rules, and their effects on fiscal policy in sweden...but fiscal policy—that eventually determines...

SWEDISH ECONOMIC POLICY REVIEW 15 (2008) 7-47

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Rules, and their effects on fiscal policy in Sweden

Peter Claeys*

Summary

Fiscal rules aim at constraining public debt. In Sweden, a combina-tion of procedural and numerical rules was introduced in response to the severe 1991 fiscal crisis. These rules have been effective: public debt has come down. The current fiscal framework does not rule out future fiscal crises, however. Spending is not sufficiently kept under control. Taxes are set procyclically, only to keep debt in check. Con-trols on debt sustainability require tighter spending rules, linked to levels of taxation. JEL classification: E60, E62, E65. Key words: Fiscal policy, debt, sustainability, Markov switching, Swe-den.

* Peter Claeys is a Research Fellow at the Universitat de Barcelona, Research Group AQR-IREA.

SWEDISH ECONOMIC POLICY REVIEW 15 (2008) 7-47

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Rules, and their effects on fiscal policy in Sweden

Peter Claeys* The sustained high deficits in most industrialised countries in the sev-enties and eighties caused some concern about the sustainability of public debt. This has raised an interest in ways of restraining this “deficit bias”. Fiscal rules that constrain the ability of governments to use spending and taxes at their discretion have generated much de-bate. In contrast to the academic discussions on monetary policy, there are many practical proposals for implementing controls on fiscal policy. Fiscal rules can take many forms. An improved design of the budget process, which is often accompanied by some institutional shake up, goes to the core of the political problem at the root of the debt problem. Alternatively, a numerical target on deficit or debt ra-tios has been imposed. These rules seem to have disciplined fiscal policy. Even if the Gramm-Rudman-Hollings Act never officially ap-plied, the Clinton Administration nevertheless governed a substantial reduction of public debt. The EU governments enshrined public debt and deficit targets in the Treaty of Maastricht and strengthened these provisions with the Stability and Growth Pact. These targets have been met in different countries through a diversity of fiscal rules. Some EU countries undertook major institutional reforms; others built political agreement around debt consolidation; many imposed simple numerical constraints.

As in most other OECD countries, Sweden also started to experi-ence fiscal trouble in the late seventies. Debt soared by more than 40 per cent of GDP in a couple of years. The brief consolidation of debt over the eighties occurred without any formal changes in the setting of the budget. These informal agreements on fiscal discipline were not sufficiently strong to prevent the most severe debt crisis of 1992.

* Peter Claeys acknowledges support by a Marie Curie Intra-European Fellowship within the 6th European Community Framework Programme. Correspondence address: Universitat de Barce-lona, Facultat de Ciències Econòmiques i Empresarials, Grup AQR IREA, Torre IV, Avin-guda Diagonal, 690, E-08034 Barcelona, Spain. Email: [email protected] tel: +34 934021010, fax: +34 934037242.

RULES, AND THEIR EFFECTS ON FISCAL POLICY IN SWEDEN, Peter Claeys

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As economic conditions worsened dramatically both at home (finan-cial crises) and abroad (EMS crisis, Russia), the deficit plunged to double digits, and debt soared once more by 40 per cent of GDP in less than a year (Figures 1 and 2). Fiscal rules were adopted in re-sponse to this fiscal havoc. Sweden is an exemplary case of a combi-nation of both institutional and numerical fiscal rules. Initially, proce-dural reform put more centralised budget procedures in the hands of the finance minister, strengthened the position of the government in budget setting and led to some institutional changes related to the budget process (Hallerberg, 2004). Numerical fiscal rules have been put in place since 1997 and consist of three parts. The government budget should aim at an overall structural surplus of one percent of GDP.1 This surplus target is anchored to an expenditure rule for the central government, which defines a rolling medium-term nominal ceiling on spending for the next three years. This is not a rigid limit: a built-in margin allows for some cyclical variation in spending and gives some flexibility in the budget planning process. Finally, local governments need to run balanced budgets, and any deficits have to be offset within two years.2

Figure 1. Debt ratio to GDP

1970 1975 1980 1985 1990 1995 2000 2005

30

40

50

60

70

80

1 This was modified in 2006 from the initial two per cent surplus target as EU regu-lations classified some parts of the pension system as belonging to the private sec-tor. 2 In addition, Sweden also needs to comply with the provisions of the Stability and Growth Pact.


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Figure 2. Surplus ratio, and output gap

1970 1975 1980 1985 1990 1995 2000 2005

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

surplus ratio gap

Note: vertical bars indicate the troughs of growth cycle recessions (ECRI). Fiscal rules are not a panacea: they always present a compromise be-

tween simplicity and comprehensiveness (Kopits and Symansky, 1998). Rules often address past policy problems to redress the fiscal situation, but do not look forward to possibly new threats to debt sus-tainability. As rules cannot provide clauses for all contingencies, sev-eral loopholes are open that governments can possibly exploit to run up deficits under some circumstances. Fiscal rules are only as strong as the political consensus that can be gathered in their favour (De-brun and Kumar, 2007). The violation of fiscal rules in recent years attests to the ease with which fiscal rules can be modified. A pessimis-tic view would be that rules are mere statements by the government about current policy, rather than working as a constraint on fiscal pol-icy. Once debt consolidation shifts down on the priority ladder of governments, fiscal policy may switch its stance. Political and eco-nomic circumstances may make it difficult not to give in to renewed calls for spending hikes or tax cuts. Without sufficiently strong insti-tutions to guarantee a continued concern for the sustainability of pub-lic finances, debt will rise again.

In this paper, I characterise these shifts in fiscal policy between al-ternating periods of debt consolidation and loose fiscal policies. I ana-lyse the mechanism behind the deficit bias by looking in detail at both spending and taxation decisions of Swedish fiscal policy since 1970. I basically test fiscal rules for the sustainability of public debt. I outline


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the arguments for the derivation of the empirical policy rules in Sec-tion 1. A concise overview of the empirical literature on systematic fiscal policy shows how we may recast a test for debt sustainability à la Bohn (1998) in terms of a fiscal policy rule. I discuss some major problems in the identification of fiscal policy in Section 2. Tthen, I follow traditions in the monetary policy literature in estimating fiscal rules in which the surplus is gradually adjusted to its target level. I de-tail the behaviour of Swedish fiscal policy by decomposing fiscal rules in spending and taxes in Section 3. I further examine the stability of these fiscal rules to lay out the mechanism behind spending and taxes that underlies debt creation in Section 4. Then, I compare the experi-ence with fiscal rules in Sweden to that of similar open economies. Conclusions follow in Section 6.

1. Fiscal rules

1.1. Sustainability of public debt, and fiscal rules

Discussions about fiscal policy rules have mostly been normative and limited to practical policy proposals. These can be roughly divided into two different types. A first group of rules explicitly imposes nu-merical deficit or debt targets. Balanced budget rules, a golden rule, debt brakes, etc. all belong to this class. A second class changes the rules of the game. A change in institutional arrangements is believed to improve budgeting procedures. Both types of rules aim at correct-ing the deficit bias in fiscal policy. The objective is a sustainable path for public finances.

