## _wp13238 - Introduction

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### Context and central question
- Recent increase in the ratio of public debt to GDP in advanced economies accompanied by assumption of banking sector liabilities by the public sector after the 2007 global crisis.
- Average contribution of financial-sector support to gross public debt: over 10 percent of GDP.
- Average contribution excluding Ireland: 6 percent of GDP.
- Banking-sector balance-sheet deterioration, accumulation of non-performing assets, funding pressures, and poor collateral quality have limited private sector access to credit and constrained output recovery.
- Fiscal consolidations have often failed to lower public debt-to-GDP ratios and can worsen budget positions under credit restrictions.
- Limited effectiveness of fiscal adjustment on interest rates due to perceived link between sovereign and financial sector credit risks; impaired monetary transmission because of financial sector dysfunction.
- Central question: How does fiscal adjustment affect medium-term output growth in the presence of credit conditions that typically follow financial crises? Focus on episodes of public debt reduction arising from discretionary fiscal adjustment, with emphasis on whether public debt was ultimately reduced.

### What explains the link between fiscal adjustment and growth?
- Measurement approaches:
  - “Traditional” approach: discretionary adjustments via changes in the cyclically-adjusted primary balance (CAPB).
  - “Narrative” approach: episodes based on budget plans and government announcements.
- Empirical patterns:
  - Traditional approach: some studies find output growth three years after consolidation.
  - Narrative approach: a 1 percent reduction in the fiscal deficit dampens output by 0.75 percent in the next two years (reported by Devries and others, 2011; Guajardo, Leigh, and Pescatori, 2011).
- Medium-term consensus:
  - If deficit cuts lower public debt, they can reduce uncertainty about debt sustainability and expected tax pressures, stimulating private investment and consumption via lower interest rates and higher labor force participation (IMF, 2012a).
  - Relationship is complex: higher public debt associated with more subdued growth; low growth can increase public debt ratios even with fiscal adjustment.
- Interaction with credit markets:
  - Financial markets generally value fiscal discipline; interest rates on long-term bonds fall when fiscal conditions improve.
  - Financial crises worsen fiscal positions and public debt; banking sector repair is often a pre-condition for successful consolidation.
  - Output and consumption multipliers are unusually high during financial distress.
  - Expansionary austerity is more difficult when interest rates are close to the zero-bound and/or when countries cannot devalue.
- Paper motivation: assess contribution of fiscal policy to medium-term economic growth during private debt deleveraging and credit constraints, and identify fiscal mixes most likely to improve output while reducing fiscal imbalances.

### Stylized framework of fiscal policy and growth during financial crises
- Framework elements:
  - Government collects taxes and provides transfers; households save to accumulate assets and consume out of wealth and income.
  - Increase in public debt above a risk-free threshold triggers higher interest rates via a non-zero credit risk premium, reducing output through lower investment and income.
  - Higher public debt indirectly reduces growth via required higher tax rates to meet the budget constraint.
- Fiscal consolidation channels:
  - Debt reduction can raise growth by reducing equilibrium tax rates and lowering the interest-rate risk premium.
  - Consolidation via tax increases: private consumption falls, capital stock declines, labor income and output fall.
  - Consolidation via cuts to government current expenditure: lower government consumption and transfers can reduce output, but debt reduction could lower risk premia and boost private investment.
- Role of fiscal composition and public capital:
  - In Keynesian view, expenditure cuts may be more harmful than tax increases because of higher fiscal multipliers of spending.
  - Reduction in public investment is more harmful than reduction in government consumption because it diminishes public capital and productivity.
  - Cuts in transfers are less damaging insofar as they affect the portion of disposable income that is not saved.
- Dependence on initial conditions:
  - Impact of spending cuts is less harmful when public debt is moderate and tax rates are low.
  - When adjustment needs are large and equilibrium tax rate is high, growth elasticity of expenditure cuts increases.
- Interaction with financial deleveraging:
  - In presence of private debt deleveraging and credit constraints, spending cuts can further lower output via adverse effects on capital accumulation.
  - Suggests preference for balanced fiscal adjustment (revenue increases plus savings) over expenditure-heavy consolidation when private debt deleveraging is present.

### Data and methodology
- Sample:
  - Starting sample: 160 episodes of public debt reduction in 107 advanced and emerging economies during 1980–2012.
  - Episodes defined as at least two consecutive years of reduction in public debt-to-GDP ratio.
  - Subsample for analysis: 79 episodes of public debt reduction through fiscal adjustment, average duration about 3.5 years.
- Data sources:
  - GDP growth and macro variables: IMF’s World Economic Outlook database.
  - Indicators of credit restrictions and bank recapitalization needs: IMF’s International Financial Statistics.
  - Budget composition: IMF’s Government Finance Statistics.
- Identification of discretionary fiscal adjustment:
  - Traditional approach based on change in CAPB.
  - Steps: select episodes with at least two consecutive years of debt reduction; require increases in CAPB of at least 0.5 percent of GDP per year sustained for two years or more during the episode; select episodes with at least one period of discretionary fiscal adjustment; average multiple adjustment periods when present.
  - Robustness tests for sensitivity to assumptions.
- Key sample statistics (selected, preserved exactly):
  - Average private investment ratio in sample: 4.1 percent of GDP.
  - During expenditure-based adjustments with credit restrictions, private investment ratio: 2.4 percent of GDP.
  - During revenue-based consolidations, private investment: 3.3.
  - Average debt reduction during episodes: 30 percentage points of GDP.
  - Alternative text present: 28.6 percentage points of GDP.
  - 45 percent of episodes reduced debt ratio below sustainable threshold.
  - Average increase in CAPB during episodes: 3.9 percent of GDP.
  - 53 percent of deficit reduction achieved through cuts in non-productive spending.
  - Annual real GDP growth averaged 3 percent in the five years after the end of the debt-reduction episode.
- Identification focus: empirically test how fiscal mix and credit conditions interact to affect medium-term output growth after public debt reduction episodes.

