Should a balanced budget be the ultimate outcome of election promises?

Abbott is waving goodbye to his pledge to deliver a surplus in his first term. AAP

In launching the Liberal Party’s campaign in Brisbane on Sunday, Tony Abbott appeared to renege on his previous announcement to bring the budget back to surplus in the first term of the Coalition government. Instead, he said that voters will be told before the 2016 election when the budget will return to balance. At the same time, he outlined a ten year timetable for reforms that should help generate budgetary savings.

This announcement, similarly to the rest of the ongoing debate on budget figures, seems to be missing a critical point: the ultimate objective of fiscal policy is not balancing the budget. A balanced budget is not necessarily an indicator of good fiscal policymaking or a competent government.

This confusion between instruments and objectives of fiscal policy started in Europe. The fiscal convergence criteria established as part of the transition towards a monetary union focused the attention of policymakers, media, and the electorate on a few magic numbers that represented the target levels of deficit and debt.

Meeting those targets, and more generally balancing the budget, became the priority of fiscal policy, even in times of economic contraction. But I do not think this was a good approach to fiscal policymaking.

I strongly believe that fiscal stability is a necessary condition for long-term growth. As an academic and professional economist, I have never come across the case of a fast-growing country that did not have an underlying solid fiscal position (for example, a structural balance between revenues and expenditures and a sustainable debt level).

However, fiscal stability is not equivalent to keeping the budget in the black all the time. In the short term, the budget may need to turn red and possibly stay in the red for a while. When economic conditions are such that more expenditure is required and/or tax revenues decline, forcing a budget surplus is simply not good fiscal policy.

In an economic downturn (or recession) the budget should be allowed to be in deficit, for two reasons. First, the downturn implies an almost automatic decrease in revenues (for a given marginal tax rate) and increase in expenditure (via the automatic stabilisers). Second, more expenditure (and lower taxes) stimulate the recovery.

The multiplier effect

On this second point there is of course a lot of disagreement among economists. This disagreement essentially boils down to the question of whether the fiscal multiplier is positive or negative, large or small. By fiscal multiplier I mean the marginal effect on output (or private consumption) of a one dollar increase in expenditure or a one dollar decrease in revenues.

If the multiplier is positive and greater than one, then an increase in government expenditure during a recession facilitates the recovery. If the multiplier is negative, then an increase in expenditure worsens the recession. A multiplier between zero and one presents an ambiguous case: an increase in expenditure still increases output, but it also crowds out some other GDP components (notably, private consumption or investment) so that the final increase in output is smaller than the initial increase in expenditure.

There is a lot of empirical research on the estimation of fiscal multipliers, and results are certainly not consensual. A few studies suggest that the multiplier might actually be negative. However, my reading of the literature is that this result is the exception rather than the rule. Most papers conclude that multipliers are positive, albeit their actual value changes significantly across studies depending on the samples and methodologies used for estimation.

In the specific case of Australia, the estimates reported in a recent paper by economist and MP Andrew Leigh on household spending imply a government purchase multiplier greater than 1 and a tax revenues multiplier smaller than 1, but still positive. An earlier study from OECD indicates that the Australian government expenditure multiplier ranges from 0.4 to 1.3 depending on (i) the type of expenditure (such as cash transfers, infrastructure expenditure, government consumption) and (ii) the lag with which expenditure is allowed to affect output.

My interpretation of a multiplier between zero and one is that more government expenditure (and/or less taxation) during a recession is still a good thing. However, while a multiplier greater than one should encourage the government to undertake “new” additional expenditure, a multiplier between zero and one should encourage the government to shift the execution of planned expenditure from times of economic expansion to times of economic downturn.

In any case, and this is probably what matters the most, a positive multiplier suggests that fiscal policy should be run counter-cyclically. This means that in a downturn government expenditure should increase and taxes decrease. If this generates a deficit, then so be it. Of course, as the cycle reverses, expenditure should decline and taxes increase, thus re-establishing the long-term balance in the fiscal position of the government.

This counter-cyclical pattern would allow the government to achieve two objectives: stabilize the business cycle; and support - through a steady supply of public goods - lower income segments of the population at a time when they need it the most (that is, in a downturn). These two objectives would be achieved without compromising the stability of the budget in the long-term. In fact, the deficit realised in a recession would be compensated by the surplus realised in the subsequent expansion. Overall, there would be no systematic accumulation of debt.

I think that this approach to fiscal policymaking is valid for any country whose fiscal multiplier is not negative. There might be countries that, at a particular time, might not have enough space to run fiscal policy counter-cyclically. This was, for instance, the case of Italy in 2011-12: the high and barely sustainable debt accumulated well before the global financial crisis and the debt crisis made it necessary to adopt fiscal austerity measures during a recession. The result was a further deepening of the recession.

But in the case of Australia debt is low by international standards and there is no sustainability problem. Therefore, I do not see any constraint that should prevent the government from running a counter-cyclical fiscal policy.

So, if we are looking for a criterion to assess party’s fiscal policy platforms in this election, then I suggest that “extent to which fiscal policy will be run counter-cyclically” is better than “when the budget will be back in the black”.