Fiscal Sustainability: The Unpleasant European Case Author(s): António Afonso Source: FinanzArchiv / Public Finance Analysis , 2005, Vol. 61, No. 1 (2005), pp. 19-44 Published by: Mohr Siebeck GmbH & Co. KG Stable URL: https://www.jstor.org/stable/40913064 JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at https://about.jstor.org/terms Mohr Siebeck GmbH & Co. KG is collaborating with JSTOR to digitize, preserve and extend access to FinanzArchiv / Public Finance Analysis This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms FinanzArchiv vol.61 no. 1 19 Fiscal Sustainability: The Unpleasant European Case António Afonso* Received 22 January 2003; in revised form 20 February 2004; accepted 8 November 2004 The sustainability of fiscal deficits has been receiving increasing attention. The issue is paramount for the newly formed euro area, and that is one of the motivations of this paper. In order to assess the sustainability of budget deficits, cointegration tests between public expenditures and public revenues, allowing for structural breaks, are performed for the EU-15 countries for the 1970-2003 period. The "unpleasant" empirical results show that with few exceptions fiscal policy may not have been sustainable. EU governments therefore may risk becoming inherently highly indebted, even though the debt-to-GDP ratios seemed to be somehow stabilizing at the end of the 1990s. Keywords: budget deficit, intertemporal budget constraint, fiscal policy sustainability, European Union JEL classification: H 62, H 63 1. Introduction In the last two decades several developed countries have experienced significant budget deficits, while the ability of government to cope with fiscal deficits has been receiving increasing attention from economists. This is an important topic with regard to both economics and public policy. The issue is paramount for the newly formed euro area, and that is one of the motivations of this paper. Theoretically, equilibrium growth paths need to be supported by adequate fiscal policy. Furthermore, the treaties governing the European Union impose the practical necessity of sustainable public accounts. It is possible to assess sustainable public finances in terms of compliance with the budgetary requirements of the European Monetary Union, viz., avoiding excessive deficits, keeping debt levels below the 60% of GDP reference value, and respecting the "close to balance or in surplus" requirement of the Stability and Growth Pact (SGP). From a forward-looking perspective, one may also notice that * The author is grateful to Jorge Santos, João Santos Silva, participants at the 36th Money Macro and Finance conference in London, 2004, colleagues at the ECB, and two anonymous referees for helpful comments. Any remaining errors are the responsibility of the author. The opinions expressed herein are those of the author and do not necessarily reflect those of the author's employer. FinanzArchiv 61 (2005), 19-44. ©2005 Mohr Siebeck - ISSN 0015-2218 This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 20 Antonio Afonso the SGP imposes commitments on Member States for budgetary position the medium term (three to five years) and does not require explicit long term targets. Therefore, sustainability is de facto ensured provided balances respect the "close to balance or in surplus" target. Quite a few studies have already addressed the issue of fiscal polic tainability and provided empirical testing of the present-value borr constraint (PVBC)1. The main analytical apparatus used to analyze th tainability of budget deficits are stationarity tests for the stock of publi and cointegration tests between government expenditures and gover revenues. This paper adds to the existing literature by applying unit-roo cointegration tests to the EU-15 countries over the period 1970-2003 consistent public finance data from one single source, the European mission AMECO database. It also tests for the existence of structural breaks during the time sample in each country. The selected time span includes therefore the run-up to the introduction of the euro and the efforts, made during the 1990s, by several countries to streamline their public accounts in order to join the common currency. Additionally, both the theoretical and analytical procedures used to assess fiscal sustainability are briefly restated. The paper is organized as follows. The next section discusses the issue of sustainability. Section 3 briefly reviews the analytical framework under which one usually assesses the sustainability of public deficits. Section 4 presents some stylized facts of fiscal policy for the EU-15 countries. It also reports and discusses the results of the empirical analysis, comprising both stationarity tests and cointegration tests between government expenditures and government revenues for the EU-15 countries, allowing for structural breaks in the series or in the cointegration relationship. Finally, section 5 provides a conclusion. 2. The Issue of Sustainability Fiscal sustainability is a recurrent topic that both individual countries and international organizations dwell upon with some regularity2. At the beginning of the 1920s, when writing about the public-debt problem faced by France, Keynes (1923, p. 24) mentioned the need for the French government to conduct a sustainable fiscal policy in order to satisfy its budget constraint. Keynes stated that the absence of sustainability would be evident when "the 1 Examples of this growing literature include, for instance, Hamilton and Flavin (1986), Trehan and Walsh (1988, 1991), Kremers (1988, 1989), Wilcox (1989), Hakkio and Rush (1991), Tanner and Liu (1994), Quintos (1995), Haug (1991, 1995), Ahmed and Rogers (1995), Payne (1997), Artis and Marcelino (1998), Bohn (1998), Fève and Hénin (2000), Uctum and Wickens (2000), and Bravo and Silvestre (2002). 