Automatic fiscal stabilisers [ Working Paper 05-02 - 28/05/2002]

In this paper, we investigate how automatic fiscal stabilisers affect economic activity in the euro area. For this purpose we apply several shocks to the NIME-model, and we compare the adjustment path of the main macroeconomic variables under a regime that allows the automatic fiscal stabilisers to operate fully, with the results for a regime that tempers the working of the automatic fiscal stabilisers. We also compare the results for the euro area with results for the United States and Japan.

In the second section of this paper, we briefly describe the NIME model. In the third section, we present simulation results for various shocks under two different fiscal regimes.

The NIME model is a macro-econometric world model developed at the FPB. This model is built to make medium- term forecasts of the Belgian international economic environment and to study the transmission of the effects of economic policies and exogenous shocks to the Belgian and European economies. In the NIME model, automatic fiscal stabilisers are determined on the expenditure side by unemployment benefits and interest payments and on the revenue side by direct labour income taxes, profit taxes, social security contributions and indirect taxes. Three shocks are applied to the model, i.e., a temporary drop in private consumption, a permanent increase in the nominal money supply, and a permanent decline in trend productivity. For each shock we simulate the model with the automatic fiscal stabilisers operating freely and we compare the simulation results with the results obtained under a sustainable alternative regime that tempers the working of the automatic fiscal stabilisers.

First we discuss the effects of the two shocks that do not have permanent real effects, i.e., a temporary decline in private consumption and a permanent increase in the money supply. The simulation results show that the effects on output are smallest if the fiscal stabilisers are allowed to operate. The evidence also suggests, however, that the automatic fiscal stabilisers delay full adjustment, if compared with an alternative regime where the direct income tax rate is manipulated to maintain fiscal balance in every period.

Next we study the case of a permanent decline in trend productivity. We note that in the long run such a shock induces a change in relative prices, and that a change in the direct labour income tax rate - or another discretionary measure - is necessary to reach, in the long run, the target debt to GDP ratio. We therefore conclude that automatic stabilisers are not sustainable in the face of real shocks, and additional discretionary measures are required. Finally, we discuss some limitations of our analysis. Our analysis does not take into account the effects of tax increases on trend productivity or on the natural rate of unemployment, nor does it consider the existence of perception and implementation lags in the design of discretionary tax policies. We also assume a well-disciplined government that allows the automatic stabilisers to operate in a downturn and uses the gains during the upturn to reduce debt.