Fiscal Sustainability: Does EU Membership Change Policy Behavior? Empirical Evidence from Central and Eastern Europe.

• Author: Bokemeier, Bettina

1. Introduction

   With the recent crisis in Europe, aspects of fiscal sustainability evoke as the public budget situation impaired, fiscal deficits increased and the debt situation regained particular interest. Regular budget sourcing through tax revenues aggravated and sustainability of public finances was challenged. This situation was not limited to Western European economies like Greece, Ireland, Portugal or Spain, who had to apply for financial assistance. Central and Eastern European Union members, like Slovenia for instance, and potential future new member states in Eastern Europe were affected, too, and suffered from serious difficulties. As mentioned by Staehr (2010) for instance Latvia and Hungary suffered from severe problems leading to bailouts.

   In this context it is important to recall that for EU members the Maastricht Treaty and the Stability and Growth Pact require sound fiscal positions, as it is recorded in Art. 121 of the treaty. Plus, regarding fiscal aspects, in the wake of the crisis these legal agreements have been extended by the European fiscal compact. (1) These requirements intensify fiscal sustainability considerations for all member states.

   In this respect it is instructive to consider the EU's first eastward enlargement of 2004. On May 1st 2004 the ten countries Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia were joining the union and all of them had to fulfill the obligations to become member states. Many of them were keen on joining the euro-zone, so they also had to fulfill the Maastricht criteria, including the fiscal ones. However, in view of the current economic situation in Europe some questions in this context arise for the new member states (NMS) (2) as regards fiscal sustainability. Amongst others, this becomes relevant since 2014 was the 10 year commemoration of the EU's eastward enlargement.

   This study contributes to the research on public finances by analyzing whether the governments of the NMS pursue sustainable fiscal policies. Moreover, it studies whether EU membership has changed fiscal policy behavior. These central research questions will be analyzed empirically by using the fiscal response approach of Bohn (1995, 1998). The idea is to test whether a government reacts in a counter-acting manner with its primary balance to changes in its debt situation. In a second step, the accession in 2004 is taken into account by analyzing if this policy behavior changed before and after joining the EU. (3) The study is conducted with annual data for the period from 1995 to 2013. So it covers some years of the transition phase as well as the recent troubles within the crisis. The remainder of this paper is organized as follows: section 2 presents a literature overview covering empirical studies on sustainability in general and those with a special focus on Central and Eastern European countries (CEEC). Section 3 presents some theoretical background on Bohn's fiscal sustainability concept. Section 4 shows the data set and the estimation results. Section 5 summarizes and concludes.

2. Literature overview

   Several papers in the economics literature address fiscal sustainability aspects, mainly based on the concept of the inter-temporal budget constraint. (4) Here, the focus is set on empirical contributions based on time series approaches, especially the fiscal reaction function.

   Bohn (1995, 1998) has introduced fiscal response functions. If the primary surplus ratio reacts in an enhancing manner to increases of the public debt ratio, fiscal sustainability seems to be given. For an overview and discussion of fiscal sustainability approaches see for example Afonso (2005) or Chalk and Hemming (2000). Many applications have followed.

   Burger (2012) and Fincke and Greiner (2011a) utilize Bohn (1995, 1998)'s approach in order to calculate stabilized debt ratio values for the US and UK or detect changes in the response over time for certain EU (crisis) economies, respectively. Also in this line, Cizkowicz et al. (2015) study sustainability for a panel of 12 euro-zone members for the years 1970-2013 with a focus on windfall gains (from bond yield convergence) related to euro introduction. Further, the divergence of the fiscal situation in periphery and core countries is analyzed. They find weakened fiscal reactions in the periphery group during the windfall years (1996-2007) compared to a strengthened response in the core countries for those years, adding that adjustment in terms of spending cuts was more pronounced for the latter group.

   However, the amount of contributions concerning specifically Eastern European countries is more sparsely. Stoian and Campeanu (2010) analyze fiscal sustainability in CEECs by applying Bohn's fiscal response approach. They estimate regression equations individually for all ten economies with OLS based on quarterly data for 2000 until 2008. The results are mixed as they indicate sustainable behavior for some countries (Bulgaria, Czech Republic, Estonia and Lithuania), whereas others (Latvia, Poland, Romania and Slovenia) face difficulties.

   Also, Staehr (2010) and Baldi and Staehr (2016) utilize fiscal response functions to study the public finance situation in CEECs with a special focus on the current crisis for the period 1999-2008 and 2000-2012 respectively. Baldi and Staehr (2016) analyze fiscal reaction functions before and after the current crisis--and possible changes--in order to explain the different fiscal performance situation of EU economies. They utilize panel regressions for different groups of EU members, diversified by characteristics of integration (in this way including CEECs) and the crisis impact. Their estimations are separated in pre-crisis and post-crisis phases and are based on quarterly data from 2000-2012. They find a change in policy: there is only a slight and rather similar response before the crisis, but a stronger debt effect after 2008, especially for crisis-affected economies.

   Concerning the link between structural breaks, fiscal reactions and specified well-defined events, there are also rather few contributions for the CEECs. Cuestas and Staehr (2013) study stationarity properties of the overall budget balance in ten NMS and especially account for effects of structural breaks over the period 1999-2010. They discover stationarity of the fiscal position without structural changes only for Slovakia and Slovenia (linear setting) and the Baltics (non-linear setting), whereas with two structural breaks all countries reveal stationary series (eventually indicating sustainability). Fincke and Wolski (2016) is a study that particularly tests for a structural break in fiscal policy for the 2004 accession with data from 2000 until 2011. They ask whether the direction of fiscal policy has changed once becoming an EU member and find that NMS conduct a more counter-cyclical behavior after joining EU.

   By applying Bohn's approach, this paper goes into a similar direction like Stoian and Campeanu (2010) and Baldi and Staehr (2016). However, a special focus is set on the 2004 enlargement. We not only test sustainability for the eastern NMS in general, but especially account for the behavior before and after EU accession. Moreover, the data set runs from 1995 until 2013 with annual data. This allows to include the early stage as well as the recent crisis.

3. Theory

   In order to conduct a profound study, some theoretical background on Bohn's fiscal sustainability concept should be provided. The starting point is the budget identity of the public sector. Like any other economic agent the government has to balance it's revenues and expenditures. If there is a funding gap, this has to be filled by issuing new bonds (credit financing). Thus, the dynamic evolution of the government budget can be stated like (cf. for instance Greiner et al. (2007) or Greiner and Fincke (2009).):

   dB(t)/dt = G(t) - T(t) + iB(t). (1)

   Revenues, which are mainly taxes, are expressed by T, and the government spending is split into two parts: primary spending G and interest payments iB on outstanding debt. Solving equation (1) leads to the two central theoretical concepts for fiscal sustainability:

   [mathematical expression not reproducible], (2)

   which indicates that the discounted of value of public debt should converge to zero asymptotically (sometimes denoted as...