literature review on fiscal policy

The effectiveness of fiscal policy: contributions from institutions and external debts

Journal of Asian Business and Economic Studies

ISSN : 2515-964X

Article publication date: 30 May 2018

Issue publication date: 16 July 2018

The effectiveness of fiscal policy is an interesting field in literature of macroeconomics. The purpose of this paper is to investigate the effects of fiscal policy on economic growth under contributions from the differences in institutions and external debt levels.

Design/methodology/approach

The authors use panel data from 2002 to 2014 from 20 emerging markets and use GMM estimators for unbalanced panel data.

The results show positive growth effects of fiscal policy across emerging markets in the examined periods. Notably, the improvement in institutions promotes higher crowding-in effects of fiscal policy. In addition, this paper finds interesting evidences that the external debt has non-linear effects on economic growth, whereas the heterogeneous effects of fiscal policy on economic growth as positive effects in low indebted level and negative effect in high indebted level may explain the mechanism of this non-linear relationship.

Originality/value

This study proposes the non-linear relationship of fiscal growth effects in emerging economies under the dynamic of debt levels.

• Institutions
• Effectiveness
• Fiscal policy
• External debt

Phuc Canh, N. (2018), "The effectiveness of fiscal policy: contributions from institutions and external debts", Journal of Asian Business and Economic Studies , Vol. 25 No. 1, pp. 50-66. https://doi.org/10.1108/JABES-05-2018-0009

Emerald Publishing Limited

Copyright © 2018, Nguyen Phuc Canh

Published in the Journal of Asian Business and Economic Studies . Published by Emerald Publishing Limited. This article is published under the Creative Commons Attribution (CC BY 4.0) licence. Anyone may reproduce, distribute, translate and create derivative works of this article (for both commercial and non-commercial purposes), subject to full attribution to the original publication and authors. The full terms of this licence may be seen at http://creativecommons.org/licences/by/4.0/legalcode

1. Introduction

The field of the effectiveness of fiscal policy has re-highlighted in light of the 2008 global financial crisis with the new contemporary drivers such as external debt ( Ruščáková and Semančíková, 2016 ). Due to the complexity of the fiscal process by which it is not fully captured, different theories provide different answers regarding macroeconomic effects of fiscal policy and arguments about the suitability and real effects of government expenditures on economic growth which are still interesting field of study ( Bouakez et al. , 2014 ). Whereas, the main question in the literature of the fiscal policy’s effectiveness is that whether fiscal policy presents crowding-out and/or crowding-in effects in a country and what its drivers. In fact, many researchers try to find evidences with the parallel existence of both and mixed conclusions (see Ahmed and Miller, 2000 ; Heutel, 2014 ; Şen and Kaya, 2014 ).

The effects of fiscal policy on economic growth are driven by many factors such as the employment in the economy, the transparency of government, the composition of government expenditures, or even the government size (see Kasselaki and Tagkalakis, 2016 ; Hemming et al. , 2002 ). In empirical literature about the determinants of fiscal policy’s effectiveness, there are, in fact, some studies that consider the role of institutional framework such as corruption situation, economic freedom, democracy (see Baldacci et al. , 2004 ; Martinez-Vazquez et al. , 2007 ). Meanwhile, the burdens of external debt on the sustainability of fiscal policy are also concerned. For instance, Amato and Tronzano (2000) find the evidence that the debt maturity and the share of foreign-denominated debt are crucial determinants of exchange rate stability in Italia. Bal and Rath (2014) find that Indian economic growth is impacted by central government debt, total factor productivity growth, and debt-services in the short-run. Recent study, Doğan and Bilgili (2014) find that external borrowing has negative impact on growth both in regime at zero and regime at one, but the public debt has higher negative effects on economic growth and development, thus they conclude a non-linear relationship between economic development and borrowing variables. However, the literature of fiscal policy is lacking of the studies about the effectiveness of fiscal policy under the contributions from the institutions and external debts in a comprehensive work. Therefore, this study is conducted under the motivations from the study of Doğan and Bilgili (2014) by investigating the effectiveness of fiscal policy on economic growth under the relationships with the changes in the institutions and the burdens of external debt in the context of 20 emerging markets including Argentina, Bangladesh, Brazil, Bulgaria, China, Colombia, Egypt, India, Indonesia, Malaysia, Mexico, Pakistan, Peru, Philippines, Romania, Russia, South Africa, Thailand, Turkey, and Vietnam.

In this paper, we achieve our objectives by implementing following strategy. We first examine the impacts of fiscal policy on economic growth through the modified model of endogenous growth theory by incorporating government expenditure and controlling other common drivers of economic growth including capital, labor, financial development, technology, economic openness (trade and capital flows). Then, the institutional factors including government effectiveness, regulatory quality, and control of corruption are incorporated, respectively, to test the impacts of institutions on economic growth. Next, we use the interaction terms between government expenditure and institutions to examine the effectiveness of fiscal policy under the associations of institutional framework. We then estimate the growth model with the explanatory variables including both external debt level to GNI and its square to examine the non-linear relationship between external debt and economic growth. After that, we divide our data into two sub-samples (the low indebted countries and high indebted countries) to investigate the effectiveness of fiscal policy under two regimes.

By doing this strategy, we believe that this study has significant contributions to both theory and practice. First, this study has contribution to the literature of fiscal policy effectiveness and fiscal indebtedness by adding the effects of government expenditures under the external debt level and the associations with institutional quality. The results find significant evidences that the institutions enhance the effectiveness of fiscal policy. Notable, the external debt level presents the non-linear relationship with economic growth through the mechanism that the fiscal policy has the heterogeneous effects on economic growth: the crowding-in effect in low indebted level and crowding-out effects in high indebted one. Second, this study has significant implications for the authorizers in implementing the long-term sustainable fiscal policy in line with borrowing policy and the solutions for the high indebted countries that face to the dilemma of ineffective fiscal policy.

This paper is structured as following. Section 1 states our motivations of this study. Section 2 briefly presents literature reviews and then our arguments on the effectiveness of fiscal policy under the contributions from institutions and external debt. Methodology and data are provided in Section 3 . Section 4 presents the results and our discussions. The concluding remarks are discussed in Section 5 .

2. Literature reviews

The fiscal policy is considered with a wide range of literature, while the effectiveness of fiscal policy is seen under its’ impacts on the economic growth and the long-term sustainable development. In the literature of fiscal policy effectiveness, it is natural place to start with the Keynesian theory. In Keynesian model, the sticky price and excess capacity are assumed that contraries to the classical economics, so that aggregate demand determines output and government expenditures have a multiplier effect on aggregate demand and output ( Coddington, 1976 ). This view is also called as the crowding-in effects of fiscal policy, where the government should undertake the expenditure in the recession time to cover the lack of private consumption and investment ( Jahan et al. , 2014 ). However, some of extensions in the line of Keynesian model allow for crowding-out effects of fiscal policy, which means the expansion of government expenditure crowds out the private demand and then influences negatively on output, through the changes in interest rates and exchange rate in the case of open economy. With the assumption that the private investment is negative impacted by the increase in interest rate, the expansionary fiscal policy that backed by borrowing leads to the lower private investment due to higher interest rates (see Mundell, 1963 ; Fleming, 1962 ).

The neo-classical views focus on the determination of goods, outputs, and income distributions in markets through both supply and demand sides by adding the assumption of utility maximization of income-constrained individuals and firms under the boundary of factors in production and available information (see Davis, 2006 ). In which, the neo-classical economics raise the rational expectations in comparing to the adaptive expectations in Keynesian economics. This brings forward adjustments in economic factors that occur more progressively so that fiscal policy matters in not only long-term but also short-term period. And the permanent fiscal changes can lead to the crowding-out effects since private sectors expect the persistent changes in interest rates and exchange rates in this case (see Buiter, 1977 ; Arestis, 1979 ; Mundell, 1963 ; Fleming, 1962 ).

In addition to neo-classical economics, the Ricardian view that is based on Ricardian equivalence theorem assumes that the individuals are forward-looking in the current activities, which is also in contrasting with the Keynesian economics view as individuals rely on current income (see Barro, 1989 ; McCallum, 1984 ). In Ricardian view, individuals anticipate a present tax cut as higher government borrowing that turns into the higher taxes in the future so that there is no change in permanent income. This condition in along with the assumptions of no liquidity constraints and perfect financial markets lead to no change in private consumption in general ( Barro, 1974 ). Thus, Ricardian view suggests neither crowding-in nor crowding-out effects of fiscal policy ( Arestis, 2011 ; Şen and Kaya, 2014 ). However, if governments change lump-sum taxes for the fiscal policy, the features of progressive taxes will have impacts on permanent income and then the aggregate demand and output. As a result, the effectiveness of fiscal policy most likely depends on how it is paid in the future and the productivity of government expenditures ( Hemming et al. , 2002 ).

All above economic views require assumptions to be presence such as no liquidity constraints, perfect financial markets in Ricardian equivalence. However, these assumptions are usually un-existed thus the significance of theories is questioned in both theory and practice ( Haque and Montiel, 1989 ). Furthermore, there are some cases that the effectiveness of fiscal policy is explained by all of these views. For instance, if government is restricted by the fiscal rules to balance the fiscal budget in the long run, thus individuals may partial adjust their behaviors if they have short-term horizon which presents the presence of both Ricardian and neo-classical views. In the same idea, if the current path of government debt is not sustainable and future tax increases will be required to lower the debt, the Ricardian view may be presence in expansionary fiscal policy seemingly with the Keynesian view which depends on the level of public debt ( Sutherland, 1997 ). Or, if the government expenditure is in line of an upward-trending stochastic process that individuals believe a sharply fall when it approaches a specific “target point,” there will be a non-linear relationship between private consumption and government expenditure ( Bertola and Drazen, 1993 ). Therefore, the argument of a non-linear relationship between fiscal policy and economic growth makes sense in literature. However, the literature needs the explanations for the mechanism and empirical evidences.

Many previous studies have investigated the effects of fiscal policy in many countries, especially in advanced countries such as USA, Japan, European area [1] . Recently, Afonso and Strauch (2007) find that the European fiscal policy makes market swap spreads response in mostly around five basis points or less in 2002. Similarly, the study of Kameda (2014a) finds that an increasing of 26-34 basis points in real ten-year interest rates in responding to a percentage point increase in both the projected/current deficit-to-GDP ratio and projected/current primary-deficit-to-GDP ratios in Japan. Kameda (2014b) documents that the diffusion index of the attitudes of financial institutions have a definite impact on fiscal expansion effects. In particular, the government expenditure has non-Keynesian effects under the demand-enhancing effects if the existence of liquidity-constrained households when banks’ attitude toward lending is tight and the fiscal condition is bad. Bhattarai and Trzeciakiewicz (2017) use a DSGE analysis to examine the fiscal policy in UK. They note the highest GDP multipliers for government consumption and investment in the short-run, whereas capital income tax and public investment have long-run crowding-out effect on GDP. Moreover, they emphasize that the fiscal policy presents decreasing effects in a small open-economy scenario.

Besides the presence of plentiful empirical literature in the effectiveness of fiscal policy, this field of study got much less evidence on the short-term effects in developing countries due to data deficiencies, the structural/institutional factors in the last century (see Hemming et al. , 2002 ). For instance, Haque and Montiel (1989) find that the Ricardian equivalence is not supported in the developing countries due to liquidity constraints. Montiel and Haque (1991) go further by using the Mundell-Fleming model with rational expectations and full employment for 31 developing countries and conclude that the increasing of government expenditures have contractionary short-term and medium-term effects. Previous, Khan and Knight (1981) find positive nominal income elasticities of government expenditures and taxes and they are close to unity in 29 developing countries. Then, other empirical studies such as Easterly et al. (1994) document evidences that fiscal policy has crowding-out effects on private investment through the impacts on interest rates in developing countries. Meanwhile, empirical studies also provide evidences supporting for partial or/and fully existences of the Ricardian equivalence in developing countries such as Masson et al. (1995) , Giavazzi et al. (2000) .

However, the economic development in emerging market economies, which is a new definition of the development level of economies and nearly relating to the developing countries definition, boosts their roles in the world economy. In addition, the better fulfill of data have re-highlighted the interesting in investigating the effectiveness of fiscal policy by adding more methods and conditions into model for this group. For example, Cuadra et al. (2010) note that emerging market economies typically exhibit a pro-cyclical fiscal policy, where governments increase (decrease) expenditures in economic expansions (recessions) and rise (reduce) tax rates in bad (good) times. This situation is in line with the characteristic of counter-cyclical default risk in their business cycle. They also note that the incomplete markets and sovereign default risk premium have important roles in explaining the pro-cyclicality of public expenditures and tax rates in these economies. Therefore, the assumptions of Ricardian view are not existed that propose for the Keynesian or neo-classical views of fiscal policy.

No surprising that the debate on the role and the effectiveness of fiscal policy are continuous argued broadly in both literature and practice. Recently, Arestis (2011) notices that the “New Consensus in Macroeconomics,” recent developments in macroeconomics and macroeconomic policy, downgrades fiscal policy’s roles in contrasting with monetary policy due to its ineffective. Through a careful literature review and discussion at recent developments on the fiscal policy literature, he then concludes that fiscal policy does still have significant roles in economic policy through its impact on allocation, distribution and stabilization. However, researchers and authorizers have to careful consider the assumptions in economic theories of fiscal policy’s effectiveness as Ricardian and non-Ricardian economic existences, liquidity-constraints, and the endogenization of labor supply and capital accumulation. Meanwhile, other features of the economy should be considered in study the effectiveness of fiscal policy such as the institutional framework and the debt burden.

The dependence of fiscal policy’s effectiveness on institutional aspects is discussed under the literature with two main strands including the inside and outside lags of effects and the political economy considerations ( Hemming et al. , 2002 ). First, the fiscal policy has inside and outside lags, where the inside lags present the needed time to see that fiscal policy should changes, the outside lags are the function of the political process and the fiscal management that is the time for fiscal measures take effects on aggregate demand ( Blinder and Solow, 1974 ). Due to the long time to design, approval, and implementation, the inside lag may be longer, while the outside lag is more variable depending on the institutional environment. Second, the fiscal policy is impacted by the political considerations such as the fiscal illusion of public and policy-makers, the favor of transferring current fiscal burden to future generations, the limitation of government due to the debt accumulation, the delay of fiscal consolidations due to the political conflicts, and the function of current budget institutions that leads to high spending.

