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Unclassified ECO/WKP(2016)76 Organisation de Coopération et de Développement Économiques Organisation for Economic Co-operation and Development 23-Nov-2016 English - Or. English ECONOMICS DEPARTMENT ECO/WKP(2016)76

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Unclassified ECO/WKP(2016)76 Organisation de Coopération et de Développement Économiques Organisation for Economic Co-operation and Development 23-Nov-2016 English - Or. English ECONOMICS DEPARTMENT ECO/WKP(2016)76 Unclassified A RE-ASSESSMENT OF FISCAL SPACE IN OECD COUNTRIES ECONOMICS DEPARTMENT WORKING PAPERS No By Jarmila Botev, Jean-Marc Fournier and Annabelle Mourougane OECD Working Papers should not be reported as representing the official views of the OECD or of its member countries. The opinions expressed and arguments employed are those of the author(s). Authorised for publication by Christian Kastrop, Director, Policy Studies Branch, Economics Department. All Economics Department Working Papers are available at English - Or. English JT Complete document available on OLIS in its original format This document and any map included herein are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area. OECD Working Papers should not be reported as representing the official views of the OECD or of its member countries. The opinions expressed and arguments employed are those of the author(s). Working Papers describe preliminary results or research in progress by the author(s) and are published to stimulate discussion on a broad range of issues on which the OECD works. Comments on Working Papers are welcomed, and may be sent to the Economics Department, OECD, 2 rue André-Pascal, Paris Cedex 16, France. Comment on the Papers is invited, and may be sent to OECD Economics Department, 2 rue André Pascal, Paris Cedex 16, France, or by to All Economics Department Working Papers are available at Recent working papers on the same topics include: Mourougane A. et al. (2016), Can an increase in public investment sustainability lift economic growth? OECD Economics Department Working Papers, No. 1351, OECD Publishing, Paris. This document and any map included herein are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area. The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law. OECD (2016) You can copy, download or print OECD content for your own use, and you can include excerpts from OECD publications, databases and multimedia products in your own documents, presentations, blogs, websites and teaching materials, provided that suitable acknowledgment of OECD as source and copyright owner is given. All requests for commercial use and translation rights should be submitted to 2 ABSTRACT/RÉSUMÉ A re-assessment of fiscal space in OECD countries To what extent can public deficits increase without putting fiscal sustainability at risk, given the specific current macroeconomic situation of protracted low growth and low interest rates, combined with relatively high government debt levels? The answer depends on many factors, such as the state of the economy, the fiscal track record and projections of population ageing and their effect on government spending. This paper makes use of three different approaches to better assess fiscal space, which can be defined in a broad manner as the extent to which public debt can increase. These approaches converge to a conclusion that there is fiscal space in most of the large advanced economies. There is also evidence that fiscal space may have risen in most OECD countries since 2014, mainly driven by the decrease in interest rates. Reforms to health and pension programmes would help to create additional fiscal space. JEL Classification: H3, C3 Keywords: fiscal space, OECD, market access, fiscal sustainability ****** Une ré-évaluation des marges de manoeuvre budgétaires dans les pays de l'ocde Dans quelle mesure les déficits publics peuvent-ils augmenter sans compromettre la viabilité budgétaire? La situation macroéconomique actuelle, caractérisée par une faible croissance prolongée et de faibles taux d intérêt, combinée à un niveau d endettement public relativement élevé, justifie une réévaluation de cette question. Sa réponse dépend de nombreux facteurs, tels que l état de l économie, les antécédents budgétaires ou les projections du vieillissement de la population et leurs effets sur les dépenses gouvernementales. Ce document utilise trois approches différentes pour mieux évaluer les marges de manœuvre budgétaires, qui peuvent être définie de manière large comme la mesure dans laquelle la dette publique peut augmenter. Ces approches convergent vers la conclusion qu il existe des marges de manœuvre budgétaires dans la plupart des grandes économies avancées. Il est également prouvé que l espace budgétaire peut avoir augmenté dans la plupart des pays de l OCDE depuis 2014, principalement sous l effet de la baisse des taux d intérêt. Les réformes des programmes de santé et de retraite aideraient à créer des marges de manœuvre budgétaires supplémentaires. Classification JEL: H3, C3 Mots clés: marges budgétaires, OCDE, accès aux marchés, soutenabilité budgétaire 3 TABLE OF CONTENTS 1. Introduction and main messages The current economic context calls for a reassessment of fiscal space... 