Sustainability means that the public sector does not leave public assets or liabilities with any positive probability, i.e., the sum of the present discounted value of expected future primary surpluses suf-fices to pay off current debt. The period-by-period dynamics of total debt bt are given by the accumulation of interest payments on past fiscal imbalances and the current primary surplus, st, which is the dif-ference between government revenues tt and government spending, gt3

. where )1( 1 ttttttt gtssbrb −=−+≡ − (1)

3 All fiscal data are expressed as a ratio to output here. Spending is inclusive of in-terest payments on public debt.


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Solving forward (1), one obtains the intertemporal budget con-straint IGBC (2)

.)1

()1

(lim101

+−

+

+=

+

++

==

∞

+

+

=∞→ ∏∑∏

jt

ntntn

jt

njt

ntn

jtnt r

tgEr

bEb (2)

The sustainability condition is met when the public sector does not

leave any public assets or liabilities with a positive probability. For this to hold, the transversality condition needs to be satisfied, i.e. when

.0)1

(lim1

=

+ +

+

=∞→ ∏

jt

ntn

jtn r

bE (3)

Some equivalent time series tests for fiscal sustainability can then

be derived under various assumptions on this condition. Cointegra-tion between non-stationary government expenditures gt and revenues tt can be shown—under some weak economic assumptions—to be a necessary condition for the IGBC to hold. Conversely, this cointegra-tion relation is also a sufficient condition under weak assumptions on the data generating process of debt, viz. that it is an I(1) process (Ahmed and Rogers, 1995). It then follows that the total government deficit series is stationary when spending and revenues—or alterna-tively the primary surplus st and public debt bt—are cointegrated.4 Most of the empirical tests of fiscal sustainability have been based on the (co)integration implications of the transversality condition. The latter relation between the primary surplus and debt can also be re-written in terms of a reaction function (4):

ttt µbθs += . (4)

Bohn (1998) proves that a strictly positive reaction of the primary

surplus st to public debt in this “fiscal rule” is a robust sufficient con-dition for the sustainability of public finances.5 4 Such “bounded” sustainability implies that undiscounted public debt is finite in the long run. With an unspecified cointegrating vector, only weak sustainability can be said to hold (Quintos, 1995). 5 I.e., rejection of this null does not mean that fiscal policies are necessarily unsus-tainable.


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Governments can run higher surpluses and reduce public spending or raise more taxes so as to pay off public debt. But there are alterna-tive policies for stabilising public debt. Inflation erodes the real value of outstanding public debt. Leeper (1991) and Sims (1994) argue that prices or output will adjust to make the IGBC hold, whenever fiscal policy disregards public debt. In that case, it is not monetary policy—but fiscal policy—that eventually determines prices. If fiscal policy is not sufficiently reactive to debt, fiscal policy is labelled as “active”. In contrast, if fiscal policy responds to debt—or is “passive”—then the budget constraint will be satisfied for all price paths. Monetary policy retains the ability to control prices in this Ricardian environment. We may test whether policy is active or passive with a fiscal rule similar to equation (4). For a passive government, 0>θ . The implications and the underlying assumptions of this “Fiscal Theory of the Price Level” have not gone unchallenged, and its validity is a fiercely debated is-sue.6

A less sanguine view on policy interaction takes account of other economic effects on the path of spending, taxation and public debt. Lower interest rates or higher inflation reduce the burden of interest payments on outstanding debt. The debt position also becomes more sustainable in a period of strong economic growth. We can redefine the fiscal rule in terms of the surplus that would be needed to bring about the stabilisation of public debt. We can write out the flow budget constraint (1) to get:

ttt

tt sb

kqb −

++

= −1)1()1( . (5)

Apart from the surplus in every period, the increase in debt also

depends on real interest rates qt as well as nominal economic growth tk . Debt remains stable if the debt-stabilizing surplus ts equals

)1/()(1 tttt kkqb +−− . If nominal GDP growth exceeds the interest cost of debt, persistent deficits are still consistent with debt stabiliza-

6 Note that identification of different policy regimes with a fiscal feedback rule still runs into identification problems. A passive rule is not uniquely defined from the data generating process for surpluses and debt, and is observationally equivalent to an off-equilibrium behaviour that is consistent with active fiscal policies (Cochrane, 1998).


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tion as real economic growth and inflation outgrow the interest pay-ments.

This presumes that interest rates and other economic variables are exogenously determined. However, empirical evidence shows that fiscal policy may have real economic effects (Blanchard and Perotti, 2002). Both fiscal and monetary policies react to—and have an effect on—current economic conditions in the short term. Some recent DSGE models have revived the interest in the public finance ap-proach towards the joint determination of fiscal and monetary poli-cies. In these Ramsey type of models, the government’s problem is that of selecting the least disruptive combination of inflation and taxa-tion that maximises the representative agent’s welfare for financing a given level of public spending (Lucas and Stockey, 1983; Chari et al., 1991).7 This approach has recently been popularised by marrying it to the growing class of DSGE models with nominal price rigidities and imperfect competition (Schmitt-Grohé and Uribe, 2004). These re-sults carry relevant insights into the systematic setting of both fiscal and monetary policy to economic conditions. A relevant joint deci-sion problem for both authorities arises as both policies can minimise the cumulative distortion in output that is caused by distortionary taxation and sticky prices. Both fiscal and monetary policy makers intend to maximise welfare by stabilising inflation and the resulting output gap. Benigno and Woodford (2003) characterise time-invariant optimal fiscal and monetary policy targeting rules. Both policies nec-essarily respond to inflation as well as output targets. Fiscal policy needs to contribute to the traditional monetary task of inflation stabi-lisation, as tax rates affect real marginal costs (and hence prices). Monetary policy needs to take account of alternative price and interest rate paths for the government budget constraint. I will not analyse such theoretical fiscal rules, but the arguments call for an analysis of fiscal policy that includes economic responses of the budget.

7 This supposes a cooperative social planner. Alternatively, fiscal and monetary pol-icy could be on a conflict course, or caught in a bad policy mix, as each can exploit its own policy instrument at its discretion (Nordhaus, 1994). This gives rise to ei-ther an inflation or a spending bias (Adam and Billi, 2006). Leadership by one or both policy makers avoids strategic moves and the non-cooperative races that are associated with the Nash equilibrium, whenever there is no agreement on the policy objectives (Dixit and Lambertini, 2003).


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1.2. The identification of fiscal policy rules

There is no comprehensive framework for analysing fiscal policy. Hence, it is useful to set some terminology for characterising fiscal policy. The main distinction is between fiscal policy actions that can be attributed to discretionary policy decisions on the one hand and automatic responses of fiscal variables to cyclical economic conditions (“automatic stabilisers”) on the other. By definition, we can decom-pose any indicator of fiscal stance tf into a structural (or cyclically

adjusted part tf ) and a cyclical component ( tyα ) as shown in (6), with α being the elasticity of the fiscal indicator with respect to out-put:

.ˆttt yff α+≡ (6)

The latter component includes the reduction of unemployment

benefits and transfer payments, or the increase in tax receipts in an economic boom.8 Typically, one would attribute the structural part to discretionary policy intervention. With a fiscal rule, in contrast, I ex-press the indicator tf as a function )(•h of cyclical conditions ty and some other variables collected in Xt, for example, political vari-ables, election cycles, etc.:

.),( tttt Xyhf ε+= (7)

We can associate cyclical reactions of fiscal policy with automatic

stabilisers. But, in addition, the government may wish to steer the economy and implement supplementary measures in response to eco-nomic conditions. The government may wish to further fuel a boom by lowering taxes or increasing spending, or lean against the wind by raising tax revenues and cutting spending. Any systematic cyclical re-actions of discretionary policy are also included in the cyclical reac-tion. The non-systematic part is the true “policy shock” tε .

The estimation of monetary policy rules has become a true re-search industry. In contrast, fiscal rules like (7) are not widely esti-mated. There are a number of reasons for this lack of evidence. 8 Figure 2 shows the close correlation between both the surplus and gap series, and the common turning points at changes in the economic growth cycle.


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First, fiscal policy indicators are not widely available. Data con-straints limit the analysis: reliable measures of fiscal variables at a quarterly frequency are available for a limited number of countries only (Perotti, 2005).

Second, the estimation of monetary policy rules has been guided by the validity of the Taylor Principle by which central banks should not accommodate changes in the price level (Clarida et al., 2000). There is no similar leitmotiv in fiscal rules. Plenty of papers limit the analysis to gauging the cyclical sensitivity of some fiscal policy indica-tor in (7). Other papers mostly focus on the response of the fiscal surplus to public debt (Bohn, 1998). Still another branch of the litera-ture focuses on political determinants of fiscal policy. Consequently, fiscal rules have hardly carried the normative policy prescriptions of the monetary Taylor rule.

