Welfare and inequality effects of debt consolidation processes: The case of Spain, 1996-2007

Viegas, Miguel; Ribeiro, Ana Paula Article Welfare and inequality effects of debt consolidation processes: The case of Spain, 1996-2007 SERIEs - Journal of the Spanish Economic Association Provided in Cooperation with: Spanish Economic Association Suggested Citation: Viegas, Miguel; Ribeiro, Ana Paula (2015) : Welfare and inequality effects of debt consolidation processes: The case of Spain, 1996-2007, SERIEs - Journal of the Spanish Economic Association, ISSN 1869-4195, Springer, Heidelberg, Vol. 6, Iss. 4, pp. 479-496, https://doi.org/10.1007/s13209-015-0133-2 This Version is available at: https://hdl.handle.net/10419/158548 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/4.0/ SERIEs (2015) 6:479–496 DOI 10.1007/s13209-015-0133-2 ORIGINAL ARTICLE Welfare and inequality effects of debt consolidation processes: the case of Spain, 1996–2007 Miguel Viegas1·Ana Paula Ribeiro2 Received: 12 August 2011 / Accepted: 31 October 2015 / Published online: 17 November 2015 © The Author(s) 2015. This article is published with open access at Springerlink.com Abstract The Spanish debt consolidation between 1996 and 2007 represents, by its size and duration, an impressive case among the European Union countries. This paper aims at characterizing the Spanish debt consolidation process in order to assess its effects on economic inequality and welfare. For that purpose we built a general equilibrium heterogeneous-agent model capable of exploring the relationship between fiscal policy variables and the endogenous cross-section distribution of income and wealth. The results show a quite impressive positive welfare gain despite significant transition costs. The simulations point to an increase of inequality during the initial transition period, reversing to more compressed distributions as the economy evolves to its final steady state equilibrium. Overall, the welfare gains are slightly biased towards wealthier individuals. Furthermore empirical data on the dynamics of some crucial variables during the consolidation period lend support to the model simulation results. Keywords European Union ·Fiscal consolidation dynamics ·Heterogeneous agent model ·Inequality ·Spain ·Welfare JEL Classification E17 ·E60 ·H60 ·I30 BMiguel Viegas [email protected] Ana Paula Ribeiro [email protected] 1GOVCOPP, DEGEI, Universidade de Aveiro, Campus Universitrio de Santiago, 3810-193 Aveiro, Portugal 2CEF.UP and Faculdade de Economia, Universidade do Porto, Rua Dr. Roberto Frias, 4200-464 Porto, Portugal 123 480 SERIEs (2015) 6:479–496 1 Introduction The history of the Spanish public administration differs from most of the other western European economies, mainly due to the late establishment of a modern democratic regime based on free elections and on the market-based economy system.1From this point of view, Spain’s recent experience is similar to other two Mediterranean countries: Portugal and Greece. The recent evolution of the Spanish public finances can be divided in two periods, before and after the establishment of democracy. During the dictatorship of Franco, public expenditure grew slowly but steadily, impelled by the 1959 Stabilization Plan, which was a first attempt to open and liberalize the Spanish economy.2 Concerning the structure of expenditure growth, the major effort was related to public infrastructures and to the development of a social security system. This period was also characterized by strong economic growth (interrupted in 1973 with the first oil shock) and balanced budgets which led to a public debt-to-output-ratio of 12.5%in 1974. Throughout the democratic period, we can distinguish two phases. The first phase between 1975 and 1985, corresponds to the development and consolidation of the welfare state. The second phase begins with a first period of fiscal consolidation initiated with the CEE membership in 1985 and interrupted by the economic and social crisis in the beginning of the 1990s, and proceeds with a second fiscal consolidation process (1996–2007) which is focused in our paper. Between 1975 and 1985, during the transition to democracy, total public expenditure almost doubled from 23.5 to 41.6 %, and public debt reached 43.7 % of GDP. The climb resulted from a succession of strong deficits, low economic growth and also from the creation of the 17 autonomous regions and the corresponding decentralization of a significant part of the public expenditure.3 The first period of debt consolidation (1986–1988) was mostly revenue-based and led to a small reduction of the debt-to-output ratio. However, this fiscal adjustment period ended by 1989, due, first, to the incapacity of government to sustain the growing trend of expenditure resulting from strong social protests and, second, to the economic crisis in the beginning of the 1990s. Budget deficit peaked at 7 % of GDP in 1993 and the debt-to-output ratio reached 66.82 % of GDP in 1996. The second period of consolidation (1996–2007), by its size and duration, represents an impressive case among the European Union (UE) countries. After a consolidation attempt in 1992, aborted in 1993, and having as horizon the European and Monetary Union membership, the Spanish authorities entailed an ambitious plan of reforms based on several structural aspects, namely a containment of social expenditure (by tightening eligibility criteria for several social benefit such as unemployment and sickness compensation, among 1The dictator Franco died in 20/11/1975, the first election occurred in 15/06/1977 and the new constitution was voted the 27/12/1978. 