects. Further, an important assumption underlying their ndings is that policy makers do not spend the higher revenues obtained from tax increases. In contrast to the real world, they can only use these revenues for decit reduction. 3.2.2. Size and persistence Our second hypothesis has been advanced by Drazen (1990), Giavazzi and Pagano (1995) and McDermott and Wescott (1996). The idea is that large and persistent scal adjustments have a much better chance of success,

112 whatever their composition. To justify this hypothesis Giavazzi and Pagano and McDermott and Wescott also refer to favourable credibility and expectation effects. Their justication is strongly related to our explanation in the previous section. First, in contrast to small and temporary ones, drastic adjustments lasting for, say, more than two years prove that policy makers are serious about ghting debt and decits. Second, drastic adjustments provide a stronger signal of a change in the policy regime and, thus, of future tax reductions. That is why they will be accompanied by a more vigorous private consumption and investment growth, and thus by stronger output growth. Another argument, suggested by Blanchard (1990), is that drastic and persistent adjustments provide clarity. They reduce uncertainty about future scal policy and may therefore also reduce precautionary savings. This further supports demand and output. Note that the composition of consolidation is irrelevant for this hypothesis. If they generate expectations of sufciently strong tax reductions in the future and reduce uncertainty, tax increases for e.g. three years can have expansionary effects on consumption (see also Blanchard, 1990). Alesina and Perotti (1996) have raised doubts about this hypothesis. One might indeed put forward just the opposite argument. Large spending cuts or tax increases may undermine the political survival of governments committed to scal consolidation. As a consequence, the credibility and expectation effects of large cuts may be the smallest. Empirically, the available evidence seems to support the size and persistence hypothesis. Giavazzi and Paganos (1995) cross-country analysis shows that private consumption tends to rise strongly during periods of government spending cuts and tax increases, if these spending cuts and tax increases are large and persistent. In the opposite case of spending cuts and tax increases that are neither large, nor persistent, the standard Keynesian effect of falling private consumption tends to be observed. Evidence provided by Cour et al. (1997) supports these ndings. McDermott and Wescott (1996) have found that the greater the magnitude of scal consolidation, the more likely it is to succeed in reducing the debt ratio. 3.2.3. Level and recent change of the debt ratio (emergency effects) Our third hypothesis is that scal consolidation has a higher probability of success when the economy is in a situation of emergency, i.e. when the debt ratio is very high or has risen strongly recently. The reason is again favourable expectation effects on private consumption and investment. In economies with very high debt ratios and strong recent debt rises, consumers and investors will be aware that the day of reckoning comes closer and a scal crisis becomes likely. In these circumstances scal consolidation may raise private

113 consumption and investment. Blanchard (1990) and Sutherland (1995) have proposed models generating this result for private consumption. Basically, the idea is the following. At low and sustainable debt levels, current consumers will face the burden of scal adjustment (e.g. tax increases) without clear perspectives of also reaping the benets of this adjustment. The unfavourable Keynesian effects of tight scal policy may then dominate. If, on the other hand, the economy is close to the brink, current consumers will also benet. They will understand that scal adjustment reduces the probability of a crisis and of disruptive tax increases in the near future. Fiscal adjustment will then strongly raise their permanent income and stimulate their consumption.5 At high debt levels consumption behaviour will be much more Ricardian. Nicoletti (1989) and Slate et al. (1995) provide some support for this hypothesis. Nicoletti has estimated private consumption functions for eight OECD countries over the 196185 period. He nds that expected future taxes are discounted much more strongly in consumer behaviour in highly indebted countries (Belgium, Italy) than in countries where the scal stance is sustainable. Whereas the traditional Keynesian view seems to be appropriate in low debt countries, there is some support for the Ricardian view on consumption in high debt countries. Slate et al. have carried out a number of experiments to test Ricardian equivalence under uncertainty. The results of these experiments suggest that the response of people to scal decits tends to be Keynesian when the probability of debt repayment is low. If, on the other hand, the probability of debt repayment is high, people act much more in a Ricardian way.