2 See for instance Chalk and Hemming (2000). This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Sustainability: The Unpleasant European Case 21 State's contractual liabilities [...] have reached an excessive proportion of the national income." In modern terms, sustainability is challenged when the debt-to-GDP ratio reaches an excessive value. There is a problem of sustainability when the government revenues are not enough to keep on financing the costs associated with the new issuance of public debt. The sustainability of fiscal policy is sometimes associated with the finan- cial solvency of the government. In practice, however, what the empirical literature ends up testing is whether both public expenditures and government revenues may continue to display in the future their historical growth patterns. If a given fiscal policy turns out to be unsustainable, it has to change in order to guarantee that the future primary balances are consistent with the budget constraint3. Theoretically any value for the budget deficit would be possible if the government could raise its liabilities without limit. Obviously, that is impossible, since the government is faced with the present value of its own budget constraint. It also is worth noticing that the hypothesis of fiscal policy sustainability is related to the condition that the trajectory of the main macroeconomic variables is not affected by the choice between issuance of public debt and an increase in taxation. Under such conditions, it would therefore be irrelevant how the deficits are financed, provided also that we assume the Ricardian equivalence hypothesis to hold. The government budget constraint is the starting point for deriving the constraint on the present value of the budget. The flow budget constraint is written as Gt + (1 + rt)Bt-X = Rt + Bt, (1) where G is the government expenditures, exclud the government revenues, B is the public debt, an Rewriting equation (1) for the subsequent peri equations recursively leads to the following inte B=^Rl+s-Gl+s+iim^B^_ -n(i+r,+,) ~"ii(1+r*) 7=1 When the second term on the RHS of equation (2) is zero, the present value of the existing stock of public debt will be identical to the present value of future primary surpluses. However, equation (2) is not appropriate for empirical 3 Cuddington (1997) and Hénin (1997) discuss this topic. Blanchard et al. (1990) present as a definition of a sustainable fiscal policy one that allows, in the short term, the debt-toGDP ratio to return to its original level after a spell of excessive variation. 4 Sometimes in the literature, for the validation of theoretical results, the real interest rate is assumed stationary, but this is a much less plausible assumption for the nominal interest rate. This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 22 Antonio Afonso testing. It is therefore useful to make several algebraic modificati equation (1). Assuming that the real interest rate is stationary, with m and defining Et it A is = Gt + possible sustainable of (rt-r)Bt-u to obtain fiscal (3) the policy followin should ens public debt, the second term of the debt to grow no fa words, it requires imposing the abse the intertemporal budget constraint the government will have to achieve value adds up to the current value way, public debt in real terms canno beyond the real interest rate5. It is also possible to derive the sol defined as a percentage of GDP6. T as ratios of GDP, with y being the G presentation purposes seigniorage re constraining Bt = 1 + rt Yt l+y,Y,-i Y, Yt' ff,-i Gt Rt Assuming the real interest rate to be stationary, with mean r, and consid also constant real growth, the budget constraint is then given by b-i - E (îtO" [*" - ei+sì + ^-(ttO + ' with bt = Bt/Yt, et = Et/Yt, and pt = Rt/Yt. When r > y, it is necessary introduce a solvency condition, given by 'imbt+s('±AS =0, 5 See Joines (1991). McCallum (1984) discusses if this is a necessary condition to ob optimal growth trajectory for the stock of public debt. 6 tor instance, hlakkio and Kusn (lyyi, p. 4JUj argue mat an analysis Dasea on ratios is more appropriate for growing economies: "in addition to examining revenue and spending directly, we also use [to] normalize these variables using real GNP and population. This is an important extension beyond previous work, since McCallum (1984), among others, deems these ratios - per capita spending and revenue, and spending and revenue as a fraction of GNP - as more pertinent for a growing economy." This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Susta inability: The Unpleasant European Case 23 in order to bound public-debt growth7. This yields the familiar result that fiscal policy will be sustainable if the present value of the future stream of primary surpluses, as a percentage of GDP, matches the "inherited" stock of government debt8. 3. Assessment of the Sustainability of Public Deficits A common practice in the literature, among the set of methods to evaluate fiscal policy sustainability, is to investigate past fiscal data to see if government debt follows a stationary process or to establish if there is cointegration between government revenues and government expenditures9. Recalling the PVBC, equation (4), it is possible to present analytically two complementary definitions of sustainability that set the background for empirical testing: (i) The value of public current debt must be equal to the sum of future primary surpluses: 00 j 5=0 ^ ' (ii) The present value of public debt must approach zero 5^00 lim-^r (1 + r)s+ 5^00 (1 + r)s+l In order to test empirically the absence of Ponzi gam stationarity of the first difference of the stock of publi tests developed by Dickey and Fuller (1981) and by (1988). It is also possible