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THE USE OF CYCLICALLY ADJUSTED BALANCES AT BANCO DE PORTUGAL* Pedro Duarte Neves** Luís Morais Sarmento** 1.INTRODUCTION The overall and primary balances do not consti- tute adequate indicators to assess the fiscal policy stance, since they are endogenous to the evolution of economic activity. Therefore, it is necessary to develop indicators that distinguish between changes in those balances that are due to the func- tioning of automatic stabilisers from those reflect- ing oth
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  THE USE OF CYCLICALLY ADJUSTED BALANCESAT BANCO DE PORTUGAL * Pedro Duarte Neves** Luís Morais Sarmento**  1.INTRODUCTION The overall and primary balances do not consti-tute adequate indicators to assess the fiscal policystance, since they are endogenous to the evolutionof economic activity. Therefore, it is necessary todevelop indicators that distinguish betweenchanges in those balances that are due to the func-tioning of automatic stabilisers from those reflect-ing other factors (discretionary fiscal measures,temporary effects on the balances, or develop-ments in structural components such as public ex-penditure on social security systems).Overall and primary balances adjusted for theinfluence of cyclical effects are commonly used toassess the stance of fiscal policy. This note explainsthe new methodology used by the  Banco de Portu- gal  to estimate cyclically adjusted balances. Oneimportant feature of the new methodology is thatit captures the impact on the revenues and expen-ditures of different growth patterns. This is an im-portant aspect, as the composition of growth mat-ters in the estimation of cyclical effects.This paper is organized as follows. Section 2describes the methodology previously used. Sec-tion 3 introduces the new approach. Tax elastici-ties are obtained through the use of fiscal rules,drawing on fairly detailed information at the mi-cro level. It also discusses the estimation of a refer-ence path for the main macroeconomic variables,through the use of the Hodrick-Prescott filter. Sec-tion 4 presents estimates for the cyclically adjusted balances for the period 1995-2000. It also presentsestimates for the sensitivity of the general govern-ment balances to the economic cycle. Finally, sec-tion 5 concludes. 2. THE METHOD PREVIOUSLY USED BY BANCO DE PORTUGAL Since 1994,  Banco de Portugal  has published – inthe  Annual Report  and occasionally in the  EconomicBulletin  – estimates of Cyclically Adjusted Bal-ances (CABs). Given the well-known difficulties inthe estimation of trend output, the analysis has been focused on changes of the CABs rather thanon the CABs themselves. The change in the cycli-cally adjusted primary balance has been used asthe main indicator of the fiscal stance (1) . The meth-odological description of the procedure previouslyused by  Banco de Portugal  is presented in Centeno(1994) and Sarmento (1999).In general terms, the approach followed by Banco de Portugal  is similar to the procedure used Banco de Portugal /Economic bulletin /September 2001 99 Articles * The views expressed in this article are those of the authors andnot necessarily those of the  Banco de Portugal.  We would like tothank Cláudia Braz, Jorge Correia da Cunha, José Machado,Maximiano Pinheiro and Patrícia Silva for very useful com-ments and suggestions. This work has greatly benefited fromtechnical discussions with fiscal experts from the EuropeanSystem of Central Banks. The authors are responsible for anyremaining errors.** Economic Research Department.(1) See, for instance, the box “Stance of Fiscal Policy”, in the  An-nual Report  for the year 1993,  Banco de Portugal .  Banco de Portu- gal  has been one of the very few Central Banks participating inthe Eurosystem that published regularly estimates of the CABs.   by the European Commission (1995). The ap-proach is described as the “tax elasticity plus gap”method, involving two main steps. In the firststep, the Hodrick-Prescott filter is used in the esti-mation of trend output. The value of the Lagrangemultiplier    was set equal to 100. Cyclical fluctua-tions – or output gaps – are obtained by subtract-ing these trend output estimates from actual out-put.The impact of these output gaps on the generalgovernment balances is calculated through the useof revenue and expenditure elasticities. As de-scribed in Centeno (1994), the tax elasticities are based on econometric estimations (tax receipts forthe main taxes as a function of GDP). The follow-ing revenue items have been considered: directtaxes on households; direct taxes on companies;social security contributions; indirect taxes; othercurrent revenue. The cyclical component of the budget item T  i  is given by: T gap T  icT G i i      ,  (1) where: T  i  – budget item  i ; T  ic – cyclical component of the budget item  i ;   T G i  ,  – budget component elasticity;Gap – output gap.On the expenditure side, it was assumed thatonly unemployment benefits should be cyclicallyadjusted. The elasticity of this component of ex-penditure to economic conditions was obtainedthrough the combination of an Okun relationshipand an estimate of the average cost of unemploy-ment benefits.The cyclically adjusted budget balance is ob-tained through the deduction of these cyclical ef-fects from the actual government budget balance.In this way, the actual budget balance can be de-composed into a cyclical and a (cyclically) ad- justed component. The cyclical component shows by how much the economic cycle contributed tothe level of the budget for a given year. The ad- justed component – i.e. the CAB – corresponds tothe budget balance which would have been ob-served if the economy was on its trend. When theoutput gap is positive (negative) – i.e. actual out-put exceeds (is smaller than the) trend output – thecycle has a positive (negative) impact on the gen-eral government balance and, therefore, the cycli-cally adjusted balance is smaller (larger) than theactual balance. 