Adjusted economic budget

What Is Adjusted Economic Budget?

The Adjusted Economic Budget, often referred to as the cyclically adjusted budget balance or structural budget balance, is a measure of a government's fiscal position that removes the effects of the economic cycle. It represents the budget balance that would prevail if the economy were operating at its full capacity, or potential output. This concept is crucial in the field of fiscal policy, as it helps policymakers distinguish between changes in the budget deficit or budget surplus that are due to underlying policy decisions and those that automatically occur because of fluctuations in economic activity⁷¹, ⁷².

By adjusting for cyclical factors, the Adjusted Economic Budget provides a clearer picture of the government's discretionary fiscal stance, separate from the temporary impacts of booms or recessions. It aims to reveal the "structural" component of the budget, reflecting the long-term implications of tax laws and government spending policies⁶⁹, ⁷⁰.

History and Origin

The concept of balancing the budget over the economic cycle, which forms the core idea behind the Adjusted Economic Budget, originated in Sweden in the 1930s with economists from the Stockholm School, notably Gunnar Myrdal. Their proposal suggested a rule allowing the government to balance its budget over an entire economic cycle, rather than on an annual basis⁶⁸.

This idea was later reinterpreted and integrated into the fiscal programs of the New Deal in the United States, particularly by the Committee for Economic Development (CED) during and after World War II. In the 1960s, Keynesian economists associated with the Kennedy and Johnson administrations further reformulated the notion, referring to it as the "High Employment Budget" or "Full Employment Surplus." This concept evolved to support counter-cyclical fiscal policy based on the relationship between aggregate demand and employment⁶⁵, ⁶⁶, ⁶⁷. Over time, the methods for calculating this cyclically adjusted measure have transformed, becoming a device to guide and limit governments' fiscal policies, including structural reforms. Its use has expanded globally, notably within the European Stability and Growth Pact and by international organizations like the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD)⁶⁴.

Key Takeaways

• The Adjusted Economic Budget, also known as the cyclically adjusted budget balance, removes the temporary effects of economic fluctuations from a government's actual budget.
• It helps distinguish between changes in budget outcomes caused by the economic cycle (cyclical component) and those resulting from deliberate policy decisions (structural component)⁶², ⁶³.
• This measure is used by policymakers to assess the underlying health and sustainability of fiscal policy and to make informed decisions about taxation and government spending⁶⁰, ⁶¹.
• A persistent structural budget deficit suggests that current fiscal policy is unsustainable in the long run, regardless of the current state of the economy⁵⁸, ⁵⁹.
• Estimating the Adjusted Economic Budget involves calculating the potential output and the sensitivity of various budget items to changes in economic activity⁵⁶, ⁵⁷.

Formula and Calculation

The calculation of the Adjusted Economic Budget primarily involves adjusting the actual budget balance by removing the estimated impact of the economic cycle. This adjustment typically considers how tax revenue and certain government spending categories (like unemployment benefits) automatically change with fluctuations in Gross Domestic Product (GDP) relative to its potential level⁵⁴, ⁵⁵.

The basic formula for the cyclically adjusted budget balance (CAB) can be expressed as:

Where the cyclical component is often estimated as:

Alternatively, by adjusting individual revenue and expenditure items:

Where:

• (\text{Revenue}_i^*) represents the (i)-th category of tax revenue if the economy were at potential output.
• (\text{Expenditure}_j^*) represents the (j)-th category of government spending if the economy were at potential output.
• The "Output Gap" is the difference between actual Gross Domestic Product and potential output, usually expressed as a percentage of potential GDP⁵³.
• The "Elasticity of Budget Balance" measures how much the budget balance changes for a given change in the output gap⁵². This involves estimating the sensitivity of various tax bases (e.g., wages, profits, consumption) and unemployment benefits to economic fluctuations⁵¹.

International institutions like the IMF and OECD use similar methodologies, often involving a two-step process: first, calculating potential output (or output gap), and second, determining how different components of the budget respond to fluctuations in economic activity⁴⁹, ⁵⁰.

Interpreting the Adjusted Economic Budget

Interpreting the Adjusted Economic Budget is key to understanding the true stance of fiscal policy. If the Adjusted Economic Budget shows a budget deficit even when the economy is at potential output, it indicates a structural deficit. This implies that the government's current tax and spending policies are unsustainable in the long run, as they would lead to increasing public debt even under normal economic conditions⁴⁸. Conversely, a structural budget surplus suggests a sustainable fiscal position that allows for debt reduction or future policy flexibility.

