Klaus Schmidt-Hebbel - Catholic University of Chile Raimundo Soto - Catholic University of Chile ERF Training on Advanced Panel Data Techniques Applied to Economic Modelling 29 -31 October, 2018 Cairo, Egypt

1. Fiscal Performance, Fiscal Rules,
and Country Size
Klaus Schmidt-Hebbel
kschmidt-hebbel@uc.cl
Raimundo Soto
rsotom@uc.cl
LAC Regional Study on Fiscal Rules and Economic Size
The World Bank, DC, September 2017

2. Spreading of de jure Fiscal Rules
• Fiscal rules started spreading in the 1990s, in both
industrial and developing/emerging countries
– Only 4 countries had rules in place in 1982
– Increased to 48 countries in 2000 and 78 in 2015
• Most rules are for target levels of the budget
balance and/or the public debt
• National rules vs supranational rules
• Source: IMF Data base on de jure fiscal rules,
extending now through 2018

3. Countries with Fiscal Rules, 1985-2015
Source: IMF Fiscal Rules Dataset, 2017

4. National and Supranational
Fiscal Rules, 1985-2015
Source: IMF Fiscal Rules Dataset, 2017
National Rules Supranational Rules

5. Fiscal Rules and Compliance
Byproduct of this project

6. Menu
1. Main Research Issues
2. A General Framework (skip)
3. Model
4. Data and Econometrics
5. Empirical Analysis

7. 1. Main Research Issues

8. Main Issues
1. Do fiscal rules promote fiscal performance?
2. Does the type of fiscal rule matter?
3. Which other fiscal institutions, political institutions,
economic conditions, and development conditions affect
fiscal performance?
4. Do fiscal rules interact with other institutional and economic
variables in their impact on fiscal performance?
5. Do the effects of fiscal rules depend on country size? (Skip)
6. Are there differences between de jure rules and de facto
rules (compliance)?

9. 2. A General Framework

10. General Framework
• Fiscal performance is linked to fundamental sets of variables:
– Fiscal institutions (including fiscal rules)
– Political institutions (and distortions)
– Economic conditions
– Structural conditions
• Growing analytical and empirical literature focuses on key
links (e.g.: Alesina, Eslava and others on pol-econ
determinants of deficits; Végh and others on determinants of
fiscal performance measures; Schmidt-Hebbel and Soto on
determinants of fiscal rules)
• Interrelations between fiscal performance measures and fiscal
institutions, political institutions, and economic/structural
conditions are complex and go in all ways

11. Fiscal Outcomes, Institutions, and
Economic/Structural Conditions

12. General Framework (skip)
• Fiscal sustainability assessments:
– Derived from sustainability models and their specific assumptions on
future growth, interest rates, and structural changes
– Hence based on judgment and future forecasts
– Constructed ad hoc, not systematically available for large country
panel, particularly small economies
• Available measures of fiscal performance:
– Government deficit
– Government debt
– Government expenditure
– Government debt price (spread)
– Cyclical measures of deficits, debt, expenditure, revenue

13. Main modelling issues
• The potential impact of rules on fiscal outcomes
(balance, debt, and procyclicality) have three defining
characteristics:
– they tend to display high persistence, thereby requiring
the use of dynamic models
– countries are highly idiosyncratic vis-à-vis unobservable
features in their tax and revenue structures, prompting the
existence of individual country effects,
– there may be reverse causation and endogeneity, since
governments may decide to implement rules as a result of
their fiscal stance.

