What do OECD countries cut first when faced with fiscal adjustments?

• Author: Sanz, Ismael
• Position: Organisation for Economic Co-operation and Development

1. Introduction

   As OECD member countries have dramatically worsened their public finances, they will be forced to undertake budgetary cuts in the next years. Developed countries will increase their public deficit to 8.8% of GDP in 2010, compared with the 2.1% (on average) of GDP for the period extending between 2000 and 2007, whereas the public debt will increase to 100.2% of GDP, up from 72.6% during the 2000-2007 period (OECD Economic Outlook 85, June 2009). Fiscal discipline will require cuts in government expenditure, leading to a trade-off between different components of government expenditure that will affect the composition of government expenditure. In this article we explore the relationship between components of government expenditure and government size during the 1970-2007 period for a sample of 25 OECD countries to shed light on how fiscal discipline might influence public spending composition in the future.

   Many authors (Dunne, Pashardes, and Smith 1984; Borge and Rattso 1995; Sturm 1998; Tridimas 2001; Shelton 2007) have underscored the surprisingly little research devoted to the determinants of the composition of government expenditure. Moreover, Baqir (2002) claims that most of the studies analyzing the effects of aggregate government expenditure on its composition have focused on the economic classification of government spending. Furthermore, those few studies examining the functional disaggregation of government expenditure have concentrated on particular functions--primarily social expenditure, including education and health (Baqir 2002), and occasionally social welfare expenditure (Ravallion 2002)--or on the composition of local government spending (Borge and Rattso 1995). The contribution of this article is to use the functional disaggregation of consolidated government expenditure, Classification of the Functions of Government (COFOG). To our knowledge, this is the first study on the effects of fiscal consolidation on the composition of government expenditure by functions for the OECD.

   The assessment of the effects of aggregate government expenditure is of great interest in the future, especially in the context of budgetary cuts and cost controls. Fiscal consolidation affects economic growth through its impact on the composition of public expenditure. Along these lines, some endogenous growth models incorporate the composition of government spending that is capable of yielding steady-state effects (Devarajan, Swaroop, and Zou 1996; Gemmell, Kneller, and Sanz 2009). Moreover, Davoodi and Zou (1998) show that there is an optimal composition of government expenditures in which the optimal share of each component equals its growth elasticity, relative to all of the growth elasticities. Therefore, by changing the composition of government expenditure, fiscal consolidation can approach or deviate the structure of public spending from its optimal structure.

   In order to investigate this aspect, section 2 reviews the existing literature on the effects of fiscal consolidation on the composition of government expenditures. In section 3, we introduce the data to be used and the empirical methodology. In section 4, we analyze how the composition of government expenditure changes when the public sector size decreases in a dynamic model framework. Section 5 checks the robustness of our conclusions by investigating the impact on the composition of government spending decreases in the public debt and deficit. In section 6, we draw the most significant conclusions.

2. Fiscal Consolidation and the Composition of Government Expenditure

   During the period ranging from 1970 to 2007, the share of government expenditure in GDP has increased in the OECD, from 30.5% in 1970 to 42.2% in 2007 (OECD: National Accounts. Volume IV: General Government Accounts). However, this expansion has fluctuated over the course of the four decades. During the 1970s and the early years of the 1980s the public sector increased its size constantly. This trend was interrupted in 1983, when public expenditure as a share of GDP became stable. At the beginning of the 1990s public expenditure began to increase its size again until 1993, the peak for the whole period. Thereafter, OECD countries have increasingly implemented government spending reforms aimed toward more controlled government spending and active deficit management (Tanzi and Schuknecht 2000).

