metadata: authors: 0: author: Riera-Crichton,Daniel
1: author: Ruiz Orrico,Pilar
2: author: Vuletin,Guillermo Javier
count: World
docna: 0: docna: From Fiscal Cyclicality to Fiscal Stress :
            The Role of Asymmetric Public Consumption Rigidities in
            Emerging Markets
docty: Policy Research Working Paper
abstracts: cdata!: Macroeconomic textbooks warn that
            procyclical public spending can amplify economic volatility
            and cause fiscal stress. However, the latter risks
            materialize only when governments fail to reduce spending
            during downturns as much as they increase it during booms.
            This study investigates asymmetries in the cyclicality of
            public consumption and finds that emerging markets exhibit
            &#x201c;downward rigidity&#x201d;: they boost
            spending during upswings but do not effectively cut back
            during downturns. In contrast, advanced economies maintain
            steady levels of public consumption regardless of economic
            conditions, making them effectively acyclical. Downward
            rigidity in public consumption not only paves the way for
            fiscal stress when the economy slows, but also leads to
            sustained growth in the size of the state.
display_title: From Fiscal Cyclicality to Fiscal
            Stress : The Role of Asymmetric Public Consumption
            Rigidities in Emerging Markets
listing_relative_url: /research/2024/11/34427475/fiscal-cyclicality-fiscal-stress-role-asymmetric-public-consumption-rigidities-emerging-markets
topicv3: Macroeconomic Vulnerability and Debt
            m1326057 1104,Macroeconomic and Structural Policies
            m1327380 439
publishtoextweb_dt: 2024-11-25T00:00:00Z
dois: 10.1596/1813-9450-10984
origu: Off of Sr VP Dev Econ/Chief Econ (DECVP)
no_of_pages: 32
author_keys: 0: author_key: 1239900
1: author_key: 2127917
2: author_key: 743651
model_extractions: Policy Research Working Paper 10984 From Fiscal Cyclicality to Fiscal Stress The Role of Asymmetric Public Consumption Rigidities in Emerging Markets _Daniel Riera-Crichton Pilar Ruiz Orrico Guillermo Vuletin_ Latin America and the Caribbean Region Office of the Chief Economist November 2024
Policy Research Working Paper 10984

# **Abstract**

Macroeconomic textbooks warn that procyclical public spending can amplify economic volatility and cause fiscal stress. However, the latter risks materialize only when governments fail to reduce spending during downturns as much as they increase it during booms. This study investigates asymmetries in the cyclicality of public consumption and finds that emerging markets exhibit “downward rigidity”: they boost spending during upswings but do not effectively cut back during downturns. In contrast, advanced economies maintain steady levels of public consumption regardless of economic conditions, making them effectively acyclical. Downward rigidity in public consumption not only paves the way for fiscal stress when the economy slows, but also leads to sustained growth in the size of the state.

This paper is a product of the Office of the Chief Economist, Latin America and the Caribbean Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/ prwp. The authors may be contacted at drieracr@bates.edu, pruizorrico@worldbank.org, and gvuletin@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **From Fiscal Cyclicality to Fiscal Stress: The Role of Asymmetric Public Consumption Rigidities in Emerging Markets**

**Daniel Riera-Crichton, Pilar Ruiz Orrico, Guillermo Vuletin**<sup>**1**</sup>

Keywords: Business Cycle; Cyclicality; Downward Rigidity; Public Consumption JEL: E320; E620; H500

> 1 Riera-Crichton: Bates College; email: drieracr@bates.edu Ruiz Orrico: World Bank; email: <u>pruizorrico@worldbank.org</u> Vuletin: World Bank; email: gvuletin@worldbank.org
# **1. Introduction**

Developing markets often grapple with fiscal challenges that can unexpectedly be traced to periods of economic prosperity. In these "good times” buoyed by robust economic growth, public revenues surge, while financing costs remain relatively low due to renewed market confidence. Consequently, emerging markets loosen the constraints on their spending. However, beyond the immediate benefits and drawbacks of these procyclical policies—such as the potential for expanded provision of essential public goods and increased economic volatility (Kaminsky, Reinhart and Végh 2005)—an underlying concern arises. Emerging markets tend to allocate resources towards public spending that prove difficult to reverse when the economic tide turns, leading to a "ratchet effect" (Hercowitz and Strawczynsk 2004). As these cyclical increases in public consumption persist, the size of the public sector steadily grows, subsequently limiting crucial fiscal space when economic downturns finally hit. In this paper, we explore "downward rigidity" on public consumption, which encompasses typically discretionary expenditures related to public employment (which includes wages, salaries and social contributions) and the procurement of goods and services.