3.2.4. International macroeconomic context Our fourth hypothesis follows from observations by Alesina and Perotti (1995) and McDermott and Wescott (1996). It says that scal consolidation has a much higher probability of success if the international macroeconomic situation is supportive, i.e. characterized by high real output growth and low real interest rates. To the extent that these conditions favourably inuence national growth and interest rates, debt reduction becomes easier (see also Equation 2). On the other hand, to reduce debt ratios in the midst of a global recession is much harder, especially if at the same time interest rates are rising. Empirically, both Alesina and Perotti (1995) and McDermott and Wescott (1996) nd that many successful scal adjustments took place in the second half of the 1980s, i.e. a period of high OECD economic growth. Efforts of scal consolidation in the early 1980s, with low economic growth in the OECD and high real interest rates, typically failed. The benecial effect of

114 low interest rates (monetary expansion) during consolidation also shows up in the simulations of Hughes Hallett and McAdam (1996). 3.2.5. Exchange rate changes before consolidation Several authors (e.g. Giavazzi and Pagano, 1990; Alesina and Perotti, 1996; Perotti, 1996) have noted that a number of very successful consolidation episodes were preceded by, or coincided with, a sizeable devaluation followed by a pegging of the exchange rate. This was the case e.g. in Denmark (198386) and Ireland (198689). From this observation one might derive the hypothesis that a devaluation contributes to the success of scal consolidation. A problem with this hypothesis, however, is that not only successful, but also many unsuccessful consolidation episodes were preceded by a devaluation. Examples are Belgium (198287), Italy (198283) and France (198387). The hypothesis that we shall therefore test is that the effects of a devaluation are not unambiguous, but depend on the characteristics of the scal adjustment programme. Specically, our nal hypothesis is that a devaluation contributes to successful consolidation if the adjustment programme is inherently strong. In particular we shall pay attention to the question whether composition is good. The potential benecial effects of a devaluation followed by a pegging of the exchange rate are obvious. First, by raising competitiveness it supports demand for output and thus economic growth during consolidation. Second, if a devaluation is part of a programme that includes other success factors mentioned above (e.g. good composition), it creates long-term exchange rate appreciation expectations which contribute to a decline in interest rates and, as a consequence, stimulate private investment and consumption. Third, by contributing to real product wage moderation and higher protability, a devaluation may improve the supply side of the economy. On the other hand, our hypothesis implies that if the consolidation programme is weak, a devaluation may make things worse. It may enhance further devaluation expectations and lead to higher interest rates and lower demand. The observation that many very unsuccessful consolidation programmes have been preceded by a devaluation, illustrates this risk.

4. Success and failure of scal consolidation: an empirical test In this section we present the results of a regression analysis of the evolution of the government debt ratio in the 39 episodes of scal consolidation described in Section 2 of this paper. Section 4.1. contains a brief methodological note. Section 4.2. presents the explanatory variables that we use in our

115 regression analysis and the results of this analysis. Section 4.3. briey goes into the robustness of our ndings. 4.1. Methodology Although the subject of our empirical work is highly similar to what has been done by Alesina and Perotti (1995, 1996) and McDermott and Wescott (1996), we differ methodologically. Standard in these authors methodology has been rst to dene episodes (countries and years) of successful and unsuccessful scal consolidation and then to compare the evolution of some crucial variables (e.g. the composition of government expenditures and revenues) during these episodes. In general, episodes were dened to consist of only one or two years. Alesina and Perotti and McDermott and Wescotts conclusion that scal adjustments that rely primarily on cutting government wages and transfers have a better chance of being successful, mainly follows from the observation that, on average, wages and transfers (as a percentage of GDP) showed a signicantly stronger decline in the group of successful episodes than in the group of unsuccessful episodes. A similar comparison underlies the conclusion that adjustments which rely primarily on tax increases and government investment cuts have a higher probability of failure. Although these are important observations, they should be considered with great caution. There are four serious problems. First, a crucial element in the methodology of Alesina and Perotti and McDermott and Wescott is to dene what is success and what is failure. Unavoidably, this introduces some arbitrariness into the analysis. Second, it should be noted that the group of successful consolidation episodes typically consists of no more than 15 cases (of one or two years), many of which concern only one specic period (1983 89) in only three countries (Denmark, Ireland and Sweden). The problem is that by splitting up consolidation episodes into short periods, one articially multiplies three or four success stories into many. A third problem is that the simple comparison of group averages for individual variables does not allow to clear out the inuence of other variables. The nal problem is that Alesina and Perotti and McDermott and Wescott dene government spending and revenue categories as a percentage of actual GDP. Such variables are largely endogenous. They are inuenced by the business cycle and, thus, by the other determinants of the effects of scal consolidation (e.g. the international macroeconomic situation or exchange rate policy). A simple example illustrates the problem. Imagine something unspecied, but unrelated to the composition of scal adjustment, that causes high economic growth. Without anything else happening, this something will reduce both the ratio of government spending to actual GDP and the government debt ratio. In

