Government Spending and Growth

Notes for Presentation at the ECB Public Finance Workshop

by

Jürgen von Hagen

University of Bonn, Indiana University Kelley School of Business, and CEPR

December 6, 2007

preliminary, do not quote without permission

Correspondence:

Jürgen von Hagen

IIW

Lennestrasse 37

D-53113 Bonn, Germany

tel +49-228-739199

email: vonhagen@uni-bonn.de

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1. Introduction

Fiscal consolidation was the most pressing problem of economic policy in the EU countries

during the 1990s and it remains a prime concern today. In 1977, the first year for which

these data are published, general government debt stood at 30 percent of GDP in the

countries now forming the EMU. National debt ratios ranged between 7.8 percent in

Finland, 11.9 percent in Luxembourg and 19.9 percent in France at the low end, and 60.1

percent in Ireland, 59.5 percent in Belgium, and 54.8 percent in Italy at the top end.

Portugal’s debt ratio was 27.3 percent, roughly equal to Germany’s. At the time of the

signing of the Maastricht Treaty in 1992, the EMU average was 59.3 percent. Luxemburg’s

debt ratio was the lowest (4.8 percent), but no other country had a debt ratio below 39.8

percent (France), and two countries had ratios in excess of 100 percent: Belgium (129

percent), and Italy (105.2 percent). The UK, which was not to join EMU had a debt ratio of

38 percent, but this was almost 20 percent lower than in 1977. Sweden and Denmark, the

other two countries that did not join EMU looked more like the first group, with debt ratios

of 63 percent each. Portugal’s debt ratio in 1992 was 51.7 percent.

In view of this rapid and, for peace times, unique expansion of public debt, the

concern that the stability of the common currency might be undermined by excessive public

debt, and the goal to regain and preserve fiscal stability were deeply ingrained in the

Maastricht Treaty. They are reflected in the definition of “sound public finances” as a

guiding principle of economic policy in the European Union (Art, 4(3)), in the rule that

countries with excessive deficits were not allowed to enter into the monetary union, and the

design of the Excessive Deficit Procedure and, later on, the Stability and Growth Pact as

collective instruments to achieve fiscal stability.

The performance of European countries has been very diverse since then. When

the monetary union started in 1999, the average debt ratio in the EMU stood at 72 percent.

On average, therefore, the Maastricht program failed quite clearly. Yet, this average hides

vast differences in individual country performance. France, Greece, and Germany

experienced the largest increases in the debt ratio between 1992 and 1999 (with 28.5

percent, 24.5 percent and 18.8 percent respectively), while Ireland, the Netherlands and

Belgium experienced the largest declines (with -43.1 percent, -18.0 percent and -13.5

percent, respectively). Portugal’s debt ratio was virtually constant over that period. Outside

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the EMU group, the debt ratios increased by 5.5 percent in the UK, and fell by 2.4 percent

and 1.1 percent in Denmark and Sweden, respectively.

In the first seven years of EMU until 2005, the average debt ratio has remained

almost constant (moving from 72.0 percent to 70.8 percent), with some consistency and

some changes in the relative performance of individual countries. Debt ratios declined by

slightly more than 20 percent in Ireland and Belgium, and Spain managed to reduce its

debt ratio by 18.4 percent. At the other end of the spectrum, Germany increased its debt

ratio by 7.3 percent, France by 8.3 percent, and Portugal by 12.6 percent. Outside the

EMU, debt ratios fell, most strongly so in Denmark and Sweden.

It is interesting to compare the increase in the debt ratios with the evolution of

government spending over the same time period. Consistent data is not available for all

countries, but a few tendencies are noticeable. First, countries which experienced the

largest increases in the debt ratio also tended to experience significant increases in the

expenditure ratios. Thus, the deficits leading to the rapidly rising debt ratios were typically

caused by expenditures growing faster than GDP and outrunning government revenues.

Second, countries where the debt ratio fell the most also tended to experience significant

declines in the government spending ratios. Thus, the key to bringing debt ratios down is

to assure that government spending grows at a pace slower than GDP. This suggests that

fiscal slippage as well as successful and lasting fiscal consolidations have a lot to do with

the relative growth of government spending and GDP.

Table 2 reports the average growth rates of EU countries during the same time

period. On average, real growth declined from 2.5 percent annually before 1992 to 2.0

percent during the run-up to EMU and 1.8 percent after the start of EMU. Again, there are

large differences in individual performance hidden behind these averages. Germany and

Italy experienced significant slowdowns in growth, as did France between the pre- and post

1992 period. Among the small EU member states, Portugal experienced the most

significant slowdown of trend growth, Belgium and Austria saw smaller reductions of

growth, while a number of other countries had rising growth rates in the 1990s. This

suggests that the run-up to EMU cannot be blamed for causing low growth.

Combining the growth rates and with debt ratios from Table 1 reveals some

interesting information. Among the countries experiencing growth rates at least 0.5%

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higher than the EU-12 average in the period from 1992 to 1999 (Spain, Ireland,

Luxembourg, the Netherlands, Portugal, Finland, Denmark, Sweden, and the UK, five had

falling average debt ratios during the same time period. In contrast, this is true for now

country in the complementary group, and all three countries with growth rate at least 0.5

percent below the EU-12 average rates, France, Germany, and Italy, saw rising debt ratios.

Thus, having below average growth is a good predictor for rising debt ratios. Conversely,

among the six countries that brought their debt ratios down in 1992-99, Belgium, Ireland

the Netherlands, Portugal, Denmark, and Sweden, all but Belgium had growth rates

exceeding the EU-12 average by at least 0.5% annually. Among the nine countries whose

debt ratios went up during this period, this is true for four. Thus, falling debt ratios are a

good predictor of having higher than average growth rates.

Turning to the period after 1999, all countries that had growth rates exceeding the

EU-12 average by at least 0.5 percent had falling debt ratios, while the countries with

growth rates at least 0.5% less than the EU-12 average, Germany and Portugal had rising

debt ratios. Among the 11 countries experiencing falling debt ratios after 1999, seven had

growth rates exceeding the EU-12 average by at least 0.5% annually. This is true for no

country in the complementary group, and two countries, Germany and Portugal, had

annual growth rates at least 0.5% below the EU-12 average. Thus, poor growth is a good

predictor for rising debt ratios.

Finally, Table 2 reports the ratio of gross private capital formation as a ratio of GDP

on average over the same time periods. These data are less informative if only because

they do not exist consistently for all countries over the relevant period. Nevertheless,

consider the correlation between the change in the debt ratio and the change in the

investment ratio. In the 1992-99 period, the correlation is zero: half of the countries

reporting rising investment ratios had falling debt ratios, four of the six countries reporting

falling investment ratios had rising debt ratios. A more clear-cut picture is suggested by

comparing the period of 1992-99 with 1999-2005. Of the 13 countries with rising

investment ratios, all but France and Portugal had falling debt ratios. Since this may be

driven by a global trend in investment ratios, we can look at the countries whose

investment ratio increased by at least one percent of GDP. Of these seven, six had falling

debt ratios, the exception being France. Thus, a strong rise in the investment ratio is a

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good predictor for falling debt ratios. If increasing investment ratios are related to economic

growth in subsequent periods, this suggests that falling debt ratios today may be friendly

to economic growth in the future.