to assess fiscal policy sustainability through cointegration tests. The implicit hypothesis concerning the real interest rate, with mean r, is also stationarity. Using again the auxiliary variable Et=Gt + (rt - r)J9,_i, and with the additional definition GGt = Gt + rtBt-u the intertemporal budget constraint may also be written as 00 7 This 1 B implies ((l+y)/(l + th r)r+1 8 According to Bui satisfied always an theory of the price 9 Hamilton and Fl (1991) and Hakkio This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 24 Antonio Afonso and with the no-Ponzi-game condition, GGt and Rt must be cointe variables of order one for their first differences to be stationary. Assuming that R and E are nonstationary variables, and that the differences are stationary variables, this implies that the series R a levels are 1(1). Then, for equation (9) to hold, its LHS will also have also stationary. If it is possible to conclude that GG and R are integrate order 1, these two variables should be cointegrated with cointegration (1, -1), for the LHS of equation (9) to be stationary. Therefore the procedure to assess the sustainability of the intert ral government budget constraint involves testing the following cointe tion regression: Rt = a + b GGt + ut. If the null of no cointegratio hypothesis that the two 1(1) variables are not cointegrated - is re (with a high-test statistic), this implies that one should accept the alter hypothesis of cointegration. For that result to hold true, the series residual ut must be stationary, and should not display a unit root. conclusions concerning the intertemporal budget constraint may t established: (i) When there is no cointegration, the fiscal deficit is not sustainable. (ii) When there is cointegration with b = 1, the deficit is sustainable. (iii) When there is cointegration with b < 1, government expenditures grow faster than government revenues, and the deficit may not be sustainable10. Hakkio and Rush (1991) also demonstrate that if GG and R are nonstationary variables in levels, the condition 0 < b < 1 is a sufficient condition for the budget constraint to be obeyed. However, when revenues and expenditures are expressed as a percentage of GDP or in per capita terms, it is necessary to have b = 1 in order for the trajectory of the debt to GDP not to diverge in an infinite horizon11. The procedure to test the sustainability of fiscal policy may be summarized, in a graphical sequential overview, by figure 1. Before proceeding it seems adequate to close the present section by summarizing the empirical findings of several previous studies, concerning the issue of sustainability. Therefore, table 1 reviews the conclusions of those papers, which cover basically the U.S. and European countries, with sometimes quite conflicting results. 10 Concerning this cointegration analysis approach, Bohn (1991, 1995) argues that a sustainable fiscal policy under certainty may become unsustainable under uncertainty. ii uuintos ^iw:>j, Anmea ana Kogers (i^j, ana Bergman (/uuij aiscuss me necessary conditions for sustainability in terms of the order of integration of public debt. This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Sustainability: The Unpleasant European Case 25 Figure 1 Fiscal Policy Sustainability: Unit-Root and Cointegration Tests Unit-root tests for R and GG GG is 1(0) and R is 1(1) sustainability v Cointegration between R tests and GG R and GG are cointegrated, CI( 1,1) Cointegrating ( n n ( _* ] ' 6 _* ] 6 vector - debt-to-GDP ratio Sustainability, debt-to-GDP ratio There is no ^ b > l ^ sustainability # As pointed out by a referee, even if there is no cointegration, sustainab a problem if, for instance, revenues are higher than expenditures. This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 26 Antonio Afonso Table 1 Some Existing Empirical Evidence Regarding Fiscal Policy Sustainability Author and date Data Period and Tests performed Sustainability? frequency country Hamilton and Annual 1962-1984 Stationarity tests Yes Flavin (1986) (U.S.) (deficit and public debt) Trehan and Walsh Annual 1890-1983 Stationarity tests (deficit) Yes (1988) (US.) Kremers Annual 1920-1985 Stationarity tests (public Yes until 1981, (1988) (US.) debt) no afterwards Elliot and Kearney Annual 1953/54-1986/87 Public revenues and Yes (1988) (Australia) expenditures cointegration Wilcox Annual 1960-1984 Stationarity test (public No (1989) (US.) debt) MacDonald and Annual 1961-1986 Stationarity tests (public Inconclusive Speight (1990) (UK.) debt); deficit and debt cointegration Hakkio and Rush Quarterly 1950:II-1988:IV Public revenues and No (1991) (US.) expenditures cointegration Smith and Zin Monthly 1946:1-1984:12 Stationarity tests (deficit No (1991) (Canada) and public debt), cointegration Trehan and Walsh Annual 1960-1984 Stationarity tests (deficit Yes (1991) (U.S.) and public debt) MacDonald (1992) Monthly 1951:1-1984:12 Stationarity tests (public No (US.) debt); deficit and debt cointegration Baglioni and Monthly 1979:1-1991:5 Stationarity tests (deficit No Cherubini (1993) (Italy) and public debt) Tanner and Liu Annual 1950-1989 Public revenues and Yes, with a (1994) (US.) expenditures cointegration break in 1982 Liu and Tanner Quarterly ? -1991 :IV Public revenues and Yes, with a (1995) (US.) expenditures cointegration break in 1982 Caporale Semi-annual 1960-1991 Stationarity tests (deficit No for Italy, (1995) and annual (EU countries) and public debt) Greece, Denmark and Germany Quintos Quarterly 1947:11-1992:111 Public revenues and Yes until 1980, (1995) (US.) expenditures cointegration no afterwards Haug Quarterly 1950:I-1990:IV Public revenues and Yes (1995) (US.) expenditures cointegration Ahmed and Rogers Annual 1692-1992 (U.S.) Public revenues and Yes (1995) 1792-1992 (UK.) expenditures