Budget consolidation taking into account planned revenue-side measures

The Covid-19 crisis and the measures to contain its impact on health, the economy and the income of private households and companies are causing public debt to rise sharply. It can be assumed that the debt ratio will rise to an even higher level than after the 2008/2009 financial and economic crisis. Unlike back then, the increase in debt is now not linked to the public sector acquiring a significant volume of assets that can be sold again at a later date. In addition, from the middle of the decade onwards, there will also be significant increases in expenditure in connection with social security in old age. This situation requires significant countermeasures to achieve a sustainable fiscal policy.

The first part of the study conducted by EcoAustria together with WIFO and IHS examines the question of how public finances will develop on the basis of current legislation. Using the "Debt Check" generation account model, a projection of the general government deficit and public debt up to 2060 is made. Based on the assumptions of the main scenario, the public debt ratio increases to just under 190% of GDP by the end of the period under review. Before the Covid-19 crisis, the same model projected an increase to less than 140%. Although the debt ratio would have met the Maastricht criterion in the medium term, up to the 2030s, public finances were not sustainable in the very long term. This is now even less the case, even in the medium term. The projected strong growth in debt is essentially driven by three major areas of expenditure. These are public pension, healthcare and long-term care expenditure. Public revenue will also increase as a percentage of GDP, but to a much lesser extent.

The long-term nature of the analysis period causes uncertainties with regard to the development of the driving factors of the model. This is taken into account in this study with sensitivity analyses. If ageing were to be more pronounced than in the main scenario (lower fertility, immigration and mortality) according to the ageing scenario of the population forecast by Statistics Austria, then debt would increase to over 250% of GDP. A more favorable labor market development than assumed in the main scenario, on the other hand, could dampen the increase, whereby a reduction in the unemployment rate (according to the international definition) by 1 percentage point would reduce the increase by around 20 percentage points. The impact of an eco-social tax reform on public finances depends not only on the level of the tax but also on the type of revenue rebate. If particularly distorting taxes, such as income tax, are reduced, studies also show positive growth effects. If these results are followed, the debt ratio can be reduced by up to 25 percentage points in 2060 with a CO2 price of 100 euros, while a further significant increase can be expected with a flat-rate refund.
Interest rate trends, which are also associated with uncertainties, have a significant influence on debt dynamics. On the one hand, permanently low interest rates until the end of the period under review would limit the increase in debt to around 130% of GDP, although even this level would still represent a significant increase compared to the current situation. On the other hand, there is a risk that the implicit interest rate for public debt could rise again much earlier than assumed in the main scenario. If, in such a situation, the markets were to lose confidence in the sustainability of public finances and the risk premium were to rise noticeably, the situation could quickly spiral out of control.

In order to bring the debt ratio back down to the Maastricht target of 60% of GDP, significant consolidation is necessary. If the target is achieved 15 years after the start of consolidation (assumed to be 2023), the necessary consolidation will amount to an improvement in the primary balance of around 2.7% of GDP. In the ageing scenario, the consolidation volume amounts to 3.7 percent of GDP. Even with a significantly more favorable development on the labor market, 2.2 percent would still be necessary. In order to meet the Maastricht target of a maximum debt ratio of 60 percent in 2060, further consolidation will be necessary as a result of the ageing of society. In the main scenario, this amounts to a total of around 3.4 percent of GDP, in the ageing scenario to 4.8 percent. The level of consolidation required to achieve the Maastricht target requires a comprehensive consolidation strategy with a particular focus on institutional reforms.

The empirical literature provides comprehensive results regarding the success factors of consolidations. The discussion as to whether the focus of consolidations should be on the expenditure or revenue side in order to be successful takes up a great deal of space. Most studies come to the conclusion that expenditure-side consolidations have a significantly higher probability of success in achieving the goal of reducing debt than revenue-side consolidations. However, it makes a difference which expenditure the consolidation targets. In particular, current expenditure and dynamic areas of public spending should be taken into account. Public investment should remain largely unaffected by the measures, as this is usually complementary to private investment activity.

Fiscal rules also play a key role in success. At the very least, they express the political decision-makers' determination to consolidate, which in turn has a positive effect on success. Clear communication of the consolidation strategy is also essential in order to increase acceptance among the population. With regard to the timing of the start of consolidation, the empirical evidence is not entirely clear. While some studies find no correlation between the initial economic situation and the success of consolidation, consolidation should nevertheless take place during stable economic conditions. The example of Greece has shown that reform efforts are very difficult to implement in a difficult macroeconomic environment.

