Fiscal policy in emerging markets: procyclicality and graduation.

• Author: Vegh, Carlos A.
• Position: Research Summaries

Five key questions have guided my research on fiscal policy in emerging markets: (1)

1. How is fiscal policy conducted in emerging markets compared to industrial countries?

2. Why has fiscal policy often been procyclical in emerging markets?

3. Are there developing countries that have "graduated"--that is, switched from being procyclical to countercyclical?

4. Has fiscal policy been an effective countercyclical tool?

5. Is the recent experience of some eurozone countries reminiscent of past fiscal behavior in emerging markets?

This summary describes the main findings that have resulted from this research agenda. In pursuing these issues, I have been very fortunate to work with many talented co-authors, whose many contributions will hopefully become clear below.

Fiscal Policy in Emerging Countries: When It Rains, It Pours

Figure 1, on the next page, shows the correlation between the cyclical components of real GDP and government spending for 96 countries (21 industrial and 75 developing) for the period 1960-2014. (2) Industrial countries are denoted by gray bars while blue bars represent emerging countries.

The visual impression is striking: With only two exceptions, Greece and Portugal, all grey bars lie to the left of the graph, indicating a negative correlation and hence countercyclical government spending in industrial countries, while 81 percent of blue bars lie to the right of the graph, indicating a positive correlation and hence procyclical government spending in developing countries. In fact, the average correlation for industrial countries is -0.23, compared to 0.21 for developing countries. Both estimates are significantly different from zero at the one percent level.

Although much less documented --mainly because data on tax rates are much harder to come by--the same is true of tax policy. Based on a novel annual dataset that comprises value-added, corporate, and personal income taxes for 62 countries (20 industrial and 42 developing) for the period 1960-2013, Guillermo Vuletin and I have concluded that tax policy has been acyclical in industrial countries and mostly procyclical in developing economies. (3) By procyclical tax policy, we mean that the correlation between the cyclical components of tax rates and GDP is negative; that is, it reinforces the business cycle.

The evidence thus strongly suggests that, unlike industrial countries, developing countries have historically pursued procyclical fiscal policy both on the spending and the revenue side. During bad times, with capital flowing out and the economy mired in recession, policymakers have often compounded the problem by contracting fiscal policy.

Why has Fiscal Policy been Procyclical in Emerging Markets?

A natural question is why policymakers in developing countries exacerbate already pronounced boom-bust cycles by pursuing procyclical fiscal policy. This has been a puzzle in search of an explanation. The two most convincing explanations are arguably that they have limited access to international credit markets in bad times, and that political incentives and institutional weaknesses tend to encourage "excessive" public spending in good times. (4)

These two channels have in fact reinforced one another in bringing about procyclical fiscal policy. Emerging countries' inability to borrow in bad times--often in conjunction with calls for "fiscal consolidation" from international creditors and organizations--has typically left them with little choice but to cut spending and raise taxes in the midst of severe recessions.

This situation has only been made worse by the tendency to save little, if any, during temporary booms fueled by surges in commodity prices and capital inflows. Time and again, policymakers have insisted that good times were here to stay and spent accordingly. Spending proceeds that are temporary in nature as though they were permanent naturally forces governments to contract spending and raise taxes in bad times to satisfy the intertemporal budget constraint (or, alternatively, default). Put differently, the textbook recommendation of saving on sunny days for rainy days has been seldom, if ever, followed in emerging markets.

Graduation

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