Thus, stylized facts suggests that fiscal policy and economic growth are not

independent. This paper focuses on the link between the two. At a first glace, the link may

go in both directions. Traditional Keynesian arguments would suggest that fiscal

consolidations reduce growth, while rising deficits promote growth. However, this is not the

perspective we want to take in this paper, as the Keynesian effect is inherently short run.

Instead, we will concentrate on the link between fiscal policy and trend economic growth.

At the same time, economic growth may affect fiscal policy performance, as strong growth

may make it easier to engage in fiscal consolidations, or promote complacency and make

consolidations less likely. In section 2, we begin with taking stock of what we know from

economic theory. Section 3 reviews some recent empirical evidence on fiscal

consolidations and economic growth. Section 4 considers the EU experience with fiscal

policies in the past 15 years, focusing on different strategies to reduce public debt. Section

5 argues that fiscal institutions are important to assure that governments use the

opportunity of economically good times to preserve fiscal stability and to choose

consolidation strategies that do not reduce the chances of future economic growth. In

section 6, we consider the link between anti-cyclical spending and tax policies and growth.

Section 7 concludes.

2. Fiscal Policy and Economic Growth: Theory

Until the late 1980s, policy debates about fiscal policy and economic growth were

dominated by neo-classical growth theories in the tradition of Solow (1956) and Swann

(1956). In this tradition, an economy’s long-term growth rate depends on the (exogenous

growth rates of the capital stock and the labor force. Since the optimal capital-labor ratio

is determined by technical parameters, the growth rate of the economy ultimately depends

on the growth rate of the labor force. Thus, even policies that change an economy’s

savings and investment rate can have only temporary effects on the level of economic

activity, but not on the trend growth rate. Apart from providing the economy with an

appropriate physical and institutional infrastructure, including good schools and universities

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to promote a faster adaption of technical progress by domestic producers, there is little

fiscal policy can do to enhance economic growth. Fiscal expansions and contractions have

transitory effects on the business cycle but not on trend growth.

The empirical inadequacy of the neoclassical framework comes from the fact that

by far the largest part of observed economic growth cannot be explained by the growth

rates of the factors of production. Instead, it is attributed to the “Solow residual,” i.e., that

part of the growth rate which remains when factor growth has been accounted for. Of

course, one might argue that this simply reflects technological progress. But treating the

largest growth force as exogenous is not satisfactory for a theory of economic growth.

Since the late 1980s, economics has responded to this challenge by developing models

of “endogenous growth.” The new approach, which started with the seminal contributions

by Romer (1986) and Lucas (1988) introduces human capital or the stock of technological

knowledge as a new factor of production in its own right. Long-term growth is explained by

the accumulation of this new factor.

Under the first approach, growth is generated by the production of new technological

knowledge resulting in new or better products. Firms producing such knowledge can realize

temporary monopoly profits rewarding them for the cost of innovation. Since each

innovation contributes to the social stock of technological knowledge, the development of

new and better products causes an externality which individual firms neglect. An

economy’s long-term growth rate depends on the growth rate, not the size, of its knowledge

capital, the productivity of its innovative sector, and the profitability of investing in the

production of innovations. Baldwin and Forslid (1999) show that policies affecting this

profitability affect the long-term growth rate of the economy. For example, tax policies

changing the relative factor costs of skilled labor or the profitability of innovative activities

can raise the rate of growth. In contrast, the growth effects of public spending policies are

more difficult to assess. Since the growth rate of the economy depends on the growth rate

rather than the level of the stock of technological knowledge, public funding for research

and education does not necessarily lead to more growth. Growth effects only result from

policies that increase the productivity of innovative activities, such as the building of

research clusters. If the government produces public goods which are substitutes for

private goods and enter the consumer’s utility directly, an increase in public spending can

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even reduce economic growth by lowering the expansion of private consumption.

Lucas’ (1988) approach focuses on human capital. Human capital combined with

physical capital can generate increasing returns to scale at the macroeconomic level.

Importantly, the returns from human capital accrue to the individual implying that the

decision to acquire it through training and education is an investment decision. In this

reasoning, the growth rate of the economy depends on the growth rate, not the level, of its

stock of human capital, which in turn depends on the productivity of learning activities. For

the individual, the return on investment in education depends primarily on the difference

between the net wages earned by skilled and unskilled labor. Thus, taxing the former too

heavily compared to the latter reduces the incentive to invest in human capital and,

therefore, the growth rate. Public spending on education can raise the growth rate if it

raises the productivity of the education system, i.e., the amount of knowledge students

acquire per unit of time.

These models treat technological knowledge or human capital in the same way as

the more traditional factors of production, hence the implication that economic growth

depends solely on the growth rate of these new factors. In contrast, Nelson and Phelps

(1966) pursue a Schumpeterian approach in which knowledge or human capital increases

the ability to develop or adapt new technologies. This makes the growth rate of the

economy a function of the level of knowledge or human capital and, therefore, of past

investment in education and training. Empirical work by Barro and Sala-i-Martin (1994) and

Benhabin and Spiegel (1994) confirms this hypothesis. However, the latter show that the

positive growth effect of past education investment works only via the rate of innovation of

an economy.

Empirical research into the growth effects of public spending is plenty in the past 10

years, but the results are not unambiguous. Pfähler et al (1996) summarize more than 70

empirical studies on the productivity effects of public infrastructure capital arguing that

more than 60 percent of the studies find no significant or negative effects. The results

depend strongly on model specifications and the countries and period used in the data set.

Less ambiguous empirical results exists for the effect of taxes on economic growth. Alesina

et al. (1999) find a significant negative effect of the tax burden in the share of investment

in GDP, Cashin (1995) finds a negative effect of the tax burden economic growth. Mofidi

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and Stone (1990) find that state and local taxes in the US affect investment negatively if

the revenues are spent on transfer programs, while Bartik reports that state and local taxes

affect local growth rates negatively. Easterly and Rebelo (1993) find a negative effect of

income tax rates on long-term growth, while other kinds of taxes have no effect. Lee and

Gordon (2004) find that statutory corporate tax rates are significantly negatively correlated

with long-term growth rates in a cross-country comparison. Ohanian (1997) shows

empirical evidence suggesting that taxing capital income results in slower growth.