In the context of consolidation, an adequate assessment of the economic framework conditions and the effects of consolidation is important. An overly optimistic assessment of economic development can lead to resistance to reform and undermine efforts, while an overly pessimistic assessment can mean that consolidation is not tackled. In this study, the economic and fiscal consequences of consolidation measures on the expenditure and revenue side were examined. In all of the reforms examined, with the exception of an increase in the statutory and actual retirement age, consolidation is associated with a negative economic development. In the case of the retirement age, GDP increases significantly, as do investments and employment. Consolidation through restraint in public consumption only has a moderately negative effect on growth in the medium and longer term. The loss of public demand is largely compensated for by private demand. In terms of taxes, the smallest effect on value added is seen in an increase in VAT and the strongest in corporation tax. Employee contributions to social security and wage and income tax have a somewhat stronger effect than VAT. It should be noted that wage and income tax affects both employed persons as well as pensioners and other income, while it was assumed that only employed persons contribute to the financing of social insurance.

The results show that as much of the consolidation as possible should be achieved by exploiting efficiency potential. Raising the retirement age can make a significant contribution to consolidating public finances. This step could also be justified by the fact that a large proportion of future additional expenditure as a result of higher life expectancy will be in the area of pensions. Consolidation via measures in the area of taxes has distorting effects beyond pure demand effects with regard to the decisions of private households and companies and has a greater dampening effect on economic development. This in turn reduces the extent of the improvement in the primary balance, as lower growth and lower employment result in weaker revenue dynamics and higher expenditure. As a result, even stronger tax increases would be necessary to achieve a corresponding consolidation target. Increases in social security contributions have a strong impact on employment, while corporation tax has a strong impact on investment activity and productivity. The effects of an increase in wage and income tax are comparable with the results of employee contributions. The heavier the burden on income from employment and the lower the burden on pension income, the more pronounced the corresponding economic effects. In the case of VAT, private consumption is more strongly affected, but the effects on employment and investment are lower.

The efficient use of public funds is a prerequisite for sustainable finances. A comparison with other countries or within a country offers the opportunity to identify efficiency potential and curb increases in expenditure. The international and national benchmarking analyses show that Austria achieves high expenditure in key public task areas, but only average output or outcome. The benchmarking analysis is abstract and cannot replace a comprehensive structural and system evaluation. Nevertheless, the results of benchmarking identify policy areas in which there is potential for more efficient task fulfillment.

The international benchmarking analysis compares performance indicators with expenditure in the areas of administration, education and health. The comparison is deliberately only made with countries that achieve at least the output or outcome of Austria and therefore have a comparable or better range of services. Across all three areas considered, the benchmarking approach results in an efficiency potential of around EUR 5 billion or more, depending on the countries selected for comparison. The efficiency potential of this international comparison is also reflected in the national benchmarking at federal state level. The national benchmarking examines the areas of public state and municipal administration, inpatient and outpatient healthcare services in hospitals, inpatient and mobile care services and general compulsory education. These areas result in an efficiency potential of around 5.3 billion euros.

Budget consolidation does not take place in an institutional vacuum, but is embedded in a network of national, sub-national and supra-national framework conditions and rules. The political-institutional structure is a key factor influencing the (political) incentives and prospects of success of consolidation efforts. Reforms are electorally more risky in 'bad times' than during an economic upswing. Theoretically, it is also ideal from a political economy perspective to remain relatively expansive in terms of fiscal policy during a recession and only plan consolidation measures when the economy recovers. In general, the political acceptance of consolidation measures in survey studies is primarily dependent on whether the respondents believe that they will be particularly negatively affected by a specific policy measure to close the budget gap. This shows that opposition to consolidation increases if the budget policy course is perceived as less than fair and untrustworthy. The favorable interest rate environment, combined with the central banks' willingness to continue their unconventional monetary policy measures, gives governments additional time to consolidate their budgets over a longer period of time. However, it is important to prevent the political incentives for consolidation from being undermined by the expectation of a prolonged period of low interest rates. A timely and planned return to the general application of the fiscal rulebook is advisable in this respect.