14. 3. Model

15. Model Strategy
• Performance variables (dependent variables)
– Fiscal Balance (% of GDP)
– Government Debt (% of GDP)
– Cyclicality of Government Expenditures (7 years, centered)
– Cyclicality of Fiscal Balance (7 years, centered)
• Independent Variables
– Fiscal rules
– Structural Variables (Development level, Financial development,
Dependency ratio, Trade openness, Capital Account Openness)
– Political Variables (Democracy, Government Stability, Control of
Corruption, Checks and Balances)
– Macro Management (Inflation)
– Macro Regimes (Exch. Regime, Monetary Union, Inflation Targeting)

16. Models
• Base Models (exclude fiscal rules)
• Fiscal Rule Models
– Any Fiscal Rule (Supranational, National)
– Any National Fiscal Rule
– Particular National Fiscal Rules
• Government Debt
• Budget Balance
• Expenditure
• Revenues (too few observations)

17. Fiscal Rules
• Fiscal Rules can be seen as a “treatment”
• Once and for all change in regime
• At a known instant in time

18. Unconditional Effect of
adopting a Fiscal Rule
Time
Fiscal
Outcome
Adoption
of rule
Difference estimator

19. Conditional Effect of
adopting a Fiscal Rule
Time
Fiscal
Outcome
Adoption
of rule
Non adopters
Adopters
Diff-in-diff estimator

20. Conditional Effect of
adopting a Fiscal Rule
Time
Fiscal
Outcome
Adoption
of rule
Non adopters
Adopters
Diff-in-diff estimator
Adopters
were more
responsible

21. Conditional Effect of
adopting a Fiscal Rule
Time
Fiscal
Outcome
Adoption
of rule
Non adopters
Adopters
Diff-in-diff estimator
Adopters
were partially
successful

22. 4. Data and Econometrics

23. Data and Econometrics
• Panel Data
– 1980-2015
– At most 155 countries
• Endogeneity of fundamentals
– Use lagged values
– Contemporaneous correlations not a problem, in general
• Endogeneity of Fiscal Rules (next class)
– Use predicted probability of having a rule, based on
Schmidt-Hebbel and Soto, 2016

24. Two and three-stage instruments
• Need an instrument for the endogeneity of fiscal rules
– Correlated with fiscal rules, uncorrelated with (lagged)
fundamentals
• Instrument 1:
– Prediction of Random Effects, Probit panel models of each
rule against fundamentals. Consistent instrument.
• Instrument 2
– Prediction of a Random Effects, Linear panel model of each
rule against fundamentals (no fiscal performance) and
instrument 1. Consistent and Efficient Instrument.

25. Econometrics
• Identification of “average treatment” (having a fiscal
rule, conditional on changing fundamentals)
– Diff. in Diff. Model
𝐹𝑂𝑖𝑡 = 𝛼𝑖 + 𝛿𝐹𝑅𝑖𝑡 + 𝛽𝑋𝑖𝑡 + 𝛾𝐹𝑅𝑖𝑡 𝑋𝑖𝑡 + 𝜀𝑖𝑡

26. Correlations between fiscal rules
Appendix Table 1
AnyBudgetBalance
NationalBudgetBalance
SupranationalBudget
Balance
AnyDebtRule
NationalDebtRule
SupranationalDebtRule
AnyExpendituresRule
NationalExpendituresRule
AnyRevenueRule
NationalRevenueRule
Any Budget Balance 1
National Budget Balance 0.6834 1
Supranational Budget Balance 0.7654 0.1788 1
Any Debt Rule 0.7841 0.3576 0.8145 1
National Debt Rule 0.3595 0.4234 0.1265 0.5552 1
Supranational Debt Rule 0.7332 0.1662 0.9640 0.8449 0.1172 1
Any Expenditures Rule 0.3951 0.3817 0.3073 0.3109 0.2213 0.2930 1
National Expenditures Rule 0.3951 0.3817 0.3073 0.3109 0.2213 0.2930 1.0000 1
Any Revenue Rule 0.2034 0.1234 0.1818 0.2698 0.2170 0.1738 0.3325 0.3325 1
National Revenue Rule 0.2034 0.1234 0.1818 0.2698 0.2170 0.1738 0.3325 0.3325 1.0000 1
Note: no supranational revenue or expenditures rules

