Heylen,Everaert (2)

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Public Choice 105: 103124, 2000. 2000 Kluwer Academic Publishers. Printed in the Netherlands.

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Success and failure of scal consolidation in the OECD: A

multivariate analysis

FREDDY HEYLEN & GERDIE EVERAERT Social Economics Research Group, University of Ghent, Hoveniersberg 4, B-9000 Ghent, Belgium

Accepted 30 October 1998

Abstract. This paper tests ve hypotheses explaining the success and failure of scal consol-idation in a multivariate regression framework. These hypotheses concern (i) the compositionof the consolidation programme, (ii) its size and persistence, (iii) the gravity of the debtsituation, (iv) the inuence of the international macroeconomic environment and (v) the con-tribution of a preceding devaluation. To test for composition effects we use cyclically-adjusteddata. Although many conclusions of the existing empirical literature are conrmed, some donot survive. A popular hypothesis that to succeed, consolidation should rely on cutting thegovernment wage bill is rejected. A new empirical result is that the contribution of a devalu-ation to the success of scal consolidation depends on the composition of the consolidationprogramme.

1. Introduction

The reduction of government debt and decits has been high on the politicalagenda in many OECD countries in the 1980s and, even more, the 1990s.

In the US it has been a major goal of the Clinton administration. In Europethe ght against government debt and decits has been the absolute priorityof macroeconomic policy since the signing of the Maastricht Treaty in 1992.Various reasons explain the perceived need for lower debt ratios (see e.g.Ball and Mankiw, 1995; IMF, 1996). First, there is the widespread belief that the massive buildup of government debt since the 1970s has resulted insignicantly higher global real interest rates and lower capital stocks. Second,many countries do not just face high debts today, but also upward pressureon debts in the future caused by growing pension costs. On current policies,future public debt paths may be unsustainable in these countries. Withoutscal consolidation today, much harder choices will have to be made in the

We want to thank Rudi Vander Vennet, Koen Vermeylen and participants at the Confer-ence on Public Decits and Monetary Union (59th International Conference of the AppliedEconometrics Association, Rome, November 1997) for useful suggestions and comments toan earlier version of this paper. Tanja Termote provided excellent research assistance. Anyremaining errors are ours.


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future. Especially in Europe scal consolidation is considered necessary tosafeguard the welfare state. A third reason is that high government debtsand decits can be inationary. If the public believes that government debtis unsustainable and that the central bank may have to monetize it in thefuture, ination expectations will rise and so may actual ination, whateverthe stance of current monetary policy (Sargent and Wallace, 1981). This per-spective may further raise real interest rates. Moreover, it shows that highdebt levels are a threat to central bank independence, which right or wrong many have begun to consider absolutely necessary on the road to prosperity.Fourth, high debt ratios affect the distribution of income. To the extent thathigh government debt raises real interest rates and undermines the capitalstock, it implies lower living standards not only for future generations, butalso for current workers. A lower capital stock reduces the productivity of labour and thus real wages. It raises the productivity of capital and thus theincome of capital owners. Quite striking is that in Europe, where debt levels

in percent of GDP have never been higher since the 1960s than today, theshare of labour in national income has never been lower than today (EuropeanCommission, 1998, p. 281).

Given the priority attached to scal consolidation in many countries inrecent years, it is not surprising that the effects of consolidation have becomean important research topic in the 1990s. Particular attention has been paidto investigating the conditions for successful consolidation, i.e. consolidationthat brings about a signicant reduction in the government debt ratio. Fivehypotheses have guided the discussion. These concern (i) the compositionof the consolidation programme, (ii) its size and persistence, (iii) the gravityof the debt situation, (iv) the inuence of the international macroeconomic

environment and (v) the contribution of a preceding devaluation. In Section 3of this paper we review these hypotheses and discuss the results of relatedempirical studies. In Section 4 we present the results of our own empiricalwork. Our aim is to explain the change in the gross government debt ratio ina sample of 39 episodes of scal consolidation in 18 OECD countries sincethe mid-1970s. We present these episodes in Section 2. As we shall see, inonly a small minority consolidation was successful and led to a substantialreduction in the debt ratio.

Our empirical approach differs in several respects from what has usuallybeen done in the literature. A rst contribution of this paper is that we opt fora multivariate regression analysis. This allows us to test the main hypothesesfrom the literature simultaneously. Second, by relying on cyclically-adjusteddata, we avoid problems of endogeneity that may have affected the results insome of the existing empirical literature. Our ndings enable us to verify


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these results. Many of them are conrmed, others are rejected, however.Section 5 summarizes our conclusions.

2. Episodes of scal consolidation in the OECD, 197595

A look at scal policy developments in the OECD countries during the lastdecades reveals ample episodes of consolidation. These episodes have beentraced by several authors relying on similar though not always the same criteria. In general, scal consolidation is dened as a signicant dis-cretionary (i.e. cyclically-adjusted) rise in the general government nancialbalance.

