academy of economic studies doctoral school of finance and banking a comparative perspective on the...

Academy of Economic StudiesDoctoral School of Finance and Banking

A COMPARATIVE PERSPECTIVE ON THE SUSTAINABILITY OF FISCAL POLICY IN

HUNGARY, POLAND AND ROMANIA

MSc Student: Dorin Mantescu

Supervisor: Professor Moisă Altăr


• The recent preoccupation and reform of the Stability and Growth Pact reiterated the need to measure in a corresponding way the sustainability of the fiscal and budget policies.

• Determining the extent to which fiscal policy is sustainable proved highly contentious, controversial and difficult.

• It is generally agreed that a fiscal policy stance is sustainable if it satisfies the government’s intertemporal budget constraint. In practice, this does not solve the problem due to the fact that the government may announce its intention and plan for offsetting current deficits and debts by generating future surpluses.


• There are overall two main streams in the economic literature regarding the assessment of the fiscal policy sustainability, the prospective and retrospective approaches.

• The main pillars for the prospective approach are represented by

- fiscal gap indicator (proposed by Blanchard and others-1990),

- stress testing by targeting primary surpluses typically aiming at the reduction of the public debt and alternative scenarios with two standard deviations shocks to interest rates and growth

- value at risk which forecasts the deficit and the public debt (Androgue, applied to Central American Countries).

- stochastic simulation models of debt accumulation. Variance of debt increases with the forecast horizon, giving rise to a “fan chart”.


• The retrospective approach is trying to answer about the implications on the fiscal policy sustainability of the maintenance of the historical policies into the future.

• Several well-known approaches. - calculation of the fiscal gap proposed by Blanchard and

others (1990) which evaluates the historical primary surplus against debt stabilizing benchmark.

- the second one is represented by the analysis of the stationarity of the budget deficit proposed by Hamilton and Flavin (1986), Wilcox (1989), Trehan and Walsh (1990, 1991) and Hakkio and Rush (1991). Solvency is guaranteed by the stationarity of the real deficit, but debt may still rise.

- cointegration of the revenues and expenditures is proposed by Bohn (1991), Hakkio and Rush (1991), Ahmed and Rogers (1995) where the solvency is guaranteed by the cointegration of primary expenditures, revenues and debt.


- The last one is represented by the link between the primary surplus and debt, where the solvency is guaranteed by the positive relationship between primary surplus and debt.

- I focus on the retrospective methodologies for assessing the sustainability of the fiscal policy in order to avoid additional uncertainty regarding the hypothesis regarding governments behavior and the possible courses of policy decision making.


• Fiscal sustainability analysis is based on the government budget constraint.

• (1) Pt*Gt+(1+Rt)Bt-1=Bt+ΔMt+Pt*Tt

• Where Pt represents the general level of prices, gt is the real government expenditure level, including the transfers toward population, Rt is the average interest rate paid to the debt contracted at the end of t-1, Bt represents the nominal value of the liabilities issued at the end of the t period, Mt is the money supply provided by the central bank at the beginning of the period t, while Tt represents the real taxes level.


• The real budgetary constraint may be written in real terms, as shares in GDP. Dividing the equation 1 by the general level of prices (Pt) and the real national income (yt) we obtain:

• (2) bt/yt=(1+ρt)*bt-1/yt-1+dt/yt

• where bt represents the real stock of public debt, ρt=(1+Rt)/(1+Лt)(1+ψt) is the real interest rate adjusted with the real GDP growth (ψt) while dt is the real primary deficit, calculated as the total deficit minus the interest payments associated to the public debt. The dynamic equation of the public debt as percent of GDP is an equation in discreet time, where is supposed that the public debt has a one year maturity.


A) ρ constant• If ρ>0 , the equation (2) can be resolved forward giving

the following result:• (3) Bt/yt=1/(1+ρ)*Et(bt+1/yt+1-dt+1/yt+1)=• (1+ρ)-n*et(bt+n/yt+n)-∑(1+ρ)-s*dt+s/yt+s

• • When n→∞, there is obtained the following

transversality condition• (4) lim (1+ ρ)-n*Et(bt+n/yt+n)=0• • According to Trehan and Walsh (1991), the budget

process is called sustainable if the present value of the future stock of public debt converge toward zero. This condition excludes a Ponzi type scheme.


• The intertemporal budgetary constraint obtained on the basis of the last two equations represents the departure point of view for the majority of the empirical estimations of the fiscal sustainability,

• (5) bt/yt= ∑(1+ρ)-s*-dt+s/yt+s.• The public sector is solvent if the present value of

the future primary surpluses is equal to the current value of the public debt, implying a zero value for the long term public debt.