cointegration This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Sustainability: The Unpleasant European Case 27 Table 1 Continued Author and date Data Period and Tests performed Sustainability? frequency country Vanhorebeek Annual 1970-1994 Stationarity tests (deficit Yes for Germany and van Rompuy (8 EU countries) and public debt) and France (1995) 1870-1993 (Belgium) Owoye Annual 1961-1990 Causality between taxes bi-directional in (1995) (G7 countries) and spending five G7 countries Payne Annual 1949-1994 Public revenues and Yes for Germany (1997) (G7 countries) expenditures cointegration Artis and Annual 1963-1994 Stationarity tests Yes, for Austria, Marcelino (1998) EU countries (public debt) Netherlands, UK Bohn Annual 1916-1995 Relationship between Yes (1998) (U.S.) primary surpluses and debt ratio Makrydakis Annual 1958-1995 Stationarity tests No (1999) (Greece) (public debt) Papadopoulos Annual 1961-1995 Public revenues and Yes for Greece and Sidiropoulos (4 European expenditures cointegration and Spain (1999) countries) Greiner and Annual 1955-1994 Stationarity tests No Semmler (1999) Germany (public debt) Olekalns Annual 1900/01-1994/95 Public revenues and No (2000) and 1978:3-1997:4 expenditures cointegration quarterly (Australia) Fève and Hénin Semi- (G-7 countries) Stationarity tests Yes for U.S., U.K., (2000) annual (public debt) and Japan Uctum and Annual 1965-1994 Stationarity tests Yes for Denmark, Wickens (U.S. and 11 EU (public debt) Netherlands, (2000) countries) Ireland, and France Martin Annual 1947-1992 Public revenues and Yes, with breaks in (2000) (U.S.) expenditures cointegration the 1970s and 1980s Getzner, Glatzer, Austria 1960-1999 Stationarity tests (central Yes for 1960-1974, and Neck (2001) public debt) no for 1975-1999 Bravo and Annual 1970-1997 Public revenues and Yes for Germany, Silvestre (2002) (EU countries) expenditures cointegration Austria, Finland, U.K., Netherlands Hatemi-J Quarterly 1963:1-2000:1 Public revenues and Yes (2002) (Sweden) expenditures cointegration Greiner, Koeller Annual 1960-2003 Relationship between Yes and Semmler (Germany, France, primary surpluses and (2004) Italy, Portugal, debt ratio and U.S.) This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 28 Antonio Afonso 4. Fiscal Policy Sustainability in the EU-15 Area This section includes some stylized facts on fiscal policy during the 1970 period for the EU-15 countries. It also reports the unit-root tests and es tion results of cointegrating relations between expenditures and revenu 4.1. Some Stylized Facts A brief characterization of the debt and fiscal burden for the EU countries is appropriate before performing the empirical testing of the sustainability hypothesis. Between the beginning of the 1970s and the end of the 1990s the debt-to-GDP ratio exhibited an increasing trend for most such countries throughout the period. For instance, general government debt increased in Italy from 37.9% of GDP in 1970, to 110.6% of GDP in 2000. In Germany the debt-to-GDP ratio was 18.2% in 1970 and went beyond 60% in 1997. According to European Commission data, in 2003 three countries still had a debt-to-GDP ratio above 100% (Italy, Belgium, and Greece), while in three other countries the debt ratio was higher than 60% (Austria, Germany, and France). Figure 2 Public Debt in Some EU Countries (percent of GDP) Source: European Commission, AMECO database (updated on January 7, 2004). This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Sustainability: The Unpleasant European Case 29 Table 2 General Government Revenues and Expenditures, EU -15 (percent of GDP) Country Revenues and 1970 1980 1990 2000 2003 A (p.p.) expenditures (1) (2) (2)-(l) Austria Revenues 39.1 45.6 47.1 50.8 50.2 11.2 Expenditures 37.9 47.2 49.6 52.6 51.2 13.3 Belgium Revenues 38.7 47.6 47.5 49.5 51.4 12.7 Expenditures 40.8 56.1 52.9 49.3 51.1 10.3 Denmark Revenues 44.8 49.9 55.1 57.2 56.4 11.6 Expenditures 40.8 53.1 56.1 54.6 55.4 14.6 Finland Revenues 34.1 42.0 51.3 56.1 53.4 19.3 Expenditures 29.9 38.7 46.0 49.0 50.9 21.0 France Revenues 37.9 45.3 48.2 51.3 50.5 12.6 Expenditures 37.1 45.4 49.7 52.7 54.7 17.6 Germany Revenues 38.0 44.3 42.1 47.1 44.9 6.9 Expenditures 37.7 47.1 44.1 48.2 49.1 11.4 Greece Revenues 24.7 26.3 32.5 47.8 44.6 19.9 Expenditures 24.2 29.0 48.4 49.8 46.3 22.1 Ireland Revenues 30.3 34.5 35.9 36.5 34.0 3.6 Expenditures 34.2 46.1 38.0 32.1 34.8 0.6 Italy Revenues 29.0 34.4 42.8 46.2 45.9 16.9 Expenditures 32.6 43.0 53.8 48.1 48.5 15.9 Luxembourg Revenues 31.7 48.0 44.9 47.5 15.7 Expenditures 28.9 48.4 38.5 48.2 19.3 Netherlands Revenues 38.9 50.6 48.0 47.5 45.9 7.0 Expenditures 40.1 54.7 53.0 46.0 48.5 8.4 Portugal Revenues 22.5 27.8 33.9 42.3 44.2 21.7 Expenditures 19.7 36.2 38.8 45.4 47.1 27.4 Spain Revenues 21.3 29.0 38.4 39.0 39.8 18.5 Expenditures 20.7 31.5 42.6 39.9 39.8 19.1 Sweden Revenues 46.3 56.1 62.6 60.9 59.2 12.8 Expenditures 42.1 60.0 58.5 57.4 59.0 16.9 UK Revenues 39.9 39.8 38.3 40.8 40.0 0.2 Expenditures 36.9 43.2 39.2 39.3 42.8 5.9 Notes: p.p.: percentage points. UMTS revenues are excluded from the n Source: European Commission, AMECO database (updated on January This content downloaded from 1f:ffff:ffff:ffff:ffff:ffff on Thu, 01 Jan 1976 12:34:56 UTC All use subject to https://about.jstor.org/terms 30 Antonio Afonso In the period 1970-2003 the highest debt-to-GDP ratios were repo in Italy and Belgium (the country with the highest debt-to-GDP ra that period; reaching 138.2% in 1993), and their high debt service payme induced substantial budget deficits despite primary budget surpluses. A versal of that general trend is noticeable only at the end of the 1990s, a several "more indebted" countries tried to fulfill or at least come closer to the Maastricht debt criterion. The consequences of choosing different