### Variables and definitions (selected)
- Domestic credit to private sector (percent of GDP): financial resources provided to the private sector through loans, purchases of nonequity securities, trade credits and other accounts receivable; for some countries includes credit to public enterprises.
- Bank recapitalization needs: change in the capital-to-assets ratio (ratio of bank capital and reserves to total assets, in percent); capital and reserves include funds contributed by owners, retained earnings, general and special reserves, provisions, and valuation adjustments.
- Debt distance variable: difference between public debt at the beginning of the episode and a target debt level of 60 percent of GDP in advanced economies and 40 percent of GDP in emerging economies.

### Control and fiscal variables (selected statistics preserved exactly)
- Control Variables (Obs.MeanStd. Dev.Min.Max.)
  - GDP growth (n+5) (percentage points) 532 2.9 2.2 -2.3 8.2
  - Initial distance from debt target (in percent of GDP) 371 28.6 19.1 2.4 67.1
  - Duration of debt consolidation (in years) 530 8.6 3.4 2 17
  - Duration of deficit cut (in years) 537 3.5 1.6 1 7
  - Size of deficit cut (in percent of GDP) 495 3.9 2.2 0.2 9.9
  - Size of debt cut (in percent of GDP) 536 30.7 26.6 0.5 120.1
  - Contemporaneous growth (in percent of GDP) 502 4.5 1.6 0.1 8.1
  - Quality of fiscal adjustment (in percent of total deficit reduction) 537 75.3 23.8 0 100
- Fiscal Variables (ObsMeanStd. Dev.MinMax) — values in percent of total revenues or total expenditures excluding outliers
  - Change in direct taxes 351 4.8 7.4 -8.8 12.1
  - Change in taxes on goods and services 330 2.6 9.6 -7.5 18.3
  - Change in transfers expenditures 396 2.4 9.1 -16 13.4
  - Change in wage expenditures 370 1.4 9.4 -14.5 14.3
  - Change in goods & services expenditures 369 2.7 7 -6 10.2
  - Change in public investment expenditures 384 3.6 8.1 -14.1 12.8

### Bivariate relationships (descriptive)
- After debt consolidation spells, economic growth negatively correlated with fiscal adjustment size.
- Post-episode growth positively associated with adjustment length and contemporaneous GDP growth.
- Post-episode growth weakly associated with quality of fiscal adjustment except in presence of credit constraints and bank deleveraging, where quality matters more.
- Quality of fiscal adjustments measured by contribution of cyclically adjusted current primary expenditures (in percent of GDP) to change in the fiscal deficit; variable between 0 and 1.

### Empirical model specification (growth regression)
- Dependent variable:
  - g_it = average growth rate of real GDP five years after the episode.
- Regressors:
  - CON_ilt: control variables (initial distance from sustainable debt target; average annual GDP growth during episode).
  - ADJ_iht: fiscal adjustment strategy variables (duration, size, quality of fiscal adjustment).
  - FIN_ijt: financial dummy variables (domestic credit growth and bank deleveraging measured by the capital-to-loans ratio).
  - BUD_int: budget composition variables (shares of direct and indirect tax revenues; shares of goods and services, transfers, and public investment in total spending).
- Interaction terms test nonlinear effects between fiscal mix and private sector credit / banking lending proclivity.
- Estimation: GLS estimator with robustness checks including robust standard errors and alternative estimators.

### Key empirical results (general)
- Focused public expenditure cuts that preserve public investment contribute positively to medium-term output growth.
- Gradually paced fiscal adjustments are positive for output expansion; large deficit cuts have contractionary effect.
- One more year in the length of the debt consolidation episode raises average economic growth by 0.22 percentage points in the subsequent five-year period.
- A 1 percent increase in contribution of cuts to fiscal adjustment increases medium-term growth by 0.32 percentage points.
- Spending-based adjustments support output growth except when there is sustained bank deleveraging or tight private sector credit conditions; interactions turn negative in those cases, offsetting benefits of expenditure cuts.
- Revenue-based adjustments can be more effective than expenditure-based adjustments at stimulating growth when banks shrink balance sheets and reduce private-sector financing.

