Working Papers,
National Institute of Economic Research

Abstract: This paper analyzes the relationship between the budget balance and the cyclical situation of the economy. There are two main purposes. In the first analysis, we develop a method for economic policy, and induced changes that arise due to changes in the economy. The discretionary component of the change in the budget balance measure changes in fiscal stance and can be used as a fiscal policy indicator. As a measure of changes in fiscal policy, the proposed indicator has two advantages over existing indicators used by international organizations. First, the adjustment of changes in the economy is attached to important tax bases, rather than to the GDP, leading to higher accuracy when tax bases are not perfectly component does not include the effect on the budget balance of structural changes in the economy (as measured by potential output), that are not directly related to fiscal policy. The induced change component can be used to evaluate the cyclical sensitivity of public finances with respect to changes in the economy, when fiscal policy is unchanged. We also suggest how a decomposition of the level of the primary budget balance into a structural and cyclical component can be conducted. The second main purpose of the study is to empirically investigate the cyclical sensitivity of public finances in the Nordic countries. The analysis focuses on the peroid 1980 to 1997. We use three different methods for evaluating the sensitivity of public finances. Overall, public finances in all the Nordic countries are sensitive to cyclical changes in the economy. The estimated sensitivity of the budget balance as a share of GDP with respect to GDP growth is 0.6-0.8 for Sweden, 0.5-0.75 for Denmark, 0.4-0.6 for Finland and Norway and 0.2-0.6 for Iceland, given constant fiscal policy. It is likely, however, that our estimates are biased downward as data problems lead us to underestimate the sensitivity while countercyclical fiscal policy may lead to even more sensitive public finances. In the empirical analysis we also study how different types of shocks affect public finances. The result show that a domestic savings shock has the strongest effect on public finances, while an aggregate demand shock affects public finances less and en export shock has the smallest effect on public finances. We conclude the paper by discussing the problems associated with analysing the effect of fiscal policy on the economy by use of simple indicators, as well as a few brief remarks on the normative question of how sensitive the budget should be to economic fluctuations.

73 pages, November 1, 1999

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