Should Measures of Fiscal Stance be Adjusted for Terms of Trade Effects?

This paper considers the case for adjusting measures of the cyclically-adjusted fiscal balance for exceptional movements in the terms of trade for those countries where production of commodities is a substantial share of output. For such countries exceptional movements in commodity prices, such as have occurred in recent years, are likely to lead to higher tax revenues, most immediately from the companies directly involved in extracting or producing the commodities, but also less directly as the consequent rise in the terms of trade increases real incomes more broadly. A simple method is proposed to allow for exceptional developments in commodity prices using an adjustment based on a concept of the real income gap rather than a real output gap. This method is subsequently applied to Australia -- one of the world?s leading producers of mined commodities -- and the results contrasted with the standard OECD method of calculating the cyclically-adjusted fiscal balance. It is shown that over much of history the two methods generate similar results, but during exceptional periods of rapid change in commodity prices the measures can be very different. The analysis highlights that a key assumption needed to adjust for commodity price developments concerns the equilibrium level of the terms of trade. While the assumption that the terms of trade returns to long-run historical trends might appear a natural benchmark, recent sustained strong growth in demand for commodities from China and other developing Asian economies raises the question as to whether this has led to a permanent increase in the terms of trade of major commodity producers like Australia and has thus permanently raised government revenues. This Working Paper relates to the 2006 OECD Economic Survey of Australia (www.oecd.org/eco/surveys/australia).