More on Cyclical versus Structural Components of the Fiscal Deficit

My previous post highlighted that the structural component of the budget deficit is relatively high. Right now, a return to economic growth will not deliver big revenue gains,  in view of the reduction of cyclically-sensitive income taxes over the last decade, such that the cyclical element in the budget is measured as low.

One feature of the upcoming fiscal adjustment could be to shift the attribution of the overall deficit between structural and cyclical components.  In particular, if cyclically-sensitive taxes are increased, then the cyclical component of a given deficit will increase and the structural component will decrease, since economy recovery will then ‘do more of the work’ in returning the overall fiscal balance to good health.

That is, a X percent deficit reduction package could translate into an X+Z improvement in the structural deficit and an X-Z improvement in the cyclical deficit.   This is relevant, since the key target should be to reduce the structural deficit.

3 replies on “More on Cyclical versus Structural Components of the Fiscal Deficit”

Philip, this is an intriguing observation, though I’m unsure about how you intend the Z’s to balance out.

The following might be complementary.

Consider a fairly standard deficit decomposition:

Def = SDef + k*Output Gap

Def = Deficit (as a share of GDP)
SDef = Structural component
k*Output Gap = Cyclical component

Now consider the impact of raising income taxes rates. This is likely to have three effects: (i) it will lower the structural deficit; (ii) it will raise the value of k, i.e. the sensitivity the deficit to the output gap; and (iii) it will (most likely) raise the output gap itself. Overall, we would expect the deficit to decline, but at a cost in terms of short-run economic activity.

Now consider adding a third term, S, to the equation: think of it as a temporary stabilisation measure. There are various possibilities: a temporary reduction in VAT rates (which would boost short-term spending); a termpoary reduction in employer PRSI; US-style income-tax rebate cheque; etc.

We could think of two ways to choose S. First, for any given increase in income tax rates, S could be chosen to maintain the overall deficit. Thus the structural deficit would decline, but the overall deficit would remain constant. This is similar to the idea in your post, at least in outcome.

Second, for any given increase in income tax rates, S could be chosen to maintain the output gap. In this way, we further the key goal of reducing the structural deficit, but without further contracting the economy.

The broader point is that once it is decided that the focus should be on the structural deficit, it opens up a richer menu of fiscal stabilisation strategies.

These seem like pretty important ideas and issues, and so I would like to see a detailed discussion of how *empirically* to disaggregate the total Irish deficit into its cyclical and structural components. To an amateur like myself, this seems a non-trivial task given that you have to make judgements about (a) how many of the bubble receipts were bubble receipts rather than boom receipts (my guess is: an awful lot, and hence my hunch, like Philip’s, is that a very big share of our current deficit is in fact structural) (b) what the future sustainable growth trajectory is for the Irish and world economies once all this is over (not obvious to me) (c) how reliable existing econometric estimates of these things are given that parameters will have been estimated with data for the past few decades, which may have been one super boom or bubble, as Martin Wolf is suggesting (d) other stuff I can’t think of right now.

I am absolutely not posing these questions to be obstructive or to say it can’t be done — I guess you guys could. But I think that unless a very clear and convincing empirical case can be made that x% of GDP is structural, and y% is cyclical, then the markets may in some sense rationally (given information costs etc) fall back on rules of thumb, such as ‘we would like to see a single digit deficit’, or ‘we would like to see the Irish Government hit the targets that it has set itself’. Which, as you are suggesting, might be suboptimal. (In that case, Karl’s suggested ‘spin’ might make sense.)

Kevin, you raise an important point. I have just been comparing the Addendum document (Department of Finance) with rthe recently released Council Opinion on the Updated Stability Programme of Ireland (both links below). The differences in the structural-cyclical split have made me despair. All the more so, since both documents manage to come to the same overall deficit projections as of January.

What is really striking is the differences in the estimates for the output gap for 2009 (and subsequent years) . The Addendum puts it at -7.1% (January 2009); the Commission records the output gap assumed in the January 2009 Stability Programme as -3.5%. That is quite a difference. More discussion from people who have thought hard about identifying potential output for Ireland is clearly warranted.

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