An important insight from both the theory and the empirical research is that it takes

a comprehensive view of fiscal policy to understand its effects on economic growth. More

specifically, policies must be regarded as bundles of taxes on consumption and income on

the one hand and government consumption and investment on the other. Taxes on income

reduce the marginal return on investment in physical and human capital or education and

have negative growth effects. In contrast, consumption taxes should not affect economic

growth. Government consumption does not affect growth either, while public investment

affects growth positively unless the public sector itself becomes too large and public

investment crowds out private investment. Although in practice the distinction between

public consumption and investment can be blurred, this results in the following pattern:

Growth effects of fiscal policy

public spending

consumption investment

taxes on income negative

positive unless the public

sector is too large

on consumption neutral positive

The idea of tax-expenditure bundles implies that the structure of public finances matters

as much, if not more, for economic growth as the level of spending and deficits. This

squares well with the notion of the quality of public finances proposed by the Lisbon EU

Summit, which called on the member state governments to achieve and maintain a

structure of public finances promoting economic growth. In our present context, the

challenge is to achieve fiscal consolidations that do not contradict this goal.

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3. Good and Bad Consolidations and Economic Growth

That the structure of public finances matters is also supported by another line of

recent research (see e.g. Perotti et al. 1998; Hughes Hallett et al (2001, 2002)). This

research shows that the success of fiscal consolidations depends significantly on the

composition of the consolidation effort. These studies define success in terms of the

longevity of the initial reduction in the government deficit. More specifically, consolidation

episodes are defined as periods where the deficit-to-GDP ratio fell by a minimum amount,

and a consolidation episode is defined as successful, if the deficit does not exceed a

maximum threshold after two years. In contrast, a consolidation episode is called

unsuccessful, if the deficit ratio quickly resorts to its old, high level.

Considering consolidation episodes in OECD countries from the 1960s on, this

research shows that the composition of the fiscal adjustment differs significantly between

successful and unsuccessful consolidations (see Table 3). While successful and

unsuccessful consolidations do not differ from each other in terms of the average size of

the fiscal adjustment, successful consolidations are characterized by significant cuts of

government expenditures, and especially of current expenditures and government

consumption. In contrast, unsuccessful consolidations leave government expenditures

unchanged as a ratio of GDP and put most of the effort into raising additional government

revenues. Hughes Hallett et al (2001) find that raising revenues accounts for 88 percent

of the total fiscal adjustment in unsuccessful consolidations, compared to 48 percent in

successful ones. The interpretation is that governments raising taxes to close a given

budget deficit are likely to spend the extra tax revenues once the funds start flowing in

instead of sticking to the goal of fiscal consolidation. This temptation does not arise in

consolidations relying on expenditure cuts.

Cutbacks in current expenditures accounts for 57 percent of the spending cuts in

successful consolidations, but only 27 percent of the spending cuts in unsuccessful ones.

Furthermore, successful consolidations typically involve cuts in politically sensitive

budgetary items such as transfers, subsidies, and public sector wage expenditures, while

unsuccessful ones put more emphasis on cutting public investment. Using statistical

methods of duration analysis, Hughes Hallett et al find that consolidation episodes last

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significantly longer when they involve cuts in transfers, wages expenditures and subsidies,

and are significantly shorter when they involve increases in revenues. The same authors

also find that expenditures continue to fall as a share of GDP in the two years following the

end of a successful consolidation episode, while they rise significantly in the two years

following an unsuccessful one.

Here, we see that the quality of public finances matters in another way. Good-quality

consolidations, which put most of the fiscal adjustment on the expenditure side are more

successful and longer-living. They also protect public investment against cuts more

strongly than poor-quality adjustments. Finally, since fiscal consolidations of poor quality

are shorter lived, they generate not only higher taxes but also more volatility of taxes, both

of which can be harmful to investment in human and physical capital and growth.

Hughes-Hallett et al (2001) also present empirical evidence answering the question

under what economic circumstances governments are more likely to undertake fiscal

consolidations, and, given that they do, what economic circumstances make the choice of

a good-quality consolidation strategy more likely. Using data for OECD government since

the 1960s, they show that a large and rising debt ratio raises the likelihood of starting a

fiscal consolidation. Furthermore, governments are more likely to start a consolidation, if

the economy is doing well, i.e., when the domestic output gap is positive and large.

However, given that governments start a consolidation, a negative output gap raises the

likelihood of a fiscal consolidation to be successful. Finally, a large and increasing output

gap during the consolidation episode raises the likelihood of the consolidation to come to

an end early. Intuitively, this says that, if a fiscal consolidation occurs in relatively good

times, governments more easily succumb to the temptation to use tax hikes to close the

deficits. Once the additional tax revenues come in, however, they are quick to use them

for additional spending. This effect is larger if the tax hike occurs in a time of relatively

strong economic growth. In contrast, governments engaging in expenditure cuts in times

of relatively weak growth are serious about the goal of improving the budget balance and

stick to it for a prolonged period of time.

This evidence points to another link between economic growth and fiscal

consolidations, which is rooted in political economy. Since positive output gaps tend to

come with strong cyclical growth rates, the results suggest that episodes of strong cyclical

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growth tend to make successful, good-quality consolidations less likely. Governments too

easily lose sight of the consolidation goal and give in to the temptation to spend more as

tax funds are pouring in. The experience with pro-cyclical fiscal expansions in most EMU

countries during the economic boom of 1999-2000 confirms the point. But if, as pointed out

in the previous section, fiscal consolidations of poor quality tend to lead to higher taxes and

higher levels of spending eventually, they may harm future prospects of long-term growth.

The government’s inability to stick to a lasting and successful program of fiscal

consolidation thus becomes a mechanism by which strong cyclical growth today reduces

long-term growth rates.

3. Fiscal Consolidations and Economic Growth: European Experiences

In this section, we characterize the fiscal policies of EMU member states since the

start of the Maastricht process to assess their structure and quality and their impact on

growth in EMU. We do this with a series of cross section regressions focusing on the

period since 1997. This is earlier than the start of EMU, but allows us to take a longer-time

perspective and disregard cyclical effects. While the cross sections have obvious data

limitations, the following bits of evidence add up to a picture that underscores the

importance of the structure of fiscal adjustments and taxes and spending more generally.

We start by noting that the fiscal policy in practices focuses on target variables

expressed as ratios of GDP, e.g., the deficit or the debt ratio. Government can reduce such

ratios in two ways, by slowing down the growth of nominal debt or by speeding up the

growth of GDP. Since inflation is no longer under the control of domestic monetary policy

for EMU governments, speeding up the growth of GDP is equivalent to speeding up the

growth of real GDP. A first question we look at considers the choice of the EMU

government between these two options.

Let d = B/Y be the ratio of public debt, B, to GDP, Y. The relative contribution of

growth in public debt and growth in real GDP to the change in this ratio in country i during

period t can be written as

1To facilitate reading the following figures, note that an R-square of 0.20 in the following regressions corresponds to the 10 percent critical value, andan R-square of 0.26 to the five percent critical value of the F-distribution of a test for statistical significance.