Although it must be acknowledged that this approach has also beencriticized, 1 it seems to be the only one that is applicable in a multi-countryanalysis (see e.g. Alesina and Perotti, 1995; Alesina and Perotti, 1996; Mc-

Dermott and Wescott, 1996; IMF, 1996; OECD, 1996a; Cour et al., 1997).For the purpose of this paper we have looked at 19 OECD countries in 197595 and have selected all periods of at least two consecutive years when thecyclically-adjusted primary balance expressed as a percentage of potentialGDP (further CAPB) improved by at least 2 percentage points. Further, it wasrequired that in the rst year of the consolidation period the CAPB improvedby at least 0.25 percentage points, whereas in all other years its change waspositive. Table 1 shows these consolidation periods as well as the relatedchange in the CAPB. In total there are 39 episodes spread over 18 countries.

Figure 1 relates the change of the CAPB in each of these periods to thechange in the ratio of gross government debt to GDP ( GD). The latter isconsidered between the years t s and t f + 2 , with t s indicating the rst year of the scal consolidation period and t f the nal year (see also Table 1). As canbe seen, the success of scal consolidation is not obvious. Only a minorityof countries have succeeded in bringing down debt ratios substantially. Mostcountries have failed. The rst group contains the well-known success storiesof Denmark (198386) and Ireland (198689). Figure 1 also shows a num-ber of consolidation failures like Germany (198085), Belgium (198287),Ireland (198284), Italy (several episodes) and Greece (several episodes). 2

3. Output growth and the outcome of scal consolidation

Sections 3 and 4 of this paper investigate the reasons for success or failure of scal adjustment. In Section 3.1. we highlight the crucial role of real outputgrowth in the consolidation period. In Section 3.2. we review the theoreticaleffects of tight scal policy on real growth and discuss ve hypotheses that


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Table 1. Episodes of scal consolidation in the OECD (197595)

Country Code Period CAPB GD Country Code Period CAPB GD(ts-tf ) (ts-tf )

Austria at1 197778 2.09 7.41 Ireland ir1 198284 5.70 33.08at2 198081 2.28 8.59 ir2 198689 7.16 19.58

at3 198485 2.60 10.50 ir3 199194 2.69 20.67Belgium be1 198287 9.58 26.70 Italy it1 197677 4.23 4.27

be2 199294 3.09 2.30 it2 198283 3.38 17.03Canada ca1 197981 3.22 11.75 it3 199193 4.90 15.89

ca2 198690 3.15 19.33 Japan ja 198087 7.67 14.96ca3 199495 2.89 0.81 Netherlands nl 198183 2.53 20.60

Denmark de 198386 12.34 9.68 Norway no1 198586 2.68 2.05

Finland 1 197576 3.64 4.66 no2 199395 5.48 4.572 198889 2.24 5.67 Portugal po 198486 8.13 11.21

France fr1 197980 2.51 2.83 Spain sp1 198687 2.02 3.00fr2 198387 3.29 5.29 sp2 199295 3.12 19.85

Germany ge1 197677 2.08 3.14 Sweden sw1 197576 2.65 5.01ge2 198085 5.49 12.29 sw2 198384 2.80 0.56

ge3 199294 2.75 19.10 sw3 198687 5.52 17.77Greece gr1 198283 3.19 18.04 sw4 199495 4.18 2.57

gr2 198687 4.27 18.20 U.K. uk 197982 5.37 6.03gr3 199094 12.52 22.48 U.S. us1 197679 2.35 3.78

us2 199395 2.25 1.76

Note : CAPB: change in the cyclically-adjusted primary government balance as a percentage

of potential GDP (change between t s 1 and t f ); GD: change in the gross debt ratio as apercentage of GDP (change between t s and t f + 2 ). Due to lack of data for the evolution of thedebt ratio, two episodes of scal consolidation in Australia (198082 and 198588) have notbeen included in our data set.Data source: OECD (1997b)

explain why growth is strong in some consolidation episodes and weak in oth-ers. Each of these hypotheses refers to the characteristics of the consolidationprogramme or to the circumstances in which it takes place. We empiricallytest these hypotheses in Section 4.

3.1. The role of real output growth

High real GDP growth is of crucial importance for the success of con-solidation efforts. Equations (1) and (2) illustrate this. Equation (1) is the


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Figure 1. Fiscal adjustment and evolution of the gross government debt ratio.Data source: OECD (1997b)

well-known equation for the dynamics of the government debt ratio. Equation(2) follows from (1) after some minor rearrangements.

GD = PB + (r g)GD 1 (1)

GD = CAPB .Y/ Y CCPB + (r g)GD 1 (2)with : PB = CAPB .Y/ Y + CCPB

In these equations GD is the government debt ratio, PB the primary govern-ment balance in percent of GDP (PB is the primary government decit), rthe real interest rate on outstanding debt, g the real GDP growth rate, CAPBthe cyclically-adjusted primary balance in percent of potential GDP, CCPBthe cyclical component of the primary balance in percent of GDP and Y / Ythe ratio of potential to actual real GDP.

Equation (2) reveals two channels of inuence of real output growth onthe change of the debt ratio. First, a higher g reduces the debt burden, (r

g)GD 1 . Second, by raising tax receipts and reducing unemployment benetexpenditures, higher real output growth raises the cyclical component of theprimary balance, CCPB. Both contribute to debt reduction ( GD < 0). The


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main other determinants of the rate of debt reduction are the size of scalconsolidation reected by changes in the CAPB and the real interest rate (r).

