Cyclical Adjustment in Fiscal Rules: Some Evidence on Real-Time Bias for EU-15 Countries

Abstract

Abstract:Most EU member states will adopt fiscal rules that refer to cyclically-adjusted borrowing limits. Under the standard cyclical adjustment procedure, trend increases in public debt based on cyclical components are prevented if the real-time output gaps used to calculate cyclical components balance over time. We analyse real-time output gaps for EU-15 countries over the 1996-2011 period as estimated by the EU, the IMF and the OECD. Compared to each institution's final estimate, we find that real-time output gaps in our sample period are negatively biased. This bias is observed (i) irrespective of the source of the data, (ii) in all real-time vintages, (iii) basically across the entire cross-section of countries. The magnitude of the bias is considerable: on average, real-time cyclical components as a percentage of GDP are biased downwards by about 0.5 percentage point per year. Our results suggest that fiscal rules should incorporate ex-post checks of the unbiasedness of the cyclical components used within the rule. Potential biases would then decrease or increase future borrowing limits.Keywords: Public finance, fiscal rules, cyclical adjustment JEL-Classification: H61, H68, E32 Non technical summaryIn the context of the Fiscal Compact most EU member states will adopt national fiscal rules that refer to cyclically-adjusted borrowing limits. Under the standard cyclical adjustment procedure, trend increases in public debt based on cyclical components are prevented if real-time output gaps used to calculate cyclical components balance over time. It is well-known from the literature that real-time output gap estimates are associated with massive uncertainty and subject to strong revisions. We focus on the application of output gap estimates in national fiscal rules and ask whether cyclical components over the last 15 years would have been biased if they had relied on international organisations' imates of the output gap. real-time estWe compile real-time data for the output gaps estimated by the EU, the IMF and the OECD for the EU-15 countries over the 2002-2011, the 2000-2011 and the 1996-2011 periods, respectively and test these estimates for bias. The data suggest that -compared to each institution's final estimate -there is a significant bias towards producing more negative output gaps in real time. For our sample period, we observe this bias (i) irrespective of the source of the estimates (ii) in all examined definitions of real time, ie comparatively early estimations (for example spring of year t-1) or comparatively late estimations (for example autumn of year t), (iii) basically across the entire cross-section of countries. The magnitude of the bias obtained from our samples is clearly relevant: the average bias of real-time cyclical components across all countries and years lies between -0.6% and -0.5% of GDP. Thus, if a national fiscal rule had relied on these output gap estimations, the admissible deficits in real-time would have been allowed to exceed their "final" (autumn 2011) values by 0.5 p...

An Exploration of Real-Time Revisions of Output Gap Estimates Across European Countries

“…According to this pattern, while the over-estimation of structural balances advocated by Kempkes (2014) holds during expansions, it turns to under-estimation during recessions.…”

“…Moreover, compared to the real-time estimate, the fi nal estimate of the fi scal stance of an economy (measured by the change in the structural balance) would be more expansionary in good times and more contractionary in recessions. Therefore, the type of corrections to realtime estimates of the structural balance suggested by Kempkes (2014) should be contingent on the degree of slack in the economy.…”

“…In contrast, output gaps are upward-biased during economic recessions. This fi nding casts doubt over the result by Kempkes (2014), who argues that resulting structural balances are always over-estimated in real time because output gaps are downward-biased in real time.…”

The Fiscal Forecasting Track Record of the European Commission and Portugal

“…The fiscal rules for the budget balance ratio based on the output gap would have been wrong, because potential output bias has been relevant. Therefore, the admissible deficit in real time would have exceeded final values (Kempkes, 2012).…”

The Negative Mean Output Gap

“…See, for example,Kempkes (2012),Marcellino and Musso (2011) orKangur et al (2019).5©International Monetary Fund. Not for Redistribution…”