2For a comprehensive review about the history of the Public Administration in Spain see de Cos et al. (1999)andFernandez (2005). 3All policy measures taken during this period resulted from an ample agreement between the most representative political parties and trade unions about wages, employment and social security, signed in October 1977 and known as the Moncloa Pact. 123 SERIEs (2015) 6:479–496 481 others), a reduction of the wage bill while maintaining high levels of public investment together with the implementation of legal and institutional changes aiming at higher budgetary discipline (European-Commission 2007). This effort has also benefited from a favorable macroeconomic environment with high growth rates and a significant drop in interest rates. This paper aims at characterizing the debt consolidation processes put forward by the Spanish authorities between 1996 and 2007, in order to assess welfare and, in particular, the inequality effects involved. For that we built a general equilibrium heterogeneous-agent model capable of exploring the relationship between fiscal policy variables and the endogenous cross-section distribution of income and wealth. We use a dynastic heterogeneous-agent model that includes a continuum of infinitely-lived rational agents who are hit by idiosyncratic wage shocks in an incomplete capital market, following seminal works by Bewley (1983), Imrohoroglu (1989), Huggett (1993) and Aiyagari (1995), among others. The model, based on Aiyagari and McGrattan (1998) and Floden (2001), includes government and the corresponding dynamic budget constraint. Besides including taxes levied on labour and capital, we additionally decompose government expenditure into transfers to private sector, and productive and unproductive spending. While productive expenditure is included in the production function and, through this channel, increases the global productivity of the economy, unproductive spending is only utility-augmenting. The model also includes optimizing firms endowed with a neoclassical Cobb-Douglas production function and optimizing households that accumulate savings during “good times” while spending them during “bad times”. The analysis of a debt consolidation process requires a transition between two steady states. Thus, besides steady-state analysis, transition paths are crucial for the computation of welfare effects and inequality. In order to simulate the transition paths imposed by a debt consolidation strategy, we follow the methodology of Rios-Rull (1999) and Mendoza et al. (2009). The simulations are conducted under an open economy framework, assuming the existence of a global market for assets and, hence, a common interest rate. This international mobility of capital implies that each country may have either a positive, negative or balanced foreign asset position. Collecting Spanish data from the AMECO database, we apply the criteria proposed by Alesina and Perotti (1995) in order to detect the successful debt consolidation processes between 1990 and 2010. Secondly, consolidation episodes are identified as active if a permanent debt reduction results mainly from the control of the cyclicallyadjusted primary deficit. Third, we further analyze the composition of the cyclicallyadjusted primary deficit in order to detect the main sources of consolidation. Fourth and finally, we use our model to mimic the Spanish consolidation processes while assessing the welfare and inequality costs involved. The paper is organized as follows. The Spanish consolidation strategies are analyzed in Sect. 2. In Sect. 3we describe the model, and define the social (aggregate) welfare metric. We proceed with the simulations and discuss the main results in Sect. 4, and conclusions are drawn in Sect. 5. 123 482 SERIEs (2015) 6:479–496 2 Identification of the consolidation strategies In order to characterize debt consolidation processes in Spain, we proceed following the approach in the seminal paper by Alesina and Perotti (1995) which identifies “significant fiscal impulses” in OECD countries between 1960 and 1992, in order to study the determinants of “successful” budget consolidation processes. In particular, they define “significant” changes in fiscal policy stance using a cyclically adjusted measure of government primary balance and set several cut-off points. Moreover, a fiscal adjustment in year tis defined as “successful” if the gross debt/GDP ratio in year t+3 is at least 5 % points lower than in year t. In our approach, we apply the criteria used by Alesina and Perotti (1995), but proceed backwards to detect all episodes of “successful” debt consolidation in Spain between 1990 and 2010. We start by identifying the periods where debt-to-output ratios are, at least, 5 % points below the value observed 3 years