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(6)

it itwhere b is the growth rate of nominal debt during this period and g is the growth rate of

ireal GDP. Thus, if C > 0, the growth of public debt contributed more to the change in the

debt ratio than the growth of real GDP, otherwise, real GDP growth dominated. In the first

case, the government has relied mainly on actively reducing the increase in public debt

(the deficit) to bring down the debt ratio; in the second case, in the second case, the

government paid attention not to let public debt grow too fast, but relied mainly on real

economic growth to bring about a desired change in the debt ratio.

itFigure 1 shows a plot of C against the real growth rates of the EU countries for two

time periods, 1992-97 and 1997 – 2003. Positive values on the x-axis indicate that the

change in the debt ratio during the period considered was due to growth rates of public

debt in excess of the growth rate of real GDP. This was true in almost all EU countries in

the first period. In contrast, public debt grew less than real GDP in all countries since 1997.

Significantly, the figure also shows a strong and statistically correlation between the

average real GDP growth rate over the post-1997 period and the relative contribution of

GDP growth to the change in the debt ratio. The corresponding relationship was barely1

significant in the first sample period. The figure thus shows that governments in relatively

fast growing countries used the opportunity of strong growth after 1997 to reduce their debt

ratios. In contrast, governments in relatively slow growing countries let public debt grow at

the same pace or faster than real GDP in the first sample period.

Figure 2 gives a plot of the relative contributions of debt and real GDP growth

against the change in the debt ratio during the period under consideration. In the earlier

period, when debt ratios increased, this was due to debt growing much faster than real

GDP. In the later years, however, the pattern is reversed. Countries that achieved a large

decline in the debt ratio are countries that achieved high real GDP growth rates relative to

the growth rate of debt over this period. Countries that achieved little real growth relative

to debt growth also did not manage to reduce their debt ratios significantly. The figure thus

suggests that a successful strategy to reduce the debt ratio is one that focuses on growing

out of the debt burden rather than one that focuses on slowing down the growth rate of

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debt while neglecting economic growth. Taking figures 1 and 2 together, a clear message

emerges. Without reviving economic growth, a significant reduction in the debt burden is

unlikely. Taking the two periods together, another message is that rising debt burdens

come from a lack of control over public sector deficits. But to reduce an excessive debt

burden, controlling debt is only a necessary condition. Without reviving economic growth,

a significant decline in the debt burden seems unlikely. This suggests that a rigid focus on

deficit and debt ratios alone, as under the current EMU fiscal framework, would only be

justified, if EMU had started in a period in which public debt burdens could be regarded as

compatible with long run equilibrium. Given that a reduction in the debt burden is

necessary particularly in the large countries, the policy framework pays too little attention

to the role of economic growth in achieving sustainable public finances.

Next, we turn to public sector revenues and spending. In figure 3, we look at the

relative contributions of debt and real GDP growth to changes in the debt ratio together

with the changes in a number of fiscal indicators after 1999. In this figure, “revenue” and

“total spending” refers to the ratios of public sector revenues and expenditures to GDP;

“social transfers” and “investment” relates to the shares of transfers to households and

total capital expenditures in total spending. The figure plots the changes in these indicators

over the 1997-2003 period for the EU countries. We note, first, that countries where

expenditure and revenue ratios fell during this period are countries that achieved a larger

contribution of economic growth to the change in the debt ratio, hence a larger reduction

in the debt ratio. However, these relations are not statistically significant.

The same figure also points to a critical role of investment spending and spending

on social transfers. Countries that increased the share of investment spending tended to

achieve a stronger contribution of GDP growth to the reduction in the debt burden, while

countries that reduced the share of investment in public spending achieved a smaller

contribution of growth to the decline in the debt ratio. Countries that increased the share

of social transfers in total spending experienced a smaller contribution of growth to the

reduction in public debt. We look at this issue n more detail below.

In Figure 4, we look at the tax burden and the composition of revenues. The figure

plots the total tax burden (general government revenues over GDP) and the share of direct

taxes and social security charges on labor in total revenues against the growth rate of real

For example, teacher salaries, which should be regarded as part of public investment in human capital, are2

counted as public consumption, and there is no consideration of the productivity of the investment projects

on which public funds are spent.

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GDP. We take the share of direct taxes and social security charges as a rough proxy for

the importance of taxes on factor incomes in a country’s tax system. Both relationships are

negative and statistically significant. The figure shows that countries with high tax burdens

in Europe grow at significantly slower rates than countries with lower tax burdens. A rough

estimate yields than an increase in the tax burden by five percent results in a reduction in

trend growth by one percent annually. The figure also shows that an increasing share of

taxes on factor incomes goes along with a falling growth rates in this sample. Increasing

the share of taxes on factor incomes in total revenues by 10 percent reduces the trend

growth rate by a bit more than 2 percent.

Figure 4 thus summarizes the German fiscal policy predicament in the 1990s. The

German government tried to reduce the deficit and achieve a fiscal consolidation

repeatedly by increasing the tax burden and especially direct taxation. As a result,

economic growth faltered and the consolidations ended unsuccessfully. The German case

thus illustrates the fallacy of a consolidation strategy relying on raising (direct) taxes: While

revenues initially come in more strongly, such a strategy undermines the necessary

condition for a successful consolidation, which is sufficient economic growth.

In Figure 5, we look at the composition of total government spending in connection

with the average real GDP growth rate of the EU countries in 1997-2003. The figure shows

a strong association of higher shares of public investment and real GDP growth. Clearly,

this correlation must be regarded with some caution, as public investment is not a very

clear concept in practice. Furthermore, the direction of causality might be that countries2

enjoying exogenously low growth rates cut public investment first, as political opposition

against cutting transfer spending is more powerful than political opposition against cutting

spending on public infrastructure etc. In fact, such political economy effects may be

particularly large under the conditions of the Excessive Deficit Procedure and the Stability

and Growth Pact in EMU, when governments are forced to cut public spending quickly to

avoid violating the numerical constraints. Still, one would have to assume that public

investment has no positive effect on growth at all to argue that this would not eventually

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lead to lower growth rates. The same figure also suggests that higher shares of transfer

spending in total spending go together with lower rates of growth, although this relation is

only marginally statistically significant.

Finally, in Figure 6, we look at the correlation between fiscal consolidation and real

GDP growth. We do this by plotting the growth rate of public debt together with the growth

rate of real GDP for the two time periods, 1992-97 and 1997-2003. The figure and the two

regressions indicate that there is no significant correlation between these two. High growth

rates of public debt in the early period apparently did nothing to stimulate economic growth,

and lower growth rates in the latter period did not reduce growth. Nor does the figure give

much credence to the concept of “non-Keynesian” effects of fiscal consolidations, i.e., the

notion that a reduction in public debt would have positive growth effects by stimulating

private investment and consumption (Giavazzi and Pagano, 1990). Such effects would lead

us to expect higher growth rates for those countries where public debt actually shrank in

the period under consideration. Obviously, the present bivariate framework is not sufficient

to achieve a strong conclusion on this matter. Nevertheless, it is in line with the results from

a larger econometric model presented in Hughes Hallett, Strauch and von Hagen (2001),

which do not indicate “non-Keynesian” effects of the fiscal consolidations in Europe in the

past decade. In passing, we note that our evidence here points to a methodological

problem of earlier studies of such effects. Specifically, most studies identify fiscal

consolidations as periods of significant reductions in public debt or deficit ratios, and “non-

Keynesian” effects as episodes where consolidations go along with vigorous economic

growth. The European experience suggests that such episodes may have more to do with

policies that succeeded in stimulating growth by restructuring public spending and taxation

and reducing tax burdens than with a reduction in public debt or deficits.