Adding to the predicament, emerging markets grapple with significant inefficiencies in public goods provision (Izquierdo, Pessino and Vuletin 2018). The rapid increase in public spending during booms can be an important source of these inefficiencies. Public finance and adjustment cost theory advises that desired increases in spending in health or education should be smooth rather than increase spasmodically over the business cycle. There are, broadly speaking, adjustment costs or time to build. Rapidly hiring teachers during an upturn when cash flushes may not permit careful vetting or drafting from successive graduate classes of training. Nor may there be time to learn from previous experience in building new medical centers. A growing number of studies precisely document the poor quality of much of public spending which, in turn, jeopardizes the future returns required to cover today’s investments (Dutu and Sicari 2016; Izquierdo, Pessino and Vuletin 2018; Joumard, et al. 2004; Miningou 2019). Ineffective spending on public education or health care, for instance, contributes to low labor productivity and diminishes the future economic returns necessary for repaying the initial expenditures. Therefore, the combination of
inefficient and semi-procyclical (increasing in good times and remaining steady in bad times) public consumption sets the stage for fiscal stress even before the onset of a recession.

Going beyond the well documented overall procyclicality found in emerging markets, this paper studies the asymmetric behavior of public consumption spending along their business cycle. While advanced economies are generally acyclical in their public consumption policies, we find emerging markets to be “semi-procyclical”. This means that they display a procyclical policy during booms and an acyclical policy during busts. We show that this asymmetry creates fiscal gaps as the expected positive correlation between spending and revenue breaks during economic downturns.

# **2. The Procyclical Puzzle: Emerging Markets and Fiscal Woes**

The fiscal behavior of emerging markets, characterized by procyclical tendencies, has been widely discussed in the public finance literature as the "original sin" responsible for their fiscal woes (see, e.g. Alesina, Campante and Tabellini 2008; Gavin and Perotti 1997; Ilzetzki and Végh 2008; Kaminsky, Reinhart and Végh 2005; Mendoza and Oviedo 2006; Talvi and Végh 2005; Tornall and Lane 1999). Contrary to standard Keynesian recommendations for stabilizing the economic cycle, empirical studies have revealed that overall primary spending in emerging markets shows a counterintuitive positive correlation with the state of the business cycle. This means that spending increases during good times and decreases during bad times.

Updating previous research by Kaminsky, Reinhart and Végh (2005), and later by Frankel, Vegh and Vuletin (2013), Figure 1 illustrates the correlation between the cyclical component of general government primary expenditure (total government expenditure excluding interest payments) and the cyclical component of aggregate output (GDP) for 71 countries (22 advanced and 49 emerging) from 1980 to 2018. In the figure, red bars represent emerging economies, while blue bars represent advanced economies. A positive correlation between the cyclical components of primary government expenditure and GDP indicates procyclical fiscal policy, whereas a negative correlation indicates countercyclical policy. As shown, most advanced economies display countercyclicality, with exceptions such as Portugal and Spain, which exhibit spending patterns
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Végh and Vuletin (2013) show that institutional frameworks characterized by property rights protection, control of corruption, higher bureaucratic quality, and a strong law and order tradition, have enabled some developing countries to break free from procyclicality in the previous decade. Céspedes and Velasco (2014), using alternative proxies for institutional quality, find consistent evidence in a sample of 60 resource-rich countries. Additionally, Alesina, Campante and Tabellini (2008) establish a positive correlation between measures of corruption and procyclical fiscal policy.

Procyclical public spending is a significant factor contributing to the excess economic volatility reported in emerging markets (Végh et al. 2018). Whereas too much economic volatility may foster economic uncertainty, hamper credit market development, and limit policy makers' ability to protect the country against negative shocks or harness positive ones,<sup>2</sup> procyclical behavior, if symmetrical across the cycle, may not necessarily lead to fiscal unsustainability. Symmetric behavior along the business cycle implies that while bonanza cycles could be financed with increased public revenues and/or temporary borrowing, retrenchments would be sizeable enough to either adjust for lower revenue or cover those. Nonetheless, the recent history of emerging markets is plagued with episodes of fiscal turmoil. Much more than advanced economies.<sup>3</sup> It is not just higher prevalence of fiscal trauma; the ensuing fiscal adjustments are also different in emerging markets. Emerging markets tend to address episodes of fiscal stress with desperate attempts at “fiscal reforms”, and disordered adjustment strategies which share little correspondence with those idealized in either the growth or equity literature.<sup>4</sup> What gives in this puzzle? We argue that downwardly rigid spending creates fiscal gaps representing the seeds of later fiscal turmoil.