fiscal policies may be exemplified by looking for instance at the public debt paths of some of the EU countries, as depicted in figure 2. For instance, the adding up of successive and significant budget deficits in Italy and in Belgium had a clearly identifiable effect on government debt, with the debt-to-GDP ratio rising steadily until the middle of the 1990s. Germany and France also exhibited a slowly growing debt ratio throughout the 1980s and 1990s. On the other hand, the debt ratio in the U.K. followed a downward path, while Ireland changed from being a high-debt country in the 1980s to a "less indebted" country in the 1990s. Concerning government expenditures and revenues, table 2 reports those items as a percentage of GDP for each country. The main conclusion is that the burden of public expenditures and revenues on GDP has increased since the 1970s in almost every country. Another obvious fact is that, between 1970 and 2003, the ratio of government expenditures to GDP, for most countries, exhibited a higher growth rate than the ratio of government revenues to GDP. This conclusion holds for all countries except Belgium, Ireland, and Italy. In Italy, for instance, the ratios of government revenues and expenditures to GDP were respectively 29% and 32.6% in 1970, compared with 45.9% and 48.5% in 2003. 5. Estimation Results for the Debt Series The focus of this subsection and of the next one is the study of fiscal-policy sustainability for each of the EU-15 countries. Augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) tests are used in an attempt to validate the sufficient sustainability condition, using the stock of real public debt. Table 3 reports the stationarity tests results for the first difference of the stock of public debt, at 1995 prices, for the period 1970-2003 (see data sources in the appendix), considering both a constant and no trend. The results allow the rejection of the null of a unit root for Austria, Portugal, and the U.K., according to ADF tests, and for France, Germany, Greece, Ireland, Luxembourg, Portugal, Spain, and Sweden, using the PP tests. Therefore the series of the first difference of public debt might be 1(0) for some countries, and the solvency condition would be satisfied in those This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Sustainability: The Unpleasant European Case 31 Table 3 Stationarity Tests for the First Difference of the Stock of Public Debt, with Constant, No Trend (at 1995 Prices) ADF PP Country Period Lags Test P-value Test P-value statistic t statistic z Austria 1970-2003 3 -4.00*** 0.00 -16.15 0.03 Belgium 1970-2003 5 -1.08 0.72 -4.05 0.53 Denmark 1971-2003 2 -2.26 0.19 -9.97 0.14 Finland 1970-2003 3 -2.41 0.14 -10.34 0.12 France 1977-2003 2 -2.50 0.12 -11.44* 0.10 Germany 1970-2003 2 -2.50 0.13 -17.48** 0.02 Greece 1970-2003 2 -2.38 0.15 -26.89*** 0.00 Ireland 1970-2003 5 -0.91 0.78 -18.35** 0.02 Italy 1970-2003 2 -1.20 0.67 -6.53 0.31 Luxembourg 1970-2003 2 -1.86 0.35 -13.45* 0.06 Netherlands 1975-2003 2 -1.21 0.67 -7.71 0.24 Portugal 1973-2003 2 -3.77*** 0.00 -29.11*** 0.00 Spain 1970-2003 5 -2.02 0.28 -14.44** 0.05 Sweden 1970-2003 2 -2.50 0.12 -13.93** 0.05 United Kingdom 1970-2003 5 -3.13* 0.10 -9.05 0.50 Note: The symbols *, **, and *** denote statistical significant at the 10%, respectively. cases. However, if one considers also a time trend, then neither the ADF nor the PP tests report that any of the series is 1(0). The previous results assume that there is no structural break in the debt series. However, this might not be the case in some countries - in particular, for Germany in view of its reunification in 1990.12 In the presence of structural changes in the trend function, ADF and PP tests that do not take account of the break in the series have low power and are biased toward the nonr ejection of a unit root. One procedure to test for unit roots in the presence of a structural break involves splitting the sample into two parts and using the unit-root test for each part. However, a result12 For instance, Greiner and Semmler (1999) report a break date for Germany in 1990, and Getzner et al. (2001) mention a break date in 1975 for Austria (but with a longer historical data set). This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 32 Antonio Afonso ing problem is that the degrees of freedom are diminished for each parts. Therefore, following Zivot and Andrews's (1992) recursive approach, we tested the null hypothesis that the series have a unit root against the alter- native of stationarity with structural change at some unknown break date denoted by TB.13 The break date is chosen endogenously as the value, over all possible break points,14 that minimizes the ¿-statistic for testing p = 1 in the following regression: Y, = ¡x + ßt + pYt_x + 6DUt + yDTt + òD(TB' k + ]TcI-AYf_I- + £i. (10) The shift in the trend is given by DTt = t - TB if t > T the shift in the mean by DUt = 1 if t > TB, and 0 ot the observation after the break point, and the addit D(TB)t = 1 if t = TB + 1, and 0 otherwise. This innov specifies that the change to the new trend function is g the ADF test statistics proposed both by Zivot and A Perron (1994) for the best-fitted regression, alongsi dates.15 The results allow the rejection of the unit-root hypothesis for Austria, Finland, and the U.K. when the Zivot-Andrews test statistic is used, and for Finland, Germany, Sweden, and the U.K. when the Perron test statistic is used. However, in general one cannot reject the unit-root null at the 5% or 10% level, implying that there is not much evidence against the unitroot hypothesis for most of the debt series in the EU-15 countries. These results are, to some extent, in line with the standard unit-root tests reported previously in table 3. Since some debt series might be stationary with breaks, the selected value of TB is a consistent estimate of the break point. Interestingly, most of the reported breaks seem to cluster in the 1990s and more specifically in the first half of the decade, namely, Austria in 1991-1992, Finland in 1990-1991, and Germany in 1993-1994. One can also notice that, for instance, in Finland the debt-to-GDP ratio increased by more than threefold between 1990 and 13 This is a variation of the test of Perron (1988), with the advantage that the break point is estimated rather than fixed exogenously. See, for instance, Hansen (2001) for a review of these issues. 