116 regression analysis the coefcients on spending categories would then be biased upwards, implying that it becomes difcult to assess their true effects. In our empirical work we try to avoid these shortcomings. We explain the evolution of the debt ratio in 39 consolidation episodes (see Table 1) by means of multivariate regression analysis. Each episode, whatever its length, is one observation. By explaining the change in the debt ratio itself, we avoid the arbitrary choice of dening successful and unsuccessful episodes. Further, a multivariate approach allows to estimate the inuence of each potential determinant of success or failure while controlling for the effect of all other determinants. Finally, composition variables will be cyclically-adjusted and expressed in percent of potential GDP. 4.2. Explanatory variables and regression results In this section we explain the change in the gross government debt ratio ( GD) in 39 consolidation episodes. Table 2 contains the OLS-regression results. These results should allow us to assess the relevance of ve hypotheses that we have presented in Sections 3.2.13.2.5. Equation (5) in Table 2 is our best equation. To draw conclusions, we shall therefore mainly rely on this equation. Note that Equation (6) is of a different kind (see the notes to Table 2). We discuss this equation in the next section. Data sources are summarized at the bottom of Table 2. The data themselves are available from the authors upon request. To test for composition effects Equations (1)-(5) include the change during the consolidation period of a number of government spending and revenue categories, expressed as a percentage of potential GDP. These categories are the government wage bill (WAGE), government investment (IG), cyclically-adjusted transfers (TR), subsidies (SUB), cyclically-adjusted direct taxes on households (TAXH), cyclically-adjusted direct taxes on business (TAXB), cyclically-adjusted social security contributions (SOC) and cyclically-adjusted indirect taxes (INTAX). Further, we have constructed TAXT as the sum of TAXH, SOC and INTAX. As for spending categories, our results show that cutting the government wage bill and government investment contributes to rising debt ratios. The estimated coefcients for WAGE and IG are always negative and in general statistically signicant. Further, Equations (4) and (5) present evidence that cutting transfers contributes to falling debt ratios. For government investment and transfers, these results conrm the existing literature. However, for government wages our result is surprising. It suggests that the negative demand effects of cutting the government wage bill dominate. This contradicts the conclusions of Alesina and Perotti (1995, 1996) and McDermott and Wescott (1996). For completeness, the coefcient on the change in subsidies generally

117
Table 2. Regression analysis of the change in the gross government debt ratio ( GD) in 39 consolidation episodes Explanatory variables Constant Composition WAGE Estimated equations (3) (4) 1.94 (0.71) 3.54 (1.45) 8.30 (5.04) 7.98 (4.39) 2.40 (2.30) 2.59 (4.12) 9.75 (7.73) 3.45 (1.22) 1.34 (2.13)

(1) 7.05 (1.46)

(2) 7.33 (1.91)

(5) 4.64 (2.15) 7.64 (5.24) 7.39 (4.60) 1.85 (1.99) 2.81 (5.05) 9.99 (9.01) 4.55 (1.82) 1.56 (2.81) 0.28 (3.11) 31.2 (5.56) 17.3 (3.73) 0.87 4.47 25.9

(6) 5.27 (1.30) 4.44 (2.01) 8.40 (2.94) 3.03 (2.04) 1.64 (1.84) 3.53 (2.63) 0.77 (0.20) 1.29 (1.28)

9.10 8.33 9.07 (3.48) (3.14) (3.48) IG 5.50 4.93 5.61 (1.93) (1.75) (1.97) TR 2.68 2.78 2.57 (1.58) (1.65) (1.52) TAXT 2.94 3.28 3.13 (2.95) (3.28) (3.15) TAXB 9.75 9.41 10.1 (4.80) (4.67) (4.95) Size and persistence LAPE 4.74 4.20 5.59 (1.02) (0.92) (1.19) International macroeconomic situation GDPG 3.35 (2.11) STRI 2.17 (2.17) BURDEN 0.027 (2.18) Exchange rate EXCH1 Dummy variables IRE2 SWE3 R2 adj. SER F