The institution is defined as the social rules of the game ( North, 1990 ), which includes “humanly devised,” “the rules of the game” to set “constraints” on human behavior, and the economic incentives (see North, 1981 ; Acemoglu and Robinson, 2008 ). The better institutions reduce asymmetric information problem, transaction cost, and risk, while they improve the market efficiency, especially efficiency of asset allocation ( Cohen et al. , 1983 ; Ho and Michaely, 1988 ; Williamson, 1981 ). Therefore, the better institutions should have positive associations with the effectiveness of fiscal policy since the lower asymmetric information problem, transaction cost, and higher market efficiency reduce both the inside and outside lags that then increase the efficiency of fiscal policy, especially the short-term effects.

The empirical literature in the field of fiscal policy had considered the role of institutional framework in some manners such as politics, democracy, economic freedom, and corruption in recent decades. Nelson and Singh (1998) , for instance, argue that a democratic political system permits active in a voluntary way, at the same time it creates competitive market forces conditions for economic growth. They also emphasize that the ineffective democracy regimes in developing countries detriments the growth. Lockwood et al. (2001) add that the political pressures determine the path of government spending, taxations and borrowing in Greece in the period 1960-1972, which means the fiscal policy may not follow a long-term efficiency for the country. Martinez-Vazquez et al. (2007) notice that the elimination of corruption is not usually an economic objective for the development, but the frustration with the lack of effectiveness of traditional economic theories and the recognition of the important roles of institutions and good governance practices have led the more attention to the corruption. Precisely, Dimakou (2015) finds that corruption constrains the fiscal capacity in taxations and increases the inflationary reliance.

However, no comprehensive study has considered the fiscal policy’s effectiveness under the institutional framework. More interesting, it lacks of empirical study in emerging market economies, which have more space in improving institutional quality and the economic growth. For example, the study of Aidt et al. (2008) document that corruption has a substantial negative impact on economic growth in high institutional quality economies, otherwise it has no impact on economic growth in low quality one. Ho et al. (2016) find that the improvement in country governance just enhances the effectiveness of banks and then promote the economic growth in developing countries, while it reduces these effects in developed countries due to smaller spaces for improvement. In addition, Wang et al. (2014) argue that the improvements in institutional quality just have strong effects on promoting economic development only when institutional quality is within a certain range. Therefore, we can argued that the improvement in institutions has strong impacts on the effectiveness of fiscal policy in emerging market economies.

The debt burdens, on the other hand, are also concerned in the literature of fiscal policy effectiveness. According to the review of Hemming et al. (2002) , the debt accumulation may be used as a strategic instrument to limit the fiscal capacity for future government, while the availability and cost of domestic and external borrowings are often major tackles on fiscal policy in developing countries. Thus, an emerging market economy with highly level of debts will determine the size of fiscal deficit in facing with more difficulties in assessing to international capital market (inaccessible or accessible with unfavorable terms), which then leads to the stronger crowding-out effects. Meanwhile, the low indebted countries have higher fiscal room for future government in implementing fiscal policy, which may undertake with the favorable terms of debt-financing, and that in turn promotes the crowding-in effects. Moreover, the individuals in high indebted countries are more sensitive to the government expenditures in following the framework of neo-classical views. The public may expect that the increasing of government expenditures in this case be in along with the less favorable terms of government’s borrowings and less efficiency of spending, which then stimulate individuals to cut back their current consumption more and more. As a result, this proposes higher crowding-out effects of fiscal policy. In contrast, the individuals in low indebted countries may less sensitive to the government expenditures, especially through the debt-financing spending, since the interest rates are less responsive and they are easier to access the financial markets, thus the fiscal policy is argued with the existence of crowding-in effects.

According to Kirchner and Wijnbergen (2016) , if banks hold substantially sovereign debt the effectiveness of expansionary fiscal is impaired since deficit-financed fiscal expansions reduce private access to credit in this case. Therefore, we use the total external debt, which includes public debt and private debt in this study to examine the impacts of debt on effectiveness of fiscal policy. This helps us consider the constraints of external debt of ability of private sector in accessing international financial markets. We argue that the expansionary fiscal policy in the highly indebted countries not only creates the crowding-out effects for the private sectors through the impacts on interest rates and exchange rates, but also crowds out the availability of private sectors in accessing into the international financial markets that creates more constraints for private sectors to implement economic activities. In contrast, these effects may not exist or less significance in the case of low indebted countries. As a summary, our hypothesis is argued that the relationship between fiscal policy with the economic growth is non-linear one as the positive effect in the low indebted level and the negative effect in the high indebted level.

In fact, the non-linear relationships between fiscal policy and economic factors are examined under some manners. Adam and Bevan (2005) investigate the relationship between fiscal deficits and economic growth for a panel of 45 developing countries and find evidence of a 1.5 percent GDP threshold deficit effect. They also find evidence that the deficits in line with high debt stocks exacerbates the adverse consequences of high deficits. While, Catão and Terrones (2005) examine inflation as non-linearly related to fiscal deficits through the sample of 107 countries over 1960-2001 period. They find a strong positive relationship between deficits and inflation among high-inflation and developing country groups, but it is not true among low-inflation advanced economies.

This fact suggests that we should consider the non-linear relationship between fiscal policy and economic growth in the emerging market economies. Emerging market economies are an emerging group of countries with interesting economic features in developing countries. While, the expected future revenue plays an important role in explaining the low fiscal limits of developing countries relating to developed countries ( Bi et al. , 2016 ). Therefore, the study of the relationships between institutions, external debts and the effectiveness of fiscal policy is more significant for both literature and practice. Next section presents the methodology and data.

3. Methodology and data

3.1 methodology.

In this paper, we recruit the common determinants of economic growth including capital, technology, labor, technology, capital flows, trade openness, and add the credit element for the basic model of economic growth from a vast of literature. With this beginning of basic model, we incorporate government expenditure to examine the impacts of fiscal policy on economic growth for 20 emerging market economies in the period 2002-2014, and follows the empirical model in Miller and Russek (1997) : (1) g i , t = ∂ 1 g i , t − 1 + ∂ 2 g d p p c i , t − 1 + α X t + β 1 G o v e x g i , t + ε t , s w i t h ε s ∼ i . i . d . N ( 0 , δ s , t 2 ) where i and t is country i at time t . g is GDP growth rate ( gdpg ) that proxies for the economic growth. The lag of g is put into the model to control for the dynamic of economic growth model, while the gdppc is logarithm of GDP per capita that presents for the starting economic development level. X is vector of control variables including: the capital investment factor that presented by the gross capital formation growth rate ( capg ); the labor factor that presented by the population growth rate ( popg ); the credit factor that presented by the logarithm of domestic credit to private sector by banks (credit); the technology factor that presented by the logarithm of total patent applications by both residents and non-residents (patent); the trade openness that presented by the logarithm of total trade to GDP (trade); and the capital flow that presented by the net inflows of foreign direct investment to GDP ( fdi ). govexg is the proxy for fiscal policy that presented by the general government final consumption expenditure growth rate. In this study, we use the government expenditure growth to proxy for the fiscal policy since it presents the changes in the fiscal policy, while the government revenue and tax have strong correlations with the government expenditure, thus in order to examine the fiscal policy effectiveness we only use the government expenditure. Even though the government expenditure can be best proxy for the fiscal policy.

All the definitions and sources of variables are presented in detail in Table I .

In next step, we also incorporate institutional factors into the model to investigate the effects of institutional quality on economic growth following the empirical model suggesting in Lee and Hong (2012) . In this step, we collect three dimensions of institutions from World Governance Indicators (Worldbank) including the government effectiveness ( Goveff ), regulatory quality ( Regu ), and control of corruption ( Concor ) to proxy for the institutional framework, respectively. Despite of critics about bias or lack of comparability and the utility of institutional quality in World Governance Indicators ( Thomas, 2010 ), there are many previous studies that use these indicators as the best proxies for institutional quality (see Zhang, 2016 ).

Next, we estimate the growth model with the explanatory variables including both external debt to GNI and its square to examine the non-linear relationship between external debt and economic growth. Basing on the results of these estimations, we then divide sample into two sub-samples basing on the level of external debt to GNI (see Table II ). Then, we apply the previous procedures to two sub-samples separately to investigate the effectiveness of fiscal policy under two debt regimes.

Our data are collected yearly from the period of 2002-2014 for 20 emerging countries [2] due to the time limitation in World governance indicators that have continuous data from 2002 to 2014. The government effectiveness, regulatory quality, and control of corruption are collected from World Governance Indicators, meanwhile all remained variables are collected from World Development Index (Worldbank). The data description is presented in Table II .

The data description shows that emerging market economies have high economic growth presenting by both average growth rates of GDP and GDP per capita. It is also noticed that they have high growth rate of investment in line with the target of FDI flows. Meanwhile, the institutional framework has wide space for improvement since their average levels are around the zero level (in the range from −2.5 to +2.5 in World governance indicators report). In addition, the governments in emerging market economies are almost under the expansionary phrases since their general government consumption growth rates are positive, but it may diversify among countries due to the high standard deviation.

4. Results and discussions

All our results are presented in the tables from Tables IV-VIII . In which, the estimators are presented with AR(2) test and Hansen/Sargan test depending on the first difference or system GMM methods. All the p -value of AR(2) test and Hansen/Sargan test are over 10 percent, which define the significance of GMM estimators as suggesting in Roodman (2009) .

Model (1) in Table III shows the results for basic model of economic growth. The significant positive impact of lag economic growth to itself shows that the higher economic growth in current year creates better conditions for growth in next year. This is easy to understand that the higher economic growth rate provides more sources such as capital and incentives for economic activities. While, the significant negative effect of log of GDP per capita with lag on economic growth suggesting the convergence trend in economy among emerging market group. Other control variables including capital formation, population growth, technology, foreign direct investment inflows, and trade openness have signs as expected by theories. It is easy to understand that the increasing of capital, labor, credit, inflow capital, trade openness, and innovations in technology have positive impacts on economic growth, especially in the case of emerging market economies that have space for all of these above drivers to contribute on growth. The results are consistent with literature and many previous empirical results. However, the insignificant positive effect of domestic credit on economic growth points out the argument that the financial markets in emerging market economies do not contribute enough to the growth.

With main explanatory variable, the growth rate of general government expenditure has significant positive effect on economic growth. This result suggests the existence of crowding-in effects of fiscal policy in the context of emerging market economies. Thus, our result supports for the Keynesian views of fiscal policy that the fiscal policy is needed to promote the economic growth in the emerging market economies since the sources for the growth from the private sectors are still limited at there and the roles of governments in creating the basic start for the development of other sectors. In addition, the public sectors still strongly present in emerging market economies through the state-owned enterprises so that the fiscal policy has significant impacts on the whole economy through its effects on public sectors.

The most important of our study, the impacts of institutions on the effectiveness of fiscal policy are examined and presented in Tables IV and V . The estimators prove that the improvement in institutions including aspects of government effectiveness, regulatory quality, and control of corruption enhances the effectiveness of fiscal policy in emerging market economies. In fact, all the interaction terms between government expenditure growth rate with each institutional indicator have positive impacts on economic growth. These results confirm our arguments that the better institutional framework helps boosting the effect of fiscal policy. This fact suggests that the better institutional quality reduces the crowding-out effects (reduces neo-classical effects) and promotes the crowding-in effects (enhances the Keynesian effects) of fiscal policy in emerging market economies. This finding has strong contributions to both literature of fiscal policy and practice in implementing fiscal policy in the context of emerging market economies. The essential requirements for the more effective fiscal policy are macro-measures to improve the institutional environment. This result also recommends that the empirical study in the field of fiscal policy should consider the institutional framework of countries that would be a potential explanatory factor. We then incorporate the external debt into the economic growth model to test the non-linear relationship. The results are provided in Table VI .

The significant positive coefficient of external debt level and significant negative coefficient of square of external debt level suggest that the external debt and economic growth has a non-linear relationship. This result is consistence with our discussion and theory, which shows strong implications for the long-term fiscal policy consolidations. Whereas, the government has to implement fiscal consolidation for the long-term sustainability of the economy. The negative coefficient of square of external debt level means that the external debt is in line with the higher economic growth when it is in low level; it is in line with lower economic growth when it is in high one. This result also requires deeper investigation for the mechanism of this non-linear relationship. The results in Tables VII and VIII provide us some interesting explanations.

By dividing the sample into two sub-samples: the low indebted countries (group 1) and high indebted countries (group 2) and regress the impacts of government expenditure and institutions on economic growth. We find that the increasing in government expenditure in group 1 has significant positive impact on economic growth, while it has insignificant negative impact in the group 2. The results suggest that the fiscal policy is effectiveness in stimulating the economic growth when countries have low debt burden, but it loses the effectiveness when countries face to high burdens of external debt. These findings are consistence with literature and our arguments. This means that the high indebted countries have less fiscal room and the unfavorable terms in accessing the international financial markets, while the high level of external debt creates constraints for the private sectors so that their fiscal policies present the crowding-out effects. We believe that the findings have significant contributions for literature, especially for the practice of fiscal policy. In addition, the results in Table VIII provide us additional interesting facts. While the fiscal policy is more effectiveness in the low indebted countries, the institutions are more effective in promoting economic growth in high indebted countries. This result suggests a very useful measure for the high indebted countries that they should not promoted to use the fiscal policy to stimulating economic growth, otherwise they must improve the institutional framework. As stated in previous findings, the fiscal policy presents crowding-out effects in the high indebted countries so that they face to the dilemma if they want to use fiscal policy to promote economic growth: they want to use the fiscal policy but they have less fiscal room, while they are under the burden of external debts and it makes fiscal policy less effective. Therefore, the rightful choice in this situation is institutional improvement and revolution.

5. Conclusion

This study collects the annual data from World Governance indicators and World Development Indicators of Worldbank for 20 emerging markets in the period 2002-2014 to examine the effectiveness of fiscal policy in the relationships with institutional framework and external debt burden. Applying the endogenous growth model with the common elements of economic growth including labor, capital, technology, credit, trade openness, and capital flow, we then incorporate the government expenditure to investigate the effective of fiscal policy. As our most notable contributions, we examine the impacts of institutions on the effectiveness of fiscal policy through the interaction terms between government expenditure and institutional indicators including government effectiveness, regulatory quality, and control of corruption. In addition, we examine the non-linear relationship between external debt and economic growth, where this relation is investigated more detail for its mechanism through the fiscal policy. Through GMM estimators for panel data, the study presents some meaningful findings.