14 Zivot and Andrews (1992) suggest estimating the autoregressions in some interval that excludes break dates near the beginning or the end of the sample. 15 The statistical algorithm used to compute these test statistics, following the sequential method proposed by Zivot and Andrews, was implemented with a TSP program, available at http://www.stanford.edu/~clint/tspex/. This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Sustainability: The Unpleasant European Case 33 Table 4 Test for Structural Change in General Government Debt (Innovational Out- lier Model) Zivot and Andrews Perron Country Period Break ADF break Lags Break ADF break Lags date point test date point test Austria 1970-2003 1992 -5.04** 1 1991 -3.71 2 Belgium 1970-2003 1991 -3.81 1 1988 -3.13 1 Denmark 1971-2003 1993 -3.50 2 1989 -3.63 2 Finland 1970-2003 1991 -8.18*** 1 1990 -9.84*** 0 France 1977-2003 1988 -3.88 2 1988 -3.72 2 Germany 1970-2003 1994 -3.28 0 1993 -4.25** 0 Greece 1970-2003 1978 -2.66 0 1991 -1.97 0 Ireland 1970-2003 1985 -4.00 0 1984 -3.85 0 Italy 1970-2003 1991 -2.39 1 1990 -2.33 1 Luxembourg 1970-2003 1986 -3.37 1 2000 -1.53 1 Netherlands 1975-2003 1991 -3.17 0 1986 -2.59 0 Portugal 1973-2003 1984 -4.34 0 1991 -3.78 1 Spain 197O-2003 1992 -2.87 0 1991 -2.80 0 Sweden 1970-2003 1997 -3.87 2 1999 -4.56*** 2 United 1970-2003 1987 -6.09*** 2 1986 -6.30*** 2 Kingdom Note: The symbols *, **, and *** denote statistical significant at the 10%, 5%, and 1% level respectively, using the critical values from Zivot and Andrews (1992, table 4). 1992 (there was a severe recession in 1991-1992). On the other hand, the estimated break date for Germany occurs only in 1993. One should also notice that the number of observations used is only 33 at most, and the accuracy problems of unit-root tests with small samples are well known. However, the alternative approach of using quarterly data would constrain the time period, so that it is preferable to use a longer sample of annual data, instead of more observations along a smaller time span. Furthermore, the rejection of the stationarity hypothesis does not mean, as already noticed above, that public accounts are not sustainable, since, as Trehan and Walsh (1991) observe, the stationarity of the variation of the stock of public debt is a sufficient condition, and stationarity rejection does not necessarily imply the absence of sustainability in the government accounts. This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 34 Antonio Afonso Figure 3 Government Expenditures and Revenues (percent of GDP) Source: European Commission, AMECO database (updated on January 7, 2004). 5.1. Cointegration Results We now proceed to study fiscal sustainability in the EU-15 countries by testing for the existence of cointegration between government expenditures and revenues, taken as a percentage of GDP, and using the sequential procedure depicted in figure 1. Visual inspection of the time series for each country may give an early clue, as can be seen by the examples in figure 3, which depict government expenditures and revenues, as a percentage of GDP, for Italy, Germany, France, and the Netherlands. One suspects in advance that Italy and France may not pass the sustainability tests. The first step is then to test the existence of a unit root for the government expenditures and revenues as a percentage of GDP and to assess whether This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Sustainability: The Unpleasant European Case 35 they are best characterized as 1(0) or as 1(1) series. The results of those tests for the series in levels are presented in Table 5. It is possible to conclude that almost all series are not stationary in levels. There are some exceptions where the ADF test statistic does not allow rejecting the hypothesis that the series are 1(0). However, this never happened with the PP test statistic, and allowing for a trend in the regressions, both the ADF and the PP tests report that all series are nonstationary. For every country it is thus necessary to test for the stationarity of the first differences of the series. According to the results also reported in table 5, in general one would not reject the stationarity of the first differences of the government expenditures and revenues series. This is true for all series according to the PP test, but less generalized under the ADF test statistics results. One can then tentatively assume that the first difference of the original series is 1(0), which means that the series in levels are 1(1). The Engle-Granger and Johansen cointegration tests were subsequently performed with the government revenues and expenditures as a percentage of GDP. Cointegration tests were made for all countries, even for the coun- tries where the ADF test statistic (but not the PP test) allows rejecting the null of unit root for the first difference of the revenue and expenditure series. The cointegration results are presented in table 6, but only for the cases where there is a cointegrating vector with a significance level of at least 10%. The test results allow the rejection of the cointegration hypothesis for the majority of the countries, except for Austria, Germany, Finland, Netherlands, Portugal, and