### Regression results (selected coefficients preserved exactly)
- Table 2 (Basic Model) — Five-Year Output Growth
  - Duration of debt consolidation: 0.228***, 0.287***, 0.330***, 0.175**, 0.272***, 0.455***.
  - Size of deficit cut: -0.276***, -0.267***, -0.278***, -0.282***, -0.300***, -0.310***.
  - Quality of fiscal adjustment: 0.0329**, 0.344***, 0.0295***, 0.0298***, 0.0384***, 0.0428***.
  - Quality* Credit constraints: -0.0342***, -0.0249***, -0.0214***.
  - Quality * Bank deleveraging: -0.0241***, -0.0193***, -0.0165***.
  - Quality * G&S Index: -0.384*** (reduced sample).
  - Number of observations: 330, 288, 330, 245, 245, 249; R-squared: 0.299, 0.334, 0.411, 0.406, 0.484, 0.327.
- Table 3 (Augmented Model) — Five-Year Output Growth
  - Duration of deficit cut: 0.286***, 0.306***, 0.232***, 0.266***, 0.187**, 0.257***.
  - Size of consolidation: -0.279***, -0.276***, -0.295***, -0.322***, -0.191***, -0.290***.
  - Quality of fiscal adjustment: 0.0340***, 0.0337***, 0.0390***, 0.0396***, 0.0315***, 0.0462***.
  - Quality* Credit constraints: -0.0264***, -0.0288***, -0.0295***, -0.0299***, -0.0334***, -0.0307***.
  - Quality * Bank deleveraging: -0.0145**, -0.0111***, -0.0147**, -0.0112***, -0.0144**, -0.0182***.
  - Policy composition effects (selected):
    - Change in direct taxes (in percent of total revenues): 0.0366***.
    - Change in taxes on goods and services: -0.0298 (insignificant in reported model).
    - Change in wage expenditures: -0.0756***.
    - Change in transfers expenditures: 0.104***.
    - Change in public investment expenditures: 0.0454**.
  - Number of observations: 245, 245, 240, 240, 190, 212; R-squared: 0.503, 0.488, 0.485, 0.497, 0.433, 0.508.

### Subsample findings (selected)
- High unemployment:
  - Gradual consolidations less clearly associated with stronger growth; spending cuts more harmful, negative impact persists even without credit constraints.
- High-tax countries:
  - High initial public debt more harmful for post-episode growth than baseline.
  - Example: Initial distance from debt target coefficients include -0.0119**, -0.0250***, -0.0101**, -0.0104**, -0.0321***, -0.0176***.
- Non-major debt reductions:
  - Negative impact of expenditure-based adjustments in presence of credit constraints weaker than baseline but still significant.
- Post-crisis episodes:
  - Negative growth impact of spending cuts during high deleveraging and credit crunch stronger than baseline (e.g., Quality* Credit constraints: -0.493***, -0.437***, -0.394***, -0.315***, -0.306***, -0.396***).
- High credit constraints:
  - Excessive spending cuts when credit restrictions significant harm growth; coefficients larger than baseline (e.g., Size of deficit cut: -0.354***, -0.397***, -0.335***, -0.350***, -0.180**, -0.357***; Quality* Credit constraints: -0.0357*** ... -0.0393***).
- Structural reform episodes:
  - Composition of fiscal adjustment less important than baseline, but public investment increases have reinforced growth-enhancing impact.
- Enlarged sample of 160 episodes:
  - Key results largely hold; positive contribution of spending-based adjustment weaker; countries with high initial debt benefit from lower growth than baseline.
- Advanced countries and open economies:
  - Advanced economies: negative effect of weak credit conditions on medium-term growth higher than baseline.
  - Open economies: importance of quality variable and other fiscal variables reduced.

### Robustness and estimation checks
- Results robust to:
  - Alternative estimation methods including robust standard errors.
  - Dropping outliers and using robust regression.
  - Random effects and OLS with panel-corrected standard errors.
  - Changing dependent variable to average output growth three years after the episode.
  - Excluding contemporaneous GDP growth control from baseline model (results unchanged).
  - Interaction of quality variable with Goldman Sachs’ Financial Conditions Index confirms main results for reduced sample.

### Policy implications and recommendations
- Gradual and adequately balanced fiscal adjustments are generally more appropriate to spur medium-term economic growth than deficit reductions driven solely by spending cuts when financial constraints exist.
- When bank deleveraging is high and private credit is scarce:
  - Public debt consolidations should be gradual and based on a combination of revenue and expenditure measures rather than spending cuts alone.
  - Fiscal mix should cut non-priority spending and protect pro-growth public investment.
- Revenue-raising measures:
  - Aim to reduce inefficiencies and encourage labor market participation and consumption.
  - Suggested directions: remove tax exemptions, lower incentives for tax avoidance and evasion, shift tax pressure away from labor to property and low-elasticity consumer goods and services.
- Structural reforms:
  - Enhance competitiveness in product and labor markets and strengthen fiscal institutions to support consolidation and limit “adjustment fatigue.”
- Priority: protect public investment during adjustment and continue funding critical infrastructure to raise productivity and potential output.

### Concluding remarks
- Both size and pace of fiscal adjustment matter for medium-term output growth.
- In environments with high private debt and subdued lending:
  - Fiscal mix is critical for post-episode output expansion.
  - Spending cuts may reduce aggregate demand and exacerbate real debt pressures via price deflation.
  - Protecting public investment and broadening direct tax base can support medium-term growth.
- Combination of bank deleveraging and public debt consolidation may weaken growth benefits of fiscal mixes that work under normal credit conditions.

