INFORME SOBRE CONTRATOS MERCANTILES QUE PUEDAN INTUIRSE EN EL CASO

This section describes the output effects of higher government debt in the QUEST model, the European Commission's dynamic stochastic general equilibrium model. In the QUEST model, simulated either as an infinitely-lived-agent model or as an OLG model with 50 years of life expectancy, the savings channel of government debt is negligible.

The negative impact of debt on GDP results from the financing of deficits via distortionary taxes. Higher government debt implies higher interest payments requiring additional revenues to service this debt. If taxes are distortionary, this has a negative impact on potential GDP. How large these long run steady state effects are depends on how distortionary the taxes used to service the debt are.

The QUEST model also includes a risk premium term to government bonds rates that depends endogenously on debt levels. This sovereign risk premium is calibrated such that a 1 percentage point increase in the debt-to-GDP ratio leads to a 3 basis-point increase in government bond rates, roughly in the middle of the range estimated by Laubach (2009). If the risk premium is economy- wide rather than only affecting sovereign debt, long-term output effects can be very large.

Graph III.3.1 shows the long-term effects of a permanent 10 percentage point increase in the EU debt to GDP ratio in the QUEST model on potential output. It shows the effect on output that comes from increasing different taxes to service the higher debt. The taxes considered are lump- sum taxes, VAT, labour and corporate taxes. The exercise is undertaken with the default model setting, where the risk premium applies to sovereign bonds. For comparison the graph also shows GDP effects without a risk premium. In all scenarios deficits are permanently increased, initially through reductions in taxes. Taxes then increase due to the higher debt servicing costs that result from the accumulation of debt. The initial tax reductions are reversed and in the long run taxes are higher. In the case of lump-sum taxes there is no long run GDP effect from higher debt,

but with distortionary taxes GDP is permanently lower.

The long run output effects are largest for corporate profit taxes, due to their effect on capital accumulation. The second largest output losses are under labour taxes, due to their distortionary impact on employment. The distortionary effects of labour taxes are larger than those of VAT. With a sovereign risk premium, debt servicing costs are higher and larger tax increases are required in the long run to keep the increase in debt at this 10 percentage point.

To illustrate the importance of the interest rate channel, Graph III.3.2 shows simulations where the risk premium not only applies to sovereign bonds, but also applies to the private sector. This shows the extent of crowding-out when an increase in debt would lead to an increased in economy- wide interest rates. This economy-wide risk premium is again calibrated at 3 basis points for a 1 percentage point increase in the debt-to-GDP ratio. In this scenario, the long run GDP effects are much larger. In this case the increase in debt leads to a large increase in the cost of capital, crowding out private capital and reducing potential output, even in the case of financing through lump-sum taxes.

Graph III.3.1: Output effects of permanent 10 percentage point increase in debt-to-GDP ratios with and without sovereign risk premium

-2.5 -2.0 -1.5 -1.0 -0.5 0.0

Lump-sum taxes VAT Labour taxes Corporate profit taxes

GDP effect w ithout riskpremia GDP effect w ith sovereign riskpremium

Source: Commission services.

To conclude, this section has illustrated the potentially significant long run GDP effects of higher debt. The channels identified in this section through which debt can affect output are through distortionary taxation for financing debt, sovereign risk premia and potentially an increase in

economy-wide interest rates. It is noteworthy that even in the case when there is no significant effect on interest rates, long-run crowding out can still be substantial, due to the size of the distortions caused by taxes. With an effect on economy-wide interest rates, the long run output losses of higher debt are much larger.

Graph III.3.2: Output effects of a permanent 10 percentage point increase in debt-to-GDP ratios with economy-wide risk premium -9 -8 -7 -6 -5 -4 -3 -2 -1 0

Lump-sum taxes VAT Labour taxes

Corporate profit taxes

issue of what determines successful fiscal consolidations. The effect of both the prevailing economic environment and the characteristics of the policy response have been studied. The main conclusions of the literature are summarised below.