37.4 (6.27) 18.4 (3.49) 0.83 5.09 21.3

0.24 (1.50) 30.3 (3.12) 19.9 (2.47) 0.60 7.74 6.77

0.55 8.26 7.56

0.55 8.23 7.65

0.55 8.23 7.66

Notes: The estimation method is OLS. Between brackets are absolute t-values. A () () indicates signicance at 10% (5%) (1%). Underlying Equations (1)-(5) are cyclically-adjusted data for the composition variables, expressed as a percentage of potential GDP. Underlying (6) are non-adjusted data as a percentage of actual GDP. Data sources: The data for the dependent variable ( GD) are shown in Table 1. For the composition variables and LAPE the source is OECD (1997b). For GDPG, STRI and BURDEN it is OECD (1997a). The devaluation percentages underlying EXCH1 have been taken from OECD, Economic Surveys (various issues). Since in OECD (1997b) data for Denmark are missing until 1987, we have relied on OECD (1996b) for this country. For further details, see also notes 79 at the end of this paper.

118 shows up highly insignicant. Therefore, this variable has been dropped in the regressions. As far as government revenue is concerned, the coefcients on SOC, INTAX and TAXH, when estimated freely, are never signicantly different from the estimated coefcient on their sum ( TAXT). Therefore, we opt for including only the latter in our regressions. As can be seen, this variable always obtains statistically signicant positive coefcients. Raising taxes on households, social security contributions or indirect taxes undermines the success of scal adjustment. By contrast, the highly negative coefcient on TAXB suggests that raising taxes on business is a very effective way of scal consolidation.6 These results largely agree with the conclusions of Alesina and Perotti. We have considered three variables to test for size and persistence effects. A rst and obvious one is the rise in the CAPB ( CAPB). However, when included in our equations, this variable always shows up highly insignicant (t-values below 1). A second variable has been inspired by Giavazzi and Pagano (1995). Following these authors we have constructed a dummy variable (LAPE) for large and persistent consolidation episodes. Specically, LAPE equals 1 in those episodes that lasted for at least three years and that led to a rise in the CAPB by at least 0.5 percentage points in the rst year of the episode and at least 3 percentage points in the rst three years.7 Including this variable yields the best regression results in terms of R2 adj and t-values. They are shown in the table. Equation (5) provides some support for Giavazzi and Paganos hypothesis. All other things equal, the change in the government debt ratio is estimated to be 4.55 percentage points lower if consolidation programmes are large and persistent. Admittedly though, this evidence is not very strong. In Equation (5) the estimated coefcient for LAPE is statistically signicant at 10% only. In the other equations, although always negative, it is never statistically signicant. As a third variable we have considered the product of LAPE and CAPB. The results for this variable were slightly less good than those for LAPE as a single variable. To test the hypothesis that scal adjustment has more favourable effects in emergency situations, i.e. in situations where debt levels are high and have risen strongly in the recent past, we have included the gross debt ratio in the year before the start of scal consolidation and the rise of the gross debt ratio during the last three years before consolidation as explanatory variables. Further, we have run regressions including their product. Since no clear evidence could be obtained, we do not show these results. Some results were favourable to the emergency hypothesis, others were not. Moreover, the estimated coefcients for the emergency variables were very unstable. Excluding one