6 Public debt has risen since the crisis... 7 and potential output has been hit hard... 7 but lower interest rates provide savings Several approaches can be used to measure fiscal space... 9 Fiscal space as a measure of distance to loss in market access Tax gaps and sustainable tax rates Making use of the Laffer curve and defining forward-looking debt limits Fiscal space has risen in most OECD countries Very low interest rates have increased fiscal space Fiscal space depends on the pace at which real interest rates and potential output growth become aligned but structural reforms to key spending programmes can help increase fiscal space Policy implications REFERENCES ANNEX 1. SYNTHETIC INDICATORS TO QUANTIFY FISCAL SPACE Interest rate growth differential Years to repay the public debt ANNEX 2. THE FISCAL MAQUETTE MODEL Specification of the main equations Parameters and calibration ANNEX 3. THE LONG-TERM SUSTAINABILITY MODEL BASED ON LAFFER CURVES Tables Table 1. Calibration of the Bi-Leeper model Figures Figure 1. Fiscal stance and public debt levels in OECD countries... 7 Figure 2. OECD Potential output growth has slowed markedly... 8 Figure 3. Fall in government interest payments... 9 Figure 4. Different aspects of fiscal space Figure 5. Determination of the debt limit Figure 6. Debt limit sensitivity analysis Figure 7. Medium term gap Figure 8. Maximum primary balance at a given period and state of the economy Figure 9. Lower interest rates increase fiscal space Figure 10. Fiscal limit cumulative distribution function Figure 11. Fiscal space loss from delay in healthcare reform Figure 12. Share of long-dated bonds in public debt A RE-ASSESSMENT OF FISCAL SPACE IN OECD COUNTRIES Jarmila Botev, Jean-Marc Fournier and Annabelle Mourougane 1 1. Introduction and main messages 1. Almost a decade after the outbreak of the financial crisis, the global economy remains in a lowgrowth trap with weak investment, trade, productivity and wage growth and rising inequality in some countries. Monetary policy is overburdened, and its ultra-accommodative stance creates distortions and may fuel financial risks and distortions. Alongside structural reforms, a stronger fiscal policy response is needed to boost near-term growth and strengthen long-term prospects for inclusive growth. 2. However, in the context where public debt has risen to high levels in most OECD countries, it is important to assess the extent of countries' fiscal space. In the past few years, the assessment of fiscal policy has focused essentially on public budget balance positions rather than on the consequences for growth. This focus has resulted in a higher debt-to-gdp ratio in the short term, as shortfalls in investment, human capital and productivity have curbed GDP growth. A rethink is needed for how the fiscal policy stance should be evaluated, particularly in the context where low sovereign interest rates provide more fiscal space. 3. In recent years, a number of new methods have complemented the more traditional approaches to assess fiscal space (see Annex 1 for an overview of the different methods). This chapter relies essentially on three, with the objective of approaching the complex reality from different angles: Ghosh et al. (2013) and Fournier and Fall (2015) focus on market access. They calculate fiscal space as the distance between actual debt levels and their estimated limits. Debt limits measure the debt level at which a sovereign borrower loses market access and hence cannot service its debt in a normal way. Debt limits depend on assumptions made on risk-free interest rates and potential output growth, the size of shocks that hit economies, the country's fiscal track record and the fiscal reaction to increasing debt. The fiscal reaction relies on the assumption that governments cannot indefinitely sustain public primary surpluses and will experience fiscal fatigue at some point. The model includes a non-linear risk premium that rises sharply if debt becomes close to the debt limit. Bi (2011) and Bi and Leeper (2013) examine sovereign default risks but account for longterm fiscal sustainability. They rely on a DSGE approach, whereby the shape of the Laffer curve (which derives expected tax revenues from tax rates) depends on macroeconomic circumstances. Shocks to the economy and long-term projections of spending and transfers are accounted for. The approach does not provide a point estimate of the debt limit, but its 1. The authors are members of the Economics Department of the OECD. They would like to thank Mark Baker, Sebastian Barnes, Sven Blondal, Ane-Kathrine Christensen, Boris Cournède, Catherine Mann, Peter Hoeller and country Desks from the Economics Department for their comments and suggestions, as well as Sylvie Foucher-Hantala for statistical support and Veronica Humi (also from the Economics Department) for editorial assistance. They also thank Zuzana Mucka (CBR) for providing us her version of the MATAB codes. 