Figure 2 demonstrates the crucial role of real economic growth. It relatesthe change in the gross debt ratio between t

sand t

f +

2to the change in the

output gap between t s 1 and t f + 1 . The latter change indicates the cumulateddifference between actual real GDP growth and potential real growth in theyears t s to tf + 1 . A clear negative relationship shows up. If we compare thisresult to the absence of a relationship between CAPB and the change in thedebt ratio in Figure 1, one may conclude that in Equation (2) output growthis the dominating factor. Fiscal consolidation tends to bring about reductionsin debt ratios only if economic growth is strong and the output gap increases.If the output gap falls, consolidation tends to fail. Only Belgium (199294)and, especially, Ireland (199194) have been able to reduce the debt ratio ina climate of low economic growth and falling output gaps. Note though thatstrong economic growth does not guarantee that consolidation succeeds. In

six countries rising output gaps went along with rising debt ratios.

Figure 2. Output gap evolution and evolution of the gross government debt ratio.Data source: OECD (1997b)


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3.2. Consolidation and growth: ve hypotheses about success and failure

Given the dominant role of the evolution of economic growth, it is notsurprising that several authors have concentrated on the determinants of growth during and after consolidation. Major contributions have been madeby, among others, Giavazzi and Pagano (1990 and 1995) and Alesina andPerotti (1995 and 1996). Alesina and Perotti (1996) and Perotti (1996) presentinteresting surveys of the literature.

Theoretically, the net effect of tight scal policy on growth is uncertain.For decades economists have paid attention mainly to its negative Keynesianeffects . The Keynesian view predicts that scal consolidation undermineseconomic growth because it leads to a reduction of aggregate demand.The fall in demand occurs either directly when the government reducesits consumption or investment, or indirectly when households reduce theirconsumption because higher taxes or lower transfers affect their disposable

income. The multiplier mechanism implies that consumption and investmentcuts are more contractionary than tax rises or transfer reductions. Moreover,the fall in aggregate demand may be reinforced when private investment re-sponds negatively to the (expected) fall in output caused by lower privateconsumption or government spending. This is the well-known accelerator mechanism discussed in many macroeconomics textbooks.

In the 1990s, however, this view has been heavily criticized. 3 Several au-thors have emphasized that scal consolidation also induces positive demandeffects. In addition to standard crowding-in effects on private investment andwealth effects on consumption , caused by falling real interest rates that resultfrom lower government decits, attention has been paid to favourable expectation effects and credibility effects , among others. Moreover, it has beenargued that consolidation also generates a number of supply effects , whichmight be positive as well. Whether these positive effects are strong enough tooverrule the negative Keynesian effects is uncertain, however. In this respectthe literature points at the crucial role of the characteristics of the consol-idation programme and at the circumstances in which consolidation takesplace. Five important hypotheses have been put forward. In the remaining partof this section we review these ve hypotheses as well as related empiricalevidence.

3.2.1. CompositionThe importance of the composition of scal consolidation has been emphas-

ized mainly by Alesina and Perotti (1995, 1996), Lane and Perotti (1996)and McDermott and Wescott (1996). Their view is that scal adjustment programmes that rely mainly on cutting government consumption, especiallythe wage bill, and transfers have a high probability of success, i.e. a high


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probability of generating strong economic growth and reducing the debt ratio.Programmes that rely mainly on tax rises and government investment cuts, onthe other hand, are expected to fail. This is our rst hypothesis. Alesina andPerotti justify this hypothesis on several grounds. They argue that governmentwage bill and transfer cuts, in contrast to tax rises and investment cuts, benetfrom favourable credibility and expectation effects on demand as well as fromfavourable supply effects.

As for credibility effects , Alesina and Perotti (1996) argue that govern-ments that tackle the politically more delicate components of the budget(e.g. public employment, social security) signal that they are really seriousabout scal adjustment. This raises their credibility and, as a consequence,reduces the risk premium (default risk, ination risk) on government debt.This effect reinforces the above mentioned fall in real interest rates and thusthe crowding-in of private investment. The stronger fall in interest rates mayalso cause an additional rise of asset prices and the market value of private

wealth, which will further encourage private consumption (see e.g. Giavazziand Pagano, 1990). Tax increases and investment cuts, on the other hand, willbe considered the easy way out, and therefore much less credible. A secondreason for higher credibility of government wage bill and transfer cuts isthat the root of the budget problem in most OECD countries is on the sideof current expenditures, especially transfers (IMF, 1996). As for expectationeffects , cuts of public employment and transfers are more sustainable thaninvestment cuts. Although their impact may be the same, one cannot postponeinvestment (e.g. the maintance of public infrastructure) forever (Alesina andPerotti, 1996). Further, given the experience of the past that tax increasestend to elicit higher spending, these provide the least convincing signal of a

permanent change in scal policy. Therefore, the probability that the publicconsiders scal consolidation to be long lasting will be higher when it reliesmainly on government wage bill and transfer cuts. This composition offersgood prospects of a permanent reduction in taxes on households and rmsin the future. It implies a rise in everyones permanent income, which willstimulate private spending and economic growth (see also Feldstein, 1982;Giavazzi and Pagano, 1990; Bertola and Drazen, 1993).