First, the fiscal policy presents the crowding-in effects in emerging market economies in the period of 2002-2014. This result confirms the important role of fiscal policy in the case of emerging market economies, it is also consistence with our arguments and theory of Keynesian views. In fact, the emerging market economies present with the low level of capital accumulations, the low level of financial development so that the interest rates may not be too sensitive with the fiscal policy, while the fiscal policy is essential to build the basic infrastructure for the economic activities of private sectors. Thus, the fiscal policy is effective in promoting economic growth. This result suggests that Vietnam should consider the fiscal policy as an effective policy in tackling the downturn of the economic growth. Second, even the fiscal policy has positive effects on economic growth; the study finds interesting evidences that fiscal policy loses this effect in the case of high indebted countries. The results have significant contributions to both theories and practice. Whereas, the external debt creates constraints for the effectiveness of fiscal policy, especially in the case of high indebted countries. This relationship may explain the mechanism for the non-linear relationship between external debt and economic growth. Third, we find evidences that the improvement in institutions boosts the effectiveness of fiscal policy. This notable finding has very useful contributions to literature and implications for the practice in the case of emerging market economies. In which, the institutions under aspects of government effectiveness, regulatory quality, and control of corruption enhance the positive impacts of government expenditure on economic growth. In addition, the empirical results also suggest us essential measures for the government in dilemma of ineffective fiscal policy when they are in high indebted level that they should focus on the institutional improvement, which enhances the effectiveness of fiscal policy in one hand, it has positive impacts directly on economic growth on the other hand.

Variables, definitions and sources

Data description

Government expenditure and economic growth

Note: *,**,***Significant 10, 5 and 1 percent levels, respectively

See Hemming et al. (2002) for the more detail summary.

In total, 20 emerging markets are defined in introduction section and the number of emerging market economies is due to the availability of data.

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Acknowledgements

This paper is funded by the University of Economics Ho Chi Minh City.

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Fiscal policy and economic growth: some evidence from China

• Original Paper
• Published: 10 May 2021
• Volume 157 , pages 555–582, ( 2021 )

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• Jungsuk Kim   ORCID: orcid.org/0000-0002-5574-1303 1 ,
• Mengxi Wang 1 ,
• Donghyun Park 1 &
• Cynthia Castillejos Petalcorin 1  

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China has experienced profound economic and social changes in recent decades. During this period, China’s fiscal policy framework has been substantially reformed. The objective of this paper is to better understand the key features of the Chinese fiscal system and their impact on China’s economic growth. The study performs empirical analysis to identify the relationship between fiscal policy variables and economic growth. Its evidence suggests that local expenditures growth has a larger impact on output growth than central expenditures growth. The results also reveal that the response of output growth to anticipated changes in taxation was impeded by liquidity constraints. During the initial stages of market-oriented reform, growth of public investment in manufacturing sector contributed the most to output growth. During more recent periods, public investment in R&D made a substantial contribution. In addition, evidence indicates that long-term debt has a significant influence on China’s fiscal system, especially on government revenues.

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1 Introduction

The strategic challenge facing Chinese policymakers is to ensure a gradual and smooth transition toward a more sustainable growth paradigm while maintaining healthy growth rates. The COVID-19 pandemic further strengthens the case for sustainable growth which protects the environment and benefits the poor. While Chinese policymakers have a number of policy tools at their disposal, fiscal policy—i.e. taxation and government expenditure is likely to be at the front and center of any policy package which can help China build back better after the pandemic. For example, fiscal spending on social safety nets may reduce risk and uncertainty facing households and thus encourage them to save less and spend more, thus strengthening domestic demand and economic recovery. Likewise, fiscal spending on COVID-19 vaccines can restore the health of the workforce and reduce social distancing restrictions which limit mobility, thus paving the way for the normalization of economic activity. Furthermore, an effective taxation system is needed to secure the fiscal resources for fiscal spending that promotes sustainable growth.

More generally, fiscal policy can influence economic growth through both macroeconomic and microeconomic channels (IMF, 2015a ). At the macroeconomic level, fiscal sustainability is the cornerstone of macroeconomic stability, which, in turn, is indispensable for economic growth. When the government spends more than its income—i.e. tax and non-tax revenues it collects on a sustained basis, the inevitable outcome is macroeconomic instability, which creates uncertainty among companies and deters private investment. At the microeconomic level, both taxes and spending can influence the behavior of firms in ways that can promote growth. For example, well-targeted tax incentives can promote greater investment by companies and foster higher productivity through research and development (R&D). Another example is public spending on education and health care, which contribute to human capital formation, a core ingredient of economic growth.

The central objective of our paper is to empirically examine the relationship between fiscal policy and economic growth in China. The effectiveness of China’s countercyclical fiscal response to the global financial crisis highlighted the sizable impact of fiscal policy on short-term growth. However, in this paper, we are interested in the effect of fiscal policy on China’s growth beyond the short term.

Our paper contributes to the existing empirical literature on the nexus between fiscal policy and economic growth in China in a number of ways. Above all, we look at the growth impact of not only central government’s fiscal policy but also the impact of local governments’ fiscal policy. In light of the substantial role of local governments in China’s fiscal policy, examining the impact both central and local governments on China’s economic growth gives us a more accurate understanding of the effect of fiscal policy on China’s growth. In addition, our empirical analysis is enriched and extended in several significant directions. In particular, we incorporate both investment and external debt into our empirical analysis of the link between fiscal policy and economic growth in China. Furthermore, we divide the sample period into three different sub-sample periods of China’s economic development. In addition, our analysis distinguishes between automatic fiscal policy and discretionary fiscal policy.

Our econometric analysis yields a number of interesting findings. Our evidence suggests that local government expenditures have a larger impact on output growth than central government expenditures or net taxes. In addition, both government expenditure and net tax multipliers seem to change during the course of a business cycle. However, net tax growth becomes relatively but progressively more influential in the long run. The rest of this paper is organized as follows. Section  2 briefly reviews the relevant literature, Sect.  3 describes the data and methodology, Sect.  4 reports and discusses the empirical results, and Sect.  5 concludes the paper.

2 Literature review

There is a growing literature on the relationship between fiscal policy and economic growth. Through government expenditure and taxation, fiscal policy can have lasting effects on medium- and long-term economic growth through several major channels. However, the mix of appropriate policies will depend on the idiosyncratic conditions, capacities, and preferences of each country (IMF, 2015b ). The country-specific nature of policy mix ensures that the policy track is sustainable in the short- and long run and also enhances the credibility of authorities (Kumhof et al., 2010 ).

Fiscal policy can promote economic growth through both macroeconomic and microeconomic channels. At the macroeconomic level, sound and responsible fiscal policy can affect aggregate demand and stabilize the economic cycle, thus boosting business confidence, investment, and long-term growth. At the microeconomic level, fiscal policy can impact private sector behavior via encouraging employment, investment, and productivity. (IMF, 2015b ; Gerson, 1999 ). For example, efficient public investment in infrastructure can boost the productivity of all firms and industries, and reforming capital income taxes can encourage private investment. It is also important to understand the feedback between microeconomic effects and aggregate effects (Ramey, 2009 ).

The distinctive features of new Keynesian conditions include imperfect competition, forward looking expectations by individuals and firms, and some form of rigidity in prices or wages. New Keynesian model arguably remains the dominant framework in most policy modeling (Gali, 2018 ). Since policy interest rates fell to their near-zero levels in the aftermath of the 2009 global financial crisis (GFC), there is a renewed enthusiasm in new Keynesian models to examine fiscal policy effectiveness at the zero lower bound of nominal interest (e.g. Christiano et al., 2011 ; Eggertson, 2009 ).

Policymakers around the world turned to fiscal stimulus packages to support economic growth during GFC (Ramey, 2009 ). US and European countries adopted countercyclical fiscal policies, including tax cuts and government purchases, mainly to boost short-run and medium-run growth (Ramey, 2009 ). Many economies in developing Asia too implemented countercyclical fiscal policy to support domestic demand during the global crisis (Jha et al., 2014 ). In comparing the magnitude of government spending multipliers in US, Cogan et al., ( 2010 ) found out that the GDP and employment impacts estimated by using new Keynesian model are much smaller than the estimates from old Keynesian models.

A growing number of studies on advanced economies based on various modelling refinements provide a mixed picture of size of the fiscal multiplier. For fiscal policy to be effective, the government multiplier should be large to make a difference in the direction of the economy. However, multipliers are largely dependent on varying country-specific circumstances (Ramey & Zubairy, 2014 ). Distinguishing between recessions and expansions, Riera-Crichton et al. ( 2014 ) found out that the response of the economy to changes in government spending is asymmetric. The long-run multiplier for bad times is 2.3 compared to 1.3 for good times, and up to 3.1 for extreme recessions. On the other hand, using US quarterly data covering wars and recessions, Ramey and Zubairy ( 2014 ) found that the estimated multipliers are below 1 irrespective of the amount of slack in the economy. But the results are more mixed for the lower zero bound state, with some specifications producing multipliers as high as 1.5. An extensive literature review by Hemming et al. ( 2002 ) concluded that fiscal multipliers are overwhelmingly positive but small. In a study of 10 developing Asian economies in 1985–1999, Jha et al. ( 2014 ) computed the tax-cut multipliers to be 2.0 at its maximum over a two-year horizon while government expenditure multipliers are around 1.0.

A number of empirical studies support a positive relationship between fiscal policy and medium- and long-term economic growth. In advanced economies, the growth effect can be as high as 0.75 percentage points and even higher in developing countries. For example, IMF ( 2015c ) finds that automatic fiscal stabilizers help prevent public debt accumulation and foster growth. Tax reform can lift long-term growth by as much as 0.5 percentage points while shifting the composition of government spending toward infrastructure can add 0.25 percentage points. Baldacci et al. ( 2010 ) concluded that fiscal deficit reductions based on broadening the tax base while maintaining public investment can support medium-term growth in both advanced and developing countries. Finally, macroeconomic instability associated with large fiscal deficits distorts price signals and thus causes volatility of returns on investment and misallocation of resources, see Fatás and Mihov ( 2013 ) and Fisher ( 1993 ).

The existing literature encompasses various empirical methodologies for assess the effect of fiscal policy shocks. The Cholesky identification approach assumes that fiscal policy variables and output variables do not have any structural effects on each other (e.g. Fatás & Mihov, 2001 ; Favero, 2002 ). The sign restriction approach, popularized by Uhlig ( 1997 ), identifies fiscal policy shocks using sign restrictions on impulse responses. The approach is traditionally used to assess the impact of monetary policy shocks (Mountford & Uhlig, 2002 ). Another is the strand of empirical studies which includes Romer ( 1994 ); Ramey and Shapiro ( 1999 ); Edelberg et al. ( 1998 ) and Blanchard and Perroti ( 1999 , 2002 ). These studies distinguish between automatic policy and discretionary policy, and estimate the elasticity of tax on output using external information. Sims and Zha ( 1999 ) presented several issues related to the calculation of error bands using Monte Carlo integration, bootstrapping, and impulse response functions (IRFs) for structural vector autoregression (VAR). The methodology was further developed and refined by Perotti ( 2002 ). In contrast to monetary policy, decision and implementation lags in fiscal policy imply that there is limited scope for discretionary fiscal policy in response to unexpected movements in economic activity within a quarter.

Fiscal policy is making a substantial contribution to China’s economic growth. For instance, a massive countercyclical fiscal stimulus during the GFC prevented a recession in China and contributed to the recovery of other emerging and developing economies (Fardoust et al., 2012 ). China's forceful fiscal response was made possible by the fact that China had ample fiscal space when the GFC hit. Kong and Feng ( 2019 ) find that China’s fiscal policy is generally countercyclical and achieves its desired economic effects. Interestingly, a tax cut is found to have a positive impact on output in China (Jha et al. 2014 ; Kong & Feng, 2019 ). This can be attributed to taxation's function in promoting a more efficient resource allocation. For instance, Lam and Wingender ( 2015 ) find that improving the progressivity of personal income taxes, introducing property taxes, and setting up a comprehensive value-added tax can promote China’s growth and boost fiscal revenues as well as reduce fiscal deficit.

Some studies have estimated China’s fiscal multipliers. Using the IMF’s GIMF model, Kumhof et al. ( 2010 ) find fiscal multipliers for China are broadly in line with United States. Chen et al. ( 2017 ) estimated that China’s fiscal multiplier increased from 0.75 in 2001–2008 to 1.4 in 2010–2015, with the biggest impact on the manufacturing sector. Using annual data for 1,800 Chinese counties, Guo et al. ( 2016 ) obtained local government fiscal multipliers of approximately 0.6, which is much lower than the estimates of most previous studies. The effects of local public spending were most pronounced in non-tradable industries. Cove et al. (2010) calibrated New Keynesian model to China and finds that public expenditures which are managed by the local authority and can be financed by raising taxes on local households and issuing local government debt can have New Keynesian effects on output growth. Some province-level studies imply that that fiscal decentralization contributed to higher economic growth (Lin & Liu, 2000 and Jin et al. 2005 ).

3 Empirical framework

In this section, we describe the data and empirical framework used in our analysis. For developing countries such as China, monthly data are difficult to find even in statistical yearbook, so we use statistical way to transfer the yearly data into monthly data. For the Dickey-Fuller test and Phillips-Perron test, we converted all variables to first differences of natural logarithms to address the unit root problem in level data. Table 1 below lists the sources of our data and Table 2 below summarizes the mean values of data in three sub-periods—1985–1997, 1998─2007, and 2008─2015. The period from 1985 to 1997 marks the pre-Asian financial crisis (AFC) period, 1998–2007 is the period between AFC and global financial crisis (GFC), and 2008–2015 is the post-GFC period. To compare the effect of fiscal policy in the three sub-periods, we also denoted the three sub-periods from economic structure reform perspective. The 3 sub-periods are domestic demand-oriented model, three-wheel-oriented (investment, consumption, and trade) model, and export-oriented model, and they track the evolution of China’s economic structure. For the identification of the fiscal policy shocks, the variables in the first structural model—government expenditure model are central government expenditure, local government expenditure, net tax, fixed asset investment, and gross domestic product per capital (GDP per capital).

In the Cholesky decomposition approach, there are several methods for estimating the precision matrix. For example, the order can be selected thorough comparison of the cross-correlation coefficients from the data, Granger causality verification, impact response function, or decomposition of expected error term (Chang & Tsay, 2010 ; Chen & Leng, 2015 ; Park, 2020 ; Wagaman & Levina, 2009 ). But in many applications, the variables often do not have a natural order. That is, the justifiable variable order is not available or the pre-determination of the variable order is not possible before the analysis (Xiaoning & Xinwei, 2020 ). When using structural VAR, one may order the variables with an economic rationale and in this case, the order would be specified by the author’s own matrix (Ludvigson et al., 2020 ).