119 or two consolidation episodes, could cause strong changes (see also Heylen, 1997). Three variables measure the inuence of the international macroeconomic situation during consolidation: (i) the international short-term real interest rate (STRI), (ii) the international real GDP growth rate (GDPG) and (iii) a variable called BURDEN which has been computed as BURDEN=(STRIGDPG)GD1, with GD1 is the gross debt ratio in the year before the start of scal consolidation.8 The variable BURDEN has been inspired by the debt dynamics Equation (1). Note the difference, though. In contrast to its counterpart in Equation (1), BURDEN is exogenous. Instead of domestic real GDP growth and interest rates, international GDP growth and interest rates have been used in its calculation. The results in Table 2 support the conclusions from earlier work (e.g. McDermott and Wescott, 1996; Hughes Hallett and McAdam, 1996) that high short-term real interest rates and weak economic growth in the international economy during consolidation undermine its success. They contribute to higher debt ratios. In the regression Equations (1)-(3) BURDEN and STRI obtain statistically signicant positive coefcients, whereas GDPG obtains a statistically signicant negative coefcient. Because of a strong negative correlation between STRI and GDPG (0.65), both variables could not be included together. In Equations (4) and (5) we include STRI. This generates marginally better results. It is not easy to assess the inuence of exchange rate developments on the outcome of scal consolidation. Because exchange rates may respond to the announcement of scal adjustment, exchange rate changes before consolidation are largely endogenous. One can, as a consequence, not just use market data in regressions like those presented in Table 2. A depreciation of the exchange rate may contribute to the success of scal adjustment, but it may also be the reection of nancial market distrust about the expected effects of the consolidation programme and announce failure. Further, as we have mentioned before, the same exchange rate change may have different effects depending on other characteristics of the consolidation programme (e.g. its composition). To shed light on the potential contribution of exchange rate changes, we have selected the episodes of scal consolidation that were accompanied by a devaluation, i.e. an exogenous exchange rate change, and have created the following kind of variables: EXCH = DEVALUE COMP where DEVALUE is the cumulated percentage of ofcial nominal devaluation in the years ts and ts1 , with ts being the rst year of consolidation9

120 and COMP is a variable reecting the composition of the consolidation programme. Equation 5 includes one such variable, EXCH1. To compute it, we have put COMP equal to TR+ TAXT IG, with TR, TAXT and IG as dened above. The positive sign of the coefcient on EXCH1 conrms our expectation that a devaluation contributes to successful consolidation if it is part of a broader programme that can convince nancial markets, in particular if it goes a long with cuts in taxes and transfers and with rising government investment (i.e. TR+ TAXT IG<0). If, on the other hand, a devaluation goes along with rising taxes and transfers and falling government investment, it contributes to higher debt ratios. Quite successful devaluations from this perspective were the devaluations of the Swedish Krone (16%) in 1982 and the Irish pound (8%) in 1986. Failures were e.g. the devaluations of the Italian lire in 198182, the Belgian franc in 1982 and the Greek Drachme in 1985. Limited changes in the denition of COMP do not change our conclusion. For example, in line with our ndings for the composition variables, we have calculated EXCH2 with COMP equal to TR+ TAXT IG TAXB and EXCH3 with COMP equal to TR+ TAXT IG TAXB WAGE. Included in Equation (5) instead of EXCH1, EXCH2 and EXCH3 obtain coefcients equal to 0.30 (t = 2.68) and 0.25 (t = 2.86) respectively. These changes do not affect the results for the other variables. Worth mentioning may be, though, that they slightly raise the degree of statistical signicance of LAPE (absolute t-values of 2.02 and 1.91 respectively). The last two variables in Table 2 are dummy variables (IRE2, SWE3). Relying on all the above mentioned explanatory variables, our equations are not able to explain the almost 20 percentage points drop in the debt ratio between 1986 and 1989 in Ireland (i.e. the second Irish consolidation episode) and between 1986 and 1987 in Sweden (i.e. the third Swedish consolidation episode). As can be derived from a comparison of Equations (3) and (4), including these two dummy variables does not fundamentally change the regression results. A favourable effect is that the degree of statistical signicance of the composition variables rises strongly. In addition to two dummies for specic consolidation episodes in Ireland and Sweden (IRE2, SWE3), we have tried country dummies for all countries in Equation (5). Only the country dummy for Greece showed up statistically signicant at 5%. Including this dummy did not at all affect our conclusions, though. 4.3. Robustness To check the robustness of our results, Equation (5) in particular, we have changed the set-up of our regression analysis in several ways. First, like Alesina and Perotti (1996) we have calculated the change in the gross debt

121 ratio over ts+1 tf+2 , rather than ts tf+2 . Second, we have introduced the percentage change in public employment during the consolidation period as an alternative for the change in the government wage bill. The correlation between these two variables is 0.42. Third, we have used the change in the net debt ratio as dependent variable. None of these changes fundamentally affect our main ndings. For example, the sign of WAGE remains signicantly negative. The change in public employment also receives a negative sign (which is statistically signicant at 10%). It must be acknowledged, though, that the results explaining the change in the net debt ratio are strongly inferior. A problem with this variable is, however, that for some countries (eight consolidation episodes) no data are available. As a fourth, more important change, we have redened the composition variables. Instead of changes in cyclically-adjusted spending and revenue categories as a percentage of potential GDP, Equation (6) in Table 2 includes actual (non-cyclically-adjusted) data as a percentage of actual GDP. This change has been inspired by the fact that non-adjusted data are commonly used in the literature. A second motivation is that cyclically-adjusted data depend on an evaluation of potential output, the calculation of which is open to discussion. As can be seen, the explanatory power of Equation (6) is far below that of Equation (5). Almost all estimated t-values decline. Most important though, this rearrangement does not change our conclusions for the effect of the composition variables.

