New research shows the link between fiscal headroom and counter-cyclical policy has strengthened
Research by Professor Gulcin Ozkan, with colleagues from the University of York and Canterbury Christ Church University, has identified an important shift in the relative ability of high and lower income countries to use government spending and tax policy to boost their economies during economic downturns.
The study, published in Economic Inquiry, examined data from 133 countries over the period 1950-2014. It found that in the downturn that followed the 2007-09 financial crisis, governments in high income countries tended to be unable to stimulate the economy by raising government spending or reducing taxation. They were forced to be 'procyclical', cutting their spending further and prolonging the downturn.
By contrast, low and middle income countries as a group had improved the amount of 'fiscal headroom' they had. From around 2000 onwards they were less likely to implement spending cuts or tax increases that would exacerbate or prolong economic downturns.
Over the period, the link between the fiscal headroom a government had, and its ability or otherwise to introduce countercyclical measures during downturns became stronger. This was particularly the case in the aftermath of the global financial crisis when the estimated impact more than doubled.
Gulcin explains:
"Our research shows that many high income countries were unable to spend more and tax less in the aftermath of the global financial crisis, resorting to cuts that prolonged the economic downturn. This is a pattern that we have seen reflected in the aftermath of the Covid-crisis. We are seeing those low and middle income countries that still have limited fiscal headroom starting to decouple from the rest because they cannot respond to the sharp slowdown in economic activity. These findings underline the importance of building fiscal headroom during upturns despite political pressure to spend on public services or to reduce taxation." – Professor Gulcin Ozkan
The research found that globally, the tendency towards 'procyclicality' (patterns of spending and taxation that heighten rather than smooth economic upturns and downturns) diminished over the period. However, this was largely driven by a minority of around 10 per cent of the countries in the sample rather than being a more general shift.
The researchers also found that the relationship between expanding fiscal headroom and the ability to implement counter-cyclical policies was non-linear. Countries needed to make significant improvements to their fiscal position before they had the flexibility to use changes to spending and taxation as a tool to counter economic downturns.