> 2 See, for example, World Bank (2013) and Baez, de la Fuente and Santos (2017).

> 3 Based on the Vulnerability Exercise for Emerging Market Economies (VEE) conducted by the International Monetary Fund (2010). Defining fiscal crisis periods as episodes of outright fiscal distress (public debt default/restructuring, need to access large-scale official/IMF support, hyperinflation) as well as extreme financing problems (spikes in sovereign bond spreads), Baldacci, Gupta and Mulas-Granados (2011) show how much more prevalent fiscal trauma is in emerging markets relative to advance economies. Indeed, since 1970, the authors estimated 135 episodes of fiscal stress in 52 emerging economies and just 41 in advanced economies.

> 4 While most fiscal stress episodes in advanced economies between 1970 and 2011 resulted in higher financing costs for relatively short periods of time, episodes in emerging markets led to longer and costlier adjustments, including 52 debt defaults or restructuring episodes and 79 IMF programs (Baldacci, Belhocine, et al. 2011).
# **3. Procyclicality of Public Consumption Meets Spending Rigidities**

Emerging markets face a unique challenge as discretionary public consumption exhibits downward rigidity during recessions. This arises from the difficulty of cutting back on public goods and services provision, and compensation to public employees. Emerging markets face an additional challenge as spending expansions often rely on increasing public wages or the number of employees, which have their own structural rigidities.<sup>5</sup> While the overall cyclicality of public spending has been extensively studied, the asymmetrical responses of public consumption to the economic cycle have received limited attention. Among the few studies exploring these issues, Balassone and Francese (2004) find evidence in OECD countries of significant asymmetry in the reaction of fiscal policy to positive and negative cyclical conditions, with budgetary balances deteriorating in contractions and not improving in expansions. This asymmetry appears to have contributed significantly to debt accumulation. Similarly, Hercowitz and Strawczynsk (2004) find that the prolonged rise in the spending-to-output ratio is partially explained by cyclical upward ratcheting due to asymmetric fiscal behavior. These authors also analyzed cyclical changes in the composition of government spending, as well as a possible link between cyclical ratcheting and government weakness. For developing countries, Carneiro and Garrido (2016) investigate the extent to which countries behave procyclically or countercyclically in different phases of the business cycle, and find a causal link between stronger institutions and less procyclical fiscal policy, even after controlling for the endogeneity of institutions and other determinants of fiscal policy. Balassone and Kumar (2007) find evidence of exuberance in government expenditures during the boom phase of an economic cycle. They conclude that procyclicality may reflect an inaccurate assessment of the cycle, particularly in emerging markets during downturns.

> 5 Formally, we usually think of public spending rigidities as limits to modifying the level or structure of expenditure over a period imposed by institutional decrees (e.g., see Cetrángolo, Jiménez and Ruiz Del Castillo 2010; Echeverry, Bonilla and Moya 2006).
<!-- Start of picture text --> Goods and Services in Emerging Countries Compensation to Employees in Emerging Countries<br>0.415 0.15 2<br>0.10 ‘ [ 0.10 | H<br>0.000.05. } 0.000.05 | |<br>-0.05 a “0.05 :<br>0.10 -0.10 '<br>0.15 -0.15<br>Recessions Expansions Recessions Expansions<br>Goods and Services in Advanced Countries Compensation to Employees in Advanced Countries<br>0.15 0.15<br>0.10 0.10<br>0.050.00 _ fo| 0.050.00 _ _<br>“0.05 0.05<br>-0.10 -0.10<br>“0.15 “0.15<br>Recessions Expansions Recessions Expansions<br><!-- End of picture text -->
maximum of 15 percent, while advanced economies limit their spending growth to a maximum of 5 percent on average. Furthermore, when analyzing the behavior of both groups during recessions, the differences remain evident. Advanced economies tend to experience near-zero growth rates during economic downturns, whereas emerging economies present growth rates ranging from minus 5 to positive 10 percent. This highlights the asymmetry in public consumption within emerging economies, where the substantial overspending during expansions is not matched by a proportional retrenchment during contractions. In contrast, advanced economies exhibit more consistent spending behavior throughout the economic cycle.

Public consumption expenditures play a crucial role in facilitating the provision of essential public goods such as education, health care, law enforcement and defense. Therefore, it is not apparent why governments would adjust the number of teachers, doctors, police officers, or military personnel in response to fluctuations in the business cycle. In theory, these decisions should be driven by societal preferences and the unique characteristics of the public goods production function. In fact, that is what we observe among advanced economies, where growth of public spending appears to be very similar throughout varying business cycles. The only visible changes over time should reflect the long-term trend of the increasing share of the public sector in the national product as countries develop (Wagner 1958).

