Public Finances in the Euro Area: Growth Shocks and Structural Factors

Abstract

Helvi Kinnunen and Pasi Kuoppamaki examine the sustainability of public finances in Finland and the four main euro area countries. The analytical framework is based on intertemporal budget dynamics. The paper shows that, in spite of the increase in age-related expenditure, the policies implicit in the 1997 primary budget balances would lead to a non-increasing debt ratio in almost all countries. The paper evaluates the implications of different growth and interest rate assumptions. The sensitivity calculations indicate that the response of the public debt and deficit ratios is stronger with respect to interest rate changes than it is to growth changes. However, the calculations show that a severe recession would lead to prolonged fiscal imbalances in some countries. Kinnunen and Kuoppamaki also estimate the tax-gaps, i.e. the change in the tax to GPD ratio, required to ensure debt stability or to fulfil the Stability and Growth Pact requirement of a balanced budget. The latter criterion is more demanding than the former. The authors note that comparisons of tax-gaps between countries should be considered very cautiously since they do not provide indications about the constraints that policymakers actually face. They also note that tax competition may significantly affect fiscal policy, in particular in highly taxed countries.