Mind the Gap – International Comparison of Cyclical Adjustment of the Budget

Cyclically adjusted budget balance (CAB) is a widely cited and widely used concept in the evaluationof fiscal situations. The key idea behind it involves the identification of potential levels of economic variables.There are two recently used methods: the aggregate approach and the unconstrained disaggregateapproach. In this paper we apply them on USA, Japan and 25 EU member countries to demonstratethat both approaches could be the source of considerable bias. While the aggregate approachcannot cope with different shocks, the unconstrained disaggregate method involves systematic biasand do not contain theoretical consideration. In order to avoid these distortions we present an alternativeframework, which is able to incorporate the advantages of both approaches. Combining arbitraryoutput gap and constrained multivariate HP filter induces theoretically motivated disaggregation wherewe also exploit the implication of production function parameterisation. We found that the price effectresulting from the composition effect of different deflators could play an important role in evaluation ofthe fiscal position. To display the importance of composition effect we analyse the cyclical componentsof Finnish, Hungarian and Italian budget balances more in detail.