The supply effects of government consumption and transfer cuts are alsobelieved to be more favourable. If tax rises or cuts in government investmentdominate, supply effects will be negative. Higher taxes will especially in theshort-run and in unionized economies cause higher labour costs, either dir-ectly (due to a rise of employer contributions to social security) or indirectly(when workers ask higher gross wages to compensate for their decreased aftertax income). A cut in government investment will, ceteris paribus, reduce thecapital stock in the economy. Some authors (see e.g. Ashauer, 1989; Munnell,


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1990) expect this to cause negative effects on private investment also, leadingto a further reduction of the economys supply potential. 4 On the other hand,government wage bill cuts (especially public employment cuts) and transfercuts may induce positive supply effects. These occur because spending cutsmay pave the way for tax cuts and because lower public employment andtransfers (e.g. unemployment benets) may change the perspectives of unionsand lead to wage moderation in the private sector. Note that in a second roundthese supply effects may also act upon the demand side of the economy.In general, benecial supply developments will strengthen the favourablecredibility and expectation effects of scal consolidation, whereas adversesupply developments will undermine them. Further, and more specically,the evolution of wage costs will inuence the international competitivenessand protability of rms, and thus affect exports and investment.

Evidence supporting the composition hypothesis has been provided byFardmanesh (1991), Alesina and Perotti (1995, 1996) and McDermott and

Wescott (1996). Fardmanesh shows that decit-reducing cuts in capitalspending are concomitant with lower economic growth, while such cuts incurrent spending have no net impact on growth. Alesina and Perotti showthat successful consolidations, leading to permanent reductions of govern-ment debt and decit ratios, mainly rely on cutting the government wagebill and transfers. Successful consolidations typically do not include directtax increases on households and increases of social security contributions.Increases of taxes on business and indirect tax increases, on the other hand,do not seem to undermine success. Unsuccessful consolidations typicallyrely on tax increases, spread over all components, and cuts of governmentinvestment.

A different opinion has been expressed by Hughes Hallett and McAdam(1996). Using the IMFs MULTIMOD to discover the scal corrections ne-cessary for the four largest European countries to meet the 3% decit toGDP ratio imposed by the Maastricht Treaty, Hughes Hallett and McAdamconclude that tax increases are more effective than spending cuts. To ex-plain the relative ineffectiveness of spending cuts, these authors refer to moreunfavourable Keynesian multiplier effects. Further, an important assumptionunderlying their ndings is that policy makers do not spend the higher reven-ues obtained from tax increases. In contrast to the real world, they can onlyuse these revenues for decit reduction.

3.2.2. Size and persistenceOur second hypothesis has been advanced by Drazen (1990), Giavazzi andPagano (1995) and McDermott and Wescott (1996). The idea is that largeand persistent scal adjustments have a much better chance of success,


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whatever their composition . To justify this hypothesis Giavazzi and Paganoand McDermott and Wescott also refer to favourable credibility and expect-ation effects. Their justication is strongly related to our explanation in theprevious section. First, in contrast to small and temporary ones, drastic adjustments lasting for, say, more than two years prove that policy makers areserious about ghting debt and decits. Second, drastic adjustments providea stronger signal of a change in the policy regime and, thus, of future taxreductions. That is why they will be accompanied by a more vigorous privateconsumption and investment growth, and thus by stronger output growth. An-other argument, suggested by Blanchard (1990), is that drastic and persistentadjustments provide clarity. They reduce uncertainty about future scal policyand may therefore also reduce precautionary savings. This further supportsdemand and output. Note that the composition of consolidation is irrelevantfor this hypothesis. If they generate expectations of sufciently strong taxreductions in the future and reduce uncertainty, tax increases for e.g. three

years can have expansionary effects on consumption (see also Blanchard,1990).

Alesina and Perotti (1996) have raised doubts about this hypothesis. Onemight indeed put forward just the opposite argument. Large spending cuts ortax increases may undermine the political survival of governments commit-ted to scal consolidation. As a consequence, the credibility and expectationeffects of large cuts may be the smallest.

Empirically, the available evidence seems to support the size and persist-ence hypothesis. Giavazzi and Paganos (1995) cross-country analysis showsthat private consumption tends to rise strongly during periods of governmentspending cuts and tax increases, if these spending cuts and tax increases are

large and persistent. In the opposite case of spending cuts and tax increasesthat are neither large, nor persistent, the standard Keynesian effect of fallingprivate consumption tends to be observed. Evidence provided by Cour et al.(1997) supports these ndings. McDermott and Wescott (1996) have foundthat the greater the magnitude of scal consolidation, the more likely it is tosucceed in reducing the debt ratio.

3.2.3. Level and recent change of the debt ratio (emergency effects)Our third hypothesis is that scal consolidation has a higher probability of success when the economy is in a situation of emergency, i.e. when the debt ratio is very high or has risen strongly recently . The reason is again favour-

able expectation effects on private consumption and investment. In economieswith very high debt ratios and strong recent debt rises, consumers and in-vestors will be aware that the day of reckoning comes closer and a scal crisisbecomes likely. In these circumstances scal consolidation may raise private


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consumption and investment. Blanchard (1990) and Sutherland (1995) haveproposed models generating this result for private consumption. Basically, theidea is the following. At low and sustainable debt levels, current consumerswill face the burden of scal adjustment (e.g. tax increases) without clearperspectives of also reaping the benets of this adjustment. The unfavourableKeynesian effects of tight scal policy may then dominate. If, on the otherhand, the economy is close to the brink, current consumers will also benet.They will understand that scal adjustment reduces the probability of a crisisand of disruptive tax increases in the near future. Fiscal adjustment will thenstrongly raise their permanent income and stimulate their consumption. 5 Athigh debt levels consumption behaviour will be much more Ricardian.