Third, the heterogeneity of fiscal policy both in its setting (compo-sition of revenues versus spending) and in its effects on different eco-nomic agents impedes a straightforward extension of fiscal rules as it implies several identification problems. The main problem relates to the automatic stabilisation component in fiscal variables. Not only do cyclical fluctuations explain an important part of the variation in fiscal variables because of the workings of the automatic stabilisers. Except under the hypothesis of Ricardian equivalence, these fluctuations may also be determined by the fiscal variable. If fiscal policy indeed has real effects on the economy, then the fiscal policy shock is likely to be correlated with the output gap in the policy rule. Second, there is a potential joint dependence between the primary deficit and debt that works via the interaction of the fiscal rule with the debt flow equation (1). Applying OLS leads to biased and inconsistent estimates and the degree of stabilisation would consequently be overestimated. Both problems suggest instrumental estimation to correct for the endoge-neity of output, and correctly label the estimation of this reaction function as a fiscal policy rule. There are only a few papers that test fiscal rules. Viren (2002) demonstrates how much the cyclical sensitiv-ity of the budget is reduced for a pool of EU states. Lane (2003) ex-amines cyclical properties of different government budget compo-nents: cyclicality is shown to vary substantially across budget items. Ballabriga and Martinez-Mongay (2003) estimate non-linear fiscal pol-icy rules for EU countries. Fiscal policy is found to be only weakly countercyclical.


18

Finally, the heterogeneity of fiscal policy also reflects the political nature of spending and tax decisions. Structural breaks in fiscal policy have not been so well documented. A range of eligible breakdates has been suggested in the literature, mostly based on ad hoc arguments. Narrative studies on the effects of fiscal policy use major US defence spending increases such as the Korean, Vietnam or the Cold War to identify fiscal shocks (Ramey and Shapiro, 1998). A common turning point for European fiscal policy is supposed to be the consolidation started under the Treaty of Maastricht (Wyplosz, 2005; Galí and Pe-rotti, 2003). For Sweden, Ohlsson and Vredin (1996) relate fiscal out-comes directly to changes in government ideology. The long-term orientation of fiscal policy probably undergoes more gradual trans-formations. Hence, fiscal rules are best understood by relating them to different regimes. A few papers explicitly model continuous regime changes in US fiscal policy (Davig and Leeper, 2005; Favero and Monacelli, 2005).

2. Methodology

Fiscal data for Sweden are available at a quarterly frequency since 1970, and cover a broad range of spending and tax items. I can thus characterise fiscal policy behaviour over a reasonably long sample and over a period with relevant policy shifts. The budget data give suffi-cient details to look at the policy conduct of governments. In order to characterise fiscal policy behaviour, I take as the baseline target rule of the government a reaction function of a surplus objective ∗

ts that is set at some long-term level *s ,9 but also varies in response to cyclical conditions and public debt,

).()(* ∗∗∗ −+−+= bbyyss tett θγ (8)

The surplus target fluctuates in response to expected deviations of

output ety from the desired target output level ∗y . The output re-

sponse γ does not only capture the automatic stabilisation responses of some spending and revenue categories; it also includes the system-atic discretionary intervention of the government to cyclical condi-

9 This could, for example, correspond to a “golden rule” deficit which allows pro-ductive investment spending to be financed by issuing debt.


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tions. If the government just lets the automatic stabilisers work over the cycle, then γ=α. The government also attaches some direct weight on debt by keeping under control deviations of debt bt from a steady state long-term level for debt b*.

We can filter the surplus target by applying the definition equation (6) to (8). Under the assumption that the long-term surplus and out-put level targets of the government are consistent, I obtain an expres-sion for the cyclically adjusted instrument ∗

ts of the fiscal authority

).())((ˆˆ * ∗∗∗ −+−−+= bbyyss tett θαγ (9)

The targeted cyclically adjusted surplus is in part structural, but is

also determined by any bias in output or debt stabilisation the gov-ernment may have.

Fiscal policy is more typically characterized by implementation lags than is monetary policy. Governments put in practice electoral prom-ises and the budget process involves lengthy parliamentary processes. Sunk decisions of previous government are not easily unwound. Hence, the anticipated (endogenous) component of fiscal policy should be adequately represented by simple feedback rules. I assume that the fiscal instrument only gradually adjusts to its target level:10

.)1(1 tttt sss υρρ +−+= ∗

− (10) This gives the following non-linear relation between the surplus

and public debt, and is the baseline empirical specification of the fis-cal rule:

[ ] ttttt bxss υθγωρρ +++−+= − )1(1 (11)

where the output gap is given by yyx tt −= . In this rule, ω equals

)()(ˆ* bbyys −−−− ∗∗ θγ and represents the long-term fiscal indica-tor adjusted for the deviation between the government’s output (debt) target and long-term output (debt). The residual term υt captures dis-

10 Alternatively, the government may implement a policy that gradually converges to some debt level.


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cretionary exogenous deviations from the rule (which is interpretable as a fiscal policy shock).

I test (11) as the baseline fiscal policy rule. Let us assume that the fiscal instrument is the primary surplus ratio to GDP. The key interest usually focuses on the systematic cyclical properties of fiscal policy. I take as the output measure the gap calculated by OECD.11 If auto-matic stabilisers are allowed to work, then αγ = and the structural surplus ts is constant at its long-term level s ceteris paribus. A positive coefficient αγ > indicates additional discretionary intervention, while αγ < procyclically magnifies the output gap. General govern-ment debt is consolidated across different government levels, and ex-pressed as a ratio to GDP. Debt sustainability has commonly been inferred from a positive coefficient, θ .12 The magnitude of this re-sponse is of minor importance: as long as a stabilising response to public debt comes about on average, this is sufficient for sustainability (Canzoneri et al., 2001).

Testing a fiscal policy rule as in (11) suffers from simultaneity be-cause of the dependence between the surplus and debt, and the eco-nomic effects of fiscal policy. I therefore use a Generalised Method of Moments (GMM) procedure to identify the equilibrium responses of the reaction coefficients in the fiscal rule. In the set of instrumental variables, I include lags of the output gap and debt. In addition, I consider unit labour costs, growth in labour productivity and the NAIRU as domestic supply side factors. A broad money aggregate takes account of domestic monetary policy. Other instruments model international monetary conditions (a synthetic interest rate of the Euro Area, oil price index, the SEK/DEM exchange rate). I test overidentifying restrictions with the J-test (Hansen, 1982); and I addi-tionally compute the F-test on the first stage regression for each of the endogenous right-hand side variables to test for weak identifica-tion.

11 Automatic stabilisers respond to real time changes in the economy. I choose the contemporaneous output gap. In case the government gives additional fiscal im-pulses to the economy, it bases this decision on current output conditions available at the time of planning government spending, rather than on data ex post. Unfor-tunately, real time data on the output gap in Sweden are available since 2000 only. 12 In FTPL terminology, a similar condition implies that fiscal policy is “passive” (see Section 2).


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3. Fiscal rules, and their effects

3.1. The baseline fiscal rule

Let us first consider a baseline fiscal rule, in which the government stabilises debt with the primary surplus. Table 1 reports the GMM estimates of the fiscal rule (11). The main finding is that the govern-ment does not sufficiently raise the primary surplus to pay off out-standing debt. The response to debt of the primary surplus is not sig-nificant. The negative sign rather indicates that deficits have been growing in the wake of rising debt. The implication is that debt in Sweden is not on a sustainable path. Time series tests for sustainabil-ity on the surplus and debt series give a similar result.13

Fiscal policy is not very sluggish. The budget surplus is less persis-tent than what it seems at first sight: after one year, about half of the budget decision has already been reconsidered. This is much faster than revisions of monetary policy, for example. These findings are in line with the results of Ballabriga and Martinez-Mongay (2003) or Galí and Perotti (2003) for Sweden.

The budget is remarkably responsive to the cycle: a 1 per cent im-provement in the output gap strengthens the budget position by about 1.40 per cent. This strong procyclical effect is known—as in other Scandinavian countries—to largely be the effect of the extensive welfare state and large automatic stabilisers built into the unemploy-ment system. But the response is much stronger than the computed elasticity of the total balance. Recent OECD studies show how the output elasticity of the total budget balance is about 0.79 in Sweden. The reform of the welfare state and the tax system has substantially brought down the sensitivity of the budget to cyclical variations. The elasticity shrunk to about 0.55.

13 Both the (primary) surplus and debt ratio are integrated of order one. In case one controls for potential breaks in the time series, both the Zivot Andrews and the Perron test indicate that the debt ratio is I(2). Further indication of unsustainable fiscal policies is given by interest payments, which also behave as an I(2) process. Cointegration tests instead show that both spending and revenues expand as a ratio to GDP, but that taxes offset the increases in primary spending and interest pay-ments. Similarly, the primary surplus and debt are cointegrated.