### Appendix I — A Simple Framework (model highlights and comparative statics)
- Model setup:
  - Closed-economy output: Yt = Ct + Gt + It.
  - Taxes proportional to labor income YL with tax rate t: Tt = t YLt  (5).
  - Labor income YL assumed exogenous.
- Government budget and debt dynamics:
  - Gt - Tt = Bt  (2).
  - Bt = (PBt + r Dt-1)  (3) where r is effective interest rate and PB is primary balance.
  - Dt+1 = -PBt + (1 + r) Dt  (4).
  - Credit risk spread R = max[0, e(D - D*)]  (9); elasticity e noted as 0.02 in advanced economies (Poghosyan, 2012).
- Behavioral and asset equations:
  - Ct = c (1 - t) YLt + v At  (6).
  - It = (1 - c) (1 - t) YLt  (7).
  - At+1 = It + r At + (1 - d) At - s At  (8), with s capturing deleveraging.
- Steady-state relations (selected):
  - (t YL - PG) / r = D  (10).
  - Y = c (1/t) r D + c (1/t) PG + (v + h) A  (15) where h = (s + d - r).
- Partial derivatives and interpretations (preserved exactly):
  - dY/dPG = c / t  > 0  (16).
  - dY/dt = -c (r D + PG) t^-2  < 0  (17).
  - dY/dA = v + h  > 0 if s + d + v > r  (18).
  - dY/dr = (1/t) c D - A  < 0  (19).
  - dY/ds = -A  < 0  (20).
  - dA/dt = -(1/h) (1 - c) YL  < 0  (21).
- Policy mechanisms highlighted:
  - Fiscal consolidation (higher t or lower PG) reduces after-tax income and government consumption, lowering output.
  - Higher interest rates r (including credit risk premium when D > D*) make debt reduction harder and negatively affect output.
  - Bank deleveraging s reduces asset stock A and thus output; higher taxes exacerbate deleveraging effects via reduced asset accumulation.
  - Fiscal multipliers are cycle-dependent and influenced by financial sector conditions.

*Source: IMF working paper content unit "_wp13238 - Introduction" (excerpts provided).*

### Introduction ...........................................................................................................

### _wp13238 - Introduction ...........................................................................................................

### Introduction: context and central question
- Recent increase in the ratio of public debt to GDP in advanced economies accompanied by assumption of banking sector liabilities by the public sector following the inception of the global crisis in 2007.
- The average contribution of financial-sector support to gross public debt has been over 10 percent of GDP.
- It is 6 percent if Ireland is excluded from the calculations.
- Banking-sector balance-sheet deterioration, accumulation of non-performing assets, funding pressures, and poor collateral quality have hampered private sector access to credit, limiting output recovery.
- Under these conditions, fiscal consolidations have often failed to lower public debt-to-GDP ratios, and deficit-reducing measures in the presence of credit restrictions have worsened budget positions without being offset by substantial increases in private activity.
- Limited effectiveness of fiscal adjustment on interest rates due to perceived link between sovereign and financial sector credit risks, and impaired monetary transmission because of financial sector dysfunction.

- Central question of the paper:
  - How does fiscal adjustment affect medium-term output growth in the presence of credit conditions that typically follow financial crises?
  - Focus: episodes of public debt reduction arising from discretionary fiscal adjustment, with emphasis on whether public debt was ultimately reduced.

### I. What explains the link between fiscal adjustment and growth?
- Measurement issue:
  - “Traditional” approach: identifies discretionary adjustments via changes in the cyclically-adjusted primary balance (CAPB).
  - “Narrative” approach: identifies episodes based on budget plans and government announcements.
  - Different identification methods yield different empirical results (examples: Alesina and Perotti, 1996; Perotti, 1999; Alesina and Ardagna, 2010 vs. Devries and others, 2011; Guajardo, Leigh, and Pescatori, 2011).
- Empirical patterns:
  - Some studies find output growth three years after consolidation under the traditional approach.
  - Narrative approach finds a 1 percent reduction in the fiscal deficit dampens output by 0.75 percent in the next two years (as reported by Devries and others, 2011; Guajardo, Leigh, and Pescatori, 2011).
- Medium-term consensus:
  - If deficit cuts lower public debt, they can reduce uncertainty about debt sustainability and expected tax pressures, stimulating private investment and consumption via lower interest rates and higher labor force participation (IMF, 2012a).
  - Relationship is complex: higher public debt associated with more subdued growth (Reinhart, Kenneth, and Rogoff, 2010); low growth can increase public debt ratios even with fiscal adjustment (Herndon, Ash, and Pollin, 2013).
- Interaction with credit markets:
  - Credit shortages and impaired financial channels damage growth; spillovers from financial sector to sovereign debt markets affect debt sustainability.
  - Literature groups:
    - Financial markets generally value fiscal discipline; interest rates on long-term bonds fall when fiscal conditions improve (Ardagna, 2004; Alesina and Ardagna, 2010; Cottarelli and Jaramillo, 2012).
    - Financial crises worsen fiscal positions and public debt (Reinhart and Rogoff, 2009; Laeven and Valencia, 2008; 2012); banking sector repair is often a pre-condition for successful consolidation (Barrios and others, 2010).
    - Interaction of crises, fiscal multipliers, and growth: expansionary fiscal policy can shorten recessions after financial crises; expenditure-based consolidations more likely to reduce public debt but their expansionary effects can dissipate when public debt is large and new revenues are needed (Baldacci, Gupta, and Mulas-Granados, 2009; 2010; 2012; IMF, 2012b).
  - Output and consumption multipliers are unusually high during financial distress (Afonso, Grüner, and Kolerus, 2010; Corsetti, Meier, and Mueller, 2012).
  - Expansionary austerity is more difficult when interest rates are close to the zero-bound and/or when countries cannot devaluate (Cottarelli and Jaramillo, 2012; Baum and others, 2012; Guajardo and others, 2012; IMF, 2012b; Blanchard and Leigh, 2013; IMF, 2013).
- Motivation of the paper:
  - Assess contribution of fiscal policy to medium-term economic growth in the context of private debt deleveraging and credit constraints typical after financial crises.
  - Focus on fiscal mix most likely to improve output while reducing fiscal imbalances.