5. Conclusions This paper tests ve hypotheses explaining the effects of scal consolidation on the gross government debt ratio in a sample of 39 consolidation episodes in 18 OECD countries. Methodologically, our main contributions are that these hypotheses are tested simultaneously and that the data testing for composition effects are cyclically-adjusted. Our results conrm many of the conclusions drawn by Alesina and Perotti (1995, 1996) and McDermott and Wescott (1996). More specically, we also obtain that the likelihood of successful consolidation rises if consolidation (i) takes place in a favourable international macroeconomic environment with high economic growth and low real interest rates, (ii) relies on cutting transfers or raising direct taxes on business, (iii) does not rely on raising taxes on households and labour, nor on cutting government investment. However, one of Alesina and Perottis and McDermott and Wescotts most popular hypotheses that to succeed consolidation should rely on cutting the government wage bill is strongly rejected. This hypothesis does not survive in a multivariate framework.

122 As for our other results, we nd some weak evidence in favour of Giavazzi and Paganos (1995) hypothesis that large and persistent consolidation programmes are more successful. Further, a new result in this paper is that if its composition is good, consolidation may benet from a preceding devaluation. Otherwise, a devaluation seems to be harmful. Finally, we nd no evidence for the hypothesis of, among others, Blanchard (1990) and Sutherland (1995) that consolidation will be more successful in economies with critical debt levels.

Notes
1. See e.g. Persson (1996). One of the reasons for criticism is that it cannot be excluded that events other than planned scal policy (e.g. unexpected shifts in private sector behaviour, a rise in ination combined with a progressive non-indexed tax system) move the government balance. Another reason concerns cyclical adjustment. This requires evaluating potential output, which is notoriously arduous. 2. For completeness, note that some recent European episodes of consolidation (e.g. France, Italy and Sweden in 199597) have not been included in Table 1 and Figure 1. The reason is that it is hardly possible to assess their effects on the debt to GDP ratio. The available information e.g. OECD projections for 1998 and 1999 is still very preliminary. 3. For earlier work, see e.g. Feldstein (1982) and Barro (1989). 4. Others are highly critical of these studies, though (see e.g. Sturm, Kuper and de Haan, 1997). 5. Although plausible, this hypothesis also has its problems. For example, in the model presented by Bertola and Drazen (1993), at very high levels of government consumption a government consumption cut may induce a fall in private consumption. This is because at high levels of government consumption a spending cut may so reduce the probability of a large stabilization in the near future as to increase the present discounted value of future expected taxes. 6. The fact that higher taxes on business strongly seem to contribute to successful consolidation is surprising, given the theory explained in Section 3.2.1. Alesina and Perotti have also found this result. They provide no convincing justication, though. 7. LAPE equals 1 in eleven consolidation episodes (see the codes in Table 1): be1, ca1, de, ge2, gr3, ir1, ir2, it3, po, sp2, uk. It is 0 in all other episodes. 8. More specically, STRI equals the average German short-term real interest rate during consolidation in all European countries and the average US short-term real interest rate during consolidation in the North American countries and Japan. International real output growth during consolidation (GDPG) equals: average real GDP growth in Europe for all European countries except Germany and the United Kingdom; average real GDP growth in France, the US and Japan for Germany; average real GDP growth in Europe and the US for the United Kingdom and Japan; average real GDP growth in Europe, Japan and Canada for the United States and average real GDP growth in the US for Canada. Including for all countries the average real output growth in the OECD during consolidation leads to highly similar results as those presented in this paper. 9. These episodes are be1 (devaluation of 8.5%), de (3%), fr2 (8.4%), gr2 (15%), ir2 (8%), it2 (12.2%), it3 (3.7%), po (14%), sp2 (11%) and sw2 (16%).

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