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Table 1. Fiscal surplus rule (1970:1-2006:4)

Primary surplus

ratio Surplus ratio

Primary surplus ratio to potential

GDP ρ 0.89

(0.00) 0.85

(0.00) 0.85

(0.00) γ 1.46

(0.00) 1996:1

1.40 (0.00) 1996:1

1.45 (0.00) 1996:1

θ -0.02 (0.76) 1995:4

-0.10 (0.12) 1995:4

-0.04 (0.49) 1995:4

R 2 0.98 0.97 0.97 F (0.00) (0.00) (0.00) dw 1.23 0.77 0.85 J (0.44) (0.79) (0.90) F1 γ (0.00) (0.00) (0.00) F1 θ (0.00) (0.00) (0.00) AQ break 1995:1

(0.00) [1994:1;1996:1]

1993:4 (0.00)

[1992:2;1995:2]

1993:4 (0.00)

[1992:2;1995:2] Bai Perron 1975 :4

1977 :4 1979 :1 1980 :3 1986 :2 1991 :4 1995 :4 2001 :4

1975 :4 1977 :4 1979 :1 1980 :3 1986 :2 1991 :4 1995 :4 2001 :4

1975 :4 1977 :4 1979 :1 1980 :3 1986 :2 1991 :4 1995 :4 2001 :4

Notes: coefficients of (11) are reported together with p-values in brackets; dates below coefficient estimates are the significant Andrews Ploberger breakdate for that coefficient; dw is Durbin Watson test; J the p-value for the Hansen test of over identification; F1 the p-value for the F-test on the significance of instrumental vari-ables in the first stage regression (test for weak instruments); AQ the supremum Andrews Quandt break test on all coefficients, and its confidence interval; Bai Per-ron is a test for multiple breaks for all coefficients.

Even if one accounts for the uncertainty surrounding the assump-

tions on the output elasticities of different tax bases, a rise in the out-put gap of one per cent will still not lead to an improvement in the budget stance of more than 0.47 to 0.62 per cent (Girouard and André, 2005). The statistically significant difference to the actual budget response lies with a countercyclical policy that gives additional fiscal impulse to the economy in a recession, and reins in deficits in


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economic booms. This finding also holds for the total surplus. This should not come as a surprise, given that interest costs on debt may vary over the cycle, owing to changes in the interest rate and inflation. The result also continues to hold if we account for cyclical fluctua-tions using filtered data. I scale the data by potential GDP to remove short-term cyclical reactions in the nominator: the cyclical response remains as large. The finding of an active fiscal policy ignoring debt is confirmed for all alternative definitions of the surplus.

Fiscal policy is a consequence of political bickering and its long-term orientations are hence likely to vary over time. The large deficits in the early eighties and nineties that created the first and second big boom in public debt have been alternating with periods of a tighter fiscal stance (Figures 1 and 2). This instability could explain the find-ing of unsustainable fiscal policies in Sweden. I test the parameters in the fiscal rule for structural breaks in three different ways. First, I search endogenously for a joint break in all coefficients and estimate this breakdate by least squares, testing its significance with the supre-mum Quandt LR test on the central 70 per cent of the sample. I mod-ify the test to account for subsample variability by conditioning the break test on a potential change in the residual variance before and after the breakdate in the coefficients. Accordingly, the modified test scales down periods of greater turbulence and magnifies relatively small policy shifts in less turbulent periods. The confidence interval around this break indicates how precisely we can locate a change in the parameter (Bai, 1997). A major break in the fiscal rule occurs in 1993:4, and heralds the gradual reduction of the record -11.5 per cent deficit to a 5 per cent surplus in 2000:3. This switch in fiscal policy is quite precisely estimated to fall between 1993 and 1995.

Consolidation could be the effect of fiscal restraint, but could as well be due to favourable economic conditions. Figure 2 shows that the Swedish economy continued to grow over the nineties, and boomed particularly strongly at the turn of the century. I test the out-put and debt reaction coefficient of the fiscal rule separately for a po-tential break with the same Quandt test. A change from a negative to a positive response to debt occurs in 1995. This shift to a sustainable fiscal policy is also visible from Figure 1. But we cannot exclude that economic growth matters for consolidation at the same time. The link between the surplus and output seems to have become substantially weaker after 1996. This further confirms that tax reform has reduced the reaction of the budget to the cycle (Girouard and André, 2005).


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Given the volatility of fiscal policy in Sweden, locating a single break seems rather peculiar. A plot of the breakpoint test statistics instead indicates several candidates for structural breaks (Figure 3). Instability in fiscal policy is spread out over the eighties and nineties. I therefore run the Bai Perron test that selects the n best breakpoints for the fiscal rule (Table 1). Fiscal policy seems to be rather erratic at the end of the seventies: there are no less than four breaks between 1975 and 1980. It is probably no surprise that this period also consti-tutes the start of the debt problem in Sweden. Only four other breaks have occurred since then. The 1986 break indicates a switch to fiscal restraint in the mid eighties. In 1991, the largest fiscal crisis in Sweden occurred. Debt started to be put under control in 1995. Fiscal policy once more shifted ten years after the 1991 crisis. However, something has changed in the fiscal policy setting. In contrast to the previous loosening of the fiscal stance, this did not lead to an increase in debt in 2001.

Figure 3. Recursive Andrews Quandt LR test statistics for stability of fiscal rule (11)

test statistics

exponential test

average test

3.2. Spending and tax rules

What kind of spending or tax policies (or a combination of both) did Swedish governments pursue that led to fiscal havoc? Does the fiscal policy strategy to consolidate debt differ from policies that create it? Figure 4 shows that dramatic spending hikes in 1980, and once more in 1991, have been far from offset by commensurate tax increases. The tax burden hovers between 60 to 65 per cent of GDP, but the variation in spending is much more pronounced. Public spending has


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fallen from its 1993 peak of 75 per cent of GDP to about 55 per cent today.

Figure 4. Spending, and revenue ratio to GDP

1970 1975 1980 1985 1990 1995 2000 2005

45

50

55

60

65

70

spending revenues

Note: vertical bars indicate the troughs of growth cycle recessions (ECRI). I estimate a fiscal spending rule by substituting for the spending

ratio to GDP in (11), and estimate this non-linear rule by GMM. It is then evident that spending increases have greatly contributed to the explosion of debt (Table 2). Only after 1993 does spending restraint contribute to the gradual consolidation of debt.

RULE

S, A

ND

TH

EIR

EFF

ECT

S O

N F

ISCA

L PO

LICY

IN S

WE

DE

N, P

eter

Clae

ys

26

Tabl

e 2.

Fis

cal s

pend

ing

rule

(197

0:1-

2006

:4)

To

tal

spen

ding

C

urre

nt

spen

ding

In

tere

st

Con

sum

p-tio

n W

ages

In

vest

men

t Su

bsid

ies

Tran

sfer

s γ

-2

.19

(0.0

0)

1995

:3

-1.7

4 (0

.00)

19

95:3

-0.0

5 (0

.11)

20

01:3

-0.0

7 (0

.21)

20

01:1

-0.5

4 (0

.00)

19

86:1

-0.1

4 (0

.00)

20

01:1

-0.3

3 (0

.00)

20

01:1

-0.6

4 (0

.00)

19

95:3

θ

0.

06

(0.0

4)

1993

:1

0.08

(0

.00)

19

77:1

0.06

(0

.00)

19

98:2

0.04

(0

.00)

19

98:1

-0.0

6 (0

.00)

19

92:2

-0.0

5 (0

.00)

19

76:2

-0.0

2 (0

.01)

19

95:4

0.17

(0

.00)

19

77:4

R

2

0.65

0.

65

0.85

0.

51

0.21

0.

61

0.02

0.

81

dw

0.60

0.

18

0.09

0.

19

0.12

0.

06

0.14

0.