5 distribution, i.e. the probability for a country to default at each value of the debt-to-gdp ratio. This distribution is derived using the expected present value of future maximum primary surpluses, which come from driving tax revenues to the peak of the Laffer curve and expenditure to its projected level. Blanchard et al. (1990) focus essentially on long-term fiscal sustainability. When the interest rate is persistently below the growth rate, governments are able to run permanent deficits of any size. When the interest rate to growth differential is positive, fiscal space is computed as the tax gap between the sustainable and the current tax-to-gdp rate, where the former is the constant tax rate that would achieve an unchanged debt-to-gdp ratio over the relevant horizon, for a given projection set of public spending and transfers. Contrary to the former two approaches, this framework does not account for macroeconomic shocks. In this paper, a variant of this methodology is used to compute sustainable tax rates with a small macroeconomic model. 4. The main messages are the following: Interest rates on government debt are very low in advanced economies, following exceptional monetary stimulus and have generated savings through lower interest payments. Measures of fiscal space -- those that focus on the gap between actual debt and estimated levels at which market access would be compromised -- appear to have risen in most OECD countries since 2014, as lower interest rates have more than offset headwinds from lower potential growth and higher debt. Measures that examine market access and account for projected long-term ageing-related spending pressures also point to some space in most of the larger advanced economies. The extent of fiscal space appears to be uncertain in Italy and depends to a large extent on whether the focus is on past developments of the primary balance ( market access approach) or on the budgetary implications of population ageing ( long-term fiscal sustainability approach). Structural reforms that effectively contain the cost of healthcare and pension spending, including by reforming entitlements, create additional space. The increase in fiscal space provides room for manoeuvre, provided that low interest rates are locked-in through long-term borrowing. In particular, countries could issue more long-dated bonds and take advantage of favourable financial conditions. Although policy requirements vary by country depending on their circumstances and positions in the cycle, most advanced countries have scope to use the expanded fiscal space in the context of a fiscal initiative which would comprise measures fostering productivity and longterm growth. 2. The current economic context calls for a reassessment of fiscal space 5. The very low level of interest rates on government debt in advanced economies raises important questions about the use of fiscal policy in the context of the low-growth trap and high debt levels. Other things being equal, low interest rates expand fiscal space - a measure of how much governments can borrow without losing market access or facing sustainability challenges. This shifts the perceived trade-off 6 between borrowing to support growth and consolidation, making it possible in some countries to borrow more without undermining sustainability. However, lower growth and higher debt, as well as risks and long-term challenges need to be taken into account when evaluating the size and desirability of using fiscal space. Public debt has risen since the crisis 6. The 2008 crisis, and the expansionary response it triggered, resulted in a surge in public debt. Fiscal policy was subsequently tightened in most OECD countries bringing the debt-to-gdp ratio onto a more sustainable path but depressing demand (Figure 1). Since 2015, the fiscal stance in the OECD has moved to being broadly neutral in many countries and financial turbulence in euro area markets has waned. Public debt has stabilised in the euro area and the United States. However, the recovery has been fragile, monetary policy is overburdened, and political uncertainties have risen. In this context, a number of OECD countries have announced in 2016 a reconsideration of fiscal policy initiatives to support near-term growth and increase long-term productive capacities. Figure 1. Fiscal stance and public debt levels in OECD countries Source: OECD Economic Outlook database. and potential output has been hit hard 7. Estimates of potential output per capita growth in the major OECD economies have declined in the aftermath of the crisis. They are estimated on average at around 1% in 2016, almost 1 percentage point below the average in the two decades preceding the crisis (Figure 2). Weak capital stock growth and declining factor productivity were the two main factors contributing to the decline. 