Nicoletti (1989) and Slate et al. (1995) provide some support for thishypothesis. Nicoletti has estimated private consumption functions for eightOECD countries over the 196185 period. He nds that expected future taxesare discounted much more strongly in consumer behaviour in highly indebted

countries (Belgium, Italy) than in countries where the scal stance is sustain-able. Whereas the traditional Keynesian view seems to be appropriate in lowdebt countries, there is some support for the Ricardian view on consumptionin high debt countries. Slate et al. have carried out a number of experiments totest Ricardian equivalence under uncertainty. The results of these experimentssuggest that the response of people to scal decits tends to be Keynesianwhen the probability of debt repayment is low. If, on the other hand, theprobability of debt repayment is high, people act much more in a Ricardianway.

3.2.4. International macroeconomic context Our fourth hypothesis follows from observations by Alesina and Perotti(1995) and McDermott and Wescott (1996). It says that scal consolidationhas a much higher probability of success if the international macroeconomicsituation is supportive, i.e. characterized by high real output growth and lowreal interest rates . To the extent that these conditions favourably inuencenational growth and interest rates, debt reduction becomes easier (see alsoEquation 2). On the other hand, to reduce debt ratios in the midst of a globalrecession is much harder, especially if at the same time interest rates arerising.

Empirically, both Alesina and Perotti (1995) and McDermott and Wescott

(1996) nd that many successful scal adjustments took place in the secondhalf of the 1980s, i.e. a period of high OECD economic growth. Efforts of scal consolidation in the early 1980s, with low economic growth in theOECD and high real interest rates, typically failed. The benecial effect of


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low interest rates (monetary expansion) during consolidation also shows upin the simulations of Hughes Hallett and McAdam (1996).

3.2.5. Exchange rate changes before consolidationSeveral authors (e.g. Giavazzi and Pagano, 1990; Alesina and Perotti, 1996;Perotti, 1996) have noted that a number of very successful consolidation epis-odes were preceded by, or coincided with, a sizeable devaluation followed bya pegging of the exchange rate. This was the case e.g. in Denmark (198386)and Ireland (198689). From this observation one might derive the hypo-thesis that a devaluation contributes to the success of scal consolidation. Aproblem with this hypothesis, however, is that not only successful, but alsomany unsuccessful consolidation episodes were preceded by a devaluation.Examples are Belgium (198287), Italy (198283) and France (198387).The hypothesis that we shall therefore test is that the effects of a devalu-ation are not unambiguous, but depend on the characteristics of the scaladjustment programme. Specically, our nal hypothesis is that a devalu-ation contributes to successful consolidation if the adjustment programme isinherently strong . In particular we shall pay attention to the question whethercomposition is good.

The potential benecial effects of a devaluation followed by a pegging of the exchange rate are obvious. First, by raising competitiveness it supportsdemand for output and thus economic growth during consolidation. Second,if a devaluation is part of a programme that includes other success factorsmentioned above (e.g. good composition), it creates long-term exchange rateappreciation expectations which contribute to a decline in interest rates and,as a consequence, stimulate private investment and consumption. Third, by

contributing to real product wage moderation and higher protability, a de-valuation may improve the supply side of the economy. On the other hand, ourhypothesis implies that if the consolidation programme is weak, a devaluationmay make things worse. It may enhance further devaluation expectationsand lead to higher interest rates and lower demand. The observation thatmany very unsuccessful consolidation programmes have been preceded bya devaluation, illustrates this risk.

4. Success and failure of scal consolidation: an empirical test

In this section we present the results of a regression analysis of the evolu-tion of the government debt ratio in the 39 episodes of scal consolidationdescribed in Section 2 of this paper. Section 4.1. contains a brief methodolo-gical note. Section 4.2. presents the explanatory variables that we use in our


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regression analysis and the results of this analysis. Section 4.3. briey goesinto the robustness of our ndings.

4.1. Methodology

Although the subject of our empirical work is highly similar to what hasbeen done by Alesina and Perotti (1995, 1996) and McDermott and Wescott(1996), we differ methodologically. Standard in these authors methodologyhas been rst to dene episodes (countries and years) of successful and unsuc-cessful scal consolidation and then to compare the evolution of some crucialvariables (e.g. the composition of government expenditures and revenues)during these episodes. In general, episodes were dened to consist of onlyone or two years.

Alesina and Perotti and McDermott and Wescotts conclusion that scaladjustments that rely primarily on cutting government wages and transfers

have a better chance of being successful, mainly follows from the observationthat, on average, wages and transfers (as a percentage of GDP) showed asignicantly stronger decline in the group of successful episodes than in thegroup of unsuccessful episodes. A similar comparison underlies the conclu-sion that adjustments which rely primarily on tax increases and governmentinvestment cuts have a higher probability of failure.