the United Kingdom. However, the estimated coefficients for expenditures, in the cointegration equations, where government revenues are the dependent variable, are always less than one. As a matter of fact, for each percentage point of GDP increase in public expenditures, for instance in the Netherlands and in Germany, public revenues only increase respectively by 0.634 and 0.521 percentage points of GDP. Notice that these two countries are the ones where the estimated coefficient b in the cointegrating vector (1, - b) has the highest absolute value. For the other countries where a significant cointegration vector was found, b is even lower in absolute value. In other words, for the period 1970-2003, government expenditures in the above-mentioned countries exhibited a higher growth rate than public revenues, challenging therefore the hypothesis of fiscal policy sustainability. These results suggest that fiscal policy may not have been sustainable for most countries, with the possible exceptions of Germany and the Netherlands. However, and as in the case of unit roots, a test for cointegration that does not take into account possible breaks in the long-run relationship will have lower power. The test will tend to underr eject the null of no cointegration if there is a cointegration relationship that has changed at some time during This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 36 Antonio Afonso 1 888383 Ö33Ö83 888388 •f ÖÖÖÖÖÖ ÖÖÖÖÖÖ ÖÖÖÖÖÖ Un g °5 ****** ****** #*#tt*# 73 «« q t^ w «n q io >> oí ^1 ^ °° <^ ^^I^i^^^ g H'-Ô H h ai o' o^ o' K in o' K o' ci h oô 'o H 'O '¿ O I o s .g0 « I I I I I I I I I I I I I I I I I I 'S i ãSSaSS S22fs§§ SSSS85 ^ 7 ÖÖÖÖÖÖ ÖÖÖÖÖÖ ÖÖÖÖÖÖ «¿ Un Ö Q 1 ^ S • ï . 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M) (NCNrOfNCOm 5 § c« On IT) ^2 (N CO M ^ OOOOOO OOOO -O^ a. a. vo Su vo B ^ « ^u N >n o' m tn o' t^ocoo ^tcd ta S h Vj O *û (S h ^j00.^^. è^^ Hts iiiiii 1117 -h -s I « 1117 'li * « ed U 73 «2^Hqi^csjr^T-H o'oom^ino tit- i^tot-tiqqcNjq rTi W g 73 o'oom^ino it- i^to g rTi W •go ^ dddddd C AN dodo S oS < 0 3 - . . . Ü «5-C »nooi^cN^ovD »n r^ T- 1 r- -îh-^ r^.ïï (NvqOT-Hoqin ï; tn h 00 to -^ 1 lililí lili S -i .£ & -1 § 13 « TD 2 2 * O « * C 'S > * Íh X) I fil "S ■S e $ë e î î i . 1 Ì *'l 1 i s . g. sí 1 sii This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms •■I 38 Antonio Afonso Table 6 Cointegration of Government Revenues and Expenditures (percent of GDP) Dependent Engle-Granger (t) Johansen (trace) Country variable cointegration test cointegration test Vector P-value Vector P-value asymptotic asymptotic Austria R [1 -0.380]*** 0.008 [1 -0.418]** 0.035 GG [1 -1.609]* 0.084 [1 -2.395]** Germany R [1 -0.521]** 0.020 [1 -0.629]** 0.017 GG [1 -1.272]** 0.018 [1 -1.589]** Finland R [1 -0.343]** 0.022 [1 -0.368]* 0.070 GG - - [1 -2.719]* Netherlands R [1 -0.634]** 0.037 [1 -0.665]** 0.016 GG [1 -1.455]* 0.100 [1 -1.505]** Portugal R [1 -0.205]*** 0.004 [1 -0.174]*** 0.009 GG - [1 -5.740]*** United R - - - Kingdom GG [1 -0.516]** 0.044 [1 -0.735]** 0.017 Notes: The symbols *, **, and *** denote statistical significant at the 10%, 5% respectively. Only cointegrating vectors with at least a 10% significance level the sample period. Therefore, to further evaluate the previous should also entertain the possibility that the series are cointegrat the linear combination has shifted at an unknown point in the da in other words, that there might be a relevant break date. Follow and Hansen (1996), the hypothesis of a structural shift in the coi relationships was then studied.16 Table 7 reports the results of th regime shift (in level, with a time trend) in cointegration of revenues and expenditures for the EU- 15 countries. It is possible to see that for the above-mentioned countries, wh tegration vector was found, the test statistics from table 7 broadly previous findings. Indeed, allowing for the existence of break dat of no cointegration is now rejected for Austria, Belgium, Denmar the Netherlands, Portugal, and the U.K., with the ADF test statis 16 A Gauss routine, from Gregory and Hensen, was used to perform the tests tion with regime shifts (see http://www.ssc. wisc.edu/~bhansen/progs/joe_ authors have extended the Engle-Granger model to allow for a single brea tegration relationship. This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Sustainability: The Unpleasant European Case 39 Table 7 Testing for Regime Shifts in Cointegration of Government Revenues and Expenditures (percent of GDP), Level Shift with Time Trend ADF test Phillips test Country ADF* Break Estimated Z* statistic Break Estimated statistic point break date point break date Austria -5.47** (0.79) 1997 -28.65 (0.76) 1996 Belgium -4.86* (0.82) 1998 -80.20*** (0.53) 1996 Denmark -5.14** (0.41) 1984 -24.41 (0.41) 1984 Finland -4.58** (0.21) 1977 -20.89 (0.15) 1975 France -3.71 (0.62) 1991 -21.95 (0.62) 1991 Germany -3.98 (0.18) 1976 -26.37 (0.56) 1989 Greece -4.45 (0.76) 1996 -25.46 (0.76) 1996 Ireland -3.32 (0.38) 1983 -20.73 (0.35) 1982 Italy -3.73 (0.59) 1990 -19.26 (0.59) 1990 Netherlands -4.75* (0.15) 1975 -25.06 (0.15) 1975 Portugal -5.59*** (0.15) 1975 -27.56 (0.15) 1975 Spain -4.23 (0.47) 1986 -24.96 (0.71) 1994 Sweden -4.41 (0.65) 1992 -21.44 (0.65) 1992 United Kingdom -4.75* (0.53) 1988 -21.05 (0.53) 1988 Notes: ADF* and Z* refer to the augmented Dickey-Fuller (ADF) and to th test statistics. The symbols *, **, and *** denote statistical significant at the 1% level respectively, using the critical values from Gregory and Hansen (199 (with the Phillips Z* test statistic the null is only rejected for Bel means that there is some long-run relationship in the data for tries. Notice also that the null of no cointegration is no longer rej Germany. Additionally, the fact that the null hypothesis