However, emerging markets’ behavior looks quite different. Emerging economies are procyclical in good times, but those are not followed by a retrenchment that is enough to cover the overspending during expansion. Once again, political economy arguments offer insights into why certain expenditures exhibit stronger cyclical responses compared to others, shedding light on the underlying dynamics of public spending. While public spending rigidities are commonly associated with institutional constraints, such as contractual obligations, entitlements, and interest payments; it can also be subject to other serious forms of rigidities. Institutional weaknesses and political economy factors can compromise the ability or willingness of governments to apply discretionary cuts to public consumption and the provision of essential public goods. Tornall and Lane (1999) developed a model where several political groups compete for fiscal resources. Using the well-known consequences of the problem of the common pool (Ostrom 2015), the authors show how this competition leads to a “voracity effect”, defined as a disproportioned response of
<!-- Start of picture text --> Argentina<br>20<br>16<br>Recession<br>a 12 — Employees<br>o —— Elsewhere Classified<br>= — Goods and Services<br>8 8 — Interests<br>2 —— Social Benefits<br>—— Capital<br>0<br>1<br>1993 1996 1999 2002 2005 2008 2011 2014 2017 2020<br>Year<br><!-- End of picture text -->
<!-- Start of picture text --> United States<br>16<br>a 12 i teem — RecessionEmployees<br>o ae. na —— Elsewhere Classified<br>= ‘i — Goods and Services<br>8 — Interests<br>2 _ —— Social Benefits<br>—— Capital<br>4<br>———<br>0<br>2001 2003 2005 2007 2009 2011 2013 2015 2017 2019<br>Year<br><!-- End of picture text -->
ascending trend, or at best, a plateau. In this way, over ten years, Argentina's spending on social benefits increased from 14 percent of GDP in 2008 to 18 percent in 2018.

# **4. Data and Estimation**

We analyze asymmetric cyclical behavior in emerging and advanced economies using the IMF's World Economic Outlook dataset from April 2019. We chose this dataset over newer versions due to its detailed disaggregation of government expenditure, which is no longer available in more recent publications. The frequency of the data is annual. The panel dataset spans from up to 1980 to 2018 and includes 71 countries from various regions and income classifications. Our findings contrast evidence from up to 49 emerging economies and 22 advanced countries. A comprehensive list of these countries is provided in Table A1 in the appendix. We employ a non-linear econometric model to estimate the elasticities of public consumption relative to aggregate output throughout the business cycle. Table 1 presents descriptive statistics for the growth rates of the specific categories of public spending under analysis, as well as the real GDP used in our regressions.

**Table 1: Descriptive Statistics**

|**Advanced Economies**||||||
|---|---|---|---|---|---|
|Variable|Obs|Mean|Std. Dev.|Min|Max|
|GDP Growth|836|.024|.022|-.086|.126|
|Compensation to Employees|469|.018|.028|-.166|.129|
|<br>Growth||||||
|Goods and Services Growth|471|.023|.039|-.16|.255|

|**Emerging Markets**||||||
|---|---|---|---|---|---|
|Variable|Obs|Mean|Std. Dev.|Min|Max|
|GDP Growth|1740|.038|.049|-.548|.368|
|Compensation to Employees|922|.044|.097|-1.234|.748|
|Growth||||||
|Goods and Services Growth|861|.04|.172|-.914|1.411|

Source: Authors’ calculations based on World Economic Outlook database 2019.

We can observe that, regarding GDP growth, while emerging markets show a higher average rate for the period considered, they also exhibit greater dispersion. This observation is consistent with
existing literature (Végh et al. 2018), which suggests that emerging markets exhibit more pronounced economic fluctuations, experiencing both more severe downturns and more robust upswings compared to advanced economies, which typically demonstrate lower but more stable growth rates over time. Similarly, for compensation to employees, we observe the same pattern: the growth rate in this category is 2.4 times higher in emerging markets compared to advanced economies, and this higher rate is associated to greater variability. Additionally, on average, the growth of the goods and services category is 1.7 times higher in emerging markets than in advanced economies, and this category demonstrates more dispersion.

# **5. Identification Strategy**

Our primary economic question focuses on how public spending reacts to changes in income, specifically analyzing the cyclicality of spending. A major concern in estimating this relationship is the potential endogeneity due to reverse causality between public consumption and aggregate income. The literature on spending multipliers extensively argues that public spending can influence aggregate output, making it challenging to disentangle the direction of causality in our estimates (e.g., Barnichon, Debortoli and Matthes 2022; Christiano, Eichenbaum and Rebelo 2011; Kraay 2012).

