Does Right or Left Matter? Cabinets, Credibility and Fiscal Adjustments

Abstract

In this paper we use the widely held assumption that left-wing cabinets favor a larger size of government to answer the question: does the pair cabinet ideology-fiscal action affect the persistence of major fiscal adjustments? For a panel of OECD countries from 1960 to 1995, we find that left and right-wing cabinets are partisan: when cutting the budget deficit, the left relies mostly on tax increases and the right on spending cuts. Our testable hypothesis is that cabinets signal commitment and gain credibility by undertaking fiscal adjustments in ways not favored by its natural constituency: specifically, the left cuts expenditures and the right increases taxes. Probit estimates of the determinants of persistence in fiscal adjustments provide evidence that cuts in spending by the left and tax increases by the right lead to more persistent adjustments. These results are consistent with the literature on fiscal adjustments that has revealed that adjustments pursued by spending cuts are more persistent. We identify other adjustment characteristics that influence the persistence of the deficit cut: coalition cabinets, as well as majority cabinets, are less likely to be successful; a high level or rising public debt tend to make the adjustment more credible. We find evidence that output and specially private investment respond to the pair cabinet ideology-fiscal action in a way that is consistent with our credibility hypothesis: cuts in spending by the left have a stronger expansionary effect on investment than cuts by the right, whereas increases in taxes by the left have a contractionary effect.