3.THE NEW METHODOLOGY This section describes the new approach used by the  Banco de Portugal  to obtain estimates of theCAB, following the methodology described inBouthevillain  et al.  (2001). This methodology has been developed in a joint effort by the NationalCentral Banks of the European Union Mem- ber-States and the European Central Bank.Subsection 3.1 deals with the cyclical adjust-ment of general government revenue and expendi-tures. The methodology of Bouthevillain  et al. (2001) has not been applied automatically to thePortuguese case. Subsection 3.2 highlights themain innovations of the Portuguese application.Finally, subsection 3.2 discusses the issue of trendoutput estimation. 3.1  Cyclical components of budget revenues andexpenditures Three main differences with respect to themethodology described in section 2 should behighlighted. First, as mentioned above, Centeno(1994) obtained the tax elasticities through econo-metric estimation. This procedure has severedrawbacks, as it fails to take into account the fre-quent changes in the tax system over the sampleperiod. Therefore, the new approach – followingclosely the methodology proposed by van denNoord (2000) obtains elasticities based on taxrules.Secondly, the relative composition of the out-put gap is explicitly taken into consideration in thecomputation of the cyclical component of the bud-get. As such, the new tax elasticities are related to  proxies  of the tax bases and not to output, as in theprevious approach. Thus, the cyclically adjusted budgets are not independent of the composition of GDPFinally, it is explicitly considered that only pri-vate components of GDP are responsible for thecyclical movements of GDP. This assumption hasimplications for the cyclical adjustment of reve-nues since tax receipts also depend on public ex- 100 Banco de Portugal /Economic bulletin / September 2001 Articles  penditure. Thus, only tax revenues generated byprivate activity are cyclically adjusted.The rest of this section discusses the proceduresused in the estimation of the relevant budgetaryelasticities. a) Direct taxes on households In Portugal, the personal income tax  (IRS ) ac-counts for almost all the fiscal receipts correspond-ing to direct taxes on households. For the purposeof this study, the  IRS  receipts can be divided inthree main parts: the withholding final tax leviedon almost all capital income received by families,the tax revenue generated by civil servants labourincome and private sector labour income (2) .The distinction between taxes on labour incomeand taxes on capital income is important, becauseonly the first one is, according to the methodology,subject to cyclical fluctuation (3) . The distinction of taxes paid by civil servants on their labour incomeand other taxes on labour income is required giventhe assumption that only the private componentshave cyclical fluctuations. The  IRS  paid by em-ployees in the non-public sector, between 1995 and2000, corresponded to approximately 60 per centof total direct taxes paid by households, accordingto information provided by the tax administra-tion (4) Total direct taxes on households ( DTH  ) can bewritten as: DTH WT LT LT  P G     (2)  being WT the withholding final taxes, and LT  G and  LT  P public and private sector labour in-come taxes, respectively.The sensitivity of labour income to cyclical fluc-tuations was estimated through the use of grouped data provided by the tax administra-tion (5) . The average tax paid in each group is t W N  iiPiP  , being  t i  the (average) per worker tax rev-enue in each group, expressed as a function of   W  i ,total wage income in that group, and  N  i , the num- ber of workers in that group. Therefore, tax re-ceipts on private sector labour income are given by: LT t W N  N  PiiPiPiniP   1 (3)  being  W  iP and  N  iP total labour income and thenumber of workers included in income class  i,  re-spectively. The total differential of   LT  P is: dLT  tW N dW N dN W N N  P iPPiiPiPiPiPiP  2 iPi iPinin tdN     11 (4) Rearranging one obtains (6) dLT LT twwttN LT dW W dN N  PPiiPiPii iPPPPPPi     1 n PP dN N     (5)     DTFN W N PPPPPP dW W dN N dN N  , Where    DTFN W N  iPiPii iPPin twwtt N LT    1 is the tax elasticitywith respect to the average wage, and  w iP is theaverage wage of class  i. Using the data supplied by the tax administra-tion (7), it was obtained a tax elasticity equal to 1.69.This figure is lower than the one calculated by theOECD for Portugal (8)(9) .The cyclical component of the tax on directtaxes on families is then: Banco de Portugal /Economic bulletin /September 2001 101 Articles (2) There are tax revenue from other sources of income (for in-stance rents), but they represent a very small amount whencompared with labour income.