According to de Castro Fernández & Hernández de Cos ( 2006 ), in the ordering between variables such as taxes and expenditure, it could be quite difficult to fully justify which one should come first. Nevertheless, this choice does not seem to substantially affect the main results, mainly due to the low and non-significant correlation between expenditure and net-tax shocks. In this regard, we decided to re-estimate under the alternative assumption that taxes or consumption come first. Since the residuals of reduced-form in the expenditure and net-tax equations showed low and non-significant correlation, the differences with the baseline VAR results, if any, were minimal. As a matter of fact, none of the variables under analysis showed different response profiles and the output multipliers were almost identical.

Barro ( 1990 ) assumed that government expenditure is financed contemporaneously by a flat-rate income tax which is 0.25 for the Cobb–Douglas case. In our study, we removed the substitution effect between government expenditure and tax through applying 75% of tax as the original tax before regression. Then we follow Perotti ( 2002 ) to build up a model including net tax but without division of the government sector into central versus local government. Table 3 below shows the summary statistics of the main variables.

The structural vector autoregression (SVAR) model can be formed as below:

Perotti ( 2002 ) divides fiscal policy into discretionary measures and automatic stabilizers. The effectiveness of discretionary measures is quantified by the size of the multipliers while the effectiveness of the automatic stabilizer is measured by the magnitude of an exogenous shock that fiscal policy can smoothen out. The formula to calculate net tax is:

The orthogonalization matrix \(P_{s} = A^{ - 1} B\) is then related to the error covariance matrix by \(\Sigma = P_{s} P_{s}^{^{\prime}}\) in the short-run SVAR model.

The variables in the second structural model—the investment model—are investment in infrastructure, investment in manufacturing, investment in R&D, net tax, and GNI. We choose these three investment variables in light of the aggregate nature of the production functions. The exact contribution of infrastructure to productivity remains limited in the sense that the production function approach does not cover all welfare aspects of infrastructure investment. For example, the impact of infrastructure investments on consumers is not taken into account. Furthermore, the production function approach cannot give an ex-ante evaluation of specific investment projects. Industrial development plays an important role in the economic growth of developing countries such as China. Furthermore, manufacturing investment influences the productivity performance of these countries. Romer ( 1986 ) developed the endogenous growth model, in which technological innovation is created in a R&D sector that combines human capital and knowledge.

The second structural model also share the Cobb–Douglas production function which is in line with Gramlich ( 1994 ) and Voss et al ( 2003 ). In this model, public capital is disaggregated into various components. This exercise is similar in spirit to Easterly and Rebelo ( 1993 ) which also examines whether particular sectors of public investment are important for economic growth. In China’s case, investment in infrastructure is calculated by adding investment in management of water, conservancy, environment and public facilities; transport, storage and post; production and supply of electricity, heat, water and gas, services to households, repair and other services; and education; culture, sports and entertainment and public management, and social security and social organizations. Data are collected for 1985–2015 from various editions of the Statistical Yearbook of China from 2003 through 2016.

In the third structural model, external debt is divided into short-term and long-term debt. Other variables are government expenditure and government revenue. Favero and Giavazzi ( 2007 ) emphasized the importance of including the debt feedback effect when estimating the effects of fiscal policy shocks. The identified system is:

where \(Y_{t} = \left( {g_{e} g_{r} } \right)\) , which denote government expenditure and government revenue, \(d_{l,t}\) is long-term debt to GDP ratio, \(d_{s,t} { }\) is short-term debt to GDP ratio, and \(d_{l}^{*}\) and \(d_{s}^{*}\) are unconditional mean values.

Generally speaking, in terms of impulse-response functions, fiscal multipliers reflect the impact of fiscal variables on GDP or GNI, or \(\frac{{\Delta Y_{t} }}{{\Delta X_{t} }},{ }\) where \(X\) is government expenditure or tax. However, Davig et al. ( 2010 ) point out that current fiscal policy will affect future fiscal policy, which means that ordinary impulse response cannot accurately capture the impact of fiscal policy on the economy. Therefore, Perotti ( 2004 ) applies the SVAR model to calculate cumulative impulse response and cumulative multipliers as \(\frac{{\mathop \sum \nolimits_{{{\text{i}} = 0}}^{{\text{k}}} \Delta {\text{Y}}_{{{\text{t}} + {\text{k}}}} }}{{\mathop \sum \nolimits_{{{\text{i}} = 0}}^{{\text{k}}} \Delta {\text{X}}_{{{\text{t}} + {\text{k}}}} }}\) , which can be interpreted as the ratio of the cumulative value of GDP or GNI to the cumulative value of government expenditure or tax. In addition, Mountford and Uhlig ( 2009 ) develop a new method assuming the discount rate as \(\frac{{\mathop \sum \nolimits_{{{\text{i}} = 0}}^{{\text{k}}} \mathop \prod \nolimits_{{{\text{i}} = 0}}^{{\text{i}}} \left( {1 + {\upgamma }_{{{\text{t}} + {\text{i}}}} } \right)^{{ - {\text{i}}}} \Delta {\text{Y}}_{{{\text{t}} + {\text{k}}}} }}{{\mathop \sum \nolimits_{{{\text{i}} = 0}}^{{\text{k}}} \mathop \prod \nolimits_{{{\text{i}} = 0}}^{{\text{i}}} \left( {1 + {\upgamma }_{{{\text{t}} + {\text{i}}}} } \right)^{{ - {\text{i}}}} \Delta {\text{X}}_{{{\text{t}} + {\text{k}}}} }}\) . In our paper, we calculate the multipliers based on three models: \(\frac{{\Delta {\text{Y}}_{{\text{t}}} }}{{\Delta {\text{X}}_{{\text{t}}} }} \times \frac{{\text{Y}}}{{\text{X}}}\) ; \(\frac{{\mathop \sum \nolimits_{{{\text{i}} = 0}}^{{\text{k}}} \Delta {\text{Y}}_{{{\text{t}} + {\text{k}}}} }}{{\mathop \sum \nolimits_{{{\text{i}} = 0}}^{{\text{k}}} \Delta {\text{X}}_{{{\text{t}} + {\text{k}}}} }} \times \frac{{\text{Y}}}{{\text{X}}}\) ; and \(\frac{{\mathop \sum \nolimits_{{{\text{i}} = 0}}^{{\text{k}}} \mathop \prod \nolimits_{{{\text{i}} = 0}}^{{\text{i}}} \left( {1 + {\text{r}}_{{{\text{t}} + {\text{i}}}} } \right)^{{ - {\text{i}}}} \Delta {\text{Y}}_{{{\text{t}} + {\text{k}}}} }}{{\mathop \sum \nolimits_{{{\text{i}} = 0}}^{{\text{k}}} \mathop \prod \nolimits_{{{\text{i}} = 0}}^{{\text{i}}} \left( {1 + {\text{r}}_{{{\text{t}} + {\text{i}}}} } \right)^{{ - {\text{i}}}} \Delta {\text{X}}_{{{\text{t}} + {\text{k}}}} }} \times \frac{{\text{Y}}}{{\text{X}}}\) ; which represent the multiplier, cumulative multiplier, and discounted cumulative multiplier.

4 Empirical results

In this section, we discuss and report the main findings of our empirical analysis, for both the full sample period of 1985─2015 as well as the three sub-periods. We use monthly data because approving and implementing new measures in response to innovations in the macroeconomic variables typically takes at least one month. Therefore, the use of monthly variables allows for setting the discretionary contemporaneous response of government expenditure or net taxes to GNI to zero. Pre-regression analysis shows the presence of co-integrating relations and hence a possible specification of a vector error correction model but the number of long-term equations shows no feasibilities. Blanchard and Perotti ( 2002 ) find no significant differences between estimated results obtained with and without taking the co-integrating relation into account. With regard to the choice of the interest rate, most existing studies use the short-term interest rate. For example, Chan et al. ( 1992 ) uses the one-month US treasury bond yield, while Nowman ( 1997 ) uses the one-month LIBOR. Footnote 1 This study selects 7-day interbank interest rate as the discount rate. It should be pointed out that our sample period 1985 to 2015 coincides with a significant expansion of China’s external debt in tandem with sustained rapid economic growth.

4.1 Test of Johansen cointegration

We use Johansen cointegration test to obtain preliminary evidence of cointegration relationships. The result provides evidence in favor of two cointegration relationship in Model 1. The lag length was chosen by final prediction error (FPE) to be 2. Footnote 2 Tables 4 and 5 show the results for Model 1 and Model 2, respectively.

In a similar way, the result of Johansen cointegration test for Model 2 shows evidence in favor of three cointegration relationship. The lag length was chosen by SBIC to be 1. Footnote 3

4.2 Test for unit roots

The structural vector autoregressive (SVAR) methodology requires that all variables be stationary. Therefore, a formal analysis of the stochastic properties of the series is needed. We make alternative assumptions about the deterministic components of the model. More specifically, before our econometric analysis, we (a) remove the different sample means from the series, and (b) remove the different fitted-trend lines from the raw series. The second issue concerns the presence of unit roots in the series, which is tested by the standard Dickey-Fuller and Phillips–Perron tests. The results are reported in Table 6 below. Both tests reject the null of unit root for the first differences of the log of the series. The t-statistic for the null hypothesis of a unit root is tested with 4 lags at 5% significance critical values. Since the t-statistic values are smaller than the critical values, we reject the null of unit root at conventional significance levels.

4.3 Test for variables order

Considering the importance of variable order on VAR/SVAR results, we carried out Granger causality Wald tests for different VAR/SVAR results in order to find the most robust variable order. In model 1, the Granger causality Wald tests results with the best variable order are shown in Table 7 . The same tests of Model 2 and Model 3 prove our model fits the best as well. The Granger causality tests show that there is a significant bidirectional causality from net taxes, central government expenditures, local government expenditures, consumption, and trade balance to GDP in China. This means that the maximum of the five variables Granger-causes the other variables and GDP, and GDP Granger-cause each of the five variables. This suggests that each of the five variables contributed to the progress of the Chinese economy.

4.4 Government expenditure model

In terms of fiscal policy, China’s government expenditure is determined primarily by the central government. The central government’s fiscal decisions substantially affect the local government’s fiscal decisions. We identified fiscal policy shocks using vector error correction model (VECM) model with 6 variables. We set the variable sequence as GDP per capita ( \(y\) ), net tax ( \(t\) ), central government expenditure ( \(c\) ), local government expenditure ( \(l\) ), consumption (a) and trade balance (b) during calculation. According to Barro ( 1990 ), under the assumption of constant returns to scale, government expenditure can change the steady growth rate. Fiscal decentralization leads to greater autonomy of local government. Zhang and Zou ( 1998 ) used the ratio of provincial government expenditure to central government expenditure as the measure of fiscal decentralization and found that decentralization affects provincial economic growth. The results of the government expenditure model are shown in Table 8 .

The impulse response results are reported in Tables 9 , 10 , and 11 along with Appendix Fig. 1 . A number of interesting patterns emerge. First, the overall trend for the full sample period indicates that the growth of both central government expenditure and local government expenditure, as discretionary fiscal policy tools, had positive effect on output growth except during the first quarter of central government expenditure. The response of output to net tax increase also appeared to be positive. Comparing the multipliers of other two impulse shocks, local government expenditure increase was more effective than central government expenditure in both short term and long term. In the first month, net tax increase had a bigger impact than local government expenditure increase.

Second, before the Asian Financial Crisis, central government expenditure increase had the biggest short-term impact on output growth, but the three fiscal variables all became permanently positive in terms long-term effects. Nevertheless, the cumulative multiplier of local government expenditure growth was larger than the cumulative multiplier of the other two fiscal variables.

Third, after the Asian Financial Crisis, the multiplier of central government expenditure was still bigger than the multiplier of local government expenditure. The multiplier of net tax growth tends to be negative after 20 quarters.

Fourth, during 2008–2015, local government expenditure increase had a significant impact on output growth, with a much larger multiplier than central government expenditure or net taxes. Its effect was positive and significant, implying that fiscal decentralization benefits economic growth.

The impulse response functions for the government expenditure model yields the following findings. For one, they provide strong evidence that fiscal policy multipliers may change over the business cycle—i.e. they tend to be larger during recessions than expansions (Woodford, 2010 ). Such evidence supports Keynesian arguments for using discretionary government expenditure during downturns to stimulate aggregate demand. Both Blanchard and Perotti ( 2002 ) and Mountfourd and Uhlig ( 2009 ) find that tax multipliers are smaller than spending multipliers in the short-term, which is plausible since theory predicts that part of the higher disposable income stemming from tax cuts is saved.

Our analysis shows that during 1998–2007, net tax multipliers show negative value, which implies that tax cuts stimulate output. During 1985–2015, central government and local government expenditure multipliers were 4.267 and 4.420, respectively, after one month. On the other hand, net tax growth multiplier was 0.508, which was smaller than central government expenditure multiplier, but it became bigger from 10th quarter onward. According to conventional wisdom, the multiplier should be larger during recessions. It is noteworthy that the effect of local government expenditure was significant, with a post-GFC discounted multiplier of 1.2778 after 20 months. Interestingly, the impact of central government expenditure on output did not change visibly after AFC.

Before 1997, the cumulative multiplier of both government expenditure and net tax declined steadily after 5 months, but the former is much larger than the latter. During 1998–2007, the cumulative multiplier of government expenditure increased from a negative value, whereas that of net tax decreased progressively. The value of government expenditure multiplier increased during 2008–2015. However, during the whole period of 1985–2015, the cumulative multiplier declined to 1.272 after 5 months. This amount is still larger than the cumulative net tax multiplier, which increased during the whole period.

4.5 Investment model

Three cointegration equation could be constructed via Johansen cointegraion tests. The results suggest that R&D investment has long-term positive impact on GNI, net tax, and infrastructure while manufacturing investment shows the opposite impact. Table 12 shows the results.

However, this result does not provide any evidence regarding the temporal stability of the parameters of the relationship. The paper constructs a 5-variable SVAR model which estimates the responses of GNI to total investment (Model 2). For convenience, the variables’ names are shortened as follows—GNI to \(y\) , net tax to t , investment in infrastructure to \(i\) , investment in manufacturing to \(m\) , and investment in R&D to \(r\) . The coefficients corresponding to the uncorrelated structural shocks \(\varepsilon_{t}^{t}\) , \(\varepsilon_{t}^{i} ,\) \(\varepsilon_{t}^{m}\) , \(\varepsilon_{t}^{r}\) , \(\varepsilon_{t}^{y}\) can be obtained in Eq. ( 5 ) below.