before. Then, we proceed with identifying the determinants leading to such positive debt dynamics - cyclically adjusted primary deficit, snow-ball and stock-flow adjustments (for more details on the definitions, see European-Commission 2009). Consolidation episodes are identified as active if the reduction in the cyclically-adjusted primary deficit dominates. We further analyze the budget composition in order to detect the main sources of primary balance adjustment. Finally, we use our model to mimic each consolidation process while assessing the welfare costs involved. Figure 1shows the Spanish debt dynamics. The light columns show the debt level ant the dark columns show the debt variation (dt−dt−3). From 1990 to 2010, we identify nine successive episodes in which the successful criteria verifies, starting at 1996 and ending in 2007. From 1996 to 2007, the debt-to-output ratio decreased from 66.82 to 36.24 %. In order to extract (active) fiscal consolidation processes, we decompose debt dynamics as usual (see, among others, European-Commission 2009): Dt=Dt−1·(1+it)+PDt+SFt(2.1) -20,00 -10,00 0,00 10,00 20,00 30,00 40,00 50,00 60,00 70,00 80,00 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Debt (3-year) debt change Fig. 1 Debt dynamics: Spain (1990–2010). Source European-Commission (2009) and AMECO database 123 SERIEs (2015) 6:479–496 483 Fig. 2 Different contribution to debt reduction: Spain (1996–2007). Source European-Commission (2009) and AMECO database Table 1 Contributions to the overall debt reduction: Spain (1996–2007) Country Debt reduction PD(adj) PD(cycle) SB SF Spain 31.18 (1996–2007) −19.38 −6.48 −11.17 +6.14 Source: European-Commission (2009) and AMECO database where, Dstands for government debt, PD for general government primary deficit, SF for the stock-flow adjustment and ifor nominal interest rate paid by the government. Equation (2.1) can be re-written in terms of debt-to-output dynamics as: Dt Yn t −Dt−1 Yn t−1 =Dt−1 Yn t−1 ·(it−nt) (1+nt)+PDt Yn t +SFt Yn t (2.2) where Ynis GDP at current market prices and nstands for the corresponding growth rate. The first term of the right part in Eq. 2.2 refers to the snow-ball effect (SB). Figure 2shows, for the whole period, the debt decomposition into primary deficit (PD), snow-ball (SB) and stock-flow adjustments (SFA) as presented in Eq. 2.2,but distinguishing between cyclically adjusted and cyclical components of primary deficit. Table 1presents the cumulative values of each effects (in % of GDP, including the cyclical (PD(cycle)), and cyclically-adjusted (PD(adj)) components of primary deficit) for the whole consolidation period. During the study period, Spain has enjoyed a good economic conjuncture with high economic growth and low interest rates. In this sense, Domingo et al. (2014) document the importance of the fiscal effort of the government, giving ample emphasis to a combination of economic growth, low interest rate and inflation. Accordingly, our results show that snow-ball effects associated with the cyclical component of primary deficit are responsible by a cumulative debt reduction of 18.04 % points. Still, according to the same data presented in Table 1, we can identify 123 484 SERIEs (2015) 6:479–496 0,00% 5,00% 10,00% 15,00% 20,00% 25,00% 30,00% 35,00% 40,00% 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 0,00% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00% 16,00% Tax Burden Final Cons. Social Transf. Gross Inv. Fig. 3 Spanish cyclically-adjusted primary deficit components (% of GDP): tax burden and final consumption (left-hand scale); social transfer other than in kind and gross fixed capital formation (right-hand scale). Source European-Commission (2009) and AMECO database the Spanish fiscal adjustment as an active consolidation process, since debt reduction process was also driven by the control over the cyclically-adjusted primary deficit. For a debt-to-output reduction of 31.18 % points, the cyclically-adjusted primary deficit accounts for a reduction of 19.38 % points.4Finally, stock-flow adjustments are responsible for an increase of debt of 6.24 % points. To characterize the cyclically-adjusted budget deficit reduction, the model considers a single instrument on the revenue side, the tax burden, and three instruments on the expenditure side: final consumption, social transfers other than in kind and gross capital formation, as in European-Commission (2009). Figure 3exhibits accordingly the cyclically-adjusted actual evolution of each of the four fiscal instruments. Spending was adjusted for the cyclical component by applying the elasticity of total expenditure (excluding interest rate) relative to the cycle to all items. Similarly, for the tax burden, we used the total government revenue elasticity. Elasticities were calculated from the AMECO Database series. During the whole consolidation process, we can see a decrease in social transfers, along with a slight increase in public investment. On the other side, the tax burden increased especially during the second-half part of the adjustment. Table 2summarizes the initial (1996) and final (2007) values (% GDP) for each of the cyclically-adjusted primary deficit components and for the debt-to-output ratio. Summing up, and according to the data in Fig. 3and Table 2, the Spanish consolidation is identified as a mixed strategy based on taxes (especially during the second half period) and a reallocation of social transfer towards public investment expenditure. 