• The first test regarding the fiscal sustainability was proposed by Hamilton and Flavin in an article published in American Economic Review. The solution proposed by Hamilton and Flavin (1986) is that the dynamic equation of the public debt as a share in GDP to be written in the following form:

• (8) bt/yt=(1+ ρt)*bt-1/yt-1+dt/yt+υt


• Iterating forward, the above equation implies the same transversality condition, the difference being related to the inclusion of an error term. Hamilton and Flavin propose a test with the null hypothesis represented by the following relationship:

• (9) bt/yt=lim(1+ ρ)-s*(-dt+s/yt+s+υt+s).• The test research if there is rejected or not the

null hypothesis against the alternative one: lim(1+ ρ)-n*Et(bt+n/yt+n)=a*(1+r)t

• If a=0 then it is a necessary and sufficient condition for the process described by the share of the public debt in GDP to be stationary.


• ρ is variable• If ρ is variable, the budgetary constraint can be solved

forward, obtaining;• (10) bt/yt=Et(П 1/(1+ ρt+s)bt+n/yt+n)-Et(∑ 1/(1+

ρt+s)*dt+s/yt+s)• Where δt,s= П 1/(1+ ρt+s)<=1, for s>=1.• The intertemporal budgetary constraint has the same

interpretation supposing that the present value of the future surpluses is sufficient to cover the current debt. For the analysis of the fiscal sustainability is necessary to define the following variables:

• xt= δt,n*bt/yt; zt= δt,n*dt/yt, where Δxt=zt.• The transversality condition becomes: lim Et(xt+n)=0

and the intertemporal budget constraint becomes: xt=- lim Et(∑ zt+s).


• Wilcox shows in 1989 that the fiscal sustainability is attained when xt is a stationary process with a zero average. However, Uctum and Wickens (2000) demonstrates a more general result, showing that this is a condition sufficient but not necessary, the fiscal sustainability being observed also when xt is a process integrated of first order and zt is a stationary process with a zero average. On the other hand, while the real interest rate is adjusted with the economic growth, Trehan and Walsh (1991) are reaching the conclusion that the fiscal policy is sustainable if the total deficit is stationary. From an econometric point of view this condition is similar with the recognition of a cointegration relationship between the primary surplus and public debt where the cointegration vector is equal to (1,-r) or the existence of cointegration relationship between total revenues, total expenditures excluding the interest rate ones and the public debt where the cointegratio vector is equal with (1,-1,-r).


• The empirical testing of the intertemporal budgetary constraint and the transversality condition by the cointegration method is presented by Trehan and Walsh (1988 and 1991) and Hakkio and Rush (1991). In order for the public debt to converge toward zero, the primary deficit in the average has to be zero. If the total governmental expenditures and the total governmental revenues are integrated of first order, then the sufficient condition for the convergence of the budget deficit toward zero is that the respective two variables are cointegrated with a cointegration vector of (-1,1).


• While the intertemporal budget constraint is generally written as equation (3), there is a need for an alternative equation to derive a more pragmatic approach for testing.

(11) Rt = a + b GGt+ t• The null hypothesis is b=1 and t is stationary. This condition

guarantees the existence of a cointegration relationship between the total real consolidated revenues and total real consolidated expenditures, implicitly guaranteeing that the government is respecting its present value budget constraint.

• Cointegration of total government expenditures GG and R is consistent with McCallum’s (1984) discussion of the government’s intertemporal budget constraint. McCallum argued that a constant, positive primary deficit cannot be financed entirely by bond sales while a constant positive total deficit can be sustained from the financing point of view.


• All of the tests advocated by Engle and Granger involve estimating the so-called equilibrium or cointegration regression

• (15) Rt = a + b GGt+ t.• The first three tests focus on the stationarity of the residuals while

the rest are examining whether the total consolidated revenues and expenditures are obeying an error correction process.

• The first test involves the Durbin Watson statistic from the equilibrium regression. If the Durbin Watson test is large, the two series are cointegrated. The second method involves the testing of the existence of an unit root of the time series of the residuals from the equilibrium relationship. In this context if there is a unit root, then the total consolidated real expenditures and total consolidated real revenues are not cointegrated. Thus there is considered the following regression and there is studied if the estimated coefficient, , equals zero.


• If the coefficient is significantly different from zero, u is stationary and the hypothesis of cointegration is accepted. The second test is represented by an augmented Dickey-Fuller test (ADF), including additional lags u in the regression equation.

• (16) u t = -u t-1 +e t• The next pair of tests focus on the question if the

estimated coefficients 1 and 2 are jointly significant, then the total consolidated expenditures and total consolidated revenues have an error correction form and are cointegrated.

Rt = c1 +11 Rt-1 +12GGt-1+t GGt= c2 +21 Rt-1 +22GGt-1+ Rt +t.