   The reduction of the public sector size does not necessarily lead to proportional decreases in the components of government spending, but it may change the composition of government expenditures by particularly affecting some of its components while protecting others. Several studies have analyzed the effects of fiscal consolidation on the composition of government expenditures, focusing on two specific components: public investments and social spending (including education, health, and social welfare expenditure). These studies predict two different and opposite outcomes. The first strand of studies claims that fiscal adjustments will affect investments while protecting social spending. Thus, Roubini and Sachs (1989) claim that during a time of fiscal consolidation, public investments are the first to be reduced because these represent the least rigid component of expenditures. Oxley and Martin (1991) also contend that political reasons make it easier to diminish or postpone investment spending than current expenditure. Furthermore, Sturm (1998) suggests that myopic governments in need of budgetary cuts reduce those less visible and long-term expenditures in order to minimize the political costs associated with government spending cutbacks. Gomes and Pouget (2008) elaborate a model in which international tax competition drives tax rates down, reducing the externality of public capital and thereby leading governments to decrease public investment. De Mello (2008) argues that current spending is increasingly downward rigid, and therefore, fiscal adjustments compress public investment. Finally, Easterly, Irwin, and Servrn (2008) argue that if governments reduce productive spending they are improving short-term cash deficit, but they might be worsening fiscal imbalances in the long term if the foregone growth reduces the present value of future government revenues by more than the immediate improvement in the cash deficit. Nevertheless, these authors contend that too much emphasis on short-term cash flows leads governments to reduce productive spending at times of fiscal adjustment and to protect non-productive spending. Along these lines, Henrekson (1988; for Sweden over the period from 1950 to 1984); Sturm (1998; for a sample of 22 OECD countries over the period from 1980 to 1992); Jonakin and Stephens (1999; for a sample of five Central American countries over the period from 1975 to 1993); Mahdavi (2004; for 47 developing countries over the period from 1972 to 2001); and Akitoby et al. (2006; for a sample of 51 developing countries over the period from 1970 to 2002) find that fiscal adjustments particularly affect public investments.

   Therefore, we could expect fiscal consolidation to fall primarily on public investments and to protect the rest of the expenditures. In fact, studies examining the effects of fiscal adjustments on pro-poor expenditures---mainly social expenditures--predict that budgetary cuts will not primarily affect social spending. Thus, Ravallion (1999) claims that if cutting expenditures save taxes to the non-poor, these voters, in turn, would be more willing to protect pro-poor expenditure. Furthermore, Ravallion (2000) contends that poor groups could build influential interest groups with Non-Governmental Organizations or non-poor groups interested in avoiding the external costs of poverty. Accordingly, Snyder and Yackovlev (2000; for a sample of 19 Latin American and Caribbean countries during the period from 1970 to 1996) and Cashin et al. and Baqir (2001 and 2002; for a sample of 179 and 167 countries during the period from 1985 to 1998, respectively) find that education and health expenditure are isolated from fiscal adjustments.

   A second strand of studies predicts that budgetary cuts will affect social expenditures and protect productive expenditures. Aubin et al. (1988) argue that reducing investments---a type of productive expenditure--has more adverse political effects than does decreasing public consumption and wages because the former is more visible. In fact, Alesina, Perotti, and Tavares (1998) show that if anything, adjustments, primarily based on public transfers and wages, increased the probability of survival of governments over the period from 1960 to 1995 in a sample of 19 OECD countries. Moreover, Tanzi (2000) maintains that globalization will reduce government revenues and expenditure because of the tax competition among jurisdictions and increased mobility of factors. These authors suggest that the reduction of government spending will not be proportional but will affect social spending in particular and preserve productive expenditures that enhance countries' competitiveness and attractiveness to foreign direct investment (FDI). Along these lines, Keen and Marchand (1997) elaborate a model in which governments encourage country competitiveness by raising the allocation to productive expenditures above its optimal level and contracting utility-enhancing spending, such as social welfare spending. Furthermore, Ghate and Zak (2002) elaborate a model in which politicians maximize votes, whereas voters support politicians depending on the transfers they receive and the output growth. As a consequence, at a first stage social welfare expenditure drives the growth of government, but then a threshold emerges at which, in order to maintain positive output growth, governments reduce aggregate government expenditure by cutting social welfare expenditure. Finally, Drazen and Eslava (2010) elaborate a model of the political budget cycle in...