Prevailing economic conditions can affect both the probability that a consolidation will be undertaken and the chances it has of success. European Commission (2007), Drazen and Grilli (1993) and Briotti (2004) find that consolidations are more likely to be undertaken when economic conditions have become unfavourable. Although consolidations should be easier to undertake in healthier economic conditions, it appears that it is easier to build the required political consensus under more difficult conditions: Kumar et al. (2007) reviews case-studies and suggests that this is indeed the case. However, some studies, such as Von Hagen and Strauch (2001) have found that favourable, rather than unfavourable, economic conditions are more likely to lead to consolidations. Moreover, the effect that the conditions in trading-partner countries have on the probability of success is also open to debate. While von Hagen and Strauch (2001) find that an unfavourable international economic outlook is more likely to lead to a successful consolidation, Alesina and Perotti (1995) and McDermott and Wescott (1996) find the opposite. Instead, they find that the possibilities of export-led growth increase the changes of a successful consolidation episode.

In terms of the policy responses there is a broad consensus that expenditure based consolidations have more chance of succeeding than ones that are primarily tax based, although recent research provides some interesting additions to the debate. Alesina and Perotti (1995) Alesina et al. (1998), Alesina and Ardagna (1998), von Hagen et al. (2002), Llera and Granados (2002), Lambertini and Tavares (2005) and European Commission (2007) all show the higher probability of success of expenditure-based consolidations. Focussing on cuts to primary expenditure, such as the government wage bill, generally enhances the probability success. However, the recent research

suggests that this relationship has become less valid in EU in countries. Instead, since the 1990s, successful consolidation episodes in the EU have been associated with cuts in transfers and non- wage government consumption.

The broad consensus that tax-based consolidations are less likely to be successful has also been qualified by the research presented in Tsibouris et al (2006). This paper shows that such consolidations can also prove to be effective where the starting tax to GDP ratio is low and where the implementation is policy changes are implemented gradually.

The speed of implementation and the accompanying structural policy changes are two important factors that are both linked with both the type of consolidation and may help determine its probability of success. In particular, one explanation of why expenditure based consolidations have tended to be more successful than tax based ones is that the former tend to be accompanied by structural reforms. These include cuts to public sector wages which can spill over to private sector wages, reductions in social security spending which can increase work incentives and improvements to public services' efficiency. Conversely, as Kumar et al. (2007) argue, tax- based consolidations have tended to be less successful as they were associated with a weak commitment to undertake structural reforms. Indeed, where such consolidations have proven successful they have tended to be accompanied by changes to the structure of the tax system which broaden tax bases, simplify the structure and reduce the tax burden on SMEs.

Gradual consolidations have also tended to be more successful than sudden, or "cold shower" ones according to European Commission (2007) and Kumar et al (2007). Again, the studies link this to the fact that during a gradual consolidation there tend to be accompanying structural reforms which aid the persistence of any improvements to the fiscal position and which tend to take time to deliver. Such gradual consolidations can take up to 10 years to deliver. Moreover, the existence or introduction of fiscal institutions or rules aiding

medium term budgeting is found to support the ability of governments to deliver lasting consolidations, as argued by European Commission (2007), Kumar et al (2007) and De Brun et al. (2008). The latter paper makes this case by focussing on the budgetary rules adopted by EU countries in the run-up to EMU.

Finally, monetary policy too can play a role. While

Ahrend et al. (2006) find that accommodative monetary conditions at the start of a consolidation episode enhance the probability of its success, other papers such as von Hagen and Strauh (2001) and Lambertini and Tavares (2005) find no such influence. Nevertheless, Kumar et al (2007) consider monetary policy alongside other determinants to conclude that accommodative monetary policy is more likely to help achieve the political consensus to support successful consolidations.

Concerning the role of the exchange rate, Lambertini and Tavares (2005) reach inconclusive results as to whether real exchange rate depreciation improves the chances that a consolidation episode will succeed.

Against the background of this evidence on the determinants of successful fiscal consolidations, this section first considers the specificities of the current crisis by looking at what the existence of both a systemic financial crisis and high debt levels might mean for the type of consolidation that should be undertaken. Descriptive evidence building on the definitions of successful fiscal consolidations used in Section III.1 is also presented. Finally, the available information is brought together in an econometric analysis on the determinants of successful fiscal consolidations.