27. Appendix Table 2
Sample Correlation of Fundamentals
EconomicDevelopment
Financialdevelopment
Inflation
BudgetaryUncertainty
DependencyRatio
TradeOpenness
Businesscycle
Cap.AccountOpenness
FixedExchangeRate
MonetaryUnion
InflationTargeting
PoliticalParticipation
CorruptionControl
GovernmentStability
Economic Development 1.00
Financial development 0.64 1.00
Inflation -0.20 -0.23 1.00
Budgetary Uncertainty -0.31 -0.39 0.22 1.00
Dependency Ratio 0.73 0.57 -0.13 -0.26 1.00
Trade Openness 0.18 0.10 -0.11 0.01 0.26 1.00
Business cycle 0.02 -0.01 -0.04 -0.11 0.02 0.02 1.00
Cap. Account Openness 0.63 0.40 -0.23 -0.26 0.41 0.17 0.01 1.00
Fixed Exchange Rate 0.16 0.04 -0.14 0.03 0.03 0.21 0.01 0.11 1.00
Monetary Union 0.11 0.05 -0.13 0.04 -0.14 0.14 0.00 0.01 0.45 1.00
Inflation Targeting 0.20 0.18 -0.09 -0.20 0.23 -0.07 0.00 0.13 -0.36 -0.14 1.00
Political Participation 0.34 0.33 -0.09 -0.33 0.21 -0.09 0.00 0.30 -0.15 0.07 0.31 1.00
Corruption Control 0.63 0.48 -0.14 -0.28 0.32 0.01 0.01 0.41 0.02 0.07 0.13 0.39 1.00
Government Stability -0.04 -0.10 -0.04 0.06 -0.01 0.10 0.07 -0.06 0.07 0.00 -0.14 -0.31 -0.04 1.00
Correlations between other fundamentals

28. 5. Results

29. Econometric Results
• Models with Political Variables
• Models without Political Variables (skip)
• Models
– Any rule (skip)
– Any National Rule (skip)
– Particular National Rules
• debt, expenditure, and budget balance

30. Base Models Results
• Models without Fiscal Rules
– Tested for fixed and random effects (Hausman
test)
• Fixed effects estimator is consistent
– Tested for poolability
• Fixed effects are needed
• Most fundamentals significant and “correct”
sign

