very high for these countries (0.99 and 0.96 respectively), we exploit the ADB tax data to extend the WDI series using the growth rates. This is the case for 2017 in Bhutan, as well as for years 1991-1996 and 2012-2017 in Pakistan. In the case of Bangladesh and Nepal, we rely on the full tax series from the ADB, which cover more years than the WDI. For India, we compute consolidated tax revenue from IMF and Reserve Bank of India data. Data on government total expenditure measured as a percentage of GDP is taken from the IMF for all countries, given that the WDI report only central government final consumption. Finally, values for the share of current and capital expenditure in total expenditure come from the ADB. Detailed sources and time coverage for countries are provided in Table A2 in the Appendix.

# **4. Cyclicality of fiscal policy**

The cyclicality of government spending is typically defined in terms of how spending moves relative to the output gap. If government spending decreases with a positive output gap, i.e. when output is above its potential, it is countercyclical. If the spending increases instead, it is procyclical. If public spending increases more than proportional with GDP, there is a so-called “voracity” effect (Tornell and Lane 1999). For taxes, it is important to differentiate between tax rates and tax revenue. Since the tax rate is an instrument rather than an outcome, the former is the correct variable to study instrument cyclicality. For many countries, including those in South Asia, systematic data on tax rates is not available, however. The inflation tax has been proposed as a viable alternative (Phelps 1973; Chari and Kehoe 1999; Calvo and Végh 1999; Kaminsky, Reinhart and Végh 2004).<sup>5</sup> The response of the tax revenue to changes in GDP, on the other hand, is an outcome and depends on the tax buoyancy, which for clarity is referred to as revenue buoyancy from now on. It depends on the structure of the tax system and can be influenced only indirectly by changing the tax structure. The revenue buoyancy together with the cyclicality of government spending is fundamental to assess whether fiscal policy stimulates or dampens demand with the business cycle. A proportional change of tax revenue and government spending leaves the tax-to-GDP ratio unchanged. A more than proportional response of the tax revenue leads to a reduction in the deficit ratio. A large short-run revenue buoyancy means that taxes act as automatic stabilizers. The long-run revenue buoyancy is important for the impact of economic growth on long-term fiscal sustainability.

In the following we will analyze the relationship of government spending, the inflation tax and tax revenue with respect to changes in economic activity. To do so, we first look at simple correlations before estimating different regression models.

## _4.1 Correlations between GDP and fiscal variables_

In Table 1, we report correlation coefficients between the fiscal variables and GDP. The correlations are reported in terms of cyclical components and in terms of growth rates. For the former, we follow the typical procedure and detrend variables with the Hedrick-Prescott filter using the standard

> 5 The inflation tax is defined as ~~�~~ ���� ~~�~~ ∗100, where π is inflation.

5