Although these are important observations, they should be considered withgreat caution. There are four serious problems. First, a crucial element in themethodology of Alesina and Perotti and McDermott and Wescott is to denewhat is success and what is failure. Unavoidably, this introduces somearbitrariness into the analysis. Second, it should be noted that the group of successful consolidation episodes typically consists of no more than 15 cases(of one or two years), many of which concern only one specic period (198389) in only three countries (Denmark, Ireland and Sweden). The problemis that by splitting up consolidation episodes into short periods, one arti-cially multiplies three or four success stories into many. A third problem isthat the simple comparison of group averages for individual variables doesnot allow to clear out the inuence of other variables. The nal problemis that Alesina and Perotti and McDermott and Wescott dene governmentspending and revenue categories as a percentage of actual GDP. Such vari-ables are largely endogenous. They are inuenced by the business cycle and,thus, by the other determinants of the effects of scal consolidation (e.g. theinternational macroeconomic situation or exchange rate policy). A simple ex-

ample illustrates the problem. Imagine something unspecied, but unrelatedto the composition of scal adjustment, that causes high economic growth.Without anything else happening, this something will reduce both the ratioof government spending to actual GDP and the government debt ratio. In


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regression analysis the coefcients on spending categories would then bebiased upwards, implying that it becomes difcult to assess their true effects.

In our empirical work we try to avoid these shortcomings. We explainthe evolution of the debt ratio in 39 consolidation episodes (see Table 1) bymeans of multivariate regression analysis. Each episode, whatever its length,is one observation. By explaining the change in the debt ratio itself, we avoidthe arbitrary choice of dening successful and unsuccessful episodes.Further, a multivariate approach allows to estimate the inuence of each po-tential determinant of success or failure while controlling for the effect of allother determinants. Finally, composition variables will be cyclically-adjustedand expressed in percent of potential GDP.

4.2. Explanatory variables and regression results

In this section we explain the change in the gross government debt ratio

( GD) in 39 consolidation episodes. Table 2 contains the OLS-regressionresults. These results should allow us to assess the relevance of ve hypo-theses that we have presented in Sections 3.2.13.2.5. Equation (5) in Table 2is our best equation. To draw conclusions, we shall therefore mainly relyon this equation. Note that Equation (6) is of a different kind (see the notesto Table 2). We discuss this equation in the next section. Data sources aresummarized at the bottom of Table 2. The data themselves are available fromthe authors upon request.

To test for composition effects Equations (1)-(5) include the changeduring the consolidation period of a number of government spending andrevenue categories, expressed as a percentage of potential GDP. Thesecategories are the government wage bill (WAGE), government investment(IG), cyclically-adjusted transfers (TR), subsidies (SUB), cyclically-adjusteddirect taxes on households (TAXH), cyclically-adjusted direct taxes on busi-ness (TAXB), cyclically-adjusted social security contributions (SOC) andcyclically-adjusted indirect taxes (INTAX). Further, we have constructedTAXT as the sum of TAXH, SOC and INTAX.

As for spending categories, our results show that cutting the governmentwage bill and government investment contributes to rising debt ratios. The es-timated coefcients for WAGE and IG are always negative and in generalstatistically signicant. Further, Equations (4) and (5) present evidence thatcutting transfers contributes to falling debt ratios. For government investmentand transfers, these results conrm the existing literature. However, for gov-

ernment wages our result is surprising. It suggests that the negative demandeffects of cutting the government wage bill dominate. This contradicts theconclusions of Alesina and Perotti (1995, 1996) and McDermott and Wescott(1996). For completeness, the coefcient on the change in subsidies generally


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Table 2. Regression analysis of the change in the gross government debt ratio ( GD) in 39consolidation episodes

Explanatory Estimated equationsvariables (1) (2) (3) (4) (5) (6)

Constant 7.05 7.33 1.94 3.54 4.64 5.27(1.46) (1.91) (0.71) (1.45) (2.15) (1.30)

CompositionWAGE 9.10 8.33 9.07 8.30 7.64 4.44

(3.48) (3.14) (3.48) (5.04) (5.24) (2.01)IG 5.50 4.93 5.61 7.98 7.39 8.40

(1.93) (1.75) (1.97) (4.39) (4.60) (2.94)TR 2.68 2.78 2.57 2.40 1.85 3.03

(1.58) (1.65) (1.52) (2.30) (1.99) (2.04)TAXT 2.94 3.28 3.13 2.59 2.81 1.64

(2.95) (3.28) (3.15) (4.12) (5.05) (1.84)TAXB 9.75 9.41 10.1 9.75 9.99 3.53

(4.80) (4.67) (4.95) (7.73) (9.01) (2.63)Size and persistenceLAPE 4.74 4.20 5.59 3.45 4.55 0.77

(1.02) (0.92) (1.19) (1.22) (1.82) (0.20) International macroeconomic situationGDPG 3.35

(2.11)STRI 2.17 1.34 1.56 1.29

(2.17) (2.13) (2.81) (1.28)BURDEN 0.027

(2.18) Exchange rateEXCH1 0.28 0.24

(3.11) (1.50) Dummy variablesIRE2 37.4 31.2 30.3

(6.27) (5.56) (3.12)SWE3 18.4 17.3 19.9

(3.49) (3.73) (2.47)

R2 adj. 0.55 0.55 0.55 0.83 0.87 0.60SER 8.26 8.23 8.23 5.09 4.47 7.74F 7.56 7.65 7.66 21.3 25.9 6.77

Notes : The estimation method is OLS. Between brackets are absolute t-values. A () ()

indicates signicance at 10% (5%) (1%). Underlying Equations (1)-(5) are cyclically-adjusted data for the composition variables,

expressed as a percentage of potential GDP. Underlying (6) are non-adjusted data as apercentage of actual GDP.