To address the reverse causality bias in our cyclicality estimates, we adopt an instrumental variables (IV) approach. This allows us to isolate exogenous variations in income that are not directly influenced by changes in public spending, thus providing a more accurate estimate of the cyclicality of public expenditure.

Our IV strategy hinges on a two-step procedure. First, we argue that domestic public consumption policy likely has limited direct effects on the aggregate income of major trade partners. However, sudden income changes in these trade partners can have substantial impacts on domestic output. This assumption forms the basis of our exclusion restriction: while shocks from the incomes of major trade partners are plausibly exogenous to domestic public consumption policy, they still exert significant influence on domestic income. Therefore, using trade partner income shocks as
an instrument for domestic income should satisfy the exclusion restriction, allowing us to estimate the impact of income changes on public spending without the bias of reverse causality. Recent studies have used idiosyncratic variation in trade partner’s income as exogenous instruments to study domestic conditions, Cravino and Levchenko (2017) examine how multinational firms play a role in the transmission of international business cycle shocks across countries, making use of global income variations as exogenous instruments. This provides a framework for understanding how foreign income shocks can affect domestic outcomes. Di Giovanni, Levchenko and Mejean (2014) explore how aggregate fluctuations are influenced by trade partners and specific destinations, using foreign demand shocks as an instrument to analyze fluctuations in output. Their approach would be quite relevant to our strategy of using exogenous income shocks from trade partners. More recently, a study by Lloyd, Manuel and Panchev (2024) explores the role of global drivers, such as foreign-weighted GDP, in shaping domestic economic risks.

The first stage in our two step-least squares dummy variable procedure follows: Where is a vector of the domestic real GDP growth rate for country i and time t, represents the trade-weighted growth rate of real output in trade partners, and ii,ii is a country-specific ii,ii YY XX continuous transition function ranging between 0 (largest expansion) and 1 (deepest recession). ii,ii RRr The trade-weighted measure is defined as: represents the instrument for country i in year t. The variable denotes the export share of country i to its trading partner j in year t, while ii,ii captures the real output growth of trading ii,ii XX ww partner j in year t. The top 10 trading partners are selected for each country i based on export ii,ii WW shares, with a minimum threshold of 30 percent of total exports to ensure that the selected partners
account for a significant portion of the country’s trade. Thus, the instrument reflects the tradeweighted average of the economic growth of the most relevant trading partners, effectively capturing external demand. The key assumption is that the growth of trading partners primarily influences the GDP growth of country i, with limited or no direct effect on domestic public spending decisions through other channels.

Drawing from Auerbach and Gorodnichenko (2011), our proxy function for the economic cycle is defined as: Here, is a normalized variable that measures the state of the business cycle. It is calculated using a 3-year moving average of the growth rate of real output and then normalized so that ii,ii zz ) = 0 and V ) = 1 for each country i. Finally, is a set of controls including the lag of total public expenditure and the lag the dependent variable. ii ii ii,ii−1 EE(zz rr(zz VV The second stage follows: Where is a vector of the real growth rate of public spending components for country i and time t, represents the estimated growth rate of real output in the first stage. Here ii,ii 1I and 2I GG represent the causal effect of income to public spending during expansions and recessions ii,ii YY<sup>�</sup> ββ ββ respectively.

To uncover differences across different country groups, we split the sample between advanced and emerging economies.
# **Table 2. Changes in GDP Growth Across the Business Cycle on Public Consumption: Elasticities from Fixed Effects and IV Regressions for Emerging and Advanced Economies**

