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NONLINEARITIES AND THE SUSTAINABILITY OF THE GOVERNMENT'S INTERTEMPORAL BUDGET CONSTRAINT

Authors

  • GABRIELLA LEGRENZI,

    1. Legrenzi: Lecturer in Economics, Department of Economics, Keele University, Keele ST5 5BG, UK. Phone 0044 (0)1782 733094, Fax 0044 (0)1782 733094, E-mail g.d.legrenzi@keele.ac.uk
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  • COSTAS MILAS

    1. Milas: Professor of Finance, Keele Management School, Keele University, Keele ST5 5BG, UK. Phone 0044 (0)1782 733094, Fax 0044 (0)1782 733094
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    • We would like to thank the editor and two anonymous reviewers for their most useful comments and suggestions on an earlier version of the paper. Former versions of this paper have been presented at the CESifo Area Conference on Public Sector Economics, the World Congress of the Public Choice Society, the annual meeting of the Society for Non-Linear Dynamics and Econometrics, the North American Summer Meeting of the Econometric Society, and the Annual Meeting of the Royal Economic Society. We would like to thank all participants for useful remarks and suggestions. Financial support from CESifo is gratefully acknowledged.


Abstract

We analyze the sustainability of the government's intertemporal budget constraint and the corresponding fiscal reaction function within a nonlinear error-correction framework. Our empirical analysis, based on Italy, provides some evidence that the Italian government is meeting its intertemporal budget constraint. Nevertheless, we show that the burden of correcting budgetary disequilibria is entirely carried out by changes in the average tax rate, with a weakly exogenous government spending, possibly determined by the political process. We also document some rigidities of the tax instrument, in terms of downward inflexibility of the average tax rate with respect to its long-run level. Finally, we provide some evidence in favor of a nonlinear adjustment toward a sustainable long-run equilibrium, as the average tax rate adjusts faster the further away it gets from the equilibrium. By considering the behavior of taxes across the economic cycle, we also provide some evidence of inflexibility of the tax instrument during bad times. (JEL C32, C51, C52, H20, H50)

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