09

J (0

.20)

(0.2

1)

(0

.15)

(0.3

5)

(0

.07)

(0.3

8)

(0

.16)

(0.2

3)

A

Q b

reak

19

93:1

(0

.00)

[-;

-]

1993

:1

(0.0

0)

[199

2:3;

19

93:3

]

1986

:4

(0.2

0)

-

1992

:3

(0.2

5)

-

1992

:4

(0.0

0)

[199

2:2;

19

93:2

]

1989

:4

(0.0

0)

[198

9:2;

19

90:2

]

1992

:4

(0.0

0)

[199

2:2;

19

93:2

]

1978

:4

(0.0

9)

-

Bai

Per

ron

1977

:4

1979

:4

1991

:4

1995

:4

1991

:4

1973

:3

1977

:4

1983

:1

1995

:3

1983

:1

1986

:1

2001

:3

2005

:2

2006

:1

2005

:2

1978

:4

1992

:3

1997

:4

2001

:3

1997

:4

1977

:4

1980

:2

1987

:4

1994

:3

1987

:4

1972

:4

1975

:4

1989

:4

1996

:2

1989

:4

1975

:2

1987

:4

1989

:4

1996

:2

1989

:4

1973

:3

1977

:4

1985

:1

1996

:2

Note

s: se

e Ta

ble

1.


27

I look in somewhat more detail at different spending items. This gives some interesting insights into the way debt was initially created, and consolidation has been achieved afterwards. Figure 5 plots the composition of total government spending over time. Over the sev-enties, social transfers as well as public wages gradually absorbed an increasingly large share of the budget. This rise was only briefly inter-rupted by the 1979 spending cut. The spending boom of 1981 let the share of transfers and spending on public wages grow to no less than two thirds of total spending. The 1991 deficit plunge once more fi-nanced a strong increase in social transfers, as well as public con-sumption. The rising burden of interest payments gradually started to crowd out various other spending categories. Public employment did not increase much further after 1991. The contraction mainly came at the expense of government investment, as well as subsidies.

Figure 5. Composition of government spending (per cent of total)

1970 1975 1980 1985 1990 1995 2000 2005

20

30

40

50

60

70

80

90

100

consumption subsidies

wages interest

investment transfers

The estimation of a spending rule for every budget item confirms

that the growing burden of interest payments has reduced the budget-ary room for other spending items. This contraction has been espe-cially pronounced for government investment. Break tests show that government investment was the first budget item to suffer cuts due to the fiscal trouble in the seventies. Likewise, subsidies have been re-duced in the wake of higher debt. The significant cut in public wage spending has by far been the most important way to fiscal restraint after 1991. In terms of economic size, public wages nowadays absorb


28

about 15 per cent of GDP, but have come down from 23 per cent of GDP in 1980. The main culprit of the debt problem is the continued rises in public consumption and social transfers. After the 1991 debt crisis, little effort has been made to tackle either of these major spending items. The tendency to expand public consumption has only been reversed since 1998. Public consumption has not been kept un-der control for long, though. The Bai Perron test indicates that al-ready in 2001, public consumption was on the rise again. Likewise, a strong increase in social transfers began in 1978, and this tendency has not ever been reversed since.

Table 3. Fiscal tax rule (1970:1-2006:4) Total revenues Tax revenues γ -0.17

(0.34) 1980:2

-0.29 (0.13) 1980:2

θ 0.07 (0.00) 1976:2

0.06 (0.01) 1976:2

R 2 0.35 0.40 dw 0.07 0.48 J (0.11) (0.11) AQ break 1998:1

(0.30) -

1998:1 (0.21)

-

Bai Perron 1975:3 1985:3 1996:1 2001:3

1975:3 1985:3 1994:4 2001:3

Notes: see Table 1. Viewed from this perspective, the fiscal rules introduced in 1997

do not seem to have been very efficient. The major consolidation ef-fort had already taken place before 1997. Hence, the spending cap has not directly imposed a constraint on the budget decisions of the gov-ernment. The spending cap rather reflected practices of the last con-solidation. The reversal of spending behaviour in 2001 shows that the rule is not binding enough. The nominal spending target is set with-out a clear reference to some basic level. The budgetary margin has been completely used for additional spending in nearly all years (IMF, 2005).


29

The immediate measure for balancing budgets has instead been to increase tax revenues (Table 3).14 In response to rising debt, tax rises have been used to finance growing spending. Higher tax levels have caught up with spending booms since the mid seventies. But the tax burden has not noticeably come down in periods of spending cuts. There are no significant breaks in the tax rule. The Bai Perron test nonetheless indicates a break in both 1996:3 and 2001:3, and points to the tax reforms undertaken in more recent years.

Table 4. Fiscal spending and tax rule, GMM system estimates (1970:1-2006:4)

Spending Revenues ρ 0.88

(0.00) 0.90 0.00)

γ -1.07 (0.04) 1980:2

-0.34 (0.37) 1980:2

θ 0.20 (0.03) 1976:2

0.09 (0.06) 1976:2

R 2 0.97 0.40 dw 1.83 0.48 J (0.61) Correlation 0.77

Notes: see Table 1.

If the government were to minimise economic distortions and

keep tax rates constant, tax revenues would vary with the economic conditions. Instead, total revenues are not responsive to the cycle. Hence, automatic tax stabilisers are not allowed to work over the cy-cle. This is most likely the consequence of decisions to raise taxes to contain the budget deficit, regardless of the current economic stance. Spending is quite countercyclical, however. In contrast to spending policies in other OECD countries (Lane, 2003), spending is consid-erably reduced during economic upturns. Hence, there does not seem to be a relevant trade-off between debt and output stabilisation on the spending side. Spending hikes that are decided upon in good eco-nomic times do not get locked in. The procyclical budget surplus is

14 I separately estimate a tax rule. As budget decisions concern both tax bases and tax rates, the analysis of different tax items is less insightful. Therefore, I limit the analysis of tax rules to total revenues.


30

mainly due to shifts in spending. The joint estimation of a spending and tax rule with system GMM does not alter these conclusions. The signs of the cyclical and debt coefficients are identical, and of a similar size (Table 4).

4. Fiscal policy regimes

Fiscal policy may switch its stance due to political and economic cir-cumstances. Even perfectly reasonable policy makers may find it justi-fied to give in to renewed calls for spending hikes or tax cuts. But policies contingent on these circumstances may turn out to be flawed when conditions change. I detail the changes in fiscal behaviour over time by estimating a Markov switching model in which the probability of each regime can vary endogenously. A priori, there should probably be two different regimes in fiscal policy: spending or taxes are either passively adjusted to keep debt under control, or fiscal policy actively disregards deficits.

4.1. Regime switching debt

The difference between an active or a passive regime for the surplus shows up in the behaviour of the debt ratio over time. I follow Davig (2004) in classifying debt behaviour in different states over time. In particular, I assume the regime generating process to be a two-state Markov chain. This Markov switching model for debt (12) is then es-timated by maximum likelihood, using the EM algorithm. I assume the debt ratio to be a simple AR(4)-model. I allow the intercept of this model to shift between two different values, contingent on some la-tent state tm

.)( 4 tttt bLmb ξω +Λ+= passiveactivemt = . (12)

Moreover, the persistence of fiscal series may reasonably be mod-

elled with autoregressive parameters that are the same under both re-gimes. It is quite plausible that after a change in regimes, the debt ra-tio quickly shoots up but smoothly converges to a different level af-terwards. I take account of higher variability of debt with regime vary-ing heteroskedasticity.15

15 All computations were done in MSVAR for Ox (Krolzig, 1998).


31

Figure 6 plots the time varying estimated probabilities associated with each regime. The filtered probabilities (indicated by the bars) only use the estimates of the MS model up to that point; smoothed probabilities are based on the full sample estimates. In order to more easily relate the regimes to the variations in the debt ratio, I also plot the debt ratio and the mean debt ratio latent in the different states of the MS-model.

It might not be surprising that there is a distinction between the periods of debt explosion and debt consolidation. At the end of the seventies, there is a shift from a low debt regime to a period of higher debt ratios. The labelling of each regime with “low” or “high” debt is perhaps not entirely adequate. The latent debt ratio of the low debt regime differs by less than 1 per cent of GDP as compared to the mean high debt ratio. This is the result of the unit root in the debt ratio: convergence to a different level of debt is very slow under both regimes.16

Figure 6. Debt ratio, Markov switching, AR(1) model, 2 regimes

1970 1975 1980 1985 1990 1995 2000 2005

50

75 debt ratio mean debt ratio

1970 1975 1980 1985 1990 1995 2000 2005

0.5

1.0 probabilities of regime 1

1970 1975 1980 1985 1990 1995 2000 2005

0.5

1.0 probabilities of regime 2

filtered smoothed Another consequence of the persistence in fiscal series is that tak-

ing control of debt is a much more gradual process. At every consoli-dation of public debt, the low debt regime gains somewhat in prob-ability. But even the consolidation after the 1991 crisis did not create 16 As a consequence, regimes are very persistent and the transition from one regime to another is rather improbable.