4We used the cyclically adjusted primary based on potential GDP. If we use the adjusted series based on the trend GDP, the results are similar, with the primary deficit cyclically adjusted accounting for a debt decrease of 21.41 % points. 123 SERIEs (2015) 6:479–496 485 Table 2 Characterization of the Spanish consolidation strategy (1996–2007) Initial values (1996) Final values (2007) dttrtgugpdttrtgugp 67.48 13.50 17.50 3.10 36.30 11.60 17.50 3.80 Source: European-Commission (2009) and AMECO database 3Model The model is built from a standard growth model modified to include a role for government together with an uninsured idiosyncratic risk and liquidity/ borrowing constraints. We rely on the original models of Aiyagari and McGrattan (1998) and Floden (2001) modified to break government expenditure into productive and unproductive. While the former is taken to be utility augmenting through inclusion in the utility function, the productive expenditure is considered as input to the production function. We also use a different approach for the calibration of the idiosyncratic shock. We set up an open economy framework composed by two countries or regions, indexed by i. Both blocks are identical except for the size and for the path of the fiscal policy instruments. Capital flows freely across borders while labour, instead, is assumed not to flow across countries. We take Spain as the domestic block, with a corresponding weight measured by the Spanish GDP over the EU15 GDP, p.Likewise, the foreign (“rest of the world”) block, with weight (1 −p), includes all the other EU15 countries (EU15-1) and is assumed to act passively to the debt reduction process in Spain. Each country/region is populated by a continuum of infinitely-lived agents of unit mass who receive after-tax wage payments, w, after-tax interest from savings, ra, and transfers, tr, from the government. Following Barro (1973) and Floden (2001, 2003), we consider that, besides private consumption, c, and leisure, l, unproductive government spending, gu, also contributes to households’ utility at decreasing returns depending on a parameter, ϑ. In each period, agents are hit by idiosyncratic shocks, et, which determines the productivity level. Borrowing is allowed only up to a certain limit band complete capital markets are ruled out. This implies that agents have to ensure themselves by saving during “good times” (at+1−at>0) while, during “bad times”, savings are negative (at+1−at<0). Each agent is endowed with one unit of time and solves the double problem of choosing between labor and leisure, and between consumption and saving in order to maximize expected lifetime utility: max ct,lt,at+1 E0∞  t=0 βt(u1(ct,lt)+ϑu2(gut))|a0,e0(3.1) Subject to the following budget constraint: ct+at+1=wt(1−lt)et+(1+rt)at+trt,ct≥0,at≥−b(3.2) 123 486 SERIEs (2015) 6:479–496 The household’s instant utility functions are specified as: u1(ct,lt)=c1−μ texp(−(1−μ)ζ(1−lt)1+γ) 1−μ(3.3) where μrepresents the degree of risk aversion, ζis constant related to average labor supply, and 1 γrepresents the labor supply elasticity, and u2(gu)=g1−μ u 1−μ(3.4) The productivity shock, et, is an idiosyncratic shock that evolves stochastically over time according to the following process: the natural logarithm of etis represented by an AR(1) process with a serial correlation coefficient ρand a standard deviation σ: log(et)=ρlog(et−1)+t(3.5) Firms are characterized by a neoclassic production function. Output in each country, Y, is produced using capital, K, labour, N, and productive government spending, Gp. Yt=F(Kt,Nt,Gpt)=(Kt)α(Nt)1−α(Gpt )η(3.6) Productive government spending is identified with the share of public gross investment on output, in line with Barro (1990) and Aschauer (1989), and enters as an input to private production.5 The parameters αand ηrepresent, respectively, the output elasticities relative to private capital and to productive government expenditure. The production function exhibits constant returns to scale over private inputs but increasing returns over all inputs. Assuming competitive markets of goods and inputs, private factors are paid according to their marginal productivity and output is exhaustively distributed. Thus: wt=(1−τt)FN(Kt,Nt,Gpt)(3.7) rt=(1−τt)(FK(Kt,Nt,Gpt )−δ) (3.8) where τis a proportional income tax rate levied in each country on labour and capital and δis the depreciation rate of capital. We must point that the pre-tax level of interest rate, r, is fixed in the international capital market. Government promotes both productive and unproductive expenditures, collects taxes and pays lump-sum transfers to households, facing the following budget constraint in real terms: gut +gpt +trt+(rt+1)dt−dt+1=τt(1−δkt)(3.9) 5In a seminal paper, Barro (1990) incorporates a public sector into a simple, constant return, model of economic growth. The ratio of real public gross investment to real GDP is assumed to correspond to a flow of services identified as the measure of infrastructure services and enters directly into the production function. 