We summarize the evidence from this section by pointing out the emergence of two

alternative strategies of fiscal adjustment in Europe. In Table 5, we report the averages of

direct taxes including social security contributions, transfers to private households and

public investment spending relative to GDP in three periods, before 1992 (which varies for

different countries according to data availability), 1992-1999, and 1999-2005. In Table 6,

we collect this data for two groups, the group with the lowest and the highest growth rates

in the EU during 1992 to 1999, and the group with the lowest and the highest growth rates

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in EMU from 1999 to 2005. We do not consider the UK in the latter period, since the UK

is not a member of the EMU and exchange rate policies might affect the results. The low

growth countries in the first time period are Germany, Italy, and France, in the second

period, they are Germany, Italy, and Portugal. The high-growth countries in the first period

are Ireland, the Netherlands, and the UK, in the second period, they are Ireland, Spain,

and Finland. The table shows that the average public debt ratio continued to grow in the

low-growth countries during both periods. In contrast, it fell by 15.6 percent in the high

growth countries during the 1992-99 period and by 14.5 percent after the start of EMU in

i1999. The average C indicator shows that most of that reduction was achieved by real

growth rates exceeding the growth of nominal public debt. In the low-growth countries, debt

continued to rise faster than real GDP.

Low growth countries in both periods were characterized by an increase in the ratio

of direct taxes to GDP and social transfers to GDP, and a reduction in the ratio of public

investment to GDP. They are also characterized by a sharp increase in transfer spending

as a share of total public expenditure and a falling share of investment spending in total

expenditures. High-growth countries, in contrast, experienced reductions in the ratio of

direct taxes to GDP and transfer spending to GDP and a slight increase in the ratio of

public investment to GDP in the second period. For these countries, the rise in investment

spending as a share of total public spending is more visible in both periods. Overall, these

observations are consistent with the predictions of economic growth theory pointed out

above. They underline the importance of choosing a growth-oriented strategy for fiscal

consolidation.

5. The Role of Budgeting Institutions

Our discussion so far and the European experience suggest that the distinction

between good-quality and poor-quality consolidation strategies is crucial. Good-quality

consolidations benefit from healthy trend growth and do not harm the growth prospects of

an economy. Poor-quality consolidations rely on short-run growth but harm the longer-term

growth prospects by increasing the tax burden on factor incomes and reducing capital

spending.

16

Our discussion also suggests that good-quality consolidations require commitment

to the policy goal of reducing public debt and the stamina to stick to it for an extended

period of time. Commitment is necessary, because good-quality consolidations need to

tackle with politically sensitive spending items like public sector wages and social transfers.

Stamina is required because good-quality consolidations must go on for some time to show

their fruits. The problem in practice is that both, commitment and stamina are notoriously

rare in democratic societies. Governments face pressures from interest groups for public

funds and special favors. Perhaps the greatest difficulty in entering a good-quality

consolidation is to overcome the political resistance of groups which perceive that they lose

government transfers or other benefits. A government must be committed to the goal of

consolidation to get over such resistance. Furthermore, democratic governments face the

challenge of elections. The more uncertain a government’s chances to win the next

election, the less likely it is to reap the fruits of a good-quality consolidation causing political

pains today, and the more tempting to give in to spending pressures before the election.

Thus, political processes make it especially difficult to pursue good-quality consolidation

strategies.

There is now a rich and growing literature showing that fiscal institutions can help

governments build the commitment and stamina necessary for good-quality consolidations.

This literature starts by recognizing that political fragmentation and instability undermine

the government’s ability to commit to a good-quality consolidation and stick to it. In our

context, two types of institutions are particularly relevant: Fiscal contracts and the

delegation of fiscal powers to a strong finance minister.

Fiscal contracts exist where governments design and adopt multi-annual fiscal

programs based on numerical targets for the key budgetary parameters. Importantly, these

targets are (re)negotiated among all relevant political actors at the outset of the annual

budget process and considered to be binding throughout the remainder of that process.

These targets must be based on reliable macroeconomic projections to assure that they

can be kept with reasonable certainty. Furthermore, they must be specific enough to

express the government’s willingness of how to address spending cuts in politically

sensitive areas. To make fiscal contracts work requires that the finance ministry can

17

effectively monitor the spending ministries during the budget year and assure that the

targets are kept. Often, fiscal targets come with rules spelling out what the government will

do under unforeseen circumstances, i.e., how unexpected revenue shortfalls will be

handled or what will be done with unexpected revenue surpluses. Fiscal contracts address

the commitment problem of democratic governments by starting the budget process with

negotiations in which a compromise agreeable to all relevant parties can be reached, and

by threatening that deviations from the targets during the fiscal year will be punished. They

provide the stamina necessary for good-quality consolidations by providing a medium-term

framework against which fiscal actions can be measured and governments can be held

accountable. Examples of successful fiscal contracts in the EU are Ireland, the

Netherlands, Sweden, Denmark, and Finland.

Delegating fiscal powers is based on the idea that the finance minister, who typically

is not bound by particular spending interests as much as the spending ministers is in a

particularly good position to decide on politically sensitive spending cuts. This model vests

the finance minister with agenda setting power over the spending ministers, i.e., the

finance minister can unilaterally - or jointly with the prime minister - set the main

parameters of the annual budget. Numerical targets typically play no or a little role in this

approach. To make it work, the finance minister needs the power to execute the budget

assuring that no deviation from the original budget occurs. In this model, the commitment

power is provided by the relative independence of the finance minister from political

spending interests. The stamina required for good-quality consolidations is provided by the

stability of the finance minister’s position in the government. Successful examples of the

delegation model in Europe are the UK, France, and Germany until the early 1990s.

The choice between these two models depends primarily on a country’s political

systems. Fiscal contracts work in settings, where the government is typically formed by

coalition governments among relatively competitive partners. The reason is that contracts

are ultimately enforced by the threat of one partner to break up the coalition, if another

partner violates the targets in his spending area. This is underlined by the fact that the

targets of the annual fiscal contract are often in practice derived from an agreement on

multi-annual fiscal targets in the coalition treaty, and that the party leadership is often

18

involved in the negotiation of the annual targets. The threat is the more effective, the more

the threatening party can expect to find another partner to form a government with in case

of a breaking-up of the ruling coalition. Hence, competitiveness of the political process

promotes enforcement. Enforcement of fiscal contracts is also strengthened by giving the

legislature strong monitoring rights over the executive.

In contrast, delegation does not work well in coalition settings. The reason is that

delegation is a hierarchical model, resting on giving one individual special powers over

others. In democracies, power hierarchies typically exist within parties, but not between

parties. Delegating strong fiscal powers to the finance minister in a coalition setting would

create the suspicion that this minister abuse his powers to favor his party’s spending

interests over those of the other parties in the coalition.