32

a real gain in probability of the low debt regime. It was not until after six years of continuous falls in the debt ratio that the regime once more switched to “low debt”. Small reversals of fiscal policy, as for example in 2005, might easily push the debt ratio back into the high debt regime. The introduction of fiscal rules in 1997 had no immedi-ate consequences on fiscal discipline.

4.2. Fiscal policy switching

Debt is the outcome of changes in policy conduct. I therefore esti-mate the baseline surplus rule by similar Markov switching tech-niques. In the fiscal rule (13), I test for changes in all coefficients of the fiscal rule. I allow for changes in the reaction coefficients of fiscal policy, as well as the persistence of the surplus. I also allow for a change in the variance of the underlying shocks in each regime

[ ] .)()()())(1()( 1 tttttttttt bmxmmmsms υθγωρρ +++−+= − (13)

Coefficients may change stochastically over time, indicated by the state tm . The regime generating process is again assumed to be a two-state Markov chain. There is no criterion for selecting the optimal number of regimes in a Markov switching model. The classification in two regimes of systematic policy behaviour corresponds to the active and passive regime in fiscal policy. Under an active regime, fiscal pol-icy disregards the path of public debt. A passive fiscal policy instead consolidates debt by cutting spending or raising taxes. A two-regime model classifies these regimes surprisingly well. As a robustness check, I also present results for a three-regime classification, but this does not substantially alter the main results.

RULE

S, A

ND

TH

EIR

EFF

ECT

S O

N F

ISCA

L PO

LICY

IN S

WE

DE

N, P

eter

Clae

ys

33

Tabl

e 5.

Reg

imes

in th

e de

bt ra

tio, M

arko

v sw

itchi

ng m

odel

(197

0:1-

2006

:4)

p i

i

Dur

atio

n O

bs.

ρ

ϖ

σ La

bel

Reg

ime

1 0.

90

10.0

2 60

.30

0.97

***

52.8

6*

0.28

lo

w d

ebt

Reg

ime

2 0.

93

13.5

3 79

.70

0.97

***

53.8

9*

1.24

hi

gh d

ebt

Note

s: p ii

is th

e pr

obab

ility

of s

tayi

ng in

one

regi

me;

***

/ **

/ *

indi

cate

s sig

nific

ance

at 1

/5/1

0%.

Tabl

e 6.

Fis

cal s

urpl

us ru

le, M

arko

v sw

itchi

ng m

odel

, 2 re

gim

es (1

970:

1-20

06:4

)

p i

i

Dur

atio

n O

bs

ρ

γ θ

σ La

bel

Reg

ime

1 0.

95

20.8

3 97

.3

0.94

***

0.09

***

0.01

***

0.37

pa

ssiv

e R

egim

e 2

0.90

10

.44

49.7

0.

93**

* 0.

13

-0.0

1 1.

19

activ

e

Note

s: se

e Ta

ble

5.


34

Table 6 and Figure 7 summarise the behaviour of fiscal policy un-der the two regimes. At the same time as the budget responds to pub-lic debt, the surplus also moves procyclically over the cycle (regime 1). In contrast, if fiscal policy does not respond to debt in the active re-gime, it does not react to the cycle either (regime 2). Only the past surplus is then significant in the setting of fiscal policy. Policy setting in the active regime seems rather erratic.17 When fiscal policy behaves as a random walk, the variance of policy shocks is three times higher than under the passive regime. A period of debt build-up is very much protracted: the creation of debt only takes two and a half years, which is half the time for consolidating it again. A plot of the regime probabilities corroborates the previous finding of quite some instabil-ity in fiscal policy from the mid seventies to the mid eighties. Fiscal policy only intermittently pays attention to public debt, but more of-ten entirely disregards its evolution. The government adopted a “stop and go” approach to the consolidation of public debt in this period. In the 1991 crisis, fiscal policy switched back quite suddenly to a loose debt stance. That approach to fiscal policy has not disappeared at all. Even after the fiscal consolidation of 1995, and after the adoption of the set of fiscal rules, there is a period (2000:4-2002:3) in which the Swedish government actively uses fiscal policy.

Figure 7. Markov switching fiscal surplus rule, 2 regimes, probabilities

1970 1975 1980 1985 1990 1995 2000 2005

0.25

0.50

0.75

1.00 probabilities of passive regime

1970 1975 1980 1985 1990 1995 2000 2005

0.25

0.50

0.75

1.00 probabilities of active regime

filtered smoothed

17 There is no important difference in the persistence of fiscal policy in each regime.


35

But for what aim do governments use fiscal policy in an active re-

gime? Periods in which the government willingly uses the budget to reinforce automatic stabilisers are also periods in which debt is of lesser concern. These periods are usually followed by periods of strong growth in debt. Fiscal impulses that were intended to respond to economic circumstances were not reversed afterwards. There is a great deal of evidence of this procyclical behaviour in bad economic times, and a consequent bad fiscal policy in good economic times, also in other European countries. The effect of the set of rules intro-duced in 1997 did not prevent a similar policy reaction in 2000. Wind-fall revenues due to buoyant economic growth pushed up the surplus (and pushed debt down). The favourable fiscal stance led to a gradual tapering off of further efforts in consolidating debt in the following years. Fortunately, as this was a positive shock to the surplus, debt did not explode. Fiscal rules were not strong enough to control the be-haviour of the government which had been so typical for the debt crises of the eighties and nineties.

4.3. Debt, economic growth and monetary policy

Governments do not need to cut spending or raise taxes to stabilise debt. Inflation and economic growth both erode public debt. The surplus that the government effectively needs to achieve to bring about the stabilisation of public debt depends on the evolution of real interest rates tq as well as nominal economic growth tk . Following (5), debt remains stable if the debt stabilizing surplus ts equals

)1()(1 tttt kkqb +−− . If nominal GDP growth exceeds the interest cost of debt, persistent deficits are still consistent with debt stabiliza-tion as real economic growth and inflation outgrow the accumulated interest payments.18 Figure 8 plots the time path of this implicit debt stabilising surplus. Persistent deficits were consistent with a stable debt to GDP ratio until 1980. This was the consequence of rather high inflation exceeding interest rates. As in most other industrialised countries, the warding off of inflation and a shift to less accommoda-tive monetary policy have made real interest rates persistently positive in Sweden since 1980. As a consequence, only in periods of strong

18 Strictly speaking, this only holds under the assumption that fiscal policy has no real effects on the economy.


36

economic growth has it been possible to run deficits. This has only been the case in three years (1987 till 1990). The recent decline in this surplus is a combination of historically low real interest rates, and strong economic growth.

Figure 8. Debt stabilising surplus (1970:1-2006:4)

1970 1975 1980 1985 1990 1995 2000 2005

-0.02

-0.01

0.00

0.01

0.02

0.03

0.04

0.05

0.06

I then substitute debt tb for this debt stabilizing surplus ts in the

fiscal rule (13). With this non-linear specification, we can test the rela-tion between ts and ts whatever the effect of nominal GDP growth and interest rates on fiscal variables (Favero and Monacelli, 2005). In this way, the fiscal rule implicitly controls for variations in debt that are not under direct control of the government itself. Fiscal policy is passive when ts enters significantly with a coefficient that is not sta-tistically different from one. In addition, the constant term ω should not be statistically different from zero.19

19 Given that an exogenous component in the surplus would indicate an active pol-icy. For spending or taxes, we may drop this restriction.

RULE

S, A

ND

TH

EIR

EFF

ECT

S O

N F

ISCA

L PO

LICY

IN S

WE

DE

N, P

eter

Clae

ys

37

Tabl

e 7.

Fis

cal r

ules

, deb

t sta

bilis

ing

surp

lus,

Mar

kov

switc

hing

mod

el, 2

regi

mes

(197

0:1-

2006

:4)

p i

i

Dur

atio

n O

bs

ϖ

γ θ

σ La

bel

Su

rplu

s R

egim

e 1

0.94

16

.80

80.5

0 0.