|VARIABLES|(1)<br>Emerging<br>economies -<br>FE|(2)<br>Advanced<br>economies -<br>FE|(3)<br>Emerging<br>economies -<br>IV|(4)<br>Advanced<br>economies -<br>IV|
|---|---|---|---|---|
|GDP Growth * Exp|1.12<br>[0.136]***|0.37<br>[0.109]***|1.10<br>[0.143]***|0.40<br>[0.091]***|
|GDP Growth * Rec|0.43|-0.22|0.36|-0.24|
||[0.244]*|[0.129]|[0.249]|[0.141]*|
|Lagged Public Consumption Growth|-0.05|0.30|-0.05|0.30|
||[0.054]|[0.096]***|[0.054]|[0.102]***|
|Lagged General Government Expense Growth|0.05|0.04|0.05|0.04|
||[0.034]|[0.065]|[0.047]|[0.058]|
|Constant|0.01<br>[0.006]*|0.01<br>[0.003]***|||
|Observations|800|432|793|418|
|R-squared|0.122|0.158|||
|Number of countries|39|18|39|18|
|Country Fixed Effect|Yes|Yes|Yes|Yes|
|Adjusted R-squared|||0.071|0.112|
|**First Stage IV Estimates**|||First Stage|First Stage|
|Trade Weighted Growth * Exp|||1.17<br>[0.03]***|1.27<br>[0.02]***|
|Trade Weighted Growth * Rec|||1.35<br>[0.03]***|1.43<br>[0.04]***|
|**Underidentification - Weak Identification - W**|**eak Instrume**|**nts Tests**|||
|LM test statistic for underidentification|||84.20|33.38|
|p-value of underidentification LM statistic (And|erson or Kleibe|rgen-Paap)|0|7.58e-09|
|F statistic for weak identification (Cragg-Donald|or Kleibergen|-Paap)|918|813.8|
|Anderson-Rubin chi-sqared test of significance|of endogenous r|egressors|65.43|22.66|
|p-value of Anderson-Rubin chi-sqared test of en|dogenous regre|ssors|0|1.20e-05|

Source: Authors’ calculations based on World Economic Outlook database 2019.

Notes: Robust standard errors in brackets. *** p<0.01, ** p<0.05, * p<0.1 Underidentification tests. Ho: matrix of reduced form coefficients has rank=K1-1 -underidentified. Ha: matrix has rank=K1-identified. Weak identification test. Ho: equation is weakly identified. Weak-instrument-robust inference. Tests of joint significance of endogenous regressors B1 in main equation. Ho: B1=0 and overidentifying restrictions are valid.

Table 2 presents the results using a fixed effects estimator (Columns 1 and 2) and an instrumental variable estimator (Columns 3 and 4). During periods of expansion (when approaches zero and E approaches one), changes in output are associated with a more than proportional increase RRr in public consumption in developing economies. In contrast, the same output change leads to a EE less than proportional effect in advanced economies. The semi-procyclical behavior is visible from
the coefficient on output growth during recessions, particularly in emerging economies, where spending is not reduced during downturns. This asymmetrical response results in the downward rigidity previously highlighted. These findings are consistent across both the fixed effects and instrumental variable estimators.

The null hypothesis of the Kleibergen-Paap LM test is that the structural equation is underidentified, meaning the rank condition fails. This test applies the rank test procedure introduced by Kleibergen and Paap (2006). Given that the associated p-values are below 1 percent, we can confidently reject the null hypothesis of underidentification for both IV regressions. Additionally, the weak identification test confirms that the instruments are strong, as the F- statistics far exceed the threshold of 10, indicating no issues with weak identification. Finally, we reject the null hypothesis that the endogenous variables are irrelevant or that their coefficients are zero, supported by the sufficiently low p-values.

Taking advantage of the continuous nature of our business cycle proxy, we use the estimates from our IV specification to visualize the output elasticities of public consumption across varying degrees of economic recessions and expansions. Figure 4 below depicts the output elasticities at different stages of the business cycle for advanced economies and emerging markets.
<!-- Start of picture text --> 2 Output Elasticity of Public Consumption<br>=<br>ee<br>b<br>‘<br>e<br>=<br>es<br>S<br>a<br>ao<br>o%<br>c<br>&<br>_ o<br>3<br>=<br>Pe<br>roar<br>=<br>5 Extreme Expansion 2 4 ar) .6 Extreme Recession<br>Eoonamic Cycle<br>+? Standard Errors ——__ Emerging Markets<br>—— Advanced Economies<br><!-- End of picture text -->
# **Table 3. Changes in Revenue Growth Across the Business Cycle on Public Consumption: Elasticities from Fixed Effects and IV Regressions for Emerging and Advanced Economies**