Note: *** represents null hypothesis rejected at 1% level of significance. \(e_{t}^{t} ,e_{t}^{i} ,e_{t}^{m} ,e_{t}^{r} e_{t}^{y}\) are the orthonormal unobserved factors from structural innovations, \(\epsilon_{t} = A^{ - 1} Be_{t}\) .

Our results show that the coefficient signs from investment increases in infrastructure and manufacturing are negative, but they are statistically insignificant. Another interesting finding was that during the 1985–2015 time period, 1% increase of investment in manufacturing led to 0.11% decrease of GNI. On the other hand, 1% increase of R&D investment generated 0.03% increase in GNI, which is significant and positive compared to the other variables.

The results are reported in Tables 13 , 14 , and 15 along with Appendix Fig. 2 . First, the response of GNI growth to manufacturing investment growth decreased in the first quarter and then recovered slightly from 2nd quarter onward. For investment growth in infrastructure and R&D, there was a positive initial impact. The responses were relatively large in the 1st quarter and peaks at 8th quarter. Until the 8th quarter, the response of GNI to R&D shock was the largest, with a discounted cumulative multiplier of 0.0078, followed by infrastructure at 0.0067. The manufacturing investment growth multiplier was only 0.0016. Second, before the AFC, GNI growth reacted negatively to increase in both infrastructure and R&D investment. During the same period, the output growth multiplier of manufacturing investment shock was positive and much higher than the other two sectors. Third, after the AFC, the discounted cumulative multiplier of manufacturing investment was much larger than that for infrastructure and R&D investment.

The impulse response functions generate a number of findings. The government was a main driver of manufacturing investment in the PRC. Due to the low efficiency of government investment and crowding out of private investment, a negative impact cannot be ruled out. Furthermore, some previous studies have shown that R&D investment can have a negative effect on economic growth. Technological progress may cause higher unemployment rate and in addition, strengthening of intellectual property rights protection may impede diffusion of new knowledge. Furthermore, infrastructure investment may promote economic growth in the long term by raising the productivity of all firms and industries. This explains why, upon the increase of infrastructure investment, the output growth multiplier increases from 0.0471 to 0.0680 during 8 quarters in 1985–2015 and from 0.2149 to 0.6375 after the AFC. The increase in the R&D multiplier after 1998 reflects China’s gradual shift from an input-based economy to a knowledge- and innovation-based economy.

For infrastructure, the cumulative multiplier reached the highest value after 10 months during 1985–1997 and 2008–2015, and even in the whole time periods except for 1998–2007. For manufacturing factor, during 1998–2017, the highest cumulative multiplier appears after 3 months, but before 1997, the value decreases as the times goes on. At last, for R&D sector, the highest value usually appeared after 3 months except before 1997.

4.6 External debt model

In the third model, we consider the potential debt feedback following Bohn ( 1998 ), who developed a fiscal reaction function in which \({d}^{*}\) is the unconditional mean of the debt-to-GDP ratio as shown in formula ( 2 ). Following Favero and Giavazzi ( 2007 ), we build a 3-variable SVAR model which includes the government expenditure to GDP ratio and the government revenue to GDP ratio, and then examine the response of the two variables to the debt-to-GDP ratio.

In Table 16 , we report the coefficients and the standard errors from the estimation for the full sample period and sub-sample periods.

The debt-to-GDP ratio has significant positive effect on both government revenue and expenditure ratios for the full period, but the effect differs across sub-periods. After the Asian financial crisis, the ratio of short-term debt to GDP has a significant effect on government revenues but an insignificant effect on government expenditure. Both government expenditure and revenue respond significantly to the ratio of long-term debt to GDP for the full sample period but there is no significant effect before the Asian financial crisis. Both long-term and short-term debt have a more significant effect on government revenues than government expenditures. This suggests that the debt level helps to stabilize government budget balance primarily through the response of government revenues to deviations of actual debt level from the target level. It is noticeable that after GFC, both of the long-term debt and short-term debt have no significant impact on government expenditure. During 2007–2008, external debt outflow, which sustained at around 16%, is much faster than inflow. Comparing to 4 trillion fiscal stimulus, paying external debt interests have little impact on government expenditure, simultaneously this means Chinese government expenditure had smaller degree of dependence on external debt.

5 Conclusion

Sustained rapid growth since the initiation of market-oriented reforms in 1978 transformed China into the world’s second largest economy. However, China’s growth has slowed down visibly since the global financial crisis, primarily due to long-term structural factors. Furthermore, the COVID-19 highlights the need for more sustainable growth which protects the environment and benefits the broader population, including the poor. China’s positive experience with countercyclical fiscal policy during the global financial crisis highlights the potential of fiscal policy as an important tool for supporting the country’s growth. A massive fiscal stimulus staved off recession and the economy weathered the global financial crisis remarkably well. In addition, fiscal policy can help China build back better after COVID-19—e.g. public investments in clean energy. China’s experiences are generally consistent with a large literature that suggests that fiscal policy can have a significant and positive effect on economic growth.

In this paper, we empirically examine the relationship between fiscal policy and economic growth in China. To do so, we use empirical methods which distinguish automatic fiscal policy from discretionary fiscal policy (e.g. Perroti, 2002 ). Our econometric analysis yields a number of interesting findings. Our evidence suggests that local government expenditures have a larger impact on output growth than central government expenditures or net taxes. However, net taxes become progressively more influential in the long run. In addition, both government expenditure and net tax multipliers seem to change depending on the phase of the business cycle. During the initial stages of market liberalization in 1990s, manufacturing investment contributed the most to output growth but in recent periods, public investment in R&D made a substantial contribution. In addition, our evidence indicates that long-term debt has a significant influence on China’s key fiscal variables, especially government revenues.

Overall, our analysis provides cautious grounds for optimism that fiscal policy can help Chinese policymakers engineer a gradual and smooth transition toward a more sustainable growth paradigm while maintaining healthy growth rates. Fiscal policy, especially government spending, seems to have a significant and positive effect on output in both short and long run. Since local government spending in particular seems to affect output, there is an urgent need to induce local governments to take sound and efficient fiscal decisions so that their expenditures can contribute to sustainable growth beyond the short term.

Samuelson emphasized the prominent position of consumption and technology in a market-oriented economy. In this connection, future research may consider adding total factor productivity as a proxy for technology shock to further enrich the model. In our analysis of China, we find that in recent years the effect of R&D investment on output exceeds the effect of infrastructure investment. It is consistent with the conventional wisdom that in order to sustain growth China has to shift from a growth strategy based on more capital and labor to one that is based on productivity and innovation. In fact, this shift has already been occurring for some time. Finally, the significant effect of long-term public debt on the fiscal balance, especially through fiscal revenues, suggests a need for China to monitor debt as an indicator of fiscal sustainability.

Change history

02 july 2021.

A Correction to this paper has been published: https://doi.org/10.1007/s10290-021-00426-1

London Inter-bank Offer Rate.

In determining the lag lengths of the Johansen’s procedure, we have to select the smallest criteria which are statistically significant. The final prediction error (FPE) meets this condition and is superior to the other criteria. In addition to FPE, for choosing the lag lengths of the Johansen’s procedure, we need to see if trace statistics is 5% higher than 1% critical value then we reject the null hypothesis that there is no cointegration among variables. We can accept the null hypothesis at rank 2 for model 1, and rank 3 for model 2 by assuring that there are no cointegrations among variables.

In determining lag lengths for the Johansen’s procedure, we need to choose the smallest criteria with statistically significant and here Schwarz’s Bayesian (SBIC) information criterion processes is the smallest by showing most efficient and consistent than the other criteria.

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See Figs.  1 and 2 .

Source : Authors’ estimation

Orthogonalized impulse-response results of government expenditure model (Model 1). Notes : IRFs depict the GDP per capital response to a 1% shock in local government expenditure, central government expenditure, consumption, GDP per capital, net tax, trade balance.

Orthogonalized impulse-response results of investment model (Model 2). Notes : IRFs depict the GNI response to a 1% shock in investment in infrastructure, investment in manufacturing and investment in R&D. The grey shadow area in the SVAR panels show 95% upper and lower confidence bands.

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Kim, J., Wang, M., Park, D. et al. Fiscal policy and economic growth: some evidence from China. Rev World Econ 157 , 555–582 (2021). https://doi.org/10.1007/s10290-021-00414-5

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Published : 10 May 2021

Issue Date : August 2021

DOI : https://doi.org/10.1007/s10290-021-00414-5

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LITERATURE REVIEW 2.1 CONCEPTUAL FRAMEWORK 2.1.1 FISCAL POLICY

In economics, fiscal policy is the use of government spending and revenue collection to influence the economy. It refers to the overall effect of the budget outcome on economic activity. Fiscal policy can be contrasted with the monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation (Chigbu and Njoku 2013). It involves the use of parameters such as taxation, budget and quotas that will influence government revenue and expenditure with a view to achieving macroeconomic objectives which monetary policy also stands to achieve. For instance, tax revenue will increase when an economy is expanding, all things being equal, even when there is no change in fiscal policy. The increase in tax revenue could further increase government spending, thus promoting more expansion given the fact that such spending are channeled into provision of basic infrastructures that complement private investment. Government can therefore use fiscal policy to stimulate the economy through manipulation of taxes and expenditure (Olanipekun and Benjamin 2015). Also, it is the use of government revenue collection (mainly taxes) and expenditure (spending) to influence the economy. According to Keynesian economics, when the government changes the levels of taxation and government spending, it influences aggregate demand and the level of economic activity. Fiscal policy is often used to stabilize the economy over the course of the business cycle. Changes in the level and composition of taxation and government spending can affect the following macroeconomic variables, amongst others, in an economy: • Aggregate demand and the level of economic activity;

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Fiscal policy is defined as the government’s measures to guide and control spending and taxation. The traditional view is that fiscal policy performs three main functions: allocation, distribution, and stabilization. The allocation function is the process of dividing total resource use between private and social goods and choosing the mix of social goods. The distribution function is the process of adjusting the distribution of income or wealth to ensure conformance with what society considers fair. The stabilization function supports achieving the main macroeconomic objectives set by policymakers to ensure economic growth, price stability, and sustainable external accounts.

This chapter concerns itself essentially with the stabilization function of fiscal policy. 1 It begins by using the traditional IS-LM aggregate supply/aggregate demand model to assess the short-run effects of fiscal policy on output, prices, and the current account of the balance of payments and to explore the interactions between fiscal policy and monetary and exchange rate policies. It then addresses issues specific to fiscal policy and macroeconomic management, including methods for measuring the fiscal balance, cyclical and structural deficits, the sustainability of the fiscal deficit, and policies for managing debt and fiscal surpluses. It concludes by exploring how the three primary instruments of fiscal policy—tax policy, expenditure policy, and overall budgetary policy—can affect a country’s long-term growth.

Impact of Fiscal Policy on Macroeconomic Policy Objectives

Effects on output.

The impact of fiscal policy on output can be analyzed within the context of traditional IS-LM analysis. 2 The IS curve depicts combinations of interest rates and output at which the goods market clears. It slopes downward because a decrease in the interest rate increases investment spending, thereby increasing aggregate demand and the level of output at which the goods market is in equilibrium. The LM curve depicts the combinations of interest rates and output at which the money market is in equilibrium. It has a positive slope because an increase in the interest rate reduces the demand for real balances, and the level of income must rise to keep the demand for real balances equal to the fixed supply. Accordingly, money market equilibrium implies that an increase in the interest rate is accompanied by an increase in the level of income.

• Closed Economy

Let us first analyze the effects of a fiscal expansion on output in the context of a closed economy. The initial equilibrium position is denoted by point E in Figure 8.1 . A debt-financed increase in government spending, for example, raises aggregate demand at each level of the interest rate and thus shifts the IS curve to the right, to IS’ . At point E, an excess demand for goods now exists. Output rises, and with it the interest rate, because the income expansion raises money demand. The new equilibrium is at point E’, and income increases by ( Y 0 ′ − Y 0 ) . Note that the increase in income is dampened by the higher interest rate, which crowds out some private investment spending.

Effect of an Increase in Government Spending on Output in a Closed Economy

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The main determinant of the extent to which crowding out takes place is the shape of the LM curve. If the LM curve is horizontal (that is, if the demand for money is very sensitive to the interest rate), crowding out does not occur, and fiscal policy will have a large effect on output (the Keynesian case). But if the LM curve is vertical, complete crowding out occurs. In this case, an increase in fiscal spending has no effect on the equilibrium level of output and increases only the interest rate (the classical case).

In the analysis given above, increased government spending may lead to a reduction in private investment through the higher interest rate (that is, the crowding-out effect). However, other indirect effects can result in reduced private spending ( Khan, 1987 ). For example, the excess demand for money generated by the higher government spending may cause households to spend less in order to accumulate cash and maintain portfolio equilibrium. Similarly, high, debt-financed government spending can reduce private spending if the private sector’s future tax liability increases because of the need to retire public debt (the Ricardian-equivalence proposition). Finally, private spending may also decline if increased government spending leads to a rise in domestic prices. These adverse effects on private spending can help to mitigate the effects of a fiscal expansion on output.

• Open Economy

Let us now extend the analysis to an open economy. For this exercise, we introduce the BP curve, which depicts combinations of interest rates and output at which the balance of payments is in equilibrium. The balance of payments consists of the current account and the capital account. The current account depends on the level of income and the exchange rate, whereas the capital account depends on the domestic interest rate. The BP curve slopes upward. If output increases and interest rates remain constant, imports will increase, and the balance of payments will be in deficit. An increase in interest rates will trigger capital inflows and restore balance of payments equilibrium.

The slope of the BP curve depends on the interest elasticity of capital flows. The greater is this elasticity, the flatter is the BP curve, because a small increase in interest rates results in balance of payments equilibrium. The BP curve is horizontal for perfect capital mobility and vertical for completely immobile capital. The BP curve also shifts when the exchange rate changes. An exchange rate depreciation, for example, creates a balance of payments surplus and shifts the BP curve to the right.

Let us now use the IS-LM framework to analyze the effects of fiscal expansion on output in the context of perfect capital mobility ( Figure 8.2 ). The equilibrium balance of payments schedule is denoted by the horizontal line BP , at which the domestic interest rate equals the foreign interest rate. First we consider the case of a country that follows a fixed exchange rate policy. 3 A debt-financed increase in government spending shifts the IS curve upward and to the right, increasing both the interest rate and output. The higher interest rate sets off a capital inflow that leads to an appreciation of the exchange rate and to an expansion in the money supply that further increases income. As such, the LM curve shifts to the right, and equilibrium is restored when the money supply has increased enough to drive the interest rate back to the original level. The new equilibrium point is thus E’ in Figure 8.2 . In this case, with an endogenous money supply, the interest rate is effectively fixed, and the Keynesian case of the maximum effect of a change in fiscal policy on output holds.