31. Determinants of the Procyclicality of Government Expenditure
------------------------------------------------------------------------------------------------------------------------
Base Model Clean Model BBR Model DR Model ER Model ER SS ER LAC ER SWF
(1) (2) (3) (4) (5) (6) (7) (8)
------------------------------------------------------------------------------------------------------------------------
1st
Lag Expenditure 0.639*** 0.665*** 0.659*** 0.664*** 0.652*** 0.637*** 0.652*** 0.677***
Procyclicality (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
2nd
lag Expenditure -0.203*** -0.195*** -0.190*** -0.188*** -0.194*** -0.187*** -0.193*** -0.221***
Procyclicality (0.003) (0.002) (0.003) (0.003) (0.004) (0.005) (0.003) (0.001)
Development -0.335** -0.210* -0.208* -0.205* -0.128 -0.132 -0.132 -0.0829
Level (0.028) (0.078) (0.070) (0.067) (0.273) (0.273) (0.248) (0.550)
Government -0.0284 -0.0303* -0.0296 -0.0298* -0.0285 -0.0261 -0.0293 -0.0256
Stability (0.110) (0.089) (0.117) (0.096) (0.142) (0.183) (0.128) (0.220)
Business Cycles 6.000** 6.800*** 6.860*** 6.910*** 6.593*** 6.358*** 6.568*** 6.074***
(0.010) (0.005) (0.005) (0.004) (0.006) (0.007) (0.007) (0.010)
Financial 0.533*** 0.401** 0.406** 0.406** 0.522*** 0.493** 0.534*** 0.565***
Openness (0.002) (0.011) (0.048) (0.022) (0.005) (0.010) (0.003) (0.003)
Price 0.812 0.710 0.711 0.730* 0.710 0.697 0.700 0.708
Instability (0.108) (0.102) (0.100) (0.091) (0.111) (0.121) (0.113) (0.101)
Revenue 0.912** 0.826** 0.810* 0.808* 0.550 0.509 0.576 0.546
Instability (0.017) (0.046) (0.054) (0.058) (0.188) (0.222) (0.177) (0.196)
Exports -0.241 -0.330** -0.325** -0.326** -0.332** -0.332** -0.334** -0.230
Concentration (0.134) (0.031) (0.038) (0.039) (0.035) (0.033) (0.036) (0.157)
Workers 0.0470
Remittances (0.151)
Fixed Exchange -0.120
Regime (0.225)
Resource Rents 0.257
Cycles (0.298)
Dependency Ratio 1.124
(0.174)
Budget Bal. Rule -0.0537
(0.905)
Debt Rule -0.0562
(0.944)
Expenditure Rule -1.434** -1.472** -1.362* -1.970**
(0.034) (0.031) (0.054) (0.034)
Expenditure Rule* 1.469
Small State (0.519)
Expenditure Rule* -0.496
LAC (0.694)
Sovereign Wealth -0.944*
Fund (0.068)
Expenditure Rule* 3.634
Sov. Wealth Fund (0.187)
Constant -0.115 4.228*** 4.173*** 4.156*** 3.614** 3.649** 3.668** 2.499
(0.973) (0.005) (0.007) (0.006) (0.026) (0.023) (0.025) (0.195)
------------------------------------------------------------------------------------------------------------------------
Observations 408 414 414 414 414 414 414 414
Number of Countries 111 111 111 111 111 111 111 111
Arellano Bond Tests -4.10*** -4.54*** -4.50*** -4.58*** -4.47*** -4.42*** -4.45*** -4.73***
-1.36 -1.59 -1.61 -1.65* -1.37 -1.33 -1.30 -1.27
Sargan Test 20.68 21.55 22.14 22.21 21.84 21.39 21.81 21.07
------------------------------------------------------------------------------------------------------------------------
Note: Dependent variable is the 10-year rolling correlation of HP-filtered expenditures of general government to HP-
filtered GDP. The econometric method used is System Dynamic Panel-data Models with Instrumental Variables. Fiscal rules
and Sovereign Wealth Fund are instrumented using the results in section 6. p-values in parentheses. * p<0.1, ** p<0.05,
*** p<0.01.

32. Main Results I
• Having fiscal rules:
– Improves fiscal balances
– Reduces procyclicality of government expenditure
– Improves procyclicality of fiscal balance
– Unclear results for government debt
– Importance of using instruments
– Magnitudes of effects are in line with size of fiscal
outcomes
• Very minor differences in results when including
or excluding political controls.

33. Table 10
Summary of Results
Fiscal Outcomes
Budget Balance Rule Debt Rule Expenditures Rule
de jure de facto de jure de facto de jure de facto
Procyclicality of government expenditures
 Is there any effect on procyclicality? No No No No Reduced Reduced
 Small states are more/less procyclical? No No No No No No
 LAC countries are more/less procyclical? No No No No No No
Procyclicality of fiscal balances
 Is there any effect on procyclicality? No No No No No No
 Small states are more/less procyclical? More No No No No No
 LAC countries are more/less procyclical? No No No No Less No
Fiscal Balance
 Do fiscal balances improve? Yes Yes Yes Yes Yes No
 Small states have higher/lower balances? No No Lower No No No
 LAC countries have higher/lower balances? No No No No No No
Government debt
 Is debt reduced? No No No No No No
 Small states have higher/lower debt? Lower No No No No No
 LAC countries have higher/lower? No No No No No Higher