(3) It is worth mentioning that this methodology assumes that cy-clical fluctuations have no impact in the interest rate and,therefore, General Government interest payments or interestincome received by households.(4) This proportion is affected, among other factors, by deposit in-terest rates. For instance, over the period 1995 to 2000 this ratioincreased from 56.2 per cent to 63 per cent.(5) The grouped data do not distinguish labour income (and taxes)of public and private sector employees. It was assumed that both income sources have the same distribution across house-holds.(6) It is assumed that the new workers entering the labour forcehave the same distribution of those already there  dN N dN N  ii  .It is also assumed that the rate of change in wages is the samefor all workers.(7) The tax administration supplied data on the number of taxpay-ers, total income and tax liability, distributed by 20 incomeclasses, referring to the year of 1998. This type of data was ana-lysed in Sarmento (1996).        DTH LT gap W gap N  C P CDTFN W N P P     ,,   (6)     gap N LT  P P  being  W  P total labour income in the private sectorand  N  P total labour employment in the privatesector. b) Direct taxes on companies In Portugal, corporations are required to makeprepayments of the corporate income tax, equal to75 or 85 per cent of the tax liability of the previousyear. So, in a given year, the tax receipt is equal tothe tax liability of the previous year minus the pre-payments made in the previous year, plus the pre-payments of the current year. However, a corpora-tion can ask for a suspension of these prepaymentswhen they estimate that the current year tax liabil-ity is equal to, or less than, the prepayments al-ready made. Based on this rule and on the fact thatthe tax is proportional, the cyclical component of the corporate income tax is given by:        DTC gap OS gap OS Ct t    min ;  1 (7)             max ;  gap OS gap OS DTC t t 1 2  0  being  OS  the gross operating surplus and  DTC  thecorporate income tax. c) Social security contributions Social contributions of the private sector areroughly proportional to private labour income. Soa tax elasticity of 1 with respect to private labourincome was considered. Therefore, the cyclicalcomponent of social security contributions is given by:   SC gap W SC C P    (8) d) Indirect taxes The receipts of taxes on goods and services can be presented as: TGS tx iini    1 (9)  being  x i  the expenditure on good  i  and  t i  the cor-responding tax rate. The total differential of the TGS , with relation to the total expenditure ( x ), is: dTGSTGS t xxxxxTGSdxx t xTG i iiinii i x yin i           1 1, Sdxx (10) (10)   IGS t xTGS gap C Ci i x yPin i       ,1 (11) where   i  is the share of commodity  i  on total con-sumption and   x y i  ,  the corresponding income elas-ticity. The complete set of income elasticities wasobtained through the estimation of an  Almost IdealDemand System  (AIDS) system of Engel curves, us-ing data drawn from the Portuguese Family Ex-penditure Survey (11) . The number of consumptioncategories considered was 25. In the computationof the tax rates both VAT and the excises dutieswere considered. This procedure produced an esti-mate of the tax elasticity with respect to consump-tion expenditure equal to 1.1. This figure meansthat, overall, taxes on goods and services have aprogressive impact. This result is in line with pre-vious findings by Albuquerque and Neves (1994). 102 Banco de Portugal /Economic bulletin / September 2001 Articles (8) The elasticity calculated by the OECD is 1.9 (see van denNoord (2000)). This difference is due, in part, to the fact that theOECD calculated the ratio between the marginal tax rateweighted by the income and the average rate weighted by in-come. In our case, it was used the tax liability as the weight, asfollows from equation (4). Given that classes with higher levelsof income are associated, on average, with smaller elasticities –and tax liability shares higher than income shares, given theprogressivity of the tax system – the OECD approach leadsnecessarily to a higher elasticity.(9) It is worth noting that both this estimate and the one presented by van den Noord (2000) exceed the OECD elasticities forcountries that have a more progressive tax system than thePortuguese (for instance the Nordic countries have elasticitiesin the 1.3 to 1.5 range). There are, however, some explanationsfor this result. First, one should not neglect the fact that, in Por-tugal, the higher tax bracket starts at a considerable lower leverof income. Second, the average tax rate in Portugal is lowerthan in the Nordic countries. Finally, it should be noted thatSarmento (1996), using 1993 data, showed that the tax table ac-counted only for 1/3 of the tax progressivity of the income tax.(10)Note that  t xTGS i i x yin i      1 can be interpreted as the tax on goodsand services elasticity with respect to the expenditure, since itcorresponds to the coefficient between the marginal tax rate (of one unit of expenditure) and the average tax rate.(11)The elasticities are drawn from Casimiro (1997).

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