### II. A stylized framework of fiscal policy and growth during financial crises
- Framework elements:
  - Government collects taxes and provides transfers; households save to accumulate assets and consume out of wealth and income.
  - Increase in public debt above a risk-free threshold triggers higher interest rates via a non-zero credit risk premium, reducing output through lower investment and income.
  - Higher public debt indirectly reduces growth via required higher tax rates to meet the budget constraint.
- Fiscal consolidation channels:
  - Debt reduction can raise growth by reducing equilibrium tax rates and lowering the interest-rate risk premium (consistent with expansionary fiscal contraction).
  - If consolidation is achieved by increasing taxes: private consumption falls, capital stock declines, labor income and output fall.
  - If consolidation is achieved by cutting government current expenditure: output can fall via lower government consumption and transfers; but debt reduction could lower risk premia and boost private investment.
- Role of fiscal composition and public capital:
  - In a Keynesian view, expenditure cuts may be more harmful than tax increases because of higher fiscal multipliers of spending.
  - Reduction in public investment is more harmful than reduction in government consumption because it diminishes public capital and productivity.
  - Cuts in transfers are less damaging insofar as they affect the portion of disposable income that is not saved.
- Dependence on initial conditions:
  - Impact of spending cuts is less harmful when public debt is moderate and tax rates are low.
  - When adjustment needs are large and the equilibrium tax rate is high, the growth elasticity of expenditure cuts increases.
- Interaction with financial deleveraging:
  - In the presence of private debt deleveraging and credit constraints, spending cuts can further lower output through their adverse effect on capital accumulation.
  - This suggests a more balanced fiscal adjustment (revenue increases plus savings) is preferable to expenditure-heavy consolidation in contexts of private debt deleveraging, to limit negative impacts on total investment and capital accumulation.

### III. Data and methodology
- Sample construction:
  - Starting sample: 160 episodes of public debt reduction in 107 advanced and emerging economies during 1980–2012.
  - Episodes defined as at least two consecutive years of reduction in public debt-to-GDP ratio.
  - In the subsample, the key factor behind debt reduction was improvement in CAPB.
  - Excluded countries that benefited from debt relief and selected public debt reduction spells in which a discretionary fiscal adjustment had taken place.
  - Resulting subsample: 79 episodes of public debt reduction through fiscal adjustment, with an average duration of about 3.5 years (Table 1).
- Variables and data sources:
  - (i) GDP growth and other macro variables from IMF’s World Economic Outlook database;
  - (ii) indicators measuring credit restrictions faced by the private sector and bank recapitalization needs from IMF’s International Financial Statistics;
  - (iii) budget composition data from IMF’s Government Finance Statistics.
- Identification of discretionary fiscal adjustment (methodology):
  - Followed the traditional approach based on change in CAPB to identify episodes of discretionary fiscal adjustment.
  - Steps:
    - Select episodes with at least two consecutive years of public debt reduction.
    - Look for spells with increases in the CAPB of at least 0.5 percent of GDP per year, sustained for two years or more during the debt reduction episode.
    - Only episodes of public debt reduction with at least one period of discretionary fiscal adjustment within that period were selected.
    - If more than two fiscal adjustment periods occurred during a public debt reduction spell, average values for fiscal adjustment variables were used.
  - Robustness tests include sensitivity to these assumptions.
- Key sample statistics (selected):
  - Average private investment ratio in sample: 4.1 percent of GDP.
  - During episodes of expenditure-based adjustments in the presence of credit restrictions, the private investment ratio goes down to 2.4 percent of GDP.
  - During episodes of revenue-based consolidations, private investment remains at 3.3.
- Analytical focus:
  - Empirically test hypotheses about how fiscal mix and credit conditions interact to affect medium-term output growth following public debt reduction episodes.

*Source: IMF working paper content unit "_wp13238 - Introduction" (excerpts provided).*

### 28.6 percentage points of GDP. The average debt reduction during the episodes amounted to

### _wp13238 - 28.6 percentage points of GDP. The average debt reduction during the episodes amounted to

### Summary of episode statistics and outcomes
- The average debt reduction during the episodes amounted to 30 percentage points of GDP.
- 28.6 percentage points of GDP. (text present in source)
- In 45 percent of the episodes, the debt ratio was reduced to levels below the sustainable threshold.
- During the debt reduction episodes:
  - The average increase in CAPB was 3.9 percent of GDP.
  - 53 percent of deficit reduction was achieved through cuts in non-productive spending.
  - Annual real GDP growth averaged 3 percent in the five years after the end of the debt-reduction episode.

### Data variables and definitions (selected)
- Domestic credit to private sector (percent of GDP): financial resources provided to the private sector through loans, purchases of nonequity securities, trade credits and other accounts receivable; for some countries, includes credit to public enterprises.
- Bank recapitalization needs: change in the capital-to-assets ratio (ratio of bank capital and reserves to total assets, in percent). Capital and reserves include funds contributed by owners, retained earnings, general and special reserves, provisions, and valuation adjustments. Total assets include all nonfinancial and financial assets.
- Debt distance variable: difference between public debt at the beginning of the episode and a target debt level of 60 percent of GDP in advanced economies and 40 percent of GDP in emerging economies.