• Bohn (1998) sustains that some of the sustainability tests based on the cointegration may produce misleading results. As an alternative test, the author proposes to analyze the relationship between primary deficit and public debt. If the primary deficit responds in a positive way to the developments in the public debt than the public debt is sustainable. The relationship proposed to be tested is of the following form:

• (18) st=ρt*dt+μt• For every t, ρ>0 a constant and μt a variable which includes other

factors. If μt is stationary then the fiscal policy is sustainable and the government observes the intertemporal budget constraint.

• The existence of this reaction function ensures that the increase of the public debt as a share of GDP decreases in every period by (1- ρ) compared to a Ponzi scheme. In this way, the public debt ahead with n period is reduced by a factor (1- ρ)n. For every positive ρ this implies that the following relationship is respected:

• Et(ut,n*dt+n)=(1- ρ)n*dt→0.


• Results Hungarian fiscal policy• Regarding the data, the unit root tests are showing that the real

consolidated revenues series are stationary in level, logarithm and per GDP forms while the real consolidated expenditures are non-stationary in level, logarithms and per GDP forms. In this context, there is no long term relationship between the real total consolidated government expenditures and real total consolidated government revenues. Intuitively, this implies that the government is violating the long term budget constraint because the total real government consolidated expenditures have a tendency to grow while the real total consolidated government revenues are stationary. In this context, the limit term derived in equation 4 does not converge to zero and implicitly the fiscal and budgetary policies promoted by the Hungarian government along the time interval studied are not sustainable.


• The regression of the real expenditures as a dependent variable against the real revenues as an independent variable, shows in the both cases (in levels and logarithm) that the real expenditures are increasing in the average quicker than the real revenues. Thus, a one percent increase in the real revenues leads to an average increase of 1.14 percent of the real expenditures. Moreover, an one billion forints increase of the real revenues leads in the average to an increase of 1.26 billion forints of the real expenditures. The coefficient attached to the independent variable has a high level of significance in the both cases, levels and logarithm


• The regression of the real primary deficit as a share in GDP as an independent variable against the real public debt as a share in GDP shows that the primary surplus is not responsive in the average to the developments in the real public debt. A one percent of GDP increase in the public debt level leads in the average to an increase of 0.06 percent of GDP of the average primary deficit. The coefficient attached to the independent variable is highly significant and its sign is negative. Moreover, the test of the stationarity of the residuals series rejects the null hypothesis


• Polish fiscal policy• The total consolidated real revenues and expenditures are not

stationary being integrated of first order. The budget deficit (in levels and per GDP), public debt (levels, per GDP and in logarithm) are not stationary and are integrated of first order.

• The regression of the real expenditures as a dependent variable against the real revenues as an independent variable, shows in the both cases (in levels and logarithm) that the real expenditures are increasing in the average quicker than the real revenues. Thus, a one percent increase in the real revenues leads to an average increase of 1,0009 percent of the real expenditures. Moreover, an one million euro increase of the real revenues leads in the average to an increase of 1,085 million euro of the real expenditures. The coefficient attached to the independent variable has a high level of significance in the both cases, levels and logarithm.


• The regression of the real primary deficit as an independent variable against the real public debt shows that the primary surplus as percent of GDP is not responsive in the average to the developments in the real public debt. A one percent of GDP increase in the public debt leads in the average to an increase by 0.025 percent of GDP in the real primary deficit. The coefficient attached to the independent variable is highly significant and its sign is negative. The residuals generated by this equation are stationary.


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Response of REALREV_SA to REALREV_SA

Response to Cholesky One S.D. Innovations ± 2 S.E.


• As can be observed from the above graphs, the response of the real expenditures to the innovations of the real revenues, is important. The real expenditures have a rapid increasing tendency on the short term and are still increasing on the long term although at a more slower pace. Moreover, the response of the real revenues to the innovations of the real expenditures is significant on the short term. However, the response is losing steam on the medium and long term.

• The Johansen cointegration test does not indicate the existence of a long term cointegration relationship between the total real consolidated revenues and the total real consolidated expenditures


• Romanian fiscal policy• The stationarity tests, represented by the

Augmented Dickey Fuller Test and by the Phillips Peron tests are showing that the total consolidated real revenues and expenditures are not stationary being integrated of first order. The primary budget deficit (per GDP), public debt (levels, per GDP and in logarithm) are stationary.


• If revenues and expenditures are non-stationary, the existence of a cointegration relationship between them is key for the government to obey its long term budget constraint. The results of the tests reports that the residuals obtained from the regression of the total government expenditures as an dependent variable against the total government revenues as an independent variable are stationary. There is a whole number of tests which are pointing to this direction, including the regression of the first difference of the residuals against its first order lags and the realization of the Dickey-Fuller, Augmented Dickey-Fuller and Phillips-Perron tests. As observed from the below table, the t-statistics and the associated probabilities are demonstrating in both levels and logarithms that the residuals are stationary and implicitly the government is obeying its long term budget constraint.