Fiscal Expansion Under a Fixed Exchange Rate and Perfect Capital Mobility

Now consider what happens when a country pursues a flexible exchange rate policy. As before, the increase in government spending shifts the IS schedule upward and to the right, increasing both output and the interest rate ( Figure 8.3 ). The increase triggers capital inflows and a currency appreciation, but here the government does not intervene in the foreign exchange market. The currency appreciation means that home goods become less competitive, and the composition of domestic demand shifts toward foreign goods and away from domestic goods. The IS schedule begins moving downward and to the left until the initial equilibrium point £ is restored. Thus, fiscal expansion has no effect on equilibrium output. As in the classical closed-economy case, full crowding out occurs—not because higher interest rates reduce private investment, but because exchange rate appreciation reduces net exports.

Fiscal Expansion Under a Flexible Exchange Rate and Perfect Capital Mobility

This analysis of the effects of fiscal expansion on output in an open economy is very sensitive to the assumption about the degree of capital mobility. To demonstrate this point, let us consider a case in which the authorities follow a flexible exchange rate policy, but capital is relatively (though not completely) immobile ( Figure 8.4 ). The BP curve is quite steep. A fiscal expansion shifts the IS curve upward and to the right (to IS’ ). As income rises, imports increase, and the balance of payments situation deteriorates. In turn, the exchange rate depreciates, leading to a further upward shift in the IS curve (to IS” ) and a shift to the right in the BP curve (to BP ’). The new equilibrium is then established at E ’, where output is even higher than it was when driven by the initial fiscal expansion.

Fiscal Expansion Under a Flexible Exchange Rate and Relative Capital Immobility

The contrasting results shown in Figures 8.3 and 8.4 can be summarized as follows. Fiscal expansion initially affects both trade flows and capital flows in the balance of payments by affecting income and the domestic interest rate, respectively. When capital is relatively immobile, the trade-flow component of the balance of payments dominates, and the consequent currency depreciation reinforces the initial expansion in output. When capital is mobile, the capital-flow component dominates, and the consequent currency appreciation offsets the initial expansionary effect on output.

• Multiplier and Accelerator Effects

The fiscal policy multiplier shows how much an increase in government spending changes the equilibrium level of income. The multiplicative effect arises because the consumers who receive the income from the increase in government spending spend at least part of this in come, generating additional income. For the sake of simplicity, let us assume that the increase in government spending does not crowd out private investment. How much will income change with a change in government spending?

In this model, saving and imports are the two leakages from the disposable income stream. Thus, if the marginal propensity to save and the marginal propensity to import (out of disposable income) are denoted by s and m , respectively, the value of the multiplier k is expressed as 4

An even more dynamic path for the income response to increased government spending occurs if the accelerator theory of investment holds. This theory depicts investment as a function not of the interest rate, but of previous changes in income. If investment is denoted by I , income by Y , and the time subscript by t , the investment function can be defined as

In this case, not only does an increase in government spending generate an increase in income as the multiplier effects operate, but the income increase generates further changes in investment. These changes in turn are subject to the multiplier, giving rise to new income changes, and so on. Empirical observation indicates, however, that the macro-economic behavior of the economy is not explosive and that income changes tend to level off.

• Effects on Prices

The impact of fiscal policy on prices can be illustrated with aggregate supply/aggregate demand analysis ( Figure 8.5 ). The aggregate demand schedule (AD) shows the combinations of the price level and the level of output at which goods and assets markets are simultaneously in equilibrium. AD slopes downward because, for example, a decline in the price level increases the quantity of real money balances, which in turn reduces interest rates and increases investment and aggregate spending. The aggregate supply curve (AS) describes the relationship between the price level and the amount of output that firms wish to supply. It generally slopes upward because an increase in output tends to reduce unemployment, thus increasing wages and prices.

Effect of an Increase in Government Spending on Prices

A debt-financed fiscal expansion shifts the AD curve to the right because spending is higher at each price level. If the AS curve slopes upward (the general case), then a rightward shift in the AD curve will increase both prices and output. In the extreme Keynesian case, when the AS curve is horizontal, firms are willing to supply whatever amount of goods is demanded at the existing price level. Thus, a fiscal expansion has no effect on prices, causing an increase only in output. At the other extreme (the classical case), when the AS curve is vertical at full-employment level Y* , a fiscal expansion causes an increase only in prices, leaving output unchanged.

• Effects on the Current Account Balance

Let us first recall the accounting link between the fiscal balance and the current account balance. Deriving from the national income identity, we can write

Equation (8.3) shows the external current account balance (NX) as the counterpart of the sum of the private sector’s investment-saving balance (Ip - Sp) and the fiscal deficit (G – T) . Thus, a fiscal deficit must be matched by a domestic private sector that saves more than it invests, by an external current account deficit, or by both.

However, we must be cautious in moving from this accounting identity to the assumption that a simple causal relationship exists between fiscal and current account deficits. A widening of the fiscal deficit may increase the current account deficit, but it can also reduce the private sector investment-saving balance by crowding out private investment. Similarly, an increase in the fiscal deficit can increase the private saving rate as individuals recognize that future tax burdens may be higher because the prospective growth in public debt must be serviced. Thus, the extent to which fiscal and external deficits are linked depends on the impact of fiscal policy on private sector saving and investment behavior.

• Interaction with Monetary Policy

The preceding analysis shows that a debt-financed fiscal expansion tends to increase interest rates and crowd out some private investment, dampening the impact of the fiscal expansion on rising income. If the monetary authorities want to prevent this effect, they can accommodate the fiscal expansion by increasing the monetary base. In the IS-LM analysis, both the IS and the LM curves shift to the right, keeping the interest rate at the original equilibrium level and maximizing the effect of the fiscal expansion on income. But this policy of accommodation, or monetization , creates a risk, because it fuels inflation. The money supply will have to continue to expand to finance the ongoing fiscal deficit (a continuous rightward shift in the LM schedule), increasing aggregate demand and putting pressure on prices. Eventually, the higher aggregate demand will raise the interest rate, and crowding out will once again occur. The objective of the policy (to prevent crowding out) will fail, and at the added cost of higher inflation.

Monetization of the fiscal deficit also has revenue implications for the government, as government spending is then financed with the creation of high-powered money rather than through explicit taxation. The revenue generated when the government creates money is often referred to as seigniorage . When the government finances a deficit by creating money, the public absorbs this additional money. People choose to increase their holdings of nominal money balances, either because their real incomes have grown, or because they want to offset the effects of inflation (the inflation tax ). The amount of revenue from this tax equals the product of the inflation rate and the real monetary base.

Although the amount of revenue the government can raise from the inflation tax initially increases with inflation, it declines after inflation reaches a certain level, because people start reducing their real money holdings as these holdings become more expensive. Individuals hold less currency, and banks hold as few excess reserves as possible. Eventually, the real money base falls so much that it reduces the total amount of revenue the government receives from the inflation tax.

Fiscal policy itself may also be affected by monetary policy. Officials may pursue a tight monetary policy, perhaps to maintain a specific nominal exchange rate. At least in the short run, this policy may lead to high real interest rates that increase the cost of debt service to the government, adversely affecting the viability of the fiscal position.

• Interaction with Exchange Rate Policy

On the basis of the traditional IS-LM analysis discussed above, the impact of fiscal policy on the exchange rate can be summarized as follows: a fiscal expansion (holding the nominal money stock constant) results in higher interest rates. If capital is fully mobile, capital inflows begin and lead to an appreciation of the currency. If capital mobility is limited, the currency must depreciate to counteract the effect of the fiscal expansion on the current account. 5

Two main assumptions underlie this analysis. First, we assume that a debt-financed deficit can go on forever, though it clearly cannot. If public debt initially grows faster than GDP, the deficit must start declining at some stage. The result is either a reduction in noninterest spending by the government, higher taxes, or both. This effect is essentially the theory of the intertemporal budget constraint. In terms of the IS-LM diagram, it means a leftward shift in the IS schedule. The interest rate will then tend to fall, leading to capital outflows. Thus, the exchange rate (which initially appreciated as a result of the fiscal expansion) depreciates.

Second, we assume that the budget deficit is not monetized, an assumption that may not be realistic. If deficits persist, the ability of the government to reduce its expenditure and raise taxes (as indicated earlier) reaches a limit. Eventually, the deficit must be monetized, causing inflation. If inflation is higher at home than it is abroad, a nominal depreciation of the currency will have to be maintained to stabilize a given real exchange rate. Consequently, a fiscal expansion leads initially to appreciation and then to depreciation.

Exchange rate policy itself affects the fiscal stance. A nominal depreciation can have a significant positive or negative effect on the fiscal balance, depending on the structure of the budget. If, for example, foreign currency-based expenditures (such as interest payments on foreign debt) outweigh foreign currency-based revenues (such as customs duties), the net effect of a depreciation is to increase the fiscal deficit.

Fiscal policy is also likely to be necessary to support a policy that seeks to adjust the real exchange rate. For example, under a fixed exchange rate regime, a nominal devaluation will immediately increase the prices of tradable goods. However, if the prices of nontradables also rise by a similar amount, the real exchange rate will not change. Avoiding an increase in the prices of nontradables usually requires introducing measures to dampen aggregate demand, the most important of which is often a reduction in the fiscal deficit. 6 And by affecting aggregate demand and prices for nontradables, a tighter fiscal policy can help to achieve real exchange rate depreciation in the long run, even without a nominal devaluation.

Issues in Fiscal Policy and Macroeconomic Management

• Measurement of the Fiscal Balance

Efforts to use the fiscal balance to assess the fiscal policy stance yield important questions about how the balance should be measured and what it covers. The most common measure of the fiscal balance is the overall balance , which is the difference between government revenue and expenditure. In principle, the government should be defined as broadly as possible, including not only the central government but also state and local authorities. But even with this encompassing definition of government, the overall balance may still provide an inadequate picture of the fiscal stance, for several reasons.

First, in many developing and transition economies, nonfinancial public enterprises that are government owned or controlled engage in activities that are significantly affected by nonmarket forces, often including the application of a soft budget constraint. The activities of these enterprises should be consolidated with the activities of the general government to form a broad measure of the fiscal operations of the nonfinancial public sector.

Second, central banks and other public financial institutions in many of these countries make financial transactions that serve the same role as taxes and subsidies (quasi-fiscal activities). The central bank plays a dual role as regulator of the exchange and financial systems and as banker to the government. Most of its quasi-fiscal activities stem from these roles, including multiple exchange rate arrangements, exchange rate guarantees, interest rate subsidies, rescue operations, and lending to the government at below-market rates. Clearly, these activities can have significant allocative and budgetary impacts and should be considered explicitly in an assessment of the fiscal stance. Any quantifiable quasi-fiscal activities should be added to the fiscal balance to provide a broader and more appropriate measure of the deficit.

Even when quasi-fiscal operations are included in the definition of the fiscal deficit, the annual fiscal balance may not provide a good indicator for assessing the viability of the fiscal stance. In particular, although the contingent liabilities of the government or of quasi-fiscal institutions may not involve costs in the present, they may require large fiscal outlays in the future. The magnitude, probability, and likely timing of these potential liabilities must be taken into account.

Measuring the fiscal balance also requires accounting for the timing of fiscal transactions. Normally, governments commit resources before they are actually disbursed on a cash basis. Some tax liabilities may also accrue for a considerable period before a taxpayer is required to make a payment, raising the question of whether the fiscal balance should be assessed on a commitment basis or only on the basis of cash transactions (the cash balance ), A cash-based measure of the fiscal balance is advantageous because it emphasizes links with financial developments, particularly in the monetary accounts. In several countries, however, governments have chosen not to meet their commitment obligations, either because they lack liquidity or because they wish to meet targets for cash-based deficit reduction. A cash-based deficit then underestimates the extent of the government’s preemption of real resources. Indeed, when the arrears are to enterprises—which, in turn, borrow from the banking system—a cash-based deficit concept also underestimates the government’s contribution to the growth of monetary aggregates and demand.

Structural and Cyclical Deficits

Two important considerations in assessing the impact of the budgetary stance are the distinction between automatic and discretionary changes and the distinction between structural and cyclical deficits. Discretionary changes are changes in government expenditure ( G ) or tax revenue ( T ) that reflect parameter changes (that is, changes in expenditure programs or tax rates). Automatic changes are changes in G and T that result from the built-in flexibility of the fiscal system. For example, as incomes decline and the economy heads into a recession, tax revenue automatically declines, and government expenditure on unemployment compensation automatically increases.

The distinction between automatic and discretionary changes is illustrated in Figure 8.6 . Government expenditure ( G ) is measured on the vertical axis, and income is measured on the horizontal axis. The schedule TT shows tax revenue T as a function of income, reflecting a given tax rate t . Let the initial income level be at Y 1 , where the budget is in balance ( G = OM ). If private investment declines and fiscal parameters do not change, the equilibrium level of income declines to Y 2 , yielding a budget deficit AB . The built-in reduction in revenue acts as a cushion, holding down the decline in income by permitting the deficit to accrue. This situation is typical when an economy goes into a recession and the budget shows a growing deficit or a declining surplus.

In the alternative scenario, the initial income is also at Y 1 , but government expenditure increases from OM to ON . Equilibrium income rises to Y3, and a deficit equal to RD emerges. But the reasons for the deficit are different. Now it is driven by an expansionary fiscal policy rather than by a downturn.

Figure 8.6 also illustrates the distinction between two concepts of the deficit. The first is the deficit that prevails if income is at full employment, yielding a corresponding level of full-employment revenue. The second is the excess of the actual over the full-employment deficit and reflects current economic conditions. The former is referred to as the structural deficit and the latter as the cyclical deficit. Thus, if Y f is full-employment income and Y 3 is the actual level of income and G = ON, the actual deficit will be RD , the structural deficit will be FH = KD , and the cyclical deficit will be RK .

The distinction between discretionary and cyclical changes can be used to derive measures that provide a more accurate indication of the budget impact than simple observation of movements in the actual budget balance. One such “fiscal impulse” measure attempts to assess the annual budget contribution—whether expansionary, neutral, or contractionary—to aggregate demand. A convenient way to derive this fiscal impulse indicator is to begin with the so-called cyclical effect of the budget (CEB) , which entails taking the actual budget deficit for any year and subtracting from it a budget deficit deemed to be cyclically neutral for that year:

where G is government expenditure, g 0 is the base-year ratio of government expenditure G to potential GNP Y p , T is revenue, and t 0 is the base-year ratio of government revenue to actual GNP.

