Testing For Government Intertemporal Solvency: A Smooth Transition Error Correction Model Approach

Abstract

Applied macroeconomists have tested for the government intertemporal solvency condition by either testing for linear stationarity in the total government de¢cit series or testing for linear cointegration between total government spending and total tax revenues. A number of authors have focused, in particular, on structural breaks in the government de¢cit process. In this paper, we use a smooth transition error correction model to test and estimate a shift in the adjustment toward a linear cointegration relationship between the government spending to output ratio and the total tax revenues to output ratio. Estimation results show that government authorities react only to large (in absolute value) changes in the government spending to output ratio. Residual diagnostic tests are provided and they show that the model is not misspeci¢ed. " IntroductionThe government's intertemporal solvency condition states that the discounted value of its debt tends to zero over time. Recently, researchers have attempted to test the solvency condition by taking into account the time series properties of ¢scal variables. Quintos (1995) showed that a necessary and su¤cient condition for intertemporal solvency is the requirement that b, the slope coe¤cient of an ordinary least squares (OLS) regression between tax revenues and government spending, is less than or equal to unity, regardless of the order of integration of the estimated residual. To be more speci¢c, Quintos distinguishes between a weak and a strong de¢nition of solvency. The former implies that the intertemporal solvency constraint holds, even though the level of undiscounted public debt is explosive over time, since it grows at a rate lower than the discount factor. The strong solvency condition refers to a stable undiscounted level of public debt. Assuming that tax revenues and government spending are both I(1), strong solvency occurs if there is cointegration and the slope coe¤cient b is unity. Weak solvency occurs

Uk Fiscal Policy Sustainability, 1955–2006*

“…They find that the introduction of the Maastricht Treaty in 1991 has caused a structural break towards sustainability; and that fiscal policy at the eve of the euro's introduction in 1999 was strong‐form sustainable in Ireland and weak‐form sustainable in the rest of their sample countries. Finally, they find evidence of non‐linear fiscal adjustment, which is consistent with the findings of Bohn (1998), Cipollini (2001), Sarno (2001), Arestis et al . (2004), Bajo‐Rubio et al .…”

Fiscal regime changes and the sustainability of fiscal imbalance in South Africa: a smooth transition error-correction approach

“…All variables have been expressed as a percentage of GDP and converted into their natural logarithmic form. We use revenue and expenditure ratios to GDP since government authorities are mainly concerned with the dynamics of the different budget items relative to the overall size of the economy (see Hakkio & Rush, 1991;Cipollini, 2001). The cointegrating relationship between the two variables is also shown in Figure 1c.…”

“…The one-and-a-half-year reaction delay (i.e. d = 6) combined with a relatively smooth switch from one regime to the other γ =10, can be explained in terms of the political-institutional processes (see Cipollini, 2001). Fiscal laws and regulations are drafted, through a budget document, and tabled to parliament for approval before implementation, a process that could be time consuming.…”

“…4 In most of the studies recorded in the literature on fiscal measures to address the solvency condition, researchers have either tested for linear stationarity in the total government deficit series or tested for linear cointegration between total government spending and total tax revenues. To the best of our understanding, few researchers have used non-linear techniques to quantify the adjustment process of fiscal and other macroeconomic variables towards the long-run equilibrium (Van Dijk & Franses, 1997;Hansen & Kim, 1996;Kunst, 1992Kunst, & 1995Dwyer, 1996;Swanson, 1996;Cipollini, 2001). In South Africa in particular, no study has tested whether the error-correction process used in the respective studies is linear.…”

A Nonlinear Approach to Public Finance Sustainability in Latin America

“…These studies point to the presence of nonlinearities in fiscal policy in the United States (Sarno, 2001) and the United Kingdom (Cipollini, 2001). …”