The first issue while analyzing the fiscal environment concerns assessing the fiscal policy direction – expansionary or contractionary. Expansionary fiscal policy entails expanding the budget deficit by cutting taxes or increasing expenditures, with a goal of stimulating the economy during slowdown. Contractionary fiscal policy works the opposite way.
The second issue regarding fiscal policy evaluation is its link with the economic cycle. Short run stability requires that, notwithstanding exceptional cases, fiscal policy should help smooth economic cycles, i.e. consolidate during a boom and expand during a recession. Analyzing fiscal policy cyclicality also allows for gauging the country's capability to pursue countercyclical fiscal policy without endangering long run fiscal sustainability.
The goal of this research publication is to provide, based on internationally utilized indicators, a short and long run analysis of discretionary fiscal policy in Georgia, estimating the policy direction, cyclicality, maneuvering space and equilibrium conditions.
Fiscal policy comprises two components: automatic stabilizers and the discretionary part. Automatic stabilizers act naturally in parallel with output fluctuations and help dampen the effect of economic cycles. For example, during a recession, revenues shrink by themselves, while social expenditures increase, resulting in a higher budget deficit (or a lower surplus). On the other hand, discretionary fiscal policy can be defined as actions undertaken by the government under its own discretion for particular purposes. In order to assess the latter, it is necessary to remove cyclical components from fiscal indicators, for which:
1. Firstly, we estimate potential GDP and the GDP gap. Potential GDP can be defined as the level of output that corresponds with utilizing resources with a normal intensity and, subsequently, stable inflation. The GDP gap shows the level by which actual GDP deviates from potential GDP, providing information about inflationary or deflationary pressures. At any moment in time actual GDP might be different from the potential one, as a result of economic cycles. According to our results, GDP was higher than its potential level in 2003-2008; also, slightly in 2011-2012. The gap has been negative since 2013, meaning that GDP remains lower than its potential level.
2. Afterwards, based on the GDP gap estimates, we determine the cyclically adjusted budget balances, which are required to evaluate discretionary fiscal policy. For this purpose, we use two indicators: a. the overall balance, which is calculated according to the IMF Government Finance Statistics Manual (GFSM 2011), and b. the overall fiscal balance, which is calculated as per the 1986 manual of the same system (GFSM 1986). After removing non-discretionary interest expenditures and filtering out the effect of economic cycles from overall balance and overall fiscal balance, we calculate the cyclically adjusted primary balances. As per our results, budget revenue elasticity with respect to the GDP gap is 1.1-1.2, meaning that a rise in the gap results in a higher than proportional rise in revenues. As for expenditures, the elasticity with respect to the output gap is statistically non-significantly different from 0, meaning that expenditure policy is discretionary.
In order to analyze the fiscal policy direction and cyclicality, we use the following indicators:
• Let's define fiscal stance as the cyclically adjusted primary balances with a negative sign. A positive fiscal stance means that the government pours more resources into the economy than it removes (fiscal expansion), while a negative fiscal stance means that the government removes more resources from the economy than it returns (fiscal consolidation).
• Let's define fiscal impulse as a change in the fiscal stance. If the output gap falls, countercyclical fiscal policy requires either smaller consolidation (in case of positive gap) or larger expansion (in case of negative gap), which means that the fiscal impulse ought to be positive. If the output gap rises, countercyclical fiscal policy requires either larger consolidation (in case of positive gap) or smaller expansion (in case of negative gap), which means that the fiscal impulse ought to be negative.
In order to comprehensively evaluate discretionary fiscal policy, it is necessary to combine the analysis of the fiscal stance and impulse according to these two criteria:
1. Fiscal policy is countercyclical if the fiscal stance is positive during recession (expansion) and negative during boom (consolidation);
2. Fiscal policy is countercyclical if the fiscal impulse is positive when the output gap falls (larger expansion or smaller consolidation) and negative when the gap rises (smaller expansion or larger consolidation).
Analyzing the indicators based on the primary budget balance, we determine:
• Evaluation of the fiscal stance that corresponds to the primary balance reveals that, in the reporting period, the fiscal stance was more contractionary than expansionary. Moreover, the fiscal stance can be deemed weakly countercyclical. Namely, the coefficient corresponding to the impact of the GDP gap on the fiscal stance falls between -0.3 and -0.5 (with different significance levels).
• The fiscal impulse corresponding to the primary balance was largely neutral in the reporting period – the number of years of consolidation and expansion were almost equal. Moreover, the fiscal impulse can be deemed weakly countercyclical. Namely, the coefficient corresponding to the impact of change in the GDP gap on the fiscal impulse falls between -0.3 and -0.5 (with different significance levels).
According to the abovementioned strict criteria, discretionary fiscal policy, as per the cyclically adjusted primary balance, can be deemed weakly countercyclical.
On the other hand, analyzing the indicators based on the primary fiscal balance, we determine:
• Evaluation of the fiscal stance that corresponds to the primary fiscal balance reveals that the fiscal stance was largely expansionary in the reporting period. Moreover, the fiscal stance can be deemed weakly procyclical or acyclical. Namely, the coefficient corresponding to the impact of the GDP gap on the fiscal stance falls between 0.1 and 0.3 (with different significance levels).
• The fiscal impulse corresponding to the primary fiscal balance was largely neutral in the reporting period – the number of years of consolidation and expansion were almost equal. Moreover, the fiscal impulse can be deemed acyclical (or very weakly procyclical). Namely, the coefficient corresponding to the impact of change in GDP gap on the fiscal impulse falls between 0.1 and 0.2 (statistically insignificant).
According to the strict criteria as given above, discretionary fiscal policy, as per the cyclically adjusted primary fiscal balance, can be deemed acyclical or very weakly procyclical.
In total, analysis based on the overall balance points to weak countercyclicality, while analysis based on the overall fiscal balance points to acyclicality. Accordingly, if we take into account the privatization proceeds and financial asset operations, the weak policy countercyclicality disappears. We can conclude that, in the reporting period, discretionary fiscal policy was not particularly aimed towards smoothening the economic cycles.
On the next step we estimate the fiscal space, which we define as the country's capability to conduct countercyclical fiscal policy without endangering long run fiscal sustainability. Our results show that, during the 2003-2007 economic boom, fiscal space slightly increased, as a consequence of a smaller rise in procyclical expenditures compared to procyclical revenues. This, possibly, facilitated fiscal expansion during the recession in the following years, which was followed by a quick closure of the GDP gap.
Finally, an important issue for fiscal policy concerns the relationship between budget revenues and expenditures. According to our results, an unexpected rise in revenues is followed by a higher than proportional rise in expenditures. Moreover, in the long run, change in revenues results in change in expenditures, but no causality is observed the other way round (the coefficient is statistically non-significantly different from 0), which is a noteworthy issue with respect to fiscal discipline and sustainability. It should also be noted that an expenditure shock has only a short run impact on revenues, while the impact of a revenue shock on expenditures is permanent. The permanent effect of a revenue shock on expenditures arises from the fact that it is expenditures that adjust to maintain the long run equilibrium. As for the independence of revenues from the expenditure shocks, this might be a result of the long run independence between public expenditures and output, which is an issue for separate research.