Estimating fiscal policy reaction functions: The role of model specification

The literature has not yet come to a consensus on the actual responses of fiscal policy to output and to past public debt levels within industrialized countries. While the cyclical adjustment literature has suggested a strong response of the primary surplus to the output gap, the time-series literature has tended to report a far smaller response. However, recent theoretical findings suggest that some of this difference may be due to the way in which the time-series literature has typically handled the issue of autocorrelation, in a way which is incompatible with the timing of automatic stabilizers. In order to find a way around this problem, we formulate and estimate a set of fiscal policy reaction functions for the euro area, which allow for the primary surplus to feature three components: a fast-moving (stabilizing) response to the output gap, a consolidating response to the debt-GDP ratio, and an exogenous, persistent fiscal policy shifter. When we formulate a fiscal reaction function in this way, our estimates are compatible in magnitude with previous estimates from the cyclical adjustment literature. Furthermore, based on a set of model comparison exercises in line with what has been done in the monetary policy literature, we argue that our specification explains the data better than does the more commonly used specification.