### Control and fiscal variables (selected statistics preserved exactly)
- Control Variables (Obs.MeanStd. Dev.Min.Max.)
  - GDP growth (n+5) (percentage points) 532 2.9 2.2 -2.3 8.2
  - Initial distance from debt target (in percent of GDP) 371 28.6 19.1 2.4 67.1
  - Duration of debt consolidation (in years) 530 8.6 3.4 2 17
  - Duration of deficit cut (in years) 537 3.5 1.6 1 7
  - Size of deficit cut (in percent of GDP) 495 3.9 2.2 0.2 9.9
  - Size of debt cut (in percent of GDP) 536 30.7 26.6 0.5 120.1
  - Contemporaneous growth (in percent of GDP) 502 4.5 1.6 0.1 8.1
  - Quality of fiscal adjustment (in percent of total deficit reduction) 537 75.3 23.8 0 100
- Fiscal Variables (ObsMeanStd. Dev.MinMax) — values in percent of total revenues or total expenditures excluding outliers
  - Change in direct taxes 351 4.8 7.4 -8.8 12.1
  - Change in taxes on goods and services 330 2.6 9.6 -7.5 18.3
  - Change in transfers expenditures 396 2.4 9.1 -16 13.4
  - Change in wage expenditures 370 1.4 9.4 -14.5 14.3
  - Change in goods & services expenditures 369 2.7 7 -6 10.2
  - Change in public investment expenditures 384 3.6 8.1 -14.1 12.8

### Bivariate relationships and figures (descriptive findings)
- Preliminary (bivariate) analysis indicates:
  - After debt consolidation spells, economic growth was negatively correlated with the fiscal adjustment size (Figure 1).
  - Post-episode growth was positively associated with the adjustment length (Figure 2) and contemporaneous GDP growth (Figure 3).
  - Post-episode economic growth is weakly associated with the quality of the fiscal adjustment (Figure 4), except in the presence of credit constraints (Figure 5) and bank deleveraging (Figure 6).
- Quality of fiscal adjustments is measured by the contribution of cyclically adjusted current primary expenditures (in percent of GDP) to the change in the fiscal deficit; this variable takes values between 0 and 1.

### Empirical model specification (growth regression)
- Dependent variable:
  - g_it = average growth rate of real GDP five years after the episode of debt consolidation.
- Regressors include:
  - CON_ilt: control variables (initial distance from the “sustainable” debt target; average annual GDP growth during the episode).
  - ADJ_iht: fiscal adjustment strategy variables (duration, size, and quality of the fiscal adjustment(s) during the episode).
  - FIN_ijt: financial dummy variables (domestic credit growth and bank deleveraging measured by the capital-to-loans ratio).
  - BUD_int: budget composition variables (share of direct and indirect tax revenues in total public revenues; share of expenditures on goods and services in total public spending; share of transfers in total public spending; share of public investment in total public spending).
- Interaction terms:
  - The model includes interactions between the fiscal consolidation mix and private sector credit and banking sector lending proclivity to test nonlinear effects: expecting that weak credit conditions make spending-cut-based adjustments less effective than more balanced revenue and expenditure measures.
- Estimation:
  - Model estimated in steps from basic to augmented versions.
  - Coefficients estimated using a GLS estimator; robust estimator results and robustness tests reported in the next section (in source).

### Key empirical results (general)
- Fiscal adjustments relying on focused public expenditure cuts that preserve public investment contribute positively to medium-term output growth.
- During debt reduction episodes:
  - Gradually paced fiscal adjustments are positive for output expansion.
  - Large deficit cuts have a contractionary effect.

*Source: _wp13238 (excerpt).*

### 0.27 percentage points. However, one more year in the length of the debt consolidation

### _wp13238 - 0.27 percentage points. However, one more year in the length of the debt consolidation

### Key empirical findings on fiscal consolidation and medium-term growth
- One more year in the length of the debt consolidation episode raises average economic growth by 0.22 percentage points in the subsequent five-year period.
- Initial public debt is not a significant impediment for future growth in the baseline statement; however, in some subsamples high initial debt is associated with lower post-episode growth (see subsamples).
- A 1 percent increase in contribution of cuts to fiscal adjustment increases medium-term growth by 0.32 percentage points.
- Spending-based adjustments support output growth after the debt consolidation episode except when there is:
  - sustained bank deleveraging, or
  - tight private sector credit conditions.
- Under sustained bank deleveraging or scarce private sector credit supply, the coefficients of interacted variables (Quality*Bank deleveraging; Quality*Credit constraints) turn negative and are larger than the quality-of-adjustment coefficient, offsetting benefits of expenditure cuts.
- Revenue-based adjustments can be more effective than expenditure-based adjustments at stimulating growth when banks shrink balance sheets and reduce private-sector financing.

### Regression results and key coefficients (Basic and Augmented Models)
- Table 2 (Basic Model) — Dependent variable: Five-Year Output Growth (selected coefficients reported across models)
  - Duration of debt consolidation: coefficients include 0.228***, 0.287***, 0.330***, 0.175**, 0.272***, 0.455***.
  - Size of deficit cut: coefficients include -0.276***, -0.267***, -0.278***, -0.282***, -0.300***, -0.310***.
  - Quality of fiscal adjustment: coefficients include 0.0329**, 0.344***, 0.0295***, 0.0298***, 0.0384***, 0.0428***.
  - Quality* Credit constraints (interaction): -0.0342***, -0.0249***, -0.0214***.
  - Quality * Bank deleveraging (interaction): -0.0241***, -0.0193***, -0.0165***.
  - Quality * G&S Index (Goldman Sachs Index on Financial Conditions): -0.384*** (noted for reduced sample).
  - Number of observations and model fit examples: Number of obs. 330, 288, 330, 245, 245, 249; R-squared 0.299, 0.334, 0.411, 0.406, 0.484, 0.327.

