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April 17, 2015

The Effect of Fiscal Policy on Growth and Stability

Does fiscal policy respond systematically to economic activity? Can fiscal policy promote macroeconomic stability? Does greater stability support stronger growth? The answer is yes on all counts. This finding, while seemingly obvious, is now backed by numbers to match each question.

The April 2015 Fiscal Monitor explores how.
A novel approach
To measure whether fiscal policy contributes to stability, the Fiscal Monitor introduces the novel concept of the fiscal stabilization coefficient (FISCO).  FISCO measures how much a country’s overall budget balance changes in response to a change in economic slack (as measured by the output gap).
If FISCO is equal to 1 it means that when output falls below potential by 1% of GDP, the overall balance worsens by the same percentage of GDP. The higher the FISCO, the more counter-cyclical is the conduct of fiscal policy, where governments build fiscal buffers in good times that they can then rely on during bad times. The average FISCO among advanced economies is 0.7, with considerable cross-country differences (see figure 1). For the FISCO for individual countries (including advanced, emerging market and developing countries) see Xavier Debrun’s blog “Growth Dividend from Stabilizing Fiscal Policies”.
The FISCO takes into account the fact that many revenue and expenditure items respond to the state of the economy even though the underlying provisions or programs were primarily designed for other reasons. Monitoring the relationship between the budget balance and the output gap would help policymakers understand how much their action contributes to output stability, including in comparison to other countries.
FM FISCO 1
Growth dividends
With the FISCO, the April 2015 Fiscal Monitor assesses the effect that fiscal policy can have on medium-term growth through its support to macroeconomic stability. The findings suggest that countries that can increase their FISCO would be able to significantly reduce macroeconomic volatility (see figure 2).
FM FISCO 2
Why is this important? First, because lower macroeconomic volatility helps avoid wasteful fluctuations in employment and growth. Second, because lower macroeconomic uncertainty provides a favorable environment for physical and social capital, thereby boosting medium-term growth.
Our results show that making fiscal policy more stabilizing would provide a significant boost to growth, as illustrated in figure 3. The effect can be large. Take, for example, the case of an advanced economy that raises its FISCO from the average level (0.7) to that in the top third of countries (about 0.8). This would reduce output volatility by about 15 percent, which in turn brings about a growth dividend of 0.3 percentage points annually. The Fiscal Monitor provides greater details of the methodology underlying this estimate, which attempts to address some of the well-known challenges with growth regressions identified in economic literature. Still, as with all econometric findings, these results must be interpreted with caution.
FM FISCO 3
What this means for countries in practice
What can countries do to improve fiscal stabilization?  In an earlier blog (written with Richard Hughes and Laura Jaramillo, Dams and Dikes for Public Finances) we argue that it is crucial to have in place a fiscal framework to manage public finance risks. Well-designed fiscal rules and medium-term frameworks can also help by enabling uninterrupted access to borrowing at favorable conditions, ensuring expenditure control over the entire cycle, and leaving flexibility to respond to output shocks.
Another important aspect of fiscal frameworks is to induce rules-like, automatic stabilizing responses to economic developments. For example, tax payments that move in sync with income, and social transfers, such as unemployment benefits can automatically boost aggregate demand during downturns and moderate it during upswings. Because they operate in real time, without political approval or implementation lags, they are a very effective way to make fiscal policy stabilizing.
Read the April 2015 Fiscal Monitor for more insights into these and other options to promote macroeconomic stability and thereby boost growth.

iMFdirect is a weblog covering the global economy and policy issues, posted by the International Monetary Fund (IMF) headquartered in Washington D.C., United States. iMFdirect posts content related to the IMF’s work in economics and finance at global or national level, and posts currently highlight the debate over policy responses to the biggest global recession since the Great Depression. The IMF is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world. (EconMatters author archive here)
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