• The regression of the real expenditures as a dependent variable against the real revenues as an independent variable, shows in the both cases (in levels and logarithm) that the real expenditures are increasing in the average slower than the real revenues. Thus, a one percent increase in the real revenues leads to an average increase of 0.86 percent of the real expenditures. Moreover, an one billion RON increase of the real revenues leads in the average to an increase of 0.94 billion RON of the real expenditures. The coefficient attached to the independent variable has a high level of significance in the both cases, levels and logarithm.


• The regression of the real primary deficit as an independent variable against the real public debt shows that the primary surplus is responsive in the average to the developments in the real public debt. A one percent of GDP increase in the real public debt leads in the average to a 0.41 percent of GDP (Annex, Table 10) diminish in the real primary deficit. The coefficient attached to the independent variable is highly significant and its sign is positive. Moreover, the residuals generated by this equation are stationary.


• The next step in our approach is to study the relationship between the public revenues and expenditures and the sustainability of the budget deficits between the period 2000-2006. The exclusion of the crisis 1999 year (Romania was about to collapse from the financial point of view due to the weak international context and the macroeconomic vulnerabilities associated with the high level of short term debt contracted in the previous years) from the dataset may lead to a better understanding on the more recent developments in the Romanian public finance area. This later period overlaps to a large extent with the finalization from the implementation point of view of the first IMF agreement after successive previous failures in the post 1989 era and with the later EU accession drive.

• We develop a vector autoregressive analysis of


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Response to Cholesky One S.D. Innovations ± 2 S.E.


• As can be observed from the above graph, the response of the real expenditures to the innovations of the real revenues, is very small (actually the real expenditures are not responding to innovations in the total real consolidated revenues). This finding is in line with the actual policy choice promoted in this period in the public finance area which had a clear orientation in reducing the excess aggregate demand by the diminish of the budget deficit. The beginning of the year revenue forecasts were usually based on very cautious hypothesis regarding the economic growth, inflation and exchange rate assumptions. The additional revenues observed along the year due to higher than initially projected nominal GDP growth, improved revenue collections and more favorable exchange rate developments were used in the average to consolidate additionally the budget deficit trough a late autumn budget rectification.


• Moreover, there is a clear evidence of a long term response in the real revenues as a result of the innovations incurred in the real expenditures. This could be an additional outcome supported by the evidence in the budgetary policymaking of the last several years when the additional real expenditures were accommodated trough the consolidation of the revenues by promoting a coherent combination of policies aiming at diminishing the direct tax rates and implementing coherent measures to enlarge the tax base and improve the tax administration and collection. However, more probably, this may point out also to a “liquidity illusion” created by the strong economic growth process and the associated performance of the public revenues, leading to the expectation of future gains in revenues and neglecting their sensitivity to the economic cycle and possible sustainability problems.


• The Johansen cointegration test indicates the existence of a long term cointegration relationship between the total real consolidated revenues and the total real consolidated expenditures.

• The long term cointegration relationship between real expenditures and real revenues in levels is of the following form: Chelt_sa=39265.43+0.42*Ven_sa. The relationship is significant from the T-statistics test result for the coefficients and the coefficient atatched to the real revenues level is smaller than unity.


• Conclusions• The fiscal policies promoted by the Polish and Hungarian

governments in the last several years are not obeying the intertemporal budget constraint and implicitly are lacking sustainability. This outcome is pointed out by a large set of indicators, including the analysis of the stationarity of the public debt and deficits, the regression of the primary surplus against the debt and the analysis of the existence of a long term cointegration relationship between the total government revenues and total government expenditures.

• The fiscal policy promoted by the Romanian government was sustainable. However, there is evidence of a “real revenue illusion” due most probably to the change of vision in the last two years, when the government promoted a more prociclical policy characterized by increased budget deficits and by the full use of the collected revenues in order to finance additional expenditures (rather than to consolidate the budget deficit).


• Although, the public debt is very low and such policy would not create sustainability problems in the short and medium term, it should be seen with caution. The increased current account deficit may pose sustainability problems as a result to the expansionary aggregate demand and the worsening of the saving-investment balance in the both public and private sectors. Moreover, this policy exposes the public budget to adverse macroeconomic shocks such as a possible slowing down of the economic growth and the associated negative impact on both public revenues and expenditures (implicitly a higher budget deficit). Such a policy outcome is undesirable given the close to 3 percent of GDP actual deficit targets for 2007 and 2008. The paper should be developed additionally in order to study in a correlated perspective the sustainability of both public and private sector developments with a peculiar focus on the relationship between the sustainability of the current account deficits and the sustainability of the budget deficits.

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