Delegation does work in governments which are formed by a single party or a two

close allies. In such a setting, the finance minister’s budget can be enforced by threatening

that spending ministers overrunning their budget allocations will be removed from office.

In contrast, contracts do not work in such an environment, as a single-party government

can simply decided to walk away from away from any targets set previously, as it faces no

penalty for doing that.

As shown in Hallerberg et al (2006), some parameters can be identified that

determine the political system in this regard. The first is the electoral system - proportional

representation versus majority rule - and district magnitude, i.e., the number of seats in

parliament coming from one electoral district. Proportional representation, especially with

low minium vote thresholds to obtain a seat in parliament, and large district magnitude are

conducive to political systems with many and competitive parties and, therefore, coalition

governments. Majority rule and proportional representation with low district magnitude and

high minimum vote thresholds are conducive to political systems with one-part

governments or coalitions of close allies such as in Germany until recently.

This reasoning is illustrated in Table 7. The table reports the parameters of the

electoral systems in the EU-15 countries together with some indicators of the

competitiveness of the government formation process and the type of coalitions prevailing.

Apart from the average number of parties in power over the sample period, these indicators

19

are the frequency of changes in a coalition whenever a change in government occurred,

the maximum ideological distance between any two coalition partners, and the existence

of pre-electoral pacts committing the parties to certain partners should they win the

election. The last column in Table 7 predicts the type of institution chosen by the country.

Hallerberg et al. show that these predictions match the observed political patterns very

closely: Where countries adopted institutions following one or the other approach, they

followed the predictions of the table.

It is interesting to take these predictions back to Table 6. There, we identified the

three fastest and the three least growing countries in the EU in the 1990s and since the

start of EMU. Obviously, all countries in the least-growing group are from the group of

delegation countries, i.e., they have relatively strong finance ministers, while fiscal

contracts play no role in their budget processes. Two of the three best-performing countries

in each period are among the countries that adopted fiscal contracts. This is in line with

more systematic evidence shown in von Hagen (2006) and Hughes Hallett et al (2001), i.e.,

that EU countries following the contract approach have achieved larger debt reductions

than countries following the delegation approach in the 1990s. This suggests that contracts

have been more effective in providing an institutional mechanism leading to good-quality

consolidations and stronger growth. Delegation is not necessarily biased against growth

and good-quality consolidations, but delegation countries seem less likely to achieve that

outcome.

6. The Role of Countercyclical Policies

One important macroeconomic function of the government budget is that it can be

used to counteract cyclical fluctuations in aggregate output and employment. While this

function is conventionally regarded as unrelated to growth issues, a recent study by Aghion

and Marinescu (2006) suggests that this may be wrong. Aghion and Marinescu argue as

follows. Consider an economy in which growth is driven by a Schumpeterian process of

innovation. Innovations are mostly produced in small and medium-sized businesses which

are particularly good environments for creative people to try out new ideas. In a

Schumpeterian model of economic growth, the principal function of recessions is to weed

out lazy innovators and firms unable to come up with ideas for new products or production

20

processes. But this benign view of recessions rests on the assumption that innovative firms

can survive recessions because they have access to a perfect capital market.

Suppose now that firms are credit constraint and their borrowing capacity is tied to

their current cash flow, a standard assumption in corporate finance. Credit constraints are

likely to be most severe for small and medium-sized firms which, therefore, are more

strongly exposed to cyclical movements of the economy; see e.g. Gertler and Gilchrist

(1996). A recession then limits the borrowing capacity of the most innovative firm and may

cause these firms to exit. As a result, economic growth is lower in economies with more

pronounced business cycles.

Aghion and Marinescu use this reasoning to suggest that the cyclical properties of

government spending and taxes can affect long-term growth. Using a panel of OECD

countries, they show that, indeed, countries with less procyclical fiscal balances have

experienced higher long-term growth rates. This is an interesting result indicating that the

dichotomy between cyclical policies and growth should be reconsidered.

7. Conclusions

The theory and evidence shown in this paper suggest that the link between

economic growth and fiscal consolidations is not unidirectional. There are strong reasons

to believe that good fiscal performance can enhance long-term economic growth. Good-

quality consolidations, which focus on cutting spending in consumptive areas of the budget

enhance economic growth as they reduce the burden of taxes falling on factor incomes

and protect capital spending. They also promote growth but providing greater certainty over

future fiscal policies than short-lived, bad-quality consolidations.

At the same time, good-quality consolidations enable governments to drive home

a growth dividend, i.e., to achieve most of the desired reduction in the public debt ratio by

real growth rather than by curbing the growth of nominal debt. Short-term growth, in

contrast, encourages governments to rely on raising taxes to close a given deficit, but most

often with the result that the consolidation is abandoned when revenues start flowing in.

Good-quality consolidations require political commitment and stamina. The extent

to which they can be achieved depends on the quality of a country’s fiscal institutions and

National fiscal councils as a commitment mechanism were first proposed by von Hagen3

and Harden (1994) and Eichengreen, Hausmann and von Hagen (1998).

21

the characteristics of its political system. What about Portugal in this regard? Table 7

places Portugal into the group of delegation countries. Hallerberg, Strauch and von Hagen

(2006) show that Portugal’s fiscal institutions today are the weakest in the group of

delegation countries. From the institutional perspective, Portugal’s weak fiscal performance

is no surprise.

To improve Portugal’s performance both in terms of deficits and debt and economic

growth, therefore, requires a strengthening of the ability of Portuguese governments to

commit to lasting, good-quality consolidations and, beyond that, consistent fiscal programs

favoring trend growth. One way to do that would be to strengthen Portugal’s fiscal

institutions, giving the finance minister more agenda-setting powers in the planning of the

annual budget and more management and enforcement powers in the execution of the

budget.

Nevertheless, this approach remains limited by the relative short life of Portuguese

governments in recent years, which prevent the finance minister from delivering the

commitment power and consistency over time required for good-quality consolidations. An

alternative to this solution is another form of delegation: the creation of an independent

national fiscal council. The main task of such a council would be to monitor the3

government’s fiscal performance, to comment on it in public and to make

recommendations for improvement. The fiscal council would set annual fiscal targets for

the change in public debt and ask the government to explain how it intends to meet these

targets. It is conceivable that the fiscal council would have the right to mandate and enforce

across-the-board spending cuts by the government, if the annual fiscal target is violated.

Otherwise, the enforcement would rest on the council’s visibility in the political debate and

the political cost it might inflict on the government in power by informing the media and the

voters about the unwillingness or incompetence of the ruling government to pursue sound

fiscal policies.

Setting and enforcing such targets would not imply setting any priorities for certain

spending items over others, nor to use spending cuts rather than tax hikes to reach a

22

desired consolidation. Thus, the council would not interfere with the governments

constitutional right to decide on the level and structure of public spending and taxation.

However, it would give the need to achieve fiscal discipline more political visibility than it

currently has. Furthermore, the process of public debate over the course of fiscal policy

and its effect on growth would strengthen the political accountability of the government and

thus improve the democratic culture.