The cyclically neutral balance is stated in the last term on the right-hand side of equation (8.4). It is determined by applying the base-year ratio of government expenditure to current-year potential output, and the base-year ratio of budget revenue to current-year actual output. Taking first the differences in CEB and rearranging, one can derive the fiscal impulse ( FI ) indicator as:

A positive FI indicates that the budget has an expansionary impact on aggregate demand, whereas a negative FI indicates a contractionary impact.

Other indicators of fiscal impulse may closely approximate this indicator. With the so-called Dutch-budget impulse indicator, the impulse is derived using the preceding year’s budget balance as a base. However, all fiscal impulse indicators have been criticized on several grounds, including the assumptions on which they are based and the fact that they are not determined by models. Furthermore, the usefulness of these measures is diminished to the extent that countries, particularly developing countries, find it difficult to identify potential and trend output and, consequently, to distinguish between cyclical effects and the underlying causes of the fiscal deficit.

• Sustainability of the Fiscal Deficit

In the short term, the sustainability of the fiscal deficit depends on whether it can be financed without generating inflation or requiring excessively high real interest rates. Over the medium term, sustainability depends on whether the deficit will increase, level off, or reduce the ratio of public debt to GDP.

The inflationary consequences of financing the budget deficit by creating money have already been noted. Here we examine the dynamics of the fiscal deficit and the public debt. First, one can distinguish between two components of the budget deficit: the primary (or noninterest) deficit, and interest payments on the public debt. The primary deficit is equal to noninterest expenditure minus revenue, and the total deficit is equal to the primary deficit plus interest payments. The distinction between interest and noninterest outlays highlights the role of public debt in the budget. Interest has to be paid when there is debt outstanding, but the overall budget will be in deficit unless the interest payments on the debt are more than matched by a primary surplus. Thus, if the budget has a primary deficit, the total budget deficit will keep growing as the deficit increases the debt, and interest payments will rise because the debt is growing.

The sustainability of the debt situation should be analyzed by relating the nominal debt level to nominal GDP. If the debt-to-GDP ratio is denoted by d , the real interest rate by r , the growth rate of real GDP by y ˙ and the ratio of the primary budget surplus to GDP by 2, then the debt-to-GDP ratio will rise over time if

The evolution of the debt-to-GDP ratio thus depends on the relationships among the real interest rate, the growth rate of output, and the primary surplus. The higher the interest rate and the lower the growth rate of output, the more likely it is that the debt-to-GDP ratio will rise. A large primary surplus tends to make the debt-to-GDP ratio fall.

• Debt-Management Policies

Public sector solvency requires that the public sector’s comprehensive net worth be positive. However, the necessity of preserving macro-economic stability in a financially integrated environment may impose stricter conditions on the public sector’s balance sheet than simply maintaining a positive value of comprehensive net worth. The composirion of assets and liabilities may matter as well. In particular, a public sector that is solvent (that is, one that can credibly honor its obligations over a sufficiently long horizon) may nevertheless be vulnerable to short-run liquidity crises. If the perception is that the public sector is unlikely to honor its short-term obligations, then creditors will be reluctant to take on the government’s short-term liabilities, and, in a vicious cycle, the government may then be unable to meet its short-run obligations. The likelihood of this run on the debt depends on the maturity and currency composition of the public sector’s liabilities compared with its assets—that is, it depends on the government’s debt management policies (see World Bank, 1997 , pages 211-13).

In managing the composition of its debt, the government faces a difficult trade-off between enhancing its credibility and exposing itself to liquidity crises. The existence of long-term (fixed-interest) domestic currency-denominated (nominal) debt provides the government with some financing options it would not have if its debt were short term and denominated in foreign currency—namely, that it can effectively repudiate the long-term debt by inflating or devaluing, reducing the debt’s real value. However, the prospect of the government exercising this option increases domestic nominal interest rates, making it expensive for the government to borrow in nominal terms over the Long run. And even if the government never intends to behave in this fashion, the time-inconsistency problem may make it very difficult for the government to convince its creditors of its honorable intentions. To reduce its borrowing costs, the government may decide to borrow in foreign currency in the short term, incurring liquid foreign currency-denominated liabilities and opening itself up to runs on the debt.

The way out of this dilemma is to note when the problem of credibility arises in acute form—namely, when the government actually retains the discretion to act as creditors fear, when it lacks credibility on other grounds, and when its revenue needs are high and conventional taxation is highly distortionary. In other words, the existence of long-term nominal debt is only one factor in the government’s decision to devalue or inflate. Creditors can rationally expect the government to forgo the option of inflating away the real value of their assets if it is institutionally unable to do so, if it is perceived as placing a high value on the credibility of its policy announcements, or if inflating creates few net benefits from the government’s perspective. Thus, the government can avoid making its borrowing costs overly sensitive to the composition of its debt by creating institutions that limit its discretion (for example, by increasing the independence of the central bank), by establishing a reputation for nondiscretionary behavior, and by choosing levels of expenditure and mobilizing sources of taxation that minimize distortions. Under these circumstances, the government may retain the option of borrowing in domestic currency in the long run, minimizing the likelihood that macroeconomic stability will be impaired by runs on government debt.

• The Desirability and Management of Fiscal Surpluses

Should a country seek to run a surplus in its fiscal accounts? A surplus may be desirable under some circumstances (see Chalk and Hemming, 1998 ). First, as discussed earlier, a large primary surplus is generally required to help reduce the debt-to-GDP ratio. In some cases, the debt problem may be so severe that an overall budget surplus is required to ameliorate it. Indeed, a surplus itself may increase the sustainability of government policies by giving economic agents a highly visible signal of the government’s prudence.

Second, surpluses may be necessary to finance certain government obligations. As part of its allocation function, the government provides public goods, many of which involve “lumpy” investments. These goods include physical infrastructure (for example, transportation and telecommunications networks) and social infrastructure (for example, schools and hospitals). To finance the provision of such infrastructure, the government may borrow and run surpluses in the future to service the costs of its borrowing. But if the government faces borrowing constraints, it may have to run surpluses in the present in order to pay for future infrastructure provision.

Third, an optimizing government that favors tax smoothing may need to run surpluses. Since the welfare costs of distortionary taxation vary in proportion to the square of the tax rate, minimizing these costs (the corollary of maximizing welfare) entails maintaining constant tax rates over time. If expenditures increase during recessions and fall during booms, and tax bases vary procyclically, the government will have to run fiscal surpluses in booms and deficits in recessions to maintain a constant tax rate over the cycle. Fiscal policy will thus be counter-cyclical.

Fourth, the government’s stabilization function provides an even stronger justification for countercyclical fiscal policy to respond to demand deficiencies and supply shocks—and thus for running surpluses. The stabilization function is also used to correct short-term macroeconomic disequilibria (for example, balance of payments difficulties and high inflation). The tightening of fiscal policy, a measure that is often necessary and that is often implemented in conjunction with appropriate monetary and exchange rate policies for restoring macroeconomic stability, may require running a fiscal surplus.

Finally, transitory capital receipts may also justify a fiscal surplus. These receipts may be in the form of foreign grants, mineral resource revenues, or privatization proceeds, among other things. Similarly, windfall gains from temporarily high commodity prices that accrue to the budget through higher taxes and other levies on export profits may justify a fiscal surplus.

Countries that have achieved fiscal surpluses have managed them in different ways. Botswana has been running a budget surplus since 1983, reflecting buoyant revenue from diamond mining. Most of the accumulated surpluses have been deposited with the central bank and invested abroad. Botswana’s foreign exchange reserves now stand at close to three years of imports, with the equivalent of six months of imports invested in short-term money market instruments and the remainder in the Pula Fund, which holds foreign equities and fixed-income securities.

In Chile, transfers from the state copper company have been the source of public sector surpluses, averaging 2 percent of GDP since 1988. Chile has used its surpluses in part to build up a stabilization fund for copper prices, to repay debt (whose stock is now negligible), to on-lend to the private sector (primarily for infrastructure development), and to build up foreign exchange reserves.

In 1990 Norway established the State Petroleum Fund (SPF) to insulate the budget from variations in oil prices and production and to mitigate the effects of “Dutch disease” by investing a large share of oil receipts abroad. In the longer term, the SPF is expected to cover rising pension and health care costs as the population ages.

In 1960 Kuwait established the Reserve Fund for Future Generations (RFFG), into which 10 percent of budget revenue (primarily from oil receipts) is currently paid. The main purpose of the RFFG is to protect public investment and social programs from the impact of a decline in world oil prices. However, Kuwait has also used the RFFG to support the budget, most notably to pay some of the reconstruction costs following the 1991 Iraqi invasion. The Kuwait Investment Authority formulates the fund’s investment strategy, and the portfolio includes domestic equities, real estate, and international financial assets.

Singapore recorded an average surplus of 12 percent of GDP from 1993 to 1997, including capital revenue from the sale of government financial assets. The accumulated assets will be used to finance the government’s Edusave and Medisave Trust Funds for education and health care. Asset holdings totaled 161.8 percent of GDP in 1996-97, but little information is available on their composition.

• Fiscal Policy Rules

Rising fiscal deficits in many industrial and developing economies, especially during the 1970s and 1980s, have sparked interest in the adoption of fiscal policy rules as a way to exercise fiscal restraint. Fiscal policy rules are measures that impose permanent constraints on fiscal policy—expressed as numerical ceilings or targets—based on summary indicators of overall fiscal performance. These indicators pertain primarily to balanced-budget rules, debt rules, and rules governing the monetary financing of deficits.

The primary rationale for fiscal policy rules is that they maintain macroeconomic stability, support other financial policies, ensure long-term sustainability, reduce negative spillovers, and maintain overall policy credibility. In principle, most of these objectives can be met with discretionary fiscal measures—if sought by a far-sighted electorate or financial market—that are captured in an annual budget or a medium-term adjustment plan. However, many fiscal consolidation programs undertaken to correct the persistent budget deficits of the past two decades have been less than successful. Their failure suggests that, although discretionary policies may be theoretically superior, well-designed fiscal policy rules may offer a useful second-best solution for countering political pressures on fiscal policymaking. Indeed, the strongest case for fiscal rules can be made on the grounds of political economy—namely, their usefulness in correcting the bias of democratically elected governments to run budget deficits that accumulate public debt at the expense of future generations. In technical terms, a major advantage of rules-based fiscal policy over discretionary policy is time consistency.

Probably the best-known fiscal policy rules are those requiring a balance between government revenue and expenditure. This balance can be specified as the overall balance, the current balance, or the operating balance that must be met each fiscal year. Alternatively, it can be defined over a longer period as a structural or cyclically adjusted balance.

According to the Maastricht Treaty, members of the European Union wishing to participate in Stage 3 of European Monetary Union (EMU, effective 1999) were required to maintain their general government deficit at a level not to exceed 3 percent of GDP by 1997, following a convergence plan under way since 1992. In addition, the EMU’s Stability and Growth Pact calls for a medium-term budgetary position that is close to balance or surplus, subject to the 3-percentage-point reference value for the deficit in any year. This requirement is intended to allow automatic stabilizers to operate (whenever appropriate) throughout the business cycle. Largely accrual-based recording standards have been issued for this purpose under the so-called excessive deficit procedure, and compliance with this requirement will be verified ex post, after the end of the calendar year.

In New Zealand, officials are required to ensure that once the government reaches a prudent public debt-to-GDP ratio, it maintains that ratio on average over a reasonable period by balancing public sector operating expenditures and revenues. The requirement allows for short-term cyclical deviations from the balanced-budget position, but it does not specify whether the deviations derive only from automatic stabilizers or from discretionary actions as well. Furthermore, officials are required to keep tax rates stable over time, so that the adjustment should take place on the expenditure side.

In Switzerland, officials have proposed a constitutional amendment that mandates balancing federal government finances over the business cycle. The balanced-budget amendment was to become effective in 2001, at which time officials should have achieved balance. The understanding is that lower levels of government will cooperate in this endeavor in order to halt the increase in the public debt-to-GDP ratio. In the United States, the balanced-budget amendment to the Constitution—proposed on several occasions (in 1982, 1995, and 1997) but thus far rejected—would require that the government balance the federal budget each fiscal year. The rule could be waived only with the approval of a three-fifths majority in each house of Congress or in case of armed conflict or a threat to national security. The rule thus would preclude an explicit role for automatic stabilizers and would omit concrete guidelines on how to meet the goal of a balanced budget.

Some of the oldest functioning fiscal rules prohibit or limit government borrowing. The borrowing constraint usually specifies the source of financing (central bank or all domestic sources) and the level of government (national or subnational) to which it applies. Most industrial and some developing economies prohibit the central bank from directly financing the general government and the rest of the nonfinancial public sector. Under the Maastricht Treaty, this rule went into effect at the beginning of Stage 2 of EMU. Normally, this rule gives central banks discretion over extending short-term advances to the government as evidence of central bank independence. The rule is somewhat less common in developing countries and economies in transition. Under a strict variant, Chile and Ecuador prohibit both direct and indirect access to central bank credit. Rather than prohibiting central bank financing outright, some developing and transition economies (in the CFA franc zone, Brazil, Egypt, Morocco, the Philippines, and the Slovak Republic) limit it to a proportion of government revenue from the preceding year (usually between 5 and 20 percent).

• The Quality of Fiscal Adjustment and Structural Reform

The degree of fiscal adjustment required is not independent of the quality of the specific measures chosen to implement it. The quality of fiscal measures can significantly shape the process of macroeconomic adjustment, the rates of economic growth and capacity utilization, and the country’s external account position. The character of a government’s tax and expenditure policies can send important signals to economic agents. It can also have pervasive effects on the economy, influencing commodity and factor prices, saving and investment incentives, external capital flows, the level and structure of capital accumulation, the effectiveness of markets, the volume of transactions in the official sector, and patterns of consumption. Furthermore, in several countries, money-losing public enterprises loom large in the production of goods and services, and an improvement in their performance can affect both aggregate production and the fiscal balance.

An assessment of quality needs to focus on the sustainability and durability of the measures being considered to reduce the budget deficit and on the relative impact of alternative policy options on investment and production incentives, as well as on the external current account. Specifically, short-term deficit reduction achieved with measures that cannot be sustained or that may have adverse effects on growth over the medium term should be viewed critically. Temporary surtaxes, tax amnesties, sales of public assets, and other measures may give a country some short-term relief but will do nothing to reduce its underlying deficit. Similarly, postponing essential operations and maintenance spending or inevitable wage increases will be of only temporary value and may do more harm than good over the medium term. Countries should choose measures that are likely to be durable over the longer term, that do not diminish the efficiency of public sector operations, and that have the least costly effects on growth in the rest of the economy.