- Table 3 (Augmented Model) — Dependent variable: Five-Year Output Growth (selected coefficients reported across models)
  - Duration of deficit cut: 0.286***, 0.306***, 0.232***, 0.266***, 0.187**, 0.257***.
  - Size of consolidation: -0.279***, -0.276***, -0.295***, -0.322***, -0.191***, -0.290***.
  - Quality of fiscal adjustment: 0.0340***, 0.0337***, 0.0390***, 0.0396***, 0.0315***, 0.0462***.
  - Quality* Credit constraints: -0.0264***, -0.0288***, -0.0295***, -0.0299***, -0.0334***, -0.0307***.
  - Quality * Bank deleveraging: -0.0145**, -0.0111***, -0.0147**, -0.0112***, -0.0144**, -0.0182***.
  - Policy composition effects (selected):
    - Change in direct taxes (in percent of total revenues): 0.0366*** (Model reporting).
    - Change in taxes on goods and services: -0.0298 (insignificant in reported model).
    - Change in wage expenditures: -0.0756***.
    - Change in transfers expenditures: 0.104***.
    - Change in public investment expenditures: 0.0454**.
  - Number of obs. and fit: Number of obs. 245, 245, 240, 240, 190, 212; R-squared 0.503, 0.488, 0.485, 0.497, 0.433, 0.508.

### Expenditure and revenue composition effects
- Tax composition:
  - An increase in the share of direct taxes in total revenue affects output growth positively.
  - Increasing the share of indirect taxes during debt consolidation episodes is generally insignificant for subsequent output growth.
- Expenditure composition:
  - Higher spending (as a share of total expenditure) on public investment and transfers spurs output growth.
  - Increasing the weight of spending on wages and purchases of goods and services is harmful for output expansion.
  - Protecting public investment during adjustment periods and continuing funds for critical infrastructure investment is essential for raising productivity and potential output.

### Robustness checks and estimation methods
- Results are robust to:
  - Alternative estimation methods, including robust standard errors.
  - Dropping potential outliers and using robust regression.
  - Random effects and OLS with panel-corrected standard errors.
  - Changing dependent variable to average output growth three years after the episode.
  - Excluding the contemporaneous GDP growth control from baseline model (results unchanged).
- Interacting the quality variable with Goldman Sachs’ Financial Conditions Index confirms main results for reduced sample (data availability constraints noted).

### Subsample analyses — key variations in findings
- High unemployment (Table 4)
  - Gradual (longer) debt consolidations are less clearly associated with stronger growth performance; evidence of reform fatigue.
  - Spending cuts are more harmful for growth relative to baseline; negative impact persists even without credit constraints.
  - Example coefficients: Duration of consolidation around 0.307*, 0.328**, 0.307**, 0.428*, 0.465*, 0.418*; Quality* Credit constraints: -0.0610* ... -0.0502*.

- High-tax countries (Table 5)
  - Starting with a high level of public debt is more harmful for post-episode growth than in baseline.
  - Example coefficients: Initial distance from debt target -0.0119**, -0.0250***, -0.0101**, -0.0104**, -0.0321***, -0.0176***.

- Countries that did not reduce debt (Non-major Debt Reductions, Table 6)
  - Negative impact of expenditure-based adjustments in presence of credit constraints is weaker than baseline but still significant.
  - Example: Quality* Credit constraints around -0.0282*** ... -0.0253***.

- Post-crisis episodes (Table 7)
  - Negative growth impact of spending cuts during periods of high deleveraging and credit crunch is stronger than baseline.
  - Example: Quality* Credit constraints: -0.493***, -0.437***, -0.394***, -0.315***, -0.306***, -0.396***.

- High credit constraints (Table 8)
  - Fiscal adjustments relying excessively on spending cuts when credit restrictions are significant can harm growth; coefficients of key variables larger than in baseline.
  - Example: Size of deficit cut: -0.354***, -0.397***, -0.335***, -0.350***, -0.180**, -0.357***; Quality* Credit constraints: -0.0357*** ... -0.0393***.

- Structural reform episodes (Table 9)
  - Composition of fiscal adjustment is less important for post-episode output growth than baseline, but growth-enhancing impact of public investment increases is reinforced.

- Enlarged sample of 160 episodes (Table 10)
  - Key results largely hold; positive contribution of spending-based adjustment is weaker; countries with high initial debt benefit from lower growth than baseline.

- Advanced countries, open economies (Tables 11–12)
  - Advanced economies: negative effect of weak credit conditions on medium-term growth is higher than before in advanced-country subsample.
  - Open economies: the importance of the quality variable and other fiscal variables is reduced, reflecting greater influence of external conditions.

### Policy implications and recommendations
- Gradual and adequately balanced fiscal adjustments are generally more appropriate to spur medium-term economic growth than deficit reductions driven solely by spending cuts when financial constraints exist.
- When bank deleveraging is high and private credit is scarce:
  - Public debt consolidations should be gradual and based on a combination of revenue and expenditure measures rather than spending cuts alone.
  - Fiscal mix should rely on cutting non-priority spending and protecting pro-growth public investment.
- Revenue-raising measures:
  - Should aim at reducing inefficiencies and encouraging labor market participation and consumption.
  - Suggested tax policy directions include removing tax exemptions, lowering incentives for tax avoidance and evasion, and shifting tax pressure away from labor to property and low-elasticity consumer goods and services.
- Structural reforms:
  - Reforms to enhance competitiveness in product and labor markets and strengthen fiscal institutions can help support debt consolidation strategies over time and limit the risk of “adjustment fatigue.”
- Priority: Protect public investment during adjustment periods and continue funding critical infrastructure to raise productivity and potential output.