|VARIABLES|(1)<br>Emerging<br>economies -<br>FE|(2)<br>Advanced<br>economies -<br>FE|(3)<br>Emerging<br>economies -<br>IV|(4)<br>Advanced<br>economies -<br>IV|
|---|---|---|---|---|
|Revenue Growth * Exp|0.31<br>[0.104]***|0.37<br>[0.081]***|0.89<br>[0.177]***|0.40<br>[0.086]***|
|Revenue Growth * Rec|-0.11<br>[0.169]|-0.01<br>[0.098]|0.09<br>[0.241]|-0.27<br>[0.153]*|
|Lagged Public Consumption Growth|-0.02|0.31|-0.07|0.31|
||[0.060]|[0.094]***|[0.062]|[0.115]***|
|Lagged General Government Expense Growth|0.05|0.02|0.06|0.01|
||[0.034]|[0.062]|[0.058]|[0.057]|
|Constant|0.04<br>[0.005]***|0.01<br>[0.002]***|||
|Observations|791|432|784|418|
|R-squared|0.050|0.190|||
|Number of countries|39|18|39|18|
|Country Fixed Effect|Yes|Yes|Yes|Yes|
|Adjusted R-squared|||-0.337|0.108|
|**First Stage IV Estimates**|||**First Stage **|**First Stage **|
|Trade Weighted Growth * Exp|||1.43<br>[.21]***|1.32<br>[.08]***|
|Trade Weighted Growth * Rec|||1.72<br>[.29]***|1.39<br>[.15]***|
|**Underidentification - Weak Identification - Wea**|**k Instruments Tes**|**ts**|||
|LM test statistic for underidentification|||41.87|30.31|
|p-value of underidentification LM statistic (Anderso<br>F statistic for weak identification (Cragg-Donald or|n or Kleibergen-P<br>Kleibergen-Paap)|aap)|9.77e-11<br>21.85|3.68e-08<br>51.14|
|Anderson-Rubin chi-sqared test of significance of e|ndogenous regress|ors|64.05|22.66|
|p-value of Anderson-Rubin chi-sqared test of endog|enous regressors||0|1.20e-05|

Source: Authors’ calculations based on World Economic Outlook database 2019.

Notes: Robust standard errors in brackets. *** p<0.01, ** p<0.05, * p<0.1 Underidentification tests. Ho: matrix of reduced form coefficients has rank=K1-1 -underidentified. Ha: matrix has rank=K1-identified. Weak identification test. Ho: equation is weakly identified. Weak-instrument-robust inference. Tests of joint significance of endogenous regressors B1 in main equation. Ho: B1=0 and overidentifying restrictions are valid.

Table 3 shows the results of running this analysis for our sample of emerging and advanced economies. Column (3) looks at the correlation of public consumption to primary revenue and shows how spending grows at more or less the same rate as revenue (beta estimates are very close
to one) during good times. But as the cycle turns and revenues start to decline (shown as a positive and symmetric relationship between foreign income changes and revenue), the correlation breaks down and spending becomes unresponsive to the declining revenue. While the beta estimates are similar and statistically close to 1 for both components of public consumption, salaries and goods and services, it looks like the latter tends to overreact to revenue relative to the former (Table A4 and Table A5 in the appendix). This makes sense as the rigid nature of public salaries may prevent quick adjustments as revenue climbs. There may be no such impediments to adjusting spending on goods and services as new revenue starts to come in.

To conclude, the asymmetric correlation between public consumption and primary revenue shows that the semi-procyclical behavior discussed above leads to partial deficits in need of financing. Using debt or decreases in public investment to cover those fiscal holes may carry significant adverse growth effects to emerging markets.

# **7. Conclusions**

This paper studies the dynamics of public consumption within emerging and advanced economies, focusing on the asymmetric responses to the business cycle. Our analysis reveals significant differences in fiscal behavior between the two groups, with implications for fiscal policy.

The results display that in advanced economies, public consumption experiences moderate growth during economic expansions. Conversely, in emerging economies, output growth induces a more pronounced positive effect on both components of public consumption, which becomes acyclical during recessions. Moreover, the elasticity observed in goods and services for both groups diminishes when employee compensation is the dependent variable, highlighting the rigidities inherent in this category.

The policy implications are that, in order to mitigate the procyclical and inefficient nature of public consumption, emerging markets need to enhance their fiscal frameworks. Improved medium-term fiscal planning, overseen by independent fiscal institutions, can provide the necessary oversight. Incorporating fiscal rules can help stabilize public spending and reduce fiscal vulnerabilities.
In conclusion, achieving fiscal sustainability in emerging markets requires a robust fiscal framework, effective institutional oversight, and targeted reforms. By adopting these measures, emerging economies can better navigate the cyclical nature of their economies, ensuring more sustainable public finances in the long term.
# **8. Appendix**

