DP4747 Does it Cost to be Virtuous? The Macroeconomic Effect of Fiscal Constraints

Author(s): Fabio Canova , Evi Pappa

Publication Date: November 2004

Keyword(s): budget restrictions , fiscal policy transmission , policy rules , dynamic panels

JEL(s): E30 , E50 , H70

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4747.asp

We study whether and how fiscal restrictions alter the business cycle features macrovariables for a sample of 48 US states. We also examine the ‘typical’ transmission properties of fiscal disturbances and the implied fiscal rules of states with different fiscal restrictions. Fiscal constraints are characterized with a number of indicators. There are similarities in second moments of macrovariables and in the transmission properties of fiscal shocks across states with different fiscal constraints. The cyclical response of expenditure differs in size and sometimes in sign, but heterogeneity within groups makes point estimates statistically insignificant. Creative budget accounting is responsible for the pattern. Implications for the design of fiscal rules and the reform of the Stability and Growth Pact are discussed.