Debt and deficit ceilings, and sustainability of fiscal policies: an intertemporal analysis

Abstract: In this paper, we examine the likely consequences for the sustainability of fiscal policy of pursuing goals that rely on restrictive ceilings on deficits and debt. We provide a formal theoretical framework for analyzing the sustainability of fiscal policy based on the government intertemporal budget constraint and derive conditions that determine whether a given fiscal stance is sustainable. This framework generalizes the existing literature in several important respects. We allow for time-varying interest rates, for the primary deficit to be endogenous, for a finite planning horizon suitable for medium-term policy making, for possible future policy shifts, we show how published forecasts can be used and we provide a measure of fiscal pressure. We then apply this analysis to the fiscal positions of the United States and the European Union countries since 1970 and to their planned positions over the next decade. We find that many countries do not have a sustainable policy. The evidence in favor of sustainability is strengthening for most countries when the data are extended to incorporate future fiscal consolidation plans, reflecting the general shift toward fiscal austerity in recent years. In contrast, with a finite horizon we show that the recent policy shift made the paths of future policies sustainable. However, imposing ceilings on debt or deficit-to-GDP ratio throws most economies onto an unsustainable path unless governments undertake a major tax or expenditure adjustment. High-debt countries can satisfy the 60 percent debt rule by 1999 only by raising (reducing) the average tax (spending) rate substantially for five years. A 3 percent plan 1999 or a zero-deficit plan by the year 2002, puts an increasingly high pressure on most economies, including the United States, requiring a gradual rise (decline) in the tax (spending) rate.

Keywords: Europe; Fiscal policy; Deficit financing;

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Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Research Paper

Publication Date: 1996

Number: 9615