Indeed, over time specific fiscal instruments may induce a supply response in the economy significant enough to reduce the magnitude of the needed deficit reduction. For example, eliminating an export tax may generate an expansion in output and export earnings over the medium term, increasing revenues from other tax sources. Similarly, a policy to reduce employment in the public sector, especially in unprofitable public enterprises, may increase efficiency and lower costs in the medium term, even though fiscal deficits may increase in the short run as outlays for separation and unemployment benefits become necessary. Consequently, such measures should be implemented as part of a strategy to achieve medium-term fiscal viability.

In view of these considerations, the following structural tax reform measures can be viewed as supporting the objectives of macroeconomic adjustment, growth, and sustainable external accounts:

removing distortions from the income tax system and lowering high marginal tax rates;

strengthening the consumption tax base;

integrating the structures of corporate taxation and personal income taxation over time, gradually eliminating double taxation;

removing export taxes;

reforming the tariff structure to reduce anti-export bias and replacing nonneutral tariffs with broad-based consumption taxes (accompanied by changes in the direct taxation rate on both imported and domestic goods) to meet revenue objectives; and

substituting import tariffs for import quotas in the short run and reforming the tariff structure over the medium term to achieve a desirable pattern of effective protection.

On the expenditure side, the following policies can help to promote increased productivity and improved utilization of existing productive capacity:

providing sufficient funds for infrastructure operations and maintenance;

avoiding across-the-board budget cuts in materials, supplies, and services;

encouraging productive government investment, particularly when combined with policies to correct distortions in relative factor and commodity prices;

addressing sources of low productivity in government;

using more cost-effective expenditure policies to attain given political goals such as income distribution, external or internal security, and self-sufficiency;

substituting explicit budget subsidies for tax exemptions (implicit tax expenditures), to highlight clearly the opportunity cost of government policy objectives and raise the consciousness of policy-makers in setting national priorities; and

reducing government consumption outlays.

Fiscal Policy and Long-Run Growth

In addition to its short-term effects, fiscal policy may have important effects on an economy’s long-run growth performance. Among the main economic factors that determine a country’s growth over the long term are the efficiency with which any existing stock of resources is utilized, the accumulation of productive resources over time, and technological progress. Each of these factors can be affected by the main instruments of fiscal policy: tax policy, expenditure policy, and overall budgetary policy. 7

Taxation and economic growth are linked in several ways. First, taxes have a distortionary effect on economic behavior, creating a net efficiency loss to the economy. Increases in the level of taxation therefore adversely affect long-run growth in output. Second, by affecting capital accumulation, the structure of taxation may have important implications for growth. For a given tax level, a relative shift from income to consumption taxation reduces the disincentive to save, thus boosting capital accumulation. Furthermore, a heavy reliance on trade taxes can prevent an economy from absorbing or developing new technologies, hampering its growth prospects by reducing the exposure of domestic industries to international markets and competition.

Third, tax policy may also have a significant positive impact on both resource accumulation and technological progress if it provides tax incentives that promote investment and research and development activities. Without these incentives, such activities will be below optimal levels. Fourth, uncertainty about the tax regime can have adverse effects on growth, since uncertainty injects volatility into the returns from investment projects, reducing or postponing investment and impeding growth.

Empirical evidence on the effects of various aspects of tax policy on growth has been mixed. 8 Although the general indication is that the relationship between either total tax or income tax revenue and growth is negative, this relationship is not robust and is sensitive to model specification. The most severe difficulty in isolating the impact of taxation on growth is that growth may be affected by key nontax variables, such as public expenditure and budget policies, that are often not independent of tax policy. Overall, empirical evidence on the relationship between taxation and growth is relatively weak compared with the theoretical predictions.

• Expenditure Policy

It was explained earlier how the crowding-out effect increases public expenditure at the expense of private investment and thus has an adverse impact on long-run output growth. However, public expenditure can also enhance growth by increasing private sector productivity (the externality or public good effect ). In this case a high level of expenditure results in a high growth rate. Thus, the impact on growth depends on the relative strengths of the crowding-out and externality effects.

Traditionally, public investment in physical infrastructural activities has been associated with strong externality effects. Some public consumption expenditures, however, may also have a similar growth-promoting impact, such as spending on elementary education and vocational training to enhance human capital, on infrastructure operations and maintenance, and on targeted research and development activities.

As with taxation, empirical evidence on the growth effects of total public expenditure (as a ratio to GDP) are inconclusive. At a more disaggregated level, evidence shows a positive correlation between growth and public investment in infrastructure. Some studies have also shown that public expenditure on education has a positive impact on growth and that military spending has a significantly adverse impact.

The difficulties noted earlier of estimating the growth effects of taxation apply to public expenditure as well. Even if the correlation between growth and public expenditure (or a subset thereof) is found to be robust, the direction of causation underlying the correlation is still unclear. Increased income growth may well generate higher demands for some or all types of public expenditure. Thus, it is at least possible that the direction of causation runs from growth to public expenditure.

• Budget Policy

Budget policy is another broad fiscal variable that can have implications for growth, in that the budget balance may have growth effects that are separate from those related to either taxation or public expenditure. For instance, budget imbalances may trigger a behavioral response from the private sector. Earlier the chapter referred to the Ricardian-equivalence proposition on the neutrality between debt and tax financing of government expenditure. If the private sector regards debt-financed budget deficits simply as delayed taxes, then it may choose to increase its own saving to neutralize the public dissaving, stabilizing the level of national saving. Alternatively, budget deficits may not induce a response in private sector saving, in which case national saving falls, hampering growth. Much research has focused on whether neutrality exists between debt and tax financing, but the empirical evidence has been inconclusive.

Budget imbalances that affect stability may also affect growth. If current budget policy is deemed to be unsustainable, expectations are that either the tax and expenditure regimes will change or that the government will resort to monetary financing. The former increases policy uncertainty and is likely to have an adverse impact on growth; the latter leads to inflation, which can also affect growth adversely. Although the relationship between inflation and growth is complex at the conceptual level, empirical evidence is growing to suggest that a significant negative correlation exists between high inflation and growth. Thus, there is a compelling case for believing that an expansionary budget policy that generates high rates of inflation will most likely retard growth.

• Appendix 8.1: The Open Economy IS-LM Model

The open economy IS-LM model can be represented by the following three equations:

Ā = autonomous spending (including government spending and autonomous private investment)

c = the marginal propensity to consume

i = the domestic interest rate

b = the coefficient of interest-sensitive investment

M/P = the demand for real money balances

k = the income coefficient of demand for real balances

h = the interest coefficient of demand for real balances

NX = net exports

X = a constant (representing all other influences)

m = the marginal propensity to import

R = the real exchange rate

v = the coefficient for the real exchange rate.

Substituting the third equation into the first yields

The IS equation yields

where s = 1 – c is the marginal propensity to save.

Equation (8.12) shows that an increase in government spending by Δ G will increase Ā by Δ G and Y by Δ G [1/( s + m )], where 1/( s + m ) is the simple open-economy multiplier.

With perfect capital mobility, one has i = i f , where i f is the foreign interest rate. Thus, the LM schedule can be expressed as

The equilibrium level of income is determined by the domestic real money supply and the foreign interest rate. In this case, the exchange rate adjusts to clear the goods market.

• Bibliography

Agénor , Pierre-Richard , and Peter J. Montiel , 1997 , Development Macroeconomics , 2nd ed. ( Princeton, New Jersey : Princeton University Press ).

• Search Google Scholar
• Export Citation

Chalk , Nigel , and Richard Hemming , 1998 , “What Should Be Done with a Fiscal Surplus?” IMF Paper on Policy Analysts and Assessment 98/10 ( Washington : International Monetary Fund ).

Corden , W. Max , 1997 , “How Would a Fiscal Expansion Affect the Exchange Rate?” in Macroeconomic Dimensions of Public Finance: Essays in Honor of Vito Tanzi ( Washington : International Monetary Fund ), pp. 131 – 45 .

Dornbusch , Rudiger , Stanley Fischer , and Richard Startz , 1998 , Macroeconomics , 7th ed. ( New York : McGraw-Hill ).

Fischer , Stanley , and William Easterly , 1990 , “The Economics of the Government Budget Constraint,” World Bank Research Observer , Vol. 5 , No. 2 , pp. 127 – 42 .

Fleming , J. Marcus , 1962 , “Domestic Financial Policies Under Fixed and Floating Exchange Rates,” Staff Papers , International Monetary Fund, Vol. 9 ( November ), pp. 369 – 79 .

International Monetary Fund, Fiscal Affairs Department , 1995 , Guidelines for Fiscal Adjustment , IMF Pamphlet Series, No. 49 ( Washington : International Monetary Fund ).

Khan , Mohsin S. , 1987 , “Macroeconomic Adjustment in Developing Countries: A Policy Perspective,” World Bank Research Observer , Vol. 2 , No. 1 , pp. 23 – 42 .

Khan , Mohsin S. , and J. Saul Lizondo , 1987 , “Devaluation, Fiscal Deficits, and the Real Exchange Rate,” World Bank Economic Review , Vol. 1 , No. 2 , pp. 357 – 74 .

Kopits , George , and Steven Symansky , 1998 , Fiscal Policy Rules , IMF Occasional Paper 162 ( Washington : International Monetary Fund ).

Mundell , Robert A. , 1962 , “The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability,” Staff Papers , International Monetary Fund, Vol. 9 ( March ), pp. 70 – 79 .

Musgrave , Richard A. , and Peggy B. Musgrave , 1989 , Public Finance in Theory and Practice , 5th ed. ( New York : McGraw-Hill ).

Tanzi , Vito , and Howell H. Zee , 1997 , “Fiscal Policy and Long-Run Growth,” Staff Papers , International Monetary Fund, Vol. 44 ( June ), pp. 179 – 209 .

World Bank , 1997 , “Challenges of Macroeconomic Management,” in Private Capital Flows to Developing Countries: The Road to Financial Integration ( New York : Oxford University Press ).

For an elaboration of the analysis contained in various sections of this chapter, see three particularly useful references: Dornbusch, Fischer, and Startz (1998) for the impact of fiscal policy on macroeconomic objectives; IMF, Fiscal Affairs Department (1995) for issues in fiscal policy and macroeconomic management; and Tanzi and Zee (1997) for the effect of fiscal policy on long-term growth.

These effects can also be examined within the context of an alternative framework that may characterize the economies of developing countries more closely. The main features of this framework are officially determined (rather than flexible) exchange rates; a portfolio (stock) specification of capital movements, rather than a flow specification; and a vertical aggregate supply curve that emphasizes the effects of fiscal policy on the price level and the real exchange rate rather than on the level of output. For an elaboration on this alternative approach, see Agénor and Montiel (1997) .

This formulation is often referred to as the Mundell-Fleming model (see Fleming, 1962; Mundell, 1962 ).

The appendix to this chapter describes how the multiplier was derived.

Corden (1997) provides an in-depth analysis of the effects of fiscal expansion on the exchange rate.

The magnitude of the required nominal devaluation to achieve a given real exchange rate objective may also depend on how the fiscal deficit is reduced. Broadly speaking, the required nominal depreciation is larger if the fiscal deficit is reduced by increasing taxes than if it is reduced by lowering expenditure, and smaller if the expenditure cuts fall on traded goods rather than on nontraded goods (Khan and Lizondo, 1987 ).

This analysis is based on Tanzi and Zee ( 1997 ), who provide a comprehensive discussion and survey of the effects of fiscal policy on long-run growth.

For sources on the literature in this section, see Tanzi and Zee ( 1997 ).

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Table of Contents

• Front Matter
• 1 Macroeconomic Management: An Overview
• 2 Adjustment and Internal-External Balance
• 3 Do IMF-Supported Programs Work? A Survey of the Cross-Country Empirical Evidence
• 4 Sources of Growth
• 5 Current Account Sustainability
• 6 The Framework of Monetary Policy
• 7 Inflation Targeting
• 8 Fiscal Policy and Macroeconomic Management
• 10 Determinants of Nominal Exchange Rates: A Survey of the Literature
• 11 The Long-Run Equilibrium Real Exchange Rate: Theory and Measurement
• Back Matter
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• Services & Resources
• CA Equity Performance and Improvement Program
• Improving Academic Achievement
• Schoolwide Programs
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• Specialized Programs Other Topics
• American Indian
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• Class Size Reduction
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• Title II, Part A Resources and Guidance
• Finance & Grants
• Criteria and Standards for Fiscal Solvency

School District Budgets 2024–25

Criteria information: budgets.

Deviations from the standards must be explained, and may affect the approval of the budget.

1 Available reserves are the unrestricted amounts in the Stabilization Arrangements, Reserve for Economic Uncertainties, and Unassigned/Unappropriated accounts in the General Fund and Special Reserve Fund for Other Than Capital Outlay Projects. Available reserves will be reduced by any negative ending balances in restricted resources in the General Fund.

2 Dollar amounts to be adjusted annually by the prior year statutory cost-of-living adjustment, as referenced in Education Code Section 42238.02, rounded to the nearest thousand.

3 A school district that is the Administrative Unit of a Special Education Local Plan Area (SELPA) may exclude from its expenditures the distribution of funds to its participating members.

4 Percentage levels equate to a rate of deficit spending which would eliminate recommended reserves for economic uncertainties over a three year period.

Supplemental Information: Budgets

Provide methodology and assumptions used to estimate ADA, enrollment, revenues, expenditures, reserves and fund balance, and multiyear commitments (including cost-of-living adjustments).

Provide information on additional indicators as requested.

1 Include multiyear commitments, multiyear debt agreements, and new programs or contracts that result in long-term obligations.

• Interim Status
• School District Budgets 2024–25 (added 13-May-2024) removed by RO --> Criteria and Standards for reviewing school district 2024–25 budgets. The criteria and standards are codified in Title 5 of the California Code of Regulations, Sections 15440-15452 for school district budgets. removed by RO -->
• County Office Budgets 2024–25 (added 13-May-2024) removed by RO --> Criteria and Standards for reviewing county office of education 2024–25 budgets. The criteria and standards are codified in Title 5 of the California Code of Regulations, Sections 15467-15475 for county office of education budgets. removed by RO -->
• First Interim Status Report, FY 2023-24 (added 18-Apr-2024) removed by RO --> Listing of local educational agencies receiving negative and qualified certifications for fiscal year 2023-24 first interim. removed by RO -->