Fiscal space and government-spending & tax-rate cyclicality patterns: A cross-country comparison, 1960-2016

Abstract

The upward trajectory of OECD policy interest rates may impose growing fiscal challenges, thus testing the fiscal space of countries and their resilience. Against this background, we compare fiscal cyclicality across Asia, Latin America, OECD, and other regions from 1960-2016, then identify factors that explain countries’ government spending and tax-policy cyclicality. Our study reveals a mixed fiscal scenery, where more than half of the countries are recently characterized by limited fiscal space, and fiscal policy is either acyclical or procyclical (though not as high the level of 1980s), notably post-GFC becoming even more procyclical in government spending when accounting for net acquisition of nonfinancial assets and capital expenditure (spending components do matter). The cyclicality is asymmetric: on average, a more indebted (relative to tax base) government spent more in good times (positive growth) and cut back the spending even more in bad times (weak economy). Added to the public debt/GDP data, we construct the ‘limited-fiscal-capacity’ statistic, measured by the size of public debt/[average tax revenue] and its volatility, which is found positively associated with the fiscal pro-cyclicality. Further, we also find that country’s sovereign wealth fund has a countercyclical effect in our estimation. The analysis depicts a significant economic impact of an enduring interest rate rise on fiscal space: a 10% increase of public debt/tax base is associated with an upper bound of 6.1% increase in government-spending procyclicality. For both government-spending cyclicality and tax-rate cyclicality, we find no one-size-fit-all explanation for all (OECD/developing) countries at all (good/bad) times. Fiscal space, trade and financial openness, the share of natural resource/manufacturing exports, inflation, and institutional risks are associated with the cross-country patterns of fiscal cyclicality, suggesting the measured cyclicality is context specific and the fiscal-monetary-political economy interactions are at work. We rank the explanatory factors across countries and regions, and discuss policies to increase the fiscal capacity for countercyclical policy.