CYCLICALLY ADJUSTED BUDGET BALANCES: AN ALTERNATIVE APPROACH 1

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Cyclically Adjusted Budget BalancesAn
Alternative Approach
Matthias MohrEuropean Central Bank Presentation
at Frankfurt University 3 June 2003 Note The
Views expressed here are those of the author and
do not necessarily reflect those of the European
Central Bank
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But the one thing economists know about cyclical
adjustments is that we do not know how to do
them... (1) (Barry Eichengreen) (1) Comment
on Alesina, Alberto/ Roberto Perotti/ José
Tavares The Political Economy of Fiscal
Adjustments, Brookings Papers on Economic
Activity , 1, 1998, p 256
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Computing CABs in 2 Steps

• 1. Assessment of the cyclical position of the
  economy
• 2. Evaluation of the impact of the cycle on the
  budget (estimating the cyclical component)
• CAB balance - cyclical component of balance

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Desirable properties of CABs

• Cyclical unbiasedness Cyclical components of the
  balance should add up to 0 over time
• Transparency
• Reliability in real time Frequent and large ex
  post revisions of the assessment of the
  structural position in the light of new
  information should be avoided.
• Reliable decomposition between structural and
  cyclical developments

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The Cyclical Position of the Economy

• An aggregate measure of the cyclical position of
  the economy is the output gap (the deviation of
  real GDP from its long run growth path) (y-y)
• There is no unique measurement of the output gap.
  Often used approaches
• Univariate filters (ESCB approach, former
  approach of the EU Commission)
• Unobserved components models (uni- or
  multivariate)
• Production function approach Solow decomposition
  of the macroeconomic production function (IMF
  former approach of the Deutsche Bundesbank )
• Mixture of the methods mentioned above (EU
  Commission, new method OECD)

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The Sensitiviy of the Budget Balance

• Definition Sensitivity of balance wrt GDP (Y),
  sB,Y

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Methods of Cyclical Adjustment

• 1) Rule of Thumb
• hR,Y ? 1, hX,Y ? 0 -gt sB,Y ? X/YN
• Sensitivity is increasing in the government share
• X/YN ? 0.5, sB,Y ? 0.5
• Apply rule of thumb on output gap Bc/Yn 0.5
  (y-y)
• Problem assumptions hR,Y ? 1, hX,Y ? 0 are nice
  as a stylistic approximation in the long run but
  can be problematic in the short run
• Therefore Revenue and expenditure elasticities
  are estimated in all approaches used in practice

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2) Standard Approach
GDP
Fixed macro elasticities
e.g. Italian case eempl,gdp 0.3
TAX AND EXPENDITURE BASES
Fixed fiscal elasticities
TAX AND EXPENDITURE ITEMS
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Macroeconomic Tax and Expenditure Bases

• Consumption indirect taxes

• Unit wages

direct taxes on households social security
contributions

• Employment

• Operating surplus taxes on firms

• Unemployment rate or N. of Unemployed

Unemployment related expenditure
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• Estimate elasticities of the budgetary items wrt
  the macroeconomic bases, hXj,Mj and hRi,Mi
• Estimate elasticities of the macroeconomic bases
  wrt to GDP, hMi,Y
• Compute cyclical component of the balance as
• equivalently

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Budgetary Elasticities in the EU Countries
Source Bouthevillain et. al. (2001)
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• Source OECD (2000)
• 1 Based on weights for 1999. Semi-elasticity,
  i.e. change in net lending as a percentage of GDP
  for a 1 per cent change in GDP.

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• Some caveats against the standard approach
• Implicitly stable short run relationships between
  the macroeconomic bases and output
• Therefore the standard method is misleading in
  the case of unbalanced growth
• Cyclical developments of prices are not accounted
  for (also a caveat against the ESCB approach)
• Revenue items and tax bases should be adjusted
  for public sector components
• part of indirect taxes is paid by government
• part of the macroeconomic base variables are
  affected by fiscal policy (as wages)

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• 3) ESCB approach
• Estimate the deviations trend of the
  macroeconomic base variables from their long run
  trend (mi - mi)
• Trends are computed using the Hodrick-Prescott
  filter
• Computing cyclical components of budget balances
  as
• The independent trend estimations of
  macroeconomic base variables allows for
  composition effects in cases of unbalanced growth

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Why the HP Filter?