Policymakers use this measure to assess whether their current policies are expansionary, contractionary, or neutral. For example, if the Adjusted Economic Budget moves towards a deficit, it suggests an expansionary fiscal stance, meaning policy is actively stimulating aggregate demand. If it moves towards a surplus, it indicates a contractionary stance⁴⁷. This distinction is critical because changes in the actual budget balance can be misleading. A rising actual deficit during a recession, for instance, might simply be due to automatic changes in tax revenue and unemployment benefits (known as automatic stabilizers), rather than new discretionary spending or tax cuts⁴⁵, ⁴⁶.

Hypothetical Example

Consider the nation of "Economia," which has an actual budget deficit of 5% of its Gross Domestic Product (GDP) in a given year. At first glance, this might seem like a deeply problematic fiscal situation.

However, Economia is currently in a significant recession, with its actual GDP 3% below its potential output. During recessions, tax revenue automatically falls as incomes and consumption decline, and government spending on programs like unemployment benefits automatically increases. These automatic responses are known as automatic stabilizers.

Let's assume the estimated sensitivity (elasticity) of Economia's budget balance to the output gap is 0.5. This means that for every 1% gap between actual and potential output, the budget balance worsens by 0.5% of GDP.

Using the calculation for the cyclical component:
Cyclical Component = Elasticity × Output Gap × Potential GDP
Cyclical Component = 0.5 × 3% = 1.5% of GDP

This 1.5% of GDP represents the portion of the 5% actual deficit that is purely due to the economic downturn.

Now, we can calculate the Adjusted Economic Budget:
Adjusted Economic Budget = Actual Budget Balance - Cyclical Component
Adjusted Economic Budget = -5% (deficit) - (-1.5%) (cyclical contribution to deficit)
Adjusted Economic Budget = -3.5% of GDP

In this hypothetical example, while Economia's actual budget deficit is 5% of GDP, its Adjusted Economic Budget is 3.5% of GDP. This indicates that even if the economy were operating at full capacity, a 3.5% of GDP budget deficit would still persist due to current fiscal policies. This structural deficit is what policymakers need to address through deliberate policy changes, such as spending cuts or tax increases, to achieve long-term fiscal policy sustainability.

Practical Applications

The Adjusted Economic Budget is a vital tool for economists, policymakers, and international organizations in various real-world scenarios:

• Fiscal Policy Assessment: Governments use the Adjusted Economic Budget to assess the true direction and sustainability of their fiscal policy. It helps determine if a budget deficit is temporary and cyclical, or if it reflects an underlying structural imbalance that requires policy intervention. T⁴³, ⁴⁴his is particularly important for guiding decisions on tax revenue and government spending.
• International Surveillance: Organizations such as the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) regularly publish estimates of cyclically adjusted budget balances for member countries. These estimates are used for multilateral surveillance and to provide policy recommendations, aiming to promote sound public finances and stable economic growth. T⁴⁰, ⁴¹, ⁴²he IMF's Fiscal Monitor, for example, frequently analyzes these balances to assess fiscal health globally.
• ³⁸, ³⁹ Medium-Term Fiscal Planning: The measure helps governments set realistic medium-term fiscal targets. By focusing on the structural component, they can develop fiscal consolidation strategies that are not derailed by short-term economic fluctuations. I³⁷t helps in evaluating the space available for stimulating the economy in a recession or preventing overheating during a boom.
  *³⁶ Evaluating Fiscal Stimulus/Austerity: During economic downturns, an increase in the structural budget deficit (i.e., a move towards an expansionary Adjusted Economic Budget) suggests active fiscal policy measures beyond automatic stabilizers. C³⁵onversely, a reduction indicates austerity or fiscal tightening.
• Debt Sustainability Analysis: Understanding the structural component of the budget balance is crucial for assessing the long-term sustainability of public debt. A persistent structural deficit implies a growing debt-to-GDP ratio, raising concerns about future fiscal burdens.

³⁴## Limitations and Criticisms

Despite its utility, the Adjusted Economic Budget, or cyclically adjusted budget balance, faces several limitations and criticisms:

• Unobservability of Potential Output: A primary challenge lies in estimating potential output, which is not directly observable. Different methodologies for estimating potential GDP or the output gap can yield varying results, leading to different cyclically adjusted budget balances. F³¹, ³², ³³or instance, the Congressional Budget Office (CBO) and the IMF may use different assumptions, leading to discrepancies in their estimates.
  *²⁹, ³⁰ Sensitivity to Assumptions: The calculation is highly sensitive to the assumed elasticities of tax revenue and government spending with respect to the economic cycle. Small changes in these elasticities can significantly alter the estimated structural balance.
  *²⁷, ²⁸ Real-Time Data Issues: Real-time data on economic activity and fiscal components are subject to revisions. This means that initial estimates of the Adjusted Economic Budget may be revised significantly later, making it difficult for policymakers to rely on them for immediate decision-making.
  *²⁶ Exclusion of Other Temporary Factors: While the Adjusted Economic Budget removes cyclical effects, it may not account for other temporary or one-off measures that can affect the budget, such as bank recapitalization costs or temporary tax hikes. S²⁴, ²⁵ome broader measures, like the "standardized budget," attempt to address these additional factors.
  *²², ²³ Composition of Gross Domestic Product: The budget's response can vary depending on the composition of GDP growth. For example, growth driven by exports might be less "tax-rich" than growth driven by domestic consumption, which standard cyclical adjustments might not fully capture.
  *²¹ Inflation Effects: While cyclical adjustment primarily focuses on real economic cycles, inflation can also influence the nominal budget balance. If spending budgets are fixed nominally but taxes adjust automatically to inflation, it can impact the fiscal position in ways not fully captured by typical cyclical adjustments.
  *¹⁹, ²⁰ Political Use/Misuse: Critics argue that the concept can be misused for political purposes, for example, by justifying austerity measures based on a perceived structural budget deficit even when the economy is weak. T¹⁸he European Union's fiscal framework, which relies heavily on structural balances, has faced scrutiny due to the inherent uncertainties in its estimation.

¹⁷## Cyclically Adjusted Budget Balance vs. Actual Budget Balance

The Adjusted Economic Budget is synonymous with the cyclically adjusted budget balance, or structural budget balance. The distinction that often causes confusion is between these adjusted measures and the actual budget balance.

The Actual Budget Balance is the observed difference between a government's total tax revenue and its total government spending over a specific period, typically a fiscal year. It reflects all revenues and expenditures as they occur, including the automatic effects of the economic cycle. D¹⁶uring a period of strong economic growth, the actual budget balance tends to improve (smaller deficit or larger surplus) due to higher tax collections and lower outlays on social safety nets like unemployment benefits. Conversely, during a recession, the actual balance typically deteriorates as tax revenues fall and spending on social programs rises.

¹⁵The Cyclically Adjusted Budget Balance (Adjusted Economic Budget), in contrast, seeks to strip away these temporary, cyclical influences. It estimates what the budget balance would be if the economy were operating at its long-run, full-employment potential. T¹³, ¹⁴he core difference lies in the removal of the cyclical component: the automatic fluctuations in revenues and expenditures that happen purely due to ups and downs in the business cycle. T¹²herefore, while the actual budget balance shows the immediate fiscal outcome, the cyclically adjusted budget balance aims to reveal the underlying and more permanent fiscal stance driven by deliberate fiscal policy decisions, making it a better indicator for assessing the sustainability of government finances over the medium to long term.

¹⁰, ¹¹## FAQs

Q: What is the main purpose of calculating an Adjusted Economic Budget?

A: The main purpose is to provide a clearer, more accurate picture of a government's underlying fiscal policy stance by removing the temporary effects of the economic cycle on tax revenue and government spending. T⁸, ⁹his helps policymakers understand if a budget deficit or surplus is due to policy choices or merely cyclical fluctuations.

⁷### Q: How does a recession affect the Adjusted Economic Budget?
A: A recession generally worsens the actual budget balance due to lower tax revenue and higher government spending on things like unemployment benefits (known as automatic stabilizers). However, the Adjusted Economic Budget specifically removes these cyclical effects, so it should remain stable or reflect only the impact of discretionary policy changes made during the recession, not the automatic changes.

⁵, ⁶### Q: Can a country have an actual budget deficit but a cyclically adjusted surplus?
A: Yes, this is possible. If an economy is experiencing a deep recession, its actual budget might show a significant budget deficit due to falling revenues and rising spending. However, if the underlying fiscal policies are generally prudent (i.e., if the economy were at potential output), the Adjusted Economic Budget could show a budget surplus. This would imply that the deficit is temporary and cyclical, rather than a structural problem.

⁴### Q: Why is the concept of "potential output" so important for the Adjusted Economic Budget?
A: Potential output is critical because it serves as the benchmark for measuring the economic cycle's influence. The Adjusted Economic Budget is calculated by determining what the budget balance would be if the economy were operating at this full-capacity level, thereby isolating the structural component from cyclical variations. E², ³rrors in estimating potential output can lead to inaccuracies in the Adjusted Economic Budget.¹