75

0.25

0.

96

0.32

Pa

ssiv

e R

egim

e 2

0.92

12

.88

62.5

0 0.

20

2.33

***

-2.6

2**

1.11

Ac

tive

Sp

endi

ng

Reg

ime

1 0.

93

15.2

6 47

.80

56.3

3***

-1

.03*

* 38

.33*

**

5.67

Ac

tive

Reg

ime

2 0.

98

42.3

8 95

.20

56.3

3***

-2

.17*

**

6.02

***

2.25

Ac

tive

Ta

x R

egim

e 1

0.95

21

.11

42.3

0 59

.55*

**

-0.2

5 39

.71*

**

4.73

Pa

ssiv

e R

egim

e 2

0.99

94

.28

100.

70

59.5

5***

-0

.22*

* 3.

24**

* 1.

42

Pass

ive

Note

s: se

e Ta

ble

5.


38

The reaction coefficients of the baseline surplus rule neatly corre-spond to an active and passive regime (Table 7). Moreover, the gov-ernment chooses to stabilise debt or smooth the cycle, but cannot do both. Under the passive regime, debt consolidation comes at the ex-pense of cyclical stabilisation. In the periods in which I locate the ac-tive regime (1975-1985, 1990-1995 and 2000-2002), there is instead a strong procyclical response of the surplus.20 This also makes the sur-plus about three times as variable in the active regime as under debt consolidation.

Switches in fiscal policy are not sudden. The creation and stabilisa-tion of public debt each takes three to four years on average. The shift in real interest rates and economic growth plays some role in ex-plaining some particular episodes. At the beginning of the eighties, the debt stabilising surplus switches because of volatile real interest rates. Fiscal policy has nonetheless continued to be lax since 1975. As long as cyclical considerations prevailed, fiscal policy intentionally dis-regarded public debt in that period. It is also much clearer that in the mid eighties, not all opportunities were taken to consolidate debt with buoyant economic growth.

Figure 9. Fiscal spending rule, debt stabilising surplus, 2 active regimes

1970 1975 1980 1985 1990 1995 2000 2005

0.5

1.0 probabilities of active regime (1)

1970 1975 1980 1985 1990 1995 2000 2005

0.5

1.0 probabilities of active regime (2)

filtered smoothed

20 The plot of regime probabilities is similar to Figure 7.


39

A combination of spending and tax policies causes policy to be ac-tive or passive. I replace the surplus by the spending or tax ratio in (13), and estimate Markov switching rules with two states by ML. I then identify spending to be active if there is a positive reaction to debt. Likewise, taxation is passive if there is a positive response to debt developments.

Given the results of section 3.2, it should not come as a surprise that spending is always classified in the active regime (Table 7). Spending hikes have been the major driving force for the explosion of debt. There have been no periods in which the government deliber-ately strived to reduce total government outlays in response to the rise of public debt. The main reason is that various Swedish governments chose to stabilise the economy at the expense of running up debt. This trade-off between cyclical and debt stabilisation is clearly re-flected in the two spending regimes. Policymakers felt little urgency to consolidate, as debt was seemingly under control before 1975 and in the mid eighties. Spending could grow without limits over periods in which real interest rates were low or economic growth strong enough to stabilise public debt (Figure 9). Too much spending restraint was not needed in that case.21 In contrast, as an economic crisis loomed, the government gave additional spending impulses to the economy. This accounts for a large part of the increases in spending in the late seventies and the early eighties (Lindh and Ohlsson, 2000). The find-ing of a countercyclical spending policy is thus not due to a benign policy maker steering the economy with spending cuts in economic booms. But there has been a marked change in spending growth since the 1991 fiscal crisis. The continued economic expansion of the nine-ties has eased the pressure to spend on various items. This has made debt consolidation through spending cuts much easier. At the same time, the introduction of the procedural fiscal rules seems to have worked in maintaining stronger control on spending hikes.22 The spending caps introduced in 1997 consolidate current practice at that time. Furthermore, these rules locked in spending decisions, as the regime of moderate growth persists up to the present day. The small reversal of spending growth in 2000 only slightly increased the prob- 21 The 1980 spike in this regime is due to the increase in real interest rates that fu-elled interest payments on outstanding debt. 22 Moderate spending growth moreover has the beneficial effect of reducing the variability of fiscal policy. In the seventies or eighties, policy was about three times as volatile as over the last 15 years.


40

ability of switching to a regime of high spending growth. The boost to spending is not the main culprit behind the slippage to an active fiscal regime.

Figure 10. Fiscal tax rule, debt stabilising surplus, 2 passive regimes

1970 1975 1980 1985 1990 1995 2000 2005

0.25

0.50

0.75

1.00 probabilities of passive regime (1)

1970 1975 1980 1985 1990 1995 2000 2005

0.25

0.50

0.75

1.00 probabilities of passive regime (2)

filtered smoothed

Taxation has always been used to stabilise debt, and can therefore be classified as passive at all times. But once more, this is the blend of a policy that gives more emphasis to the cycle or to debt, but does not stabilise both contemporaneously. It is somewhat intricate to separate out the discretionary intervention of the government in the tax system from the underlying economic fluctuations. For given tax rates, total tax receipts would usually move together with the cycle. Total reve-nues are procyclical. Discretionary changes in tax rates can offset this quantity effect and instead make tax revenues acyclical or counter-cyclical. In economic booms, taxes are cut; in recessions, taxes are raised again to avoid growing fiscal deficits. This is exactly what has occurred in Sweden. Under a first regime, taxes are raised very aggres-sively in response to debt regardless of the current economic stance (Table 7). In the early seventies, increases in spending are offset by adequate tax measures that keep debt under control (Figure 10). A similar policy is followed at the end of the eighties. However, the economic boom did not fully translate into more revenues because tax policy was slightly relaxed. Tax revenues are not responsive to


41

output. Under a second regime, tax policy is used in a more discre-tionary way. Tax hikes magnified the economic cycle during the eco-nomic slack of the early eighties, but contributed little to consolidate debt.

At present, and since the 1991 crisis, fiscal policy in Sweden is still in such a regime. This has had no immediate consequences on the economy so far. The main reason is that over the nineties, the pro-longed economic boom has made it possible for taxation levels to come down without affecting total tax revenues too much. Due to the gradual consolidation of spending, the combination with a procyclical tax policy did not blow deficits. Windfall tax revenues have not been used to further consolidate debt, however. The sudden drop from a 5 per cent surplus at the 2000 peak of the boom to a new deficit in just two years shows what can go wrong. The end of the economic boom made an abrupt end to the bright estimates of tax receipts. At the same time, spending started to rise again. The fiscal spending caps have not worked to restrain further increases in spending. Rather, the safety margin on spending caps has nearly been entirely consumed for new spending hikes. The consequence is that fiscal policy switched to an active regime over the period 2000-2002. This combination of procyclical tax and relaxed spending policies did not have any dra-matic consequences for public debt, as this occurred after a period of economic boom in which debt had been reduced. The fiscal frame-work could be less resilient in a period of prolonged economic bust. For example, in an economic recession, spending might easily grow faster than the ceiling imposed three years earlier (and likely faster than the safety margin). In particular, unemployment benefits or so-cial transfers would rise. Compliance with the fiscal rules would re-quire spending cuts in other expenditure areas. Possibly, taxes would need to be raised in order to stick to the 2 per cent surplus target. Such a procyclical policy is not only economically costly. It may also be politically unpopular. The fiscal rules may not survive the stress test of another economic crisis, and this might again trigger a fiscal crisis.

5. Fiscal policy rules in a small open economy

Fiscal policy in Sweden is rather unusual, given the sheer size of the budget. Moreover, Sweden is a small open economy and prone to changes in economic conditions abroad. This is likely to have some


42

impact on the setting of tax policy or spending. How does the sys-tematic behaviour of Swedish fiscal policy compare to that in some other small open economies with a large welfare state? Finland has experienced an economic and fiscal crisis of the same depth as Swe-den between 1991 and 1993. Both the Netherlands and Denmark ex-perienced serious fiscal trouble at the beginning of the eighties. Den-mark is renowned for the so-called “non Keynesian” consolidation that mainly focused on the reduction of spending and few increases in taxes, which is argued to have had positive effects on economic growth. The Netherlands have instead adopted a much more gradual approach to consolidation. Norway stands slightly apart as its natural reserves have a direct impact on the budget.