• The HP filter is a symmetric, univariate filter
  the trend series is a two sided, symmetric moving
  average of the input series
• Fullfills adding up constraints.
• Trend of sum of series is aquivalent to summing
  up the trend series.
• It is therefore compatible to the disaggregated
  approach
• It is simple, transparent and widely used
• Deviations from trend approximately balance out
  over the medium term

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Comparison of cyclical components for the Euro
area
ESCB Commission OECD IMF 1998 1999
2000 1998 1999 2000 1998 1999 2000 1998 1999
2000 ??????????????????????????????? -0.3
0.0 0.2 -0.4 -0.4 0.0 -0.8 -0.6
-0.2 -0.8 -0.7 -0.2 ??????????????????????
????????? change 98-00 0.5 0.4 0.6 0.6
Based on data available in June 2001

• Also, at country level, larger differences across
  estimates

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Composition effects for the euro area
Based on Data available in June 2001
Composition effects are small at the aggregate
level.
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Composition effects in individual countries
Based on Data available in June 2001
Composition effect are important in the case of
individual countries
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Problems of the ESCB approach

• Problems of the HP Filter
• Diagnosis problem Structural breaks in real time
  are not easily recognized (part of the change in
  the structure is allocated to cyclical movements)
• Use of the filter implies a discretionay choice
  of the smoothing parameter lambda. Choice of
  lambda not straightforward
• Filter suffers from an endpoint problem
• No cyclical movements in prices accounted for
• Approach does not explicitely account for
  theoretical linkages between macroeconomic base
  variables (and GDP)

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HP Filter Endpoint Problem
Additional Slides II HP Filter
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End
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References
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Additional Slides
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The New Production Function Approach of the
European Commission
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The Solow decomposition of output
TFP total factor productivityu unemployment
rateu NAIRUP participation
rateN population in the working
ageK capitalY output
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Relative Contributions of Input Factors to
Potential Output Growth
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The old and the new approach of the
EC Comparison of Output Gaps
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OECD Output Gaps, the Case of Italy

• Release April 1963-01 October 1963-03
• ??????????????????????????
• Positive observations 12 15
• ??????????????????????????
• Negative observations 27 26
• ??????????????????????????
• Average 1963-01 -0.71 1963-03 -0.34
• ??????????????????????????
• output gap 1970 1.8 3.2
• 1971 -0.5 1.0
• ??????????????????????????
• Also, from 1992 to 2003 always negative output
  gaps
• (12 and possibly more consecutive negative years)
  

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Budget elasticities
ESCB - OECD estimates broadly similar for most
countries ESCB method on private sector only (eg
employment)
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The Filter as an Allocation Scheme

• A filter is a device to decompose the variability
  of a time series into trend and cyclical
  variability
• Time series can be thought of as being composed
  by cycles of different lengths.
• A filter is an allocation scheme, allocating
  cycles up to a certain length to the cyclical
  component and longer cycles to the trend
  component.

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The HP Filter in the Frequency Domain
II. HP Filter
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Value of 30Filter Gain

• Cycles of 8 years or shorter should be included
  in the cyclical component almost entirely.
• Compression not more than 10 of amplitude of
  cycles up to 8 years length.
• Implies ?30.

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Leakage and Compression Different Values of ?
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Filter Gain and Values of ?
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Value of 30 Critical Length

• Critical length of cycle
• 8 years as an appropriate horizon for medium term
  fiscal analysis.
• Common critical length for all countries
• No large differences in business cycle lengths
  across the European Union.
• Cyclical patterns are likely to converge further
• Common time span for fiscal analysis desirable.

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Value of ? Implications for Trend Growth
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Value of ? Implications for Trend
Deviations(Example Real GDP, Germany)
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Value of ? Implications for Trend Growth
Spain, real GDP