Today, two countries in Europe have adopted models of that nature, though with

different specifications. In Belgium, the High Council of Finance annually determines the

main fiscal parameters for the central government and the regions. In the Netherlands, the

Central Planning Bureau, an independent economic research institute, provides annual

assessments of the government’s fiscal policy and assessments of the fiscal

consequences of the economic programs of all parties competing in national elections. In

both countries, these institutions are regarded as important safeguards of fiscal discipline.

They might provide examples for how to achieve better fiscal outcomes in Portugal.

References

Aghion, P. und P. Howitt (1998), Growth Theory. MIT Press

Aghion, P, and I. Marinescu (2006), Cyclical Budgetary Policy and Economic Growth: What Do weLearn from OECD Panel Data? Mimeo

Alesina, A., S, Ardagna, R. Perotti, F. Schiantarelli (1999): Fiscal policy, profits and investment,NBER working paper 7207.

Barro, R. & Sala-i-Martin, X. (1994); Quality Improvements in Models of Growth. NBER WorkingPaper

Benhabib, J. und M.M. Spiegel (1994); The Role of Human Capital in Economic Development:Evidence from Aggregate Cross-Country Data. Journal of Monetary Economics 34, 143-73

Cashin, P., 1995: Government Spending, Taxes and Economic Growth; IMF Staff Papers vol.42(2), pp. 237-269.

Easterly, W. und Rebelo, S., 1993: Fiscal Policy and Economic Growth, an Empirical Investigation,Journal of Monetary Economics, vol. 32, pp. 417-458.

Gertler, M. and S. Gilchrist (1996), “Monetary Policy, Business Cycles, and the Behavior of SmallManufacturing Firms.” Quarterly Journal of Economics 109:309-40

Lee, Young, and Roger H. Gordon (2004), “Tax Structure and Economic Growth.” Mimeo, UCSan Diego

Lucas, R.E. (1988): On the mechanics of economic growth, Journal of Monetary Economics 22,3-42.

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Mofidi, Alaeddin and Joe A. Stone (1990), “Do State and Local Taxes Affect Economic Growth?”Review of Economics and Statistics 72:4, 686-91

Nelson, R. und E. Phelps (1966), Investment in Humans, Technological Diffusion, and EconomicGrowth. American Economic Review 56, 69-75

Ohanian, Lee E. (1997), “How Capital Taxes Harm Ecoomic Growth: Britain versus the UnitedStates.” Federal Reserve Bank of Philadelphia Business Review July-August, 17-28

Perotti, R., R. Strauch und J. von Hagen (1998): Sustainability of Public Finances, London: CEPR.

Pfähler, W., Hofmann, U. & Bönte, W., 1996: Does Extra Public Infrastructure Capital Matter? AnAppraisal of Empirical Literature; Finanzarchiv N.F., vol 53, pp. 68-112; Mohr SiebechVerlag.Romer, P.M. (1990): Endogenous technological change, Journal of PoliticalEconomy 98, S71- 102.

Solow, R., 1956: A Contribution to the Theory of Economic Growth; QJE, vol. 70(1), pp. 65-94.Swan, T., 1956: Economic Growth and Capital Accumulation; Economic Record, 32, pp. 334-361.Tanzi, V. und H.H. Zee (1997), Fiscal Policy and long-run growth, IMF Staff papers 44, 179-209.

24

Table 1: Average Change in Government Debt and Spending (%of GDP)

Country Change in General Government DebtRatio

Change in General GovernmentExpenditures Ratio

1997-92 1992-99

1999-05 1977-92 1992-99 1999-05

B 69.5 -13.5 -20.4 2.5 -3.4 2.2

DE 15.3 18.8 7 -1.5 0.9 -1.3

EL 67.9 24.5 -4.8 0.1 -2.7

ES 33 15.6 -18.4 -1.5

FR 20 28.5 8.3 7.8 -1.8 1.1

IE 31.4 -43.1 -21 -10.4 -0.1

IT 50.4 8.5 -7.1 14.5 -7.2 0

LU -6.2 1.9 -0.7 -0.8 4

NL 37.5 -18 -8.4 4.6 -9.2 -0.6

AT 27.3 10.7 -1.9 5.9 -0.5 -3.3

PT 24.4 -0.3 12.6 14.6 -0.7 4.6

FI 32.8 5.5 -4.2 20.9 -10.8 -1.6

EU-12 29.3 12.7 -1.2 -0.6

DK 52.9 -10.6 -21.5 11.9 -2.1 -2.9

SE 36.6 -1.1 -11.8 -3.6

UK -20.1 6.6 -1.9 0.5 -6.1 4.8

Source: own calculations based on EUROSTAT data.

25

Table 2: Average Real Growth Rate and Investment

Country Average annual real growth (%) Average investment ratio (% of GDP)

1977-92 1992-99

1999-05

1977-92 1992-99 1999-05

B 2.2 2 1.9 17.3 18.2 18.6

DE 2.6 1.5 1.1 18.3 20 17.6

EL 1.4 2.2 4.4 19.2 17 20.1

ES 2.4 2.8 3.5 20.4 22.9

FR 2.5 1.9 1.9 16.2 15 16.2

IE 3.7 8.1 5.9 18.5 18.8 19.5

IT 2.6 1.4 1.1 18.8 17.1 18.2

LU 4.5 4.5 3.9 16.8 16.8 17.3

NL 2.1 3.3 1.6 16.8 18.8 17.3

AT 2.4 2.3 1.8 19.6 20 20.9

PT 3.4 2.8 1.2 22.7 20.1 21

FI 2.3 3.6 2.9 21.5 15 16.5

EU-12 2.5 2 1.8 18.4 17.8 18.3

DK 2 2.7 1.7 24.9 15.8 18.2

SE 1.8 2.5 2.6 13.3 13.8

UK 1.9 3.1 2.7 13.1 14 15.5

Source: OECD data except for DE, EL, and PT which are based on EUROSTAT data. Data for DE start in 1990, for ES start in 1995, for

FR in 1978, for IE in 1990, for IT in 1980, for EUR-12 in 1990.

