The Long Term Negative Relationship Between Public Deficit and Structural Unemployment: An Empirical Study of OECD Countries (1980–2009)

Abstract

With the new European fiscal compact, fiscal rules requiring balanced budgets net of the annual cyclical component have been introduced to limit growth in the ratio of debt to GDP. The objection may arise that such rules would have an adverse effect, especially in the long run on employment and growth. We test the unemployment proposition by investigating, with a panel of 22 OECD countries (1980–2009), the relationship between the non-accelerating inflation rate of unemployment (NAIRU) as the dependent variable, and fiscal policy indicators such as underlying net lending of government as a percentage of potential GDP (UNLG/pot.GDP), and general government total receipts as a percentage of GDP, controlling for additional variables. We find that both UNLG/pot.GDP and the increase in fiscal burden may be relevant in increasing the NAIRU in the long run. High budget deficits not only do not reduce unemployment, but also aggravate it in the long run. Results are robust to the presence of cross sectional correlation. These results suggest that deficits in excess of that allowed by the cyclical budget balance increase structural unemployment. Since high taxes appear to have the same effect, the EU fiscal compact, with respect to the structural employment objective, needs to include a rule on tax burden limits. Further analysis should test whether exogenous causes of high NAIRU have an impact on budget deficits.