Fiscal Balance

Understanding Fiscal Balances

The fiscal (or budgetary) balance, also called financial balance or net government lending, is the difference between income and expenditure.

There is a fiscal (or budget) surplus when the balance is positive and a fiscal (or budget) deficit when the balance is negative.

The primary spending concept translates into a primary balance concept, to which we will discuss in next entry because it is useful for determining the dynamics of public debt Opens in new window:

Financial balance (net lending) = primary balance – interest payments on the debt

chiasmus diagram showing abba pattern Figure I Financial and primary balance in percentage of gross domestic product (GDP), Italy, 1960 – 2016.
Authors’ calculations with OECD data.

Figure I displays the evolution since 1960 of the financial balance and the primary balance for Italy, a country that has, for a quarter-century, struggled with public debt at or above 100% of GDP.

It is apparent that the difference between the two concepts (corresponding to interest payments, represented as bars on the graph) was insignificant in the 1960s and the early 1970s, a period when both public debt ratios and interest rates were low.

The gap then gained in importance as a consequence of both high interest rates and recurrent deficits leading up to public debt Opens in new window increases.

  • Primary surpluses only returned in the 1990s, as a consequence of fiscal consolidation and a stronger macroeconomic environment.
  • The peak was reached in 1997, when Italy qualified for the euro by reducing its deficit to 3% of GDP.
  • Interestingly, interest payments also decreased markedly in the second half of the 1990s, again because of both lower interest rates and somewhat lower debt levels.
Fiscal balances tend to rise when economic activity is buoyant and to decline when it is depressed.

This is because tax receipts fluctuate in line with economic activity (for instance, value-added tax [VAT] revenues depend on household consumption and corporate income tax receipts on corporate profits), whereas public spending does not vary accordingly, or, for specific items such as unemployment Opens in new window benefits or transfers, rises in economic downturns.

This spontaneous variation of the fiscal balance has a stabilizing effect on aggregate demand Opens in new window and the private sectors’ net income (hence the notion of automatic stabilizers). For this reason, countries with larger governments tend to exhibit more aggregate macroeconomic stability.

In order to capture changes in fiscal policy Opens in new window, it is useful to calculate a cyclically adjusted balance that measures what the financial balance should be, would output be at its potential level.

The change in the cyclically adjusted balance from one period to next is traditionally regarded as providing a measure of the fiscal impulse or fiscal stance because, in contrast to changes resulting from the automatic stabilizers, it is supposed to result from discretionary fiscal policy decisions.

The evolution of the financial balance can thus be decomposed into a cyclical component and a discretionary component, equal to the variation of the cyclically adjusted balance:

Financial balance (net lending) = cyclical balance + cyclically-adjusted balance

The cyclically adjusted balance is often also called the structural balance. In the EU fiscal framework, however, there is a slight difference between the two concepts: the structural balance is also purged from one-off receipts or expenditures, such as proceeds from asset sales or bank recapitalizations:

Structural balance = cyclically-adjusted balance – one-off net receipts

The same decomposition applies to the primary balance, which can therefore be split into a cyclical component and the structural primary balance, also called the cyclically adjusted primary balance (CAPB):

Primary balance = cyclical primary balance + CAPB

A decomposition of the primary budget balance into the structural and cyclical primary balances indicates that the latter accounts for a large part of the short-term fluctuation. Over the longer term, however, variations of the structural balance are key.

The structural deficit is the main indicator used by international organizations such as the IMF Opens in new window, the Organization for Economic Cooperation and Development (OECD) Opens in new window and the European Commission Opens in new window to monitor budgetary developments and formulate policy recommendations. However, it is not directly observable, and its measurement raises a host of technical difficulties.

Two major pitfalls are, first, that the output gap is not measured with accuracy and, second, the instability of the estimated sensitivity of government expenditures and receipts to the level of economic activity.

As a consequence, estimates of the structural balance vary across institutions and are subject to significant revisions. A particularly striking case is that of Ireland in 2007: it was initially assessed by the European Commission to be in safe structural surplus territory, yet successive revisions led to a reversal of the initial assessment.

Another problem is that whereas the change from one year to the next in the cyclically adjusted balance is meant to represent discretionary policy actions, it often does not match estimates based on actual tax and spending decisions, with the difference being sometimes wide.

The concept of structural balance is therefore both an important one for policy discussions and a far from reliable one for policy decisions. Its use for budgetary surveillance is a cause for concern and a potential matter for disputes.

For 10 years, between 2005 and 2015, the EU gradually increased its emphasis on structural balance indicators. Especially, the Treaty on Stability, Coordination and Governance (TSCG) of 2013 (also called fiscal compactOpens in new window commits the signatories to keeping structural deficits below 0.5% of GDP over the medium term and mandates the setting of this objective in national laws (Germany introduced such a constitutional rule already in 2009, with a structural deficit limit set at 0.35% of GDP).

The resulting fiscal framework has proved perplexing. Since the mid-2010s, doubts have grown in the EU over the wisdom of micromanaging fiscal positions on the basis of unobservable data.