26

Table 3: Composition of Fiscal Adjustments

Budget item (relativeto potential output)

All Consolidations

SuccessfulConsolidations

UnsuccessfulConsolidations

Difference

Structural surplus 2.29 (23.61) 2.37 (18.30) 2.17 (14.96) 0.20

Total expenditures -0.84 (-5.00)

-1.23 (-5.57)

-0.26 (-1.18)

-0.97***

Total revenues 1.45 (10.24) 1.13 (6.24) 1.91 (9.83) 0.78***

Current expenditures -0.45 (-3.69)

-0.70 (-4.58)

-0.07 (-0.41)

-0.63**

Capital expenditures -0.39 (-3.88)

-0.53 (-3.34)

-0.18 (-2.56)

-0.35*

Subsidies, transfers -0.22 (-2.70)

-0.35 (-3.31)

-0.02 (-0.17)

-0.33**

Social transfers -0.07 (-1.34)

-0.09 (-1.42)

-0.03 (-0.38)

-0.06

G o v e r n m e n tconsumption

-0.23 (-3.91)

-0.35 (-4.70)

-0.05 (-0.61)

-0.30**

Spending on goodsand services

-0.11 (-3.96)

-0.10 (-3.02)

-0.12 (-3.52)

0.02

Wage expenditures -0.12 (-2.65)

-0.25 (-4.93)

0.06 (0.85) -0.31***

Tax revenues 1.38 (10.71) 1.10 ( 6.71)

1.79 (9.86) -0.69**

Non-tax revenues 0.07 (1.16) 0.03 (0.38) 0.12 (1.86)* -0.09

Note: Numbers in parentheses are t-ratios. ***, **, and * indicate that the difference between the

two averages is statistically significant at a level less than one percent, between one and five percent, and

between five and ten percent, respectively. Source: Hughes Hallett et al. (2002)

27

Table 4: Post-Consolidation Performance

Budget item (relative topotential output)

S u c c e s s f u lConsolidations

UnsuccessfulConsolidations

Difference

Structural balance 0.84 (5.62) -1.43 (-7.00) 2.27***

Total expenditures -0.22 (-1.37) 1.08 (4.87) -1.30***

Total revenues 0.62 (4.93) -0.35 (-1.47) 0.97***

Note: Numbers in parentheses are t-ratios. ***, **, and * indicate that the difference between the two

averages is statistically significant at a level less than one percent, between one and five percent, and

between five and ten percent, respectively. Source: Hughes Hallett et al. (2002)

28

Table 5: Selected Fiscal Aggregates (% of GDP)

Country

Direct taxes Social transfers Publicinvestment

until1992

1992-99

1999-05

until1992

1992-99

1999-05

until1992

1992-99

1999-05

B 31.1 32.6 33.3 23.4 24 24.5 1.8 1.9 1.8

DE 28.3 29.8 30.7 23.9 26.5 28.1 2.7 2.2 1.6

EL 21.0 25.8 27.8 19.2 21 23.1 3.0 3.3 3.8

ES 22.8 23.2 16.2 15.6 3.4 3.3

FR 28.1 28.9 29.6 23.2 24.9 25.3 3.6 3.2 3.1

IE 21.0 20.6 18.4 15.7 14.8 12.4 2.1 2.4 3.2

IT 28.4 29 26.6 18.9 19.8 20.5 3.1 2.3 2.3

LU 24.5 26 26 19.2 20.8 22.1 4.1 4.1 4.4

NL 32.4 30.2 26.4 29.3 27.3 24.3 3 3.1 3.3

AT 27.4 29.4 30 23.5 25.5 26.4 3 2.6 1.3

PT 16.7 19.1 20.9 17.6 21.4 24 3.4 3.8 3.5

FI 30.5 31.8 30.7 21.5 24.6 20.9 3.6 2.9 2.7

DK 30.6 32.3 32.2 20.5 22.3 20.6 1.7 1.8 1.7

SE 34.5 34.7 23.8 22.5 3.5 3

UK 23.5 22.8 24.1 15.4 16.6 15.8 2.3 1.8 1.6

29

Table 6: Fiscal Strategies in Slow and Fast Growing EU Countries

1992-1999 1999-2005

Direct taxes Socialtransfers

Publicinvestment

Change indebt ratio

iC Directtaxes

Socialtransfers

Publicinvestment

Changein debtratio

iC

Countrygroup

Average of 3 least growing economiesD, F, I

Average of 3 least growing economiesD, I, PT

% of GDP 1 1.7 -0.6 17.8 0.8 0.1 1.6 -0.3 4.2 -0.5

% of totalrevenue/expenditures

-0.3 2.3 -0.6 -1.2 4.6 -0.5

Average of 3 fastest growing economiesEI, NL, UK

Average of 3 fastest growing economiesEI, ES, FI

% of GDP -1.1 -0.6 0 -15.6 -7 -0.9 -2.2 0.2 -14.5 -6.4

% of totalrevenue/expenditures

-0.3 1.8 0.6 0.5 0.4 1.8

30

Table 1: Electoral System, Government Constellation and Type of Fiscal Governance, 1980-2000

Electoral System DistrictMagnitude

Average No ofParties

Change inCoalition orRuling Party

MeanIdeological Range

Ideological RangeSmall or Large

Frequency of Pre-Electoral Pacts

Predicted Form ofGovernance

Austria 2-tier PR 20/91 1.9 37.5 0.26 L 84-99, S 00- 0.71 C 84-99, D 00-Belgium PR 23 4.5 63.6 0.36 L 0.59 CDenmark 2-tier PR 7/175 2.5 60.0 0.34 L 0.33 CFinland PR 13 3.9 66.7 0.41 L 0.14 CFrance Plurality 1 1.6 53.8 0.11 S 0.71 DGermany 2-tier PR 1/603 1.9 30.0 0.04 S 0.93 DUnitedKingdom

Plurality 1 1.0 20.0 0.00 S0.14

D

Greece reinforced PR 6 1.0 42.8 0.02 S . DIreland STV 4 1.8 77.8 0.20 L 85-97, S 98- 0.50 C 85-97, D 98-Italy 2-tier PR 19/625 4.2 23.5 0.13 L 85-96, S 97- 0.31 C 85-96, D 97-Luxembourg PR 14 2.0 40.0 0.20 L 0.33 CNetherlands PR 150 2.4 71.4 0.30 L 0.38 CPortugal PR 12 1.7 18.2 0.14 S 0.78 DSpain PR 6 1.0 28.6 0.07 S 1.00 DSweden 2-tier PR 11/350 1.5 40.0 0.22 L 0.41 C

Note: Data for electoral systems and district magnitude are taken from Hallerberg and von Hagen (1999). The data were updated where necessary.

Other data are own calculations based on data provided by Georges Tsebelis (see Table A1 for details). A two-tiered electoral system is one where an upper level

of seats is used to fill in the results at a lower level to make the overall distribution of seats more proportional; in Denmark, for example, there are seven seats per

electoral district on average but there are 175 seats used to fill in the results so that the proportion of seats a party wins matches more closely the proportion of

votes it receives. In all 2 tier systems, the district magnitude lists first the number of seats per district at the lower level then the number of seats in the upper

level. The average number of parties in government and changes in the coalition or ruling party include data until 1995 for Italy and exclude three short-term

caretaker governments in Greece (1989-90). The mean ideological range is computed for the years 1985 to 2004 to match the years in the empirical results

below. They are calculated according to Tsebelis (2002) and normalized to be on a scale between 0 and 1. A score of 0 means that there are no ideological

differences among the party(ies) in government. Abbreviations in the last column indicate whether the ideological scores are considered Small or Large based on

the average ideological range and on the overall pattern displayed in Graph 1. The data on the frequency of electoral pacts is for the period 1945-98, and it

comes from Nadenichek Golder (2005).

31

32

33

34

35

36

37