Fill the Gap – Measurement of the Cyclical Effect on Budgets

One of the most vivid discussions in every country is with regard to the assessment of fiscal policy. Since budgets are influenced by business cycles, there is enormous interest in disentangling the underlying fiscal position from the effect of the business cycle. The two main methods used by international institutions to determine this cyclical factor – the aggregated and disaggregated approaches – arguably do not fulfil the necessary requirements for obtaining correct results. In this paper we introduce an alternative disaggregated methodology which is not only able to incorporate theoretical considerations, but is also easily computable, and does not require unavailable data. We also demonstrate that if the deflators of variables are different, then the real cyclical component has to be corrected to obtain the nominal cyclical component. We show that standard cyclical adjustment methods applying constant elasticities are consistent with the broadest definition of discretionary measures, but possibly inconsistent with the underlying deficit. Standard estimations of the cyclical and underlying components can be faulted due to the specific non-linear features of tax systems and unemployment benefit schemes