Publication - A RE-ASSESSMENT OF FISCAL SPACE IN OECD COUNTRIES ECONOMICS DEPARTMENT WORKING PAPERS No. 1352
Introduction and main messages
1. Almost a decade after the outbreak of the financial crisis, the global economy remains in a lowgrowth trap with weak investment, trade, productivity and wage growth and rising inequality in some countries. Monetary policy is overburdened, and its ultra-accommodative stance creates distortions and may fuel financial risks and distortions. Alongside structural reforms, a stronger fiscal policy response is needed to boost near-term growth and strengthen long-term prospects for inclusive growth.
2. However, in the context where public debt has risen to high levels in most OECD countries, it is important to assess the extent of countries' fiscal space. In the past few years, the assessment of fiscal policy has focused essentially on public budget balance positions rather than on the consequences for growth. This focus has resulted in a higher debt-to-GDP ratio in the short term, as shortfalls in investment, human capital and productivity have curbed GDP growth. A rethink is needed for how the fiscal policy stance should be evaluated, particularly in the context where low sovereign interest rates provide more fiscal space.
3. In recent years, a number of new methods have complemented the more traditional approaches to assess fiscal space (see Annex 1 for an overview of the different methods). This chapter relies essentially on three, with the objective of approaching the complex reality from different angles:
Ghosh et al. (2013) and Fournier and Fall (2015) focus on market access. They calculate fiscal space as the distance between actual debt levels and their estimated limits. Debt limits measure the debt level at which a sovereign borrower loses market access and hence cannot service its debt in a normal way. Debt limits depend on assumptions made on risk-free interest rates and potential output growth, the size of shocks that hit economies, the country's fiscal track record and the fiscal reaction to increasing debt. The fiscal reaction relies on the assumption that governments cannot indefinitely sustain public primary surpluses and will experience fiscal fatigue at some point. The model includes a non-linear risk premium that rises sharply if debt becomes close to the debt limit.
Bi (2011) and Bi and Leeper (2013) examine sovereign default risks but account for longterm fiscal sustainability. They rely on a DSGE approach, whereby the shape of the Laffer curve (which derives expected tax revenues from tax rates) depends on macroeconomic circumstances. Shocks to the economy and long-term projections of spending and transfers are accounted for. The approach does not provide a point estimate of the debt limit, but its distribution, i.e. the probability for a country to default at each value of the debt-to-GDP ratio. This distribution is derived using the expected present value of future maximum primary surpluses, which come from driving tax revenues to the peak of the Laffer curve and expenditure to its projected level.
Blanchard et al. (1990) focus essentially on long-term fiscal sustainability. When the interest rate is persistently below the growth rate, governments are able to run permanent deficits of any size. When the interest rate to growth differential is positive, fiscal space is computed as the tax gap between the sustainable and the current tax-to-GDP rate, where the former is the constant tax rate that would achieve an unchanged debt-to-GDP ratio over the relevant horizon, for a given projection set of public spending and transfers. Contrary to the former two approaches, this framework does not account for macroeconomic shocks. In this paper, a variant of this methodology is used to compute sustainable tax rates with a small macroeconomic model.
4. The main messages are the following:
Interest rates on government debt are very low in advanced economies, following exceptional monetary stimulus and have generated savings through lower interest payments.
Measures of fiscal space -- those that focus on the gap between actual debt and estimated levels at which market access would be compromised -- appear to have risen in most OECD countries since 2014, as lower interest rates have more than offset headwinds from lower potential growth and higher debt.
Measures that examine market access and account for projected long-term ageing-related spending pressures also point to some space in most of the larger advanced economies.
The extent of fiscal space appears to be uncertain in Italy and depends to a large extent on whether the focus is on past developments of the primary balance ("market access" approach) or on the budgetary implications of population ageing ("long-term fiscal sustainability" approach).
Structural reforms that effectively contain the cost of healthcare and pension spending, including by reforming entitlements, create additional space.
The increase in fiscal space provides room for manoeuvre, provided that low interest rates are locked-in through long-term borrowing. In particular, countries could issue more long-dated bonds and take advantage of favourable financial conditions.
Although policy requirements vary by country depending on their circumstances and positions in the cycle, most advanced countries have scope to use the expanded fiscal space in the context of a fiscal initiative which would comprise measures fostering productivity and longterm growth.
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