123 SERIEs (2015) 6:479–496 493 Table 4 Debt consolidation effects on inequality: Spain Initial steady state Final steady state WG IG WG IG 0.3410 0.3315 0.3222 0.3174 WG wealth Gini index, IG income Gini index 0 0.01 0.02 0.03 Asset Holding Welfare 0 5 10 15 20 25 30 0 1 2 x 10 Distribution Welfare gain Initial distribution Fig. 6 Welfare gains across wealth following debt consolidations in Spain are the ones who benefit more from the consolidation episode. Viegas and Ribeiro (2013b) have shown that the welfare distribution moves negatively with debt and positively with transfer and unproductive expenditures while productive expenditures are neutral. Decreasing social transfers as well as unproductive expenditures leads to a worse welfare distribution. Differently, debt reduction should improve the welfare distribution. Apparently, in terms of welfare inequality, transfer and unproductive spending effects have dominated over the debt effect during the Spanish consolidation process: despite debt reduction, welfare inequality across wealth increased (despite the positive welfare gain for every household). The definition of welfare includes consumption, leisure and unproductive expenditures (public services). The global negative effect on the welfare distribution results from the dynamics of all these individual variables affecting welfare. As shown in Fig. 4, both disposable income and wealth Gini indexes present an humped shaped curve before converging to lower final levels (see, also, Table 4). In order to make a simple test on the robustness of our results, we have collected data on actual disposable income Gini coefficient (Fig. 7) and on the net foreign asset (NFA) position (Fig. 8) for Spain, during the consolidation process. Although income distribution depends on the dynamics of multiple variables, some of which are missing from our model, the initial humped shaped curve and the afterwards downward path 123 494 SERIEs (2015) 6:479–496 Spain: Disposable income Gini index 0,29 0,30 0,31 0,32 0,33 0,34 0,35 0,36 1995 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Fig. 7 Effective disposable income Gini coefficient (1996–2007). Source OECD.Stat Net Foreign Asset: Spain (1996- 2007) -0,90 -0,80 -0,70 -0,60 -0,50 -0,40 -0,30 -0,20 -0,10 0,00 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Fig. 8 Net Foreign Asset position: Spain. Source Lane and Milesi-Ferretti (2006) to a lower level relative to the initial level seem to lend support to the prediction of our model. Capital flows also depend on many other factors which the model fails to capture. Nevertheless, the downward path of NFA in Fig. 8confirms the initial inward flow of capital and the depressed NFA position described above (see Fig. 4). However empirical data fail to replicate the second phase when capital flows out, increasing above the initial level. Thus, the actual dynamics of the Gini coefficient and the NFA position can be partially justified by the fiscal consolidation strategy. 5 Conclusion By using a general equilibrium model with heterogeneous agents, we simulate the Spanish consolidation episode that occurred between 1996 and 2007 to assess the underlying welfare and inequality effects. We use the endogenous cross-section distribution to compute several inequality indexes and we also assess the aggregate welfare intensity measured as a percentage change of life-time consumption Our results show a quite impressive positive net welfare gain, representing almost 20 % of life time consumption. However, the transition costs are also significant, reducing in more than 25 % the potential (gross) welfare gain. According to our 123 SERIEs (2015) 6:479–496 495 simulation the final output level increases 16.37 % relative to the initial level. But the initial fiscal effort depresses strongly the economy: during the first phase, output decreases 16.17 %, recovering the initial output level only after 6 years. This upfront recession affects strongly the poorer, as it can be seen through the Gini index path. However, the wealth and disposable income distributions become more compressed as the economy moves towards the final steady state equilibrium. Summing up, in terms of welfare there is a slight bias towards the wealthier individuals, which means that consolidation costs were mostly fell on the poor. Finally, the empirical data observed during the consolidation period can be partially explained by our debt-modeling process. The observed disposable income Gini index path reproduces the humped-shaped curve of the model. As for international flows of capital, the model reproduces the initial deterioration of the Spanish NFA position. However, data does not confirm (at least yet) the asset demand recovery and the reversal in the NFA position, which surpasses the initial steady state level as the economy evolves to the final steady-state equilibrium. Open Access This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons license, and indicate if changes were made. References Aiyagari S (1994) Uninsured idiosyncratic risk and aggregate saving. 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