is now r Belgium implies that structural changes in the cointegration vecto important. Since for the remainder of the countries both ADF test statistics reject the null of no cointegration, no inference tha change has occurred is warranted. Our results, as most of the results reported in the literature we without considering additional sources of government revenues: fo seigniorage and privatization revenues. Information on privati enues is not easily available for the EU-15 countries. Additional ment assets (wealth) should be taken into account to make judgm the sustainability of public finances (even though data are mostly This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 40 Antonio Afonso 6. Conclusion The fiscal policy sustainability issue has been reviewed and discussed in this paper, using the government budget constraint as the key element of the analysis, and also as the starting point to derive analytical formulations suitable for empirical testing. Formally, the PVBC requires that the total of future net tax revenues (i.e., tax revenues less transfers of current and all future generations measured in present-value terms) be enough to cover the present value of future government consumption and to service the existing stock of government debt17. The paper's results reveal that with few exceptions, EU-15 governments may have sustainability problems, although debt-to-GDP ratios showed signs of stabilizing at the end of the 1990s. Using government expenditures and revenues as a percentage of GDP, a cointegration approach was adopted. However, and even if a cointegration vector was identified for Austria, Germany, Finland, Netherlands and Portugal, the estimated coefficients for expenditures in the cointegration equations for those countries, where public revenues is the dependent variable, are less than one. The results of this paper are comparable with the ones from some of the existing cross-country literature, and might be considered as "unpleasant" from a policymaker's point of view18. A small number of countries seem to emerge as less likely to exhibit sustainability problems, namely, Germany, Netherlands, Finland, Austria, and the U.K. Of these, Germany and the Netherlands almost always appear as less likely to have sustainability problems. However, our results also show that even for those two countries, the absolute value of the relevant estimated coefficient in the cointegration relation is considerably below unity, implying that their fiscal positions may not be sustainable. Therefore, the aforementioned countries face the problem of having a higher growth rate for expenditures than the growth rate of revenues. In other words, if fiscal policy were to be conducted in the future as it was in the past, there could still be some problems ahead, even for this set of countries that started, early in the 1990s, to make efforts in order to meet strict budgetary criteria. This problem may even become more critical in the light of some unpleasant available projections for the EU-15 countries, concerning future public financial responsibilities. As a matter of fact, the EC (2001) reported that aging populations could lead to increased expenditure on public pensions by between 3 and 5 percentage points of GDP in 17 One should note that it does not assume that government debt is ever paid off. 18 See, in particular, Vanhorebeek and van Rompuy (1995), Payne (1997), Artis and Marcelino (1998), Uctum and Wickens (2000), and Bravo and Silvestre (2002). This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms Fiscal Sustainability: The Unpleasant European Case 41 most Member States, with larger increases in several countries. Moreover, recent fiscal developments during the period 2001-2003 in several EU-15 countries do not seem reassuring with regard to sustainability of public finances. It is nevertheless important to keep in mind that the budgetary problems in developed countries during futur population growth combined with generous pay-as-yousystems. Since this population shift towards older societ new phenomenon, it cannot be considered in terms of ec based exclusively on past data. This does not constitute a against purely econometric methods of measuring fiscal is instead an argument for expanding the database. Inde lic pension liabilities, as part of a country's global fiscal to be understood as future borrowing requirements, not ful the public fiscal figures and leading therefore to added sust lems19. Also, one must recall that even for some of the c identified as not having had in the past an unsustainable ports claim that sustainability may not be a feature of such policies20. 7. Appendix: Data Sources All data was taken from the European Commission AMECO (Annual Macro-Economic Data) database, updated on January 7, 2004. The relevant AMECO codes are reported below: - General government public debt (national currency). Code: UDGGL (linked series). - Price deflator of final private consumption expenditure. Code: PCPH. - General government total revenues, national currency. Code: URTG (ESA 1995); URTGF (former definition). - General government total expenditures, national currency. Code: UUTG (ESA 1995); UUTGF (former definition). - Gross domestic product, at market prices. Code: UVGDH (ESA 1995); UVGD (former definition). 19 For a review of this topic and some interesting data simulation see, for instance, EPC (2003), Rother et al. (2003), and Holzmann et al. (2004). 20 See, for instance, Raffelhüschen (1999) and EC (1999, 2001). This content downloaded from 193.136.145.20 on Wed, 28 Sep 2022 15:14:15 UTC All use subject to https://about.jstor.org/terms 42 Antonio Afonso References Ahmed, S., and Rogers, J. (1995), Government Budget Deficits and Trade Deficits. 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