Nonlinearities and the Sustainability of the Government's Intertemporal Budget Constraint

Abstract

We analyze the sustainability of the government's intertemporal budget constraint and the corresponding fiscal reaction function within a nonlinear error‐correction framework. Our empirical analysis, based on Italy, provides some evidence that the Italian government is meeting its intertemporal budget constraint. Nevertheless, we show that the burden of correcting budgetary disequilibria is entirely carried out by changes in the average tax rate, with a weakly exogenous government spending, possibly determined by the political process. We also document some rigidities of the tax instrument, in terms of downward inflexibility of the average tax rate with respect to its long‐run level. Finally, we provide some evidence in favor of a nonlinear adjustment toward a sustainable long‐run equilibrium, as the average tax rate adjusts faster the further away it gets from the equilibrium. By considering the behavior of taxes across the economic cycle, we also provide some evidence of inflexibility of the tax instrument during bad times. (JEL C32, C51, C52, H20, H50)

Nonlinear policy behavior, multiple equilibria and debt-deflation attractors

“…Additional evidence on nonlinear fiscal adjustments over the U.S. fiscal history is provided by Sarno (2001), Arestis, Cipollini and Fattouh (2004), and Cipollini, Fattouh and Mouratidis (2009). Such a type of 'delayed' budgetary policy measures when debt tends to accumulate overtime is also detected for the historical fiscal record in the U.K since 1919 (Considine and Gallagher, 2008;Arghyrou and Fan, 2013) and for European countries historically subject to fiscal imbalances-such as Italy, Spain, Portugal, Ireland and Greece (Bajo-Rubio, Esteve, 2004, 2006;Arghyrou and Luintel, 2007;Legrenzi and Milas, 2012a, 2012bPiergallini and Postigliola, 2013). Postponed corrective actions in the conduct of fiscal policy are further shown to have occurred in Latin American and Caribbean countries (Chortareas, Kapetanios and Uctum, 2008).…”

Non-linear budgetary policies: Evidence from 150 years of Italian public finance

“…For Italy, Arghyrou and Luintel (2007) …nd evidence of non-linear …scal adjustments of revenues to expenditures from 1957 to 1998; Ricciuti (2008) …nds that taxes and spending display non-linear trend stationarity from 1862 to 1998, and further they non-linearly co-trend; Legrenzi and Milas (2012b) show the occurrence of sustainable non-linear tax increases with no evidence for spending corrections from 1960 to 2008; Legrenzi and Milas (2012a) examine the stochastic properties of the debt-GDP ratio series and detect non-linear mean reversion from 1861 to 2010. This paper makes use of the Italy's overall historical …scal record to assess the empirical performance of feedback budgetary policies, that allow for possible tax-smoothing objectives (Barro, 1979(Barro, , 1986, and explicitly react to debt (Bohn 1998(Bohn , 2008 in a non-linear way.…”

Fiscal Sustainability in the Euro-Zone: Is There A Role for Euro-Bonds?

“…For example, Papadopoulos and Sidiropoulos (1999), De Castro and Hernandez de Cos (2002), Trachanas & Katrakilidis (2013), Arghyron and Luintel (2007), Bajo-Rubio et al (2009), and Legrenzi and Milas (2012) have found evidence that supports the existence of fiscal sustainability in countries that include Greece, Italy, and Spain. Afonso (2005) and Corsetti and Roubini (1991), on the other hand, reported results that indicate nonsustainability of the fiscal position of the countries.…”