Data sources : The data for the dependent variable ( GD) are shown in Table 1. For the com-position variables and LAPE the source is OECD (1997b). For GDPG, STRI and BURDEN it isOECD (1997a). The devaluation percentages underlying EXCH1 have been taken from OECD,Economic Surveys (various issues). Since in OECD (1997b) data for Denmark are missing until1987, we have relied on OECD (1996b) for this country. For further details, see also notes 79at the end of this paper.


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shows up highly insignicant. Therefore, this variable has been dropped in theregressions.

As far as government revenue is concerned, the coefcients on SOC,INTAX and TAXH, when estimated freely, are never signicantly differ-

ent from the estimated coefcient on their sum ( TAXT). Therefore, we optfor including only the latter in our regressions. As can be seen, this variablealways obtains statistically signicant positive coefcients. Raising taxes onhouseholds, social security contributions or indirect taxes undermines thesuccess of scal adjustment. By contrast, the highly negative coefcient on

TAXB suggests that raising taxes on business is a very effective way of scal consolidation. 6 These results largely agree with the conclusions of Alesina and Perotti.

We have considered three variables to test for size and persistence effects .A rst and obvious one is the rise in the CAPB ( CAPB). However, whenincluded in our equations, this variable always shows up highly insignicant

(t-values below 1). A second variable has been inspired by Giavazzi and Pa-gano (1995). Following these authors we have constructed a dummy variable(LAPE) for large and persistent consolidation episodes. Specically, LAPEequals 1 in those episodes that lasted for at least three years and that ledto a rise in the CAPB by at least 0.5 percentage points in the rst year of theepisode and at least 3 percentage points in the rst three years. 7 Including thisvariable yields the best regression results in terms of R 2 adj and t-values. Theyare shown in the table. Equation (5) provides some support for Giavazzi andPaganos hypothesis. All other things equal, the change in the governmentdebt ratio is estimated to be 4.55 percentage points lower if consolidationprogrammes are large and persistent. Admittedly though, this evidence is not

very strong. In Equation (5) the estimated coefcient for LAPE is statisticallysignicant at 10% only. In the other equations, although always negative, itis never statistically signicant. As a third variable we have considered theproduct of LAPE and CAPB. The results for this variable were slightly lessgood than those for LAPE as a single variable.

To test the hypothesis that scal adjustment has more favourable effects inemergency situations , i.e. in situations where debt levels are high and haverisen strongly in the recent past, we have included the gross debt ratio in theyear before the start of scal consolidation and the rise of the gross debt ratioduring the last three years before consolidation as explanatory variables. Fur-ther, we have run regressions including their product. Since no clear evidencecould be obtained, we do not show these results. Some results were favour-able to the emergency hypothesis, others were not. Moreover, the estimatedcoefcients for the emergency variables were very unstable. Excluding one


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or two consolidation episodes, could cause strong changes (see also Heylen,1997).

Three variables measure the inuence of the international macroeconomicsituation during consolidation: (i) the international short-term real interestrate (STRI), (ii) the international real GDP growth rate (GDPG) and (iii) avariable called BURDEN which has been computed as BURDEN=(STRI-GDPG)GD 1, with GD 1 is the gross debt ratio in the year before the startof scal consolidation. 8 The variable BURDEN has been inspired by thedebt dynamics Equation (1). Note the difference, though. In contrast to itscounterpart in Equation (1), BURDEN is exogenous. Instead of domestic realGDP growth and interest rates, international GDP growth and interest rateshave been used in its calculation.

The results in Table 2 support the conclusions from earlier work (e.g.McDermott and Wescott, 1996; Hughes Hallett and McAdam, 1996) thathigh short-term real interest rates and weak economic growth in the interna-

tional economy during consolidation undermine its success. They contributeto higher debt ratios. In the regression Equations (1)-(3) BURDEN and STRIobtain statistically signicant positive coefcients, whereas GDPG obtainsa statistically signicant negative coefcient. Because of a strong negativecorrelation between STRI and GDPG (0.65), both variables could not beincluded together. In Equations (4) and (5) we include STRI. This generatesmarginally better results.

It is not easy to assess the inuence of exchange rate developments onthe outcome of scal consolidation. Because exchange rates may respond tothe announcement of scal adjustment, exchange rate changes before con-solidation are largely endogenous. One can, as a consequence, not just use

market data in regressions like those presented in Table 2. A depreciationof the exchange rate may contribute to the success of scal adjustment, butit may also be the reection of nancial market distrust about the expectedeffects of the consolidation programme and announce failure. Further, as wehave mentioned before, the same exchange rate change may have differenteffects depending on other characteristics of the consolidation programme(e.g. its composition).