It would be interesting to see how these countries have handled the pressure of public finances. Norway introduced a stabilisation mechanism to build up fiscal reserves at times of high oil prices. Finland introduced a similar set of spending caps over three years but these are stronger than in Sweden: they aim at a gradual reduction of spending. Dutch fiscal policy initially coped with public debt through a reform of its fiscal institutions in the eighties. The fiscal framework was further strengthened with spending caps and tax plans in 1994. In contrast to the Swedish spending rule, spending is subject to strict limits and can only increase with the planned cyclically adjusted tax intake. Additional windfall revenues can only be used for tax reduc-tions or debt consolidation.

I estimate a fiscal surplus, spending and tax rule for all four coun-tries. Unfortunately, data are not available at the quarterly frequency. Hence, I use annual fiscal data over the period 1970-2006. The set of instrumental variables for the GMM procedure is similar. I also repeat the estimates for Sweden on annual data.

In none of the countries is the reaction of the fiscal surplus to public debt significant (Table 8). We could always classify fiscal policy as active in Northern Europe. A significant break in the debt response occurs already in 1984 in Denmark, and in 1992 in both Finland and the Netherlands. Fiscal policy also becomes passive after these dates, as it does in Sweden after 1995. Only in Norway has public debt been growing at a much higher rate since 1999.


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Table 8. Small open economies, fiscal surplus rule (1970-2006)

Surplus rule Sweden Finland Norway Denmark Netherlands ρ 0.63

(0.00) 0.50

(0.00) 0.82

(0.07) 0.66

(0.00) 0.65

(0.24) γ 2.09

(0.00) -

0.68 (0.00)

-

1.69 (0.22)

-

0.02 (0.98)

-

1.02 (0.58)

- θ 0.32

(0.10) 1995

-0.02 (0.53) 1992

0.80 (0.27) 1999

-0.06 (0.32) 1984

-0.28 (0.33) 1992

R 2 0.83 0.80 0.68 0.76 0.06 F (0.00) (0.00) (0.00) (0.00) (0.00) dw 1.61 2.59 2.09 2.32 2.51 J (0.29) (0.71) (0.82) (0.72) (0.98) F1 γ (0.00) (0.00) (0.00) (0.00) (0.36)

F1 θ (0.00) (0.00) (0.00) (0.00) (0.00) Spending rule Sweden Finland Norway Denmark Netherlands ω 65.15

(0.00) 43.62 (0.00)

46.54 (0.00)

44.95 (0.00)

48.03 (0.00)

γ -1.99 (0.00)

-

-1.29 (0.00) 1990

-1.65 (0.00)

-

-1.44 (0.00) 1996

-0.85 (0.31)

- θ 0.09

(0.05) 1995

0.12 (0.00) 1992

0.05 (0.69)

-

0.16 (0.00)

-

0.05 (0.30) 1993

R 2 0.57 0.78 0.43 0.81 0.02 F (0.00) (0.00) (0.00) (0.00) (0.00) dw 0.54 0.22 0.78 1.11 0.07 J (0.24) (0.36) (0.99) (0.31) (0.09) F1 γ (0.00) (0.00) (0.00) (0.00) (0.00)

F1 θ (0.00) (0.00) (0.00) (0.00) (0.00) Tax rule Sweden Finland Norway Denmark Netherlands ω 60.93

(0.00) 47.35 (0.00)

42.76 (0.00)

55.66 (0.00)

48.07 (0.00)

γ 0.09 (0.67)

-

-0.24 (0.03)

-

-0.04 (0.86) 1999

0.47 (0.21) 1984

-0.68 (0.25)

- θ 0.01

(0.78) 2000

0.11 (0.00) 1984

0.33 (0.00) 1984

0.01 (0.77) 1986

0.00 (0.89) 1993

R 2 0.08 0.53 0.98 0.16 0.22 F (0.00) (0.00) (0.00) (0.00) (0.00) dw 0.36 0.32 0.57 0.60 0.23 J (0.36) (0.32) (0.19) (0.55) (0.08) F1 γ (0.00) (0.00) (0.00) (0.00) (0.00)

F1 θ (0.00) (0.00) (0.00) (0.00) (0.00)

Notes: see Table 1.


44

Large spending hikes, whether sudden as in Finland or more grad-ual as in the Netherlands, have substantially contributed to the in-crease in public debt. This seems to be the consequence of a similar destabilising spending policy. Spending is very countercyclical, and this is due to spending hikes in an economic bust. With the exception of the Netherlands, a worsening of economic conditions results in a more than proportional increase in spending. The means by which consolidation has been achieved are strikingly similar across countries. Fiscal consolidation has implied significant reductions in spending since the beginning of the nineties. After the initial 1984 consolida-tion, public spending in Denmark has not been kept under further control. In contrast, the introduction of the Dutch spending rule al-lowed a reduction of public spending from 54 per cent to 44 per cent of GDP in about six years. Nonetheless, its implementation has been less strict since 2000. As in Sweden, consolidation has in first the in-stance relied on tax increase. But these initial tax increases have not continued after the mid eighties, once the tax share exceeds 50 per cent of GDP. In the Netherlands, in contrast to the other countries, the tax burden has been substantially reduced since 1993.

In summary, the mechanism that creates debt by lavish spending in an economic bust, and raises taxes in an attempt to stabilise debt is not typical for Sweden. A gradual consolidation strategy implies bringing down spending and tax levels. Such policies remain prone to a sudden reversal if debt is not further consolidated.

6. Conclusions

Fiscal policy rules address problems of debt sustainability. In Sweden, the derailing of public debt in the early eighties only led to informal agreements to consolidate debt. This fiscal framework did not survive a stress test when external economic factors deteriorated. Debt ex-ploded by about 40 per cent of GDP between 1990 and 1992. This fiscal crisis urged a reform. Initially, procedural reform aimed at plac-ing the budget decision power more firmly in the hands of the finance minister and the government and additionally led to some institutional changes. Numerical rules, introduced in 1997, aim at an overall struc-tural surplus of two percent of GDP. This surplus target is anchored to an expenditure rule for the central government, which defines a rolling medium term nominal ceiling on spending for the next three


45

years. In addition, local governments are bound by a balanced budget rule.

I estimate empirical fiscal rules to test sustainability for Swedish fiscal policy over the period 1970-2006. I look in detail into govern-ment spending and taxes to lay out the mechanism behind debt crea-tion and consolidation. The characteristics of fiscal crises are re-markably common over time. Unconstrained fiscal policy responds to economic instability by boosting spending and raising taxes. Institu-tional reform did not put a brake on the continued rise in government spending, in particular on public consumption and social transfers. Taxes are raised, regardless of the economic stance, to fill budget gaps. The combination of unrestrained growth in spending, and the belated rise in taxes, has caused growing deficits.

The fiscal spending rule has been useful in limiting additional in-creases in the budget. It put in stone the efforts of the consolidation of the nineties, but does not address the problems of spending man-agement in normal times. Spending rules have not eradicated destabi-lising policies. I find evidence that over the period 2000-2002, similar mechanisms once more started to cause fiscal problems. Debt did not rise thanks to favourable economic conditions. The main policy im-plication is that a further refinement of fiscal rules is necessary to avoid future fiscal crises. A better control of further rises in spending is necessary. This could happen by relating the increase in the level of public spending to some economic criterion. I think in particular of the level of debt (“debt brake”), potential growth (“balanced spend-ing”) (Danninger, 2002), or the current surplus target. This would provide for an expenditure target in the medium to long term that is robust to economic fluctuations in the short term.23 This decision should also reflect a longer-term view on the sustainability of public finances. This probably implies some discussion across tiers of gov-ernment as well. The desired level of spending should also be related to the level of taxation. Preferably, this should allow for a gradual ad-justment in taxation in order to avoid procyclical shifts in taxation.

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23 See also the work of the Commission of the Swedish Ministry of Finance.


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rules, and their effects on fiscal policy in sweden...but fiscal policy—that eventually determines...

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