The Fiscal Policy of Bulgaria from the Standpoints of the Business Cycle and the Twin Deficits Hypothesis

Abstract

Macroeconomic management of a small open economy in a currency board arrangement faces two serious problems: first, under a fixed exchange rate, fiscal policy is the only effective macroeconomic instrument for smoothing out the business cycle; second, the twin deficits phenomenon, if it exists, may jeopardize the stability of the currency board arrangement. This paper uses quarterly seasonally adjusted Eurostat data for the period of 1999–2019, the Hodrick–Prescott filter and a vector autoregression (VAR) to answer the three questions that are of utmost importance to Bulgarian policy-makers: first, is the discretionary fiscal policy of the Bulgarian government procyclical or countercyclical? Second, do the automatic stabilizers in the Bulgarian state budget function properly? Finally, is the twin deficits hypothesis valid for Bulgaria? Our findings imply that the fiscal discretion of the Bulgarian government is procyclical, while the automatic fiscal stabilizers do not work effectively. The first part of the twin deficits hypothesis (the causal link between the fiscal balance and the current account balance) is confirmed but the second part of the twin deficits hypothesis (the positive relationship between the fiscal balance and the current account balance) is rejected for Bulgaria. It may be inferred that both sides of the Bulgarian state budget (revenue and expenditure) need to be improved in order to increase the effectiveness of Bulgaria’s fiscal policy. Low budget deficits (not higher than 3% of GDP) are recommended for improving the current account balance and encouraging economic growth.