### Concluding remarks
- Both the size and pace of fiscal adjustment matter for medium-term output growth.
- In environments where private debt remains high and lending to the private sector is subdued:
  - The fiscal mix is critical for post-episode output expansion.
  - Spending cuts may reduce aggregate demand and exacerbate real debt pressures via price deflation.
  - Protecting public investment can support medium-term output growth.
  - Revenue increases that broaden the direct tax base can be beneficial for medium-term growth.
- The combination of bank deleveraging and public debt consolidation may alter agents’ assessment of government policy effects, weakening the growth benefits of fiscal mixes that would work under normal credit conditions.

*Source: _wp13238 - 0.27 percentage points. However, one more year in the length of the debt consolidation*

### Appendix I. A Simple Framework

### Appendix I. A Simple Framework

### Model setup
- Output Y is defined as Yt = Ct + Gt + It + (Xt - Mt), and the economy is assumed closed (drop (X-M)) so Yt = Ct + Gt + It.
- Taxes are proportional to labor income YL with tax rate t:
  - Tt = t YLt  (5)
- Labor income YL is assumed exogenous.

### Government budget and debt dynamics
- Each year excess government spending over taxes is financed by borrowing:
  - Gt - Tt = Bt  (2)
- Government budget rewritten:
  - Bt = (PBt + r Dt-1)  (3)
  - where r is the effective interest rate on public debt and PB is the primary balance T - (G - rD), with primary spending PG = (G - rD).
- Public debt dynamics:
  - Dt+1 = -PBt + (1 + r) Dt  (4)
- Credit risk spread R depends on public debt relative to a risk-less threshold D* with long-run elasticity e:
  - R = max[0, e(D - D*)]  (9)
  - Note: In Poghosyan (2012) this elasticity takes a value of 0.02 in advanced economies.

### Behavioral equations and asset dynamics
- Private consumption and investment:
  - Ct = c (1 - t) YLt + v At  (6)
  - It = (1 - c) (1 - t) YLt  (7)
- Asset stock motion equation (takes into account new investment, initial capital, depreciation d, and deleveraging s):
  - At+1 = It + r At + (1 - d) At - s At  (8)
- Interpretation:
  - v At captures returns on accumulated assets affecting consumption.
  - s At accounts for deleveraging in the banking sector reducing private capital and affecting consumption via lower return on assets and reduced credit provision.

### Steady-state conditions (for comparative statics)
- With I = (s + d - r) A, steady-state conditions are:
  - (t YL - PG) / r = D  (10)
  - C = c (1 - t) YL + v A  (11)
  - I = (1 - c) (1 - t) YL  (12)
  - A = (1/h) (1 - c) (1 - t) YL  (13)
  - Y = c (1 - t) YL + v A + G + h A  (14)
- Substituting YL = (1/t) (r D + PG) into the output equation:
  - Y = c (1/t) r D + c (1/t) PG + (v + h) A  (15)
  - where h = (s + d - r).
- Note: Fiscal savings are necessary for debt reduction but higher interest rates make adjustment more difficult; fiscal consolidation reduces after-tax income and government consumption directly affects output.

### Partial derivatives and fiscal multipliers
- Fiscal multipliers and output responses depend on propensity to consume c, inverse of the tax rate 1/t, public debt D, interest rate r (which depends on credit risk premia and debt), and primary spending PG.
- Partial derivatives presented:
  - dY/dPG = c / t  > 0  (16)
  - dY/dt = -c (r D + PG) t^-2  < 0  (17)
  - dY/dA = v + h  > 0 if s + d + v > r  (18)
  - dY/dr = (1/t) c D - A  < 0  (19)
  - dY/ds = -A  < 0  (20)
  - dA/dt = -(1/h) (1 - c) YL  < 0  (21)
- Interpretations:
  - dY/dPG shows positive output effect from higher primary spending PG scaled by c/t.
  - dY/dt shows negative output effect from higher tax rate, proportional to c and (r D + PG), scaled by t^-2.
  - dY/dA positive if (s + d + v) > r; asset accumulation raises output when returns and net accumulation exceed the interest rate.
  - dY/dr negative; higher interest rates reduce output in proportion to c, 1/t, D, and the asset stock A.
  - dY/ds negative; increased bank deleveraging reduces output proportionally to A.
  - dA/dt negative; higher taxes reduce the stock of capital, especially when propensity to save and credit risk premia are high.

### Policy implications and mechanisms highlighted
- Fiscal consolidation (higher t or lower PG) reduces after-tax income and government consumption, thereby lowering output.
- Higher interest rates r (including credit risk premium R when D > D*) make debt reduction harder and negatively affect output.
- Bank deleveraging (s) reduces asset stock A and thus output; higher taxes exacerbate the negative impact of deleveraging through reduced asset accumulation (dA/dt < 0).
- The size of fiscal multipliers is cycle-dependent and influenced by financial sector conditions; empirically the size of multipliers varies with the state of the economy.

*Source: Appendix I. A Simple Framework, _wp13238 - Appendix I. A Simple Framework*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13238.pdf_