## Optimal Fiscal Path Considerations

## Source details

**Canonical URL:** [Optimal Fiscal Path Considerations](https://www.imf.org/-/media/files/publications/selected-issues-papers/2023/english/sipea2023045.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/selected-issues-papers/2023/english/sipea2023045.pdf.md)
- [Structured JSON version](/-/media/files/publications/selected-issues-papers/2023/english/sipea2023045.pdf.json)

---

### Overview and purpose
- The paper analyzes considerations for Portugal’s fiscal policy and public debt to stay on a sustainable path under alternative economic conditions.  
- Despite a nearly 20 percentage points of GDP spike in 2020 at the onset of Covid-19 shock, the public debt-to-GDP fell below its pre-pandemic level by end-2022; the debt ratio was 113.9 percent of GDP in end-2022.  
- The note uses an analytical model—the Buffer Stock model (Fournier, 2019)—to determine optimal medium-term structural consolidation under uncertainty and to balance economic stabilization and debt sustainability.  
- The model is a forward-looking structural stochastic model of the general government that features: countercyclical fiscal smoothing, debt-sensitive borrowing costs, a risk of losing market access, and hysteresis effects on potential output.

### Baseline recommendation and timing
- Baseline calibration (aligned with the 2023 Article IV Staff Report forecast) recommends an increase in the structural primary balance averaging at around 2.1 percentages points of potential GDP relative to 2022 during 2024-2028, implying the average level of 2.7 percent of potential GDP.  
- The model recommends a front-loaded fiscal consolidation path reflecting the higher initial debt level and the need to build fiscal buffers.

### How recommendations vary across scenarios
- Higher long-run interest rates:
  - Baseline long-run real effective interest rate assumption: 2.5 percent.  
  - Alternative calibrations considered: 2.8 percent (observed over 2002-19) and about 2.0 percent (low levels over the same period removing sovereign crisis and Covid-19 periods).  
  - For a 30-basis point increase in long run real interest rates, the recommended additional annual increase in the structural primary balance (relative to the baseline) would be some 0.2 percentage points higher than the baseline.
- Lower medium-term growth:
  - Baseline medium-term potential growth incorporates RRP investment and structural reforms.  
  - Alternative scenario with long-term potential growth of ¾ percent (the average growth recorded during 2002-19) would necessitate an additional 0.3 p.p. average increase in structural primary balance starting in 2024 over the medium-term relative to the baseline.  
  - Additional risks: possible fiscal cliff effects at the end of the NGEU period could reduce long term growth further.
- Market sensitivity to debt:
  - Higher sensitivity of interest rates to the debt level necessitates stronger consolidation over the medium-term.  
  - The model includes a positive probability of losing market access as debt approaches a model-specific limit.

### Model structure and policy trade-offs
- Key interactions captured:
  - Two-way feedback between fiscal policy and output: tightening the structural primary balance reduces output via a fiscal multiplier; output affects fiscal outcomes through automatic stabilizers.  
  - Macro-stabilizing role of fiscal policy is constrained by high debt: as debt rises, interest rates rise, reducing the feasible fiscal response to negative shocks and increasing the value of building fiscal buffers.  
  - Hysteresis: recessions have persistent negative effects on potential output through loss of physical and human capital and lower investment.
- Policy implication: When debt is low, optimal policy favors countercyclical smoothing of adverse shocks; as debt increases toward the model’s market-access limit, the optimal response shifts toward preserving fiscal room rather than smoothing shocks.

### Quantitative calibration highlights and parameter values
- Welfare and macro parameters:
  - Discount factor, β: 0.99  
  - Risk aversion, σ: 2  
  - Labor elasticity, η: 1/0.3  
  - Weight of labor, ξ: 1
- Fiscal parameters:
  - Fiscal multiplier, m1: 0.5  
  - Fiscal multiplier sensitivity to shocks, m2: 3  
  - Automatic stabilizers (primary balance semi-elasticity to the gap): 0.4  
  - Adjustment cost, χ: 3
- Interest rate and debt parameters:
  - Effect of debt level on the risk premium, α: 2.5% (implies an increase of 2.5 bps per 1 p.p. increase in debt-to-GDP ratio)  
  - Effect of debt change on the risk premium, α2: 0.5%  
  - Debt level at which the risk to lose market access is 50%, d: 150%  
  - Debt limit accuracy, d1: 3  
  - Effect of debt change on the risk to lose market access, d2: 1  
  - Effect of debt change on the risk to lose market access, d3: 0
- Economy and shock parameters:
  - Potential growth, long-term: 1.3%  
  - Population growth: -0.4%  
  - Real interest rate: 2.5%  
  - Shock persistence: 0.77  
  - Shock size: 0.032  
  - Hysteresis: 10%  
  - Hysteresis threshold: -1%
- Additional calibration notes:
  - The cumulative discount factor implied by interaction with GDP growth is 0.975.  
  - The risk-premium calibration (α = 2.5%) is in line with literature (Henao-Arbelaez and Sobrinho, 2017) and implies a 50 percent probability of losing market access at a debt-to-GDP ratio of 150 percent.

### Conclusion and policy message
- The Buffer-Stock model suggests the appropriate fiscal consolidation path for Portugal will critically depend on medium-term output dynamics and market risk appetite.  
- While debt is forecast to decline under the model’s baseline scenario in line with staff’s baseline projections, the model calls for more ambitious consolidation: an average increase in the structural primary balance of around 2.1 percentages points of potential GDP during 2024-2028 relative to 2022.  
- The recommended fiscal effort rises under adverse scenarios: higher long-term interest rates, lower medium-term growth, or greater market sensitivity to debt.

*Source: IMF Selected Issues Paper No. SIP/2023/045, "Optimal Fiscal Path Considerations (Portugal)" (completed June 1, 2023).*

---


_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2023/english/sipea2023045.pdf_