spending and output. The match of this feature is very interesting not only because some authors have claimed that the “procyclicality of fiscal policy is a puzzle in search of explanation” (Talvi and Végh, 2000) but also because this type of evidence has been reported as proof of the destabilizing conduct of fiscal policy. For instance, based on a positive correlation between the growth rate of real government spending and output, Gavin et al. (1996) concluded that the volatility of the LAC economies had been augmented by highly procyclical fiscal responses. Agénor et al. (1999), Stein et al. (1999) and Talvi and Végh (2000) reported a positive correlation between Hodrick-Prescott filtered components of government spending and output in order to draw conclusions on how fiscal policy behaves over the business cycle. The striking result generated by the model economy is that the presence of such a feature says nothing about how polices are conducted over the business cycle. In the model economy, government spending follows an exogenous Markov process, which, by definition, does not take into account the endogenous state of the economy. The model proves that attributing intentionality to fiscal policy (i.e., policymakers increase government consumption during expansions and decrease it during recessions) on the basis of the above mentioned correlation is incorrect. This sheds doubt on how well-grounded the generally accepted claim that fiscal policy is procyclical in the developing world is.

Lane (2003) proposes a regression-based measure of cyclicality of fiscal policy for OECD countries. To that end, he estimated an OLS regression of the growth rate of government spending against the growth rate of output (and a constant). I used Monte Carlo experiments to assess the power of this approach. A total of 1200 sets of time series were created by simulations, following the general procedure described before. Using unfiltered data, Lane’s regression was estimated as many times and a significance test was repeatedly applied to examine whether the approach rejects the hypothesis of no response of government spending to cyclical conditions, as should be the case in our model. The average estimated regression coefficient was 0.87 (0.62) and in 48% (37%) of the 1200 trials, it turned out to be significantly different from zero using a t-test with a nominal size of 5 percent for the economy populated by both Ricardian and nonRicardian (Ricardian) households. This exercise suggests - based on the difference between the nominal and empirical sizes of the t-test - that Lane’s approach fails to make the correct inference more often than expected. Additional Monte Carlo experiments indicated that regression-based measures of cyclicality are correct when current output growth is instrumented to control possible endogeneity bias. This methodology has not been employed until recently (see Galí and Perotti, 2003, for industrial countries; Fatás and Mihov, 2004, for a sample of industrial and developing countries).

# **5.2 Automatic Stabilizers in the LAC Area**

# **Automatic Revenue Stabilizers**

The issue of the degree of stabilization provided by the tax structure is addressed by comparing the volatility of aggregate output in an economy with a given tax structure to that of an economy with lump-sum taxation (i.e., with ℘ = 0 ). In each simulated economy (including the reference economy with non-distortionary taxation), the level of tax collection is the same (15.7% of GDP, as in the benchmark parameterization). This 24