34. Table 10
Summary of Results
Fiscal Outcomes
Budget Balance Rule Debt Rule Expenditures Rule
de jure de facto de jure de facto de jure de facto
Procyclicality of government expenditures
 Is there any effect on procyclicality? No No No No Reduced Reduced
 Small states are more/less procyclical? No No No No No No
 LAC countries are more/less procyclical? No No No No No No
Procyclicality of fiscal balances
 Is there any effect on procyclicality? No No No No No No
 Small states are more/less procyclical? More No No No No No
 LAC countries are more/less procyclical? No No No No Less No
Fiscal Balance
 Do fiscal balances improve? Yes Yes Yes Yes Yes No
 Small states have higher/lower balances? No No Lower No No No
 LAC countries have higher/lower balances? No No No No No No
Government debt
 Is debt reduced? No No No No No No
 Small states have higher/lower debt? Lower No No No No No
 LAC countries have higher/lower? No No No No No Higher

35. Table 10
Summary of Results
Fiscal Outcomes
Budget Balance Rule Debt Rule Expenditures Rule
de jure de facto de jure de facto de jure de facto
Procyclicality of government expenditures
 Is there any effect on procyclicality? No No No No Reduced Reduced
 Small states are more/less procyclical? No No No No No No
 LAC countries are more/less procyclical? No No No No No No
Procyclicality of fiscal balances
 Is there any effect on procyclicality? No No No No No No
 Small states are more/less procyclical? More No No No No No
 LAC countries are more/less procyclical? No No No No Less No
Fiscal Balance
 Do fiscal balances improve? Yes Yes Yes Yes Yes No
 Small states have higher/lower balances? No No Lower No No No
 LAC countries have higher/lower balances? No No No No No No
Government debt
 Is debt reduced? No No No No No No
 Small states have higher/lower debt? Lower No No No No No
 LAC countries have higher/lower? No No No No No Higher

36. Table 10
Summary of Results
Fiscal Outcomes
Budget Balance Rule Debt Rule Expenditures Rule
de jure de facto de jure de facto de jure de facto
Procyclicality of government expenditures
 Is there any effect on procyclicality? No No No No Reduced Reduced
 Small states are more/less procyclical? No No No No No No
 LAC countries are more/less procyclical? No No No No No No
Procyclicality of fiscal balances
 Is there any effect on procyclicality? No No No No No No
 Small states are more/less procyclical? More No No No No No
 LAC countries are more/less procyclical? No No No No Less No
Fiscal Balance
 Do fiscal balances improve? Yes Yes Yes Yes Yes No
 Small states have higher/lower balances? No No Lower No No No
 LAC countries have higher/lower balances? No No No No No No
Government debt
 Is debt reduced? No No No No No No
 Small states have higher/lower debt? Lower No No No No No
 LAC countries have higher/lower? No No No No No Higher

37. Table 10
Summary of Results
Fiscal Outcomes
Budget Balance Rule Debt Rule Expenditures Rule
de jure de facto de jure de facto de jure de facto
Procyclicality of government expenditures
 Is there any effect on procyclicality? No No No No Reduced Reduced
 Small states are more/less procyclical? No No No No No No
 LAC countries are more/less procyclical? No No No No No No
Procyclicality of fiscal balances
 Is there any effect on procyclicality? No No No No No No
 Small states are more/less procyclical? More No No No No No
 LAC countries are more/less procyclical? No No No No Less No
Fiscal Balance
 Do fiscal balances improve? Yes Yes Yes Yes Yes No
 Small states have higher/lower balances? No No Lower No No No
 LAC countries have higher/lower balances? No No No No No No
Government debt
 Is debt reduced? No No No No No No
 Small states have higher/lower debt? Lower No No No No No
 LAC countries have higher/lower? No No No No No Higher

38. APPENDIX

39. Data Issues
• Full model with political variables (122 countries):
– Too few observations of small countries (only 12)
– Not many “interesting countries” for LAC (BHR, BWA,
CYP, EST, GAB, GMB, GNB, LUX, NAM, QAT, SUR, TTO)
• Models excluding political variables
– Around 45 small economies
– Potential Misspecification
• Omitted variables: democracy & gov. stability low correlation
• Control of corruption, high correlation (development levels)