7 Figure 2. OECD Potential output growth has slowed markedly Contribution to potential per capita growth Note: Assuming potential output (Y*) can be represented by a Cobb-Douglas production function in terms of potential employment (N*), the capital stock (K) and total factor productivity (E*) then y* = a * (n*+e*) + (1 - a) * k, where lower case letters denote logs and a is the wage share. If P is the total population and PWA the population of working age (here taken to be aged 15-74), then the growth rate of potential GDP per capita (where growth rates are denoted by the first difference, d( ), of logged variables) can be decomposed into the four components depicted in the figure: d(y* - p) = a * d(e*) + (1-a) * d(k - n*) + d(n* - pwa) + d(pwa - p). 1. Potential employment rate refers to potential employment as a share of the working-age population (aged 15-74). 2. Active population rate refers to the share of the population of working age in the total population. 3. Percentage changes. With growth in Ireland in 2015 computed using gross value added at constant prices excluding foreignowned multinational enterprise dominated sectors. Source: Economic Outlook database. but lower interest rates provide savings 8. The fall in interest rates on government debt in advanced economies has in part reflected exceptional monetary policy stimulus, with just over 30% of OECD government debt currently trading at negative yields. This continues a long trend of declining nominal and real yields over past decades, which has been compounded by very low or even negative policy rates and large-scale central bank purchases at long maturities, as well as the reduction in the term premium following changes in banking regulations. In the euro area, declining risk spreads since the crisis have contributed to lower borrowing costs. At the same time, many governments have used the opportunity to extend the maturity of outstanding debt, locking in low rates (OECD, 2016). 9. Declining interest rates have resulted in savings on interest costs for governments. Looking forward, and partially accounting for the maturity structure of public debt, further reduction in interest costs are likely if yields remain around the current level as old debt at higher yields matures. This would generate significant additional savings, notably in Italy and to a lesser extent in France and the United Kingdom over , under the assumption that 15% of the initial stock of debt is rolled over each year and the rest is valued at an implicit rate that captures the maturity structure of the debt (Figure 3). Assuming an alternative scenario of 25% of debt maturing each year would lead to even stronger gains. 8 Figure 3. Fall in government interest payments Estimated budget gains over due to lower interest rates Note: Based on general government debt at the end of 2014, assuming that 15% or 25% of this initial debt stock matures each year, comparing the interest rate on 10-year government bonds in 2014 with the interest rate for 2015 and the 2016 average until August for 2016 and The remaining stock of debt is valued at the implicit interest rate, which depends on the maturity structure. The computation does not incorporate the most recent increase in sovereign bond yields, as the latter do not markedly change the results. Source: OECD Economic Outlook database and OECD analytical database. 3. Several approaches can be used to measure fiscal space 10. With conventional monetary policy facing constraints and evidence pointing to a greater effectiveness of fiscal policy to stabilise the economy than in the past, fiscal space needs to be reassessed (Furman, 2016). At first glance, fiscal space appears to be a relatively intuitive concept and can be defined as the room in a government's budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its financial position or the stability of the economy (Heller, 2005). 11. A simple way to measure fiscal space is to use synthetic indicators such as the interest rate to growth differential or de facto fiscal space (Aizenman and Jinjarak, 2010; see Annex 1 for a review of such indicators). Such indicators send clear signals and are easy to communicate. However, their simplicity also means that they fail to capture important factors determining fiscal space. 12. This paper focuses on three approaches that are described in more detail in the following sections, as fiscal space can be measured in terms of either losing market access or achieving long-term sustainability. I
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