To shed light on the potential contribution of exchange rate changes, wehave selected the episodes of scal consolidation that were accompanied bya devaluation, i.e. an exogenous exchange rate change, and have created thefollowing kind of variables:

EXCH = DEVALUE COMP

where DEVALUE is the cumulated percentage of ofcial nominal devalu-ation in the years t s and t s 1 , with t s being the rst year of consolidation 9


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and COMP is a variable reecting the composition of the consolidation pro-gramme. Equation 5 includes one such variable, EXCH1. To compute it, wehave put COMP equal to TR+ TAXT IG, with TR, TAXT and IGas dened above. The positive sign of the coefcient on EXCH1 conrms ourexpectation that a devaluation contributes to successful consolidation if it ispart of a broader programme that can convince nancial markets, in particularif it goes a long with cuts in taxes and transfers and with rising governmentinvestment (i.e. TR+ TAXT IG


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ratio over t s+ 1 tf + 2, rather than t s tf + 2 . Second, we have introduced thepercentage change in public employment during the consolidation period asan alternative for the change in the government wage bill. The correlationbetween these two variables is 0.42. Third, we have used the change in thenet debt ratio as dependent variable. None of these changes fundamentallyaffect our main ndings. For example, the sign of WAGE remains signic-antly negative. The change in public employment also receives a negativesign (which is statistically signicant at 10%). It must be acknowledged,though, that the results explaining the change in the net debt ratio are stronglyinferior. A problem with this variable is, however, that for some countries(eight consolidation episodes) no data are available.

As a fourth, more important change, we have redened the compositionvariables. Instead of changes in cyclically-adjusted spending and revenue cat-egories as a percentage of potential GDP, Equation (6) in Table 2 includesactual (non-cyclically-adjusted) data as a percentage of actual GDP. This

change has been inspired by the fact that non-adjusted data are commonlyused in the literature. A second motivation is that cyclically-adjusted datadepend on an evaluation of potential output, the calculation of which is opento discussion. As can be seen, the explanatory power of Equation (6) is farbelow that of Equation (5). Almost all estimated t-values decline. Most im-portant though, this rearrangement does not change our conclusions for theeffect of the composition variables.

5. Conclusions

This paper tests ve hypotheses explaining the effects of scal consolida-tion on the gross government debt ratio in a sample of 39 consolidationepisodes in 18 OECD countries. Methodologically, our main contributionsare that these hypotheses are tested simultaneously and that the data testingfor composition effects are cyclically-adjusted. Our results conrm many of the conclusions drawn by Alesina and Perotti (1995, 1996) and McDermottand Wescott (1996). More specically, we also obtain that the likelihood of successful consolidation rises if consolidation (i) takes place in a favourableinternational macroeconomic environment with high economic growth andlow real interest rates, (ii) relies on cutting transfers or raising direct taxeson business, (iii) does not rely on raising taxes on households and labour,

nor on cutting government investment. However, one of Alesina and Perottisand McDermott and Wescotts most popular hypotheses that to succeedconsolidation should rely on cutting the government wage bill is stronglyrejected. This hypothesis does not survive in a multivariate framework.


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As for our other results, we nd some weak evidence in favour of Giavazziand Paganos (1995) hypothesis that large and persistent consolidation pro-grammes are more successful. Further, a new result in this paper is that if itscomposition is good, consolidation may benet from a preceding devaluation.Otherwise, a devaluation seems to be harmful. Finally, we nd no evidencefor the hypothesis of, among others, Blanchard (1990) and Sutherland (1995)that consolidation will be more successful in economies with critical debtlevels.

Notes

1. See e.g. Persson (1996). One of the reasons for criticism is that it cannot be excluded thatevents other than planned scal policy (e.g. unexpected shifts in private sector behaviour,a rise in ination combined with a progressive non-indexed tax system) move the gov-ernment balance. Another reason concerns cyclical adjustment. This requires evaluatingpotential output, which is notoriously arduous.

2. For completeness, note that some recent European episodes of consolidation (e.g. France,Italy and Sweden in 199597) have not been included in Table 1 and Figure 1. The reasonis that it is hardly possible to assess their effects on the debt to GDP ratio. The availableinformation e.g. OECD projections for 1998 and 1999 is still very preliminary.

3. For earlier work, see e.g. Feldstein (1982) and Barro (1989).4. Others are highly critical of these studies, though (see e.g. Sturm, Kuper and de Haan,

1997).5. Although plausible, this hypothesis also has its problems. For example, in the model

presented by Bertola and Drazen (1993), at very high levels of government consumptiona government consumption cut may induce a fall in private consumption. This is becauseat high levels of government consumption a spending cut may so reduce the probability of a large stabilization in the near future as to increase the present discounted value of future

expected taxes.6. The fact that higher taxes on business strongly seem to contribute to successful consolid-

ation is surprising, given the theory explained in Section 3.2.1. Alesina and Perotti havealso found this result. They provide no convincing justication, though.

7. LAPE equals 1 in eleven consolidation episodes (see the codes in Table 1): be1, ca1, de,ge2, gr3, ir1, ir2, it3, po, sp2, uk. It is 0 in all other episodes.

8. More specically, STRI equals the average German short-term real interest rate duringconsolidation in all European countries and the average US short-term real interest rateduring consolidation in the North American countries and Japan. International real outputgrowth during consolidation (GDPG) equals: average real GDP growth in Europe for allEuropean countries except Germany and the United Kingdom; average real GDP growthin France, the US and Japan for Germany; average real GDP growth in Europe and the USfor the United Kingdom and Japan; average real GDP growth in Europe, Japan and Canadafor the United States and average real GDP growth in the US for Canada. Including forall countries the average real output growth in the OECD during consolidation leads tohighly similar results as those presented in this paper.

9. These episodes are be1 (devaluation of 8.5%), de (3%), fr2 (8.4%), gr2 (15%), ir2 (8%),it2 (12.2%), it3 (3.7%), po (14%), sp2 (11%) and sw2 (16%).


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