**Table A1. Classification of Countries Included in the Analysis**

|**Advanced Economies**||
|---|---|
|Australia|Japan|
|Austria|Luxembourg|
|Belgium|Netherlands|
|Canada|New Zealand|
|Denmark|Norway|
|Finland|Portugal|
|France|Spain|
|Germany|Sweden|
|Hong Kong SAR, China|Switzerland|
|Israel|United Kingdom|
|Italy|United States|

|**Emerging Markets**||
|---|---|
|Argentina|Mauritius|
|Bahrain, Kingdom of|Mexico|
|Bangladesh|Morocco|
|Botswana|Namibia|
|Brazil|Nigeria|
|Bulgaria|Pakistan|
|Chile|Panama|
|China, P.R.: Mainland|Peru|
|Colombia|Philippines|
|Croatia|Poland|
|Cyprus|Qatar|
|Czechia|Romania|
|Côte d'Ivoire|Russian Federation|
|Egypt, Arab Rep.|Slovak Republic|
|Estonia|Slovenia|
|Ghana|South Africa|
|Hungary|Sri Lanka|
|Iceland|Taiwan, China|
|India|Thailand|
|Indonesia|Tunisia|
|Jamaica|Türkiye|
|Kazakhstan|United Arab Emirates|
|Lebanon|Viet Nam|
|Lithuania|Zambia|
|Malaysia||
# **Table A2. Changes in GDP Growth Across the Business Cycle on Compensation to Employees: Elasticities from Fixed Effects and IV Regressions for Emerging and Advanced Economies**

|VARIABLES|(1)<br>Emerging<br>economies -<br>FE|(2)<br>Advanced<br>economies -<br>FE|(3)<br>Emerging<br>economies -<br>IV|(4)<br>Advanced<br>economies -<br>IV|
|---|---|---|---|---|
|GDP Growth * Exp|0.92<br>[0.145]***|0.34<br>[0.124]**|0.92<br>[0.159]***|0.34<br>[0.095]***|
|GDP Growth * Rec|0.34|-0.15|0.29|-0.16|
||[0.218]|[0.125]|[0.237]|[0.145]|
|Lagged Compensation to Employees Growth|-0.06|0.26|-0.06|0.29|
||[0.088]|[0.066]***|[0.084]|[0.122]**|
|Lagged General Government Expense Growth|0.07|0.07|0.07|0.03|
||[0.039]*|[0.086]|[0.045]|[0.059]|
|Constant|0.02<br>[0.006]**|0.01<br>[0.003]**|||
|Observations|873|432|866|418|
|R-squared|0.086|0.128|||
|Number of Countries|42|18|42|18|
|Country Fixed Effect|Yes|Yes|Yes|Yes|
|Adjusted R-squared|||0.034|0.082|
|**First Stage IV Estimates**|||**First Stage **|**First Stage **|
|Trade Weighted Growth * Exp|||1.19<br>[.03]***|1.27<br>[.02]***|
|Trade Weighted Growth * Rec|||1.36<br>[.03]***|1.43<br>[.04]***|
|**Underidentification - Weak Identification - Wea**|**k Instruments Tes**|**ts**|||
|LM test statistic for underidentification|||84.54|33.42|
|p-value of underidentification LM statistic (Anderso<br>F statistic for weak identification (Cragg-Donald or|n or Kleibergen-P<br>Kleibergen-Paap)|aap)|0<br>857.5|7.42e-09<br>804.6|
|Anderson-Rubin chi-sqared test of significance of e|ndogenous regress|ors|40.41|13.91|
|p-value of Anderson-Rubin chi-sqared test of endog|enous regressors||1.68e-09|0.000952|

Source: Authors’ calculations based on World Economic Outlook database 2019.

Robust standard errors in brackets.*** p<0.01, ** p<0.05, * p<0.1.Underidentification tests. Ho: matrix of reduced form coefficients has rank=K1-1 -underidentified. Ha: matrix has rank=K1-identified. Weak identification test. Ho: equation is weakly identified. Weak-instrument-robust inference. Tests of joint significance of endogenous regressors B1 in main equation. Ho: B1=0 and overidentifying restrictions are valid.
# **Table A3. Changes in GDP Growth Across the Business Cycle on Goods and Services: Elasticities from Fixed Effects and IV Regressions for Emerging and Advanced Economies**

|VARIABLES|(1)<br>Emerging<br>economies -<br>FE|(2)<br>Advanced<br>economies -<br>FE|(3)<br>Emerging<br>economies -<br>IV|(4)<br>Advanced<br>economies -<br>IV|
|---|---|---|---|---|
|Real GDP Growth * Exp|1.60<br>[0.218]***|0.48<br>[0.183]**|1.58<br>[0.526]***|0.63<br>[0.139]***|
|Real GDP Growth * Rec|0.38<br>[0.366]|-0.36<br>[0.214]|0.29<br>[0.399]|-0.45<br>[0.166]***|
|Lagged Goods and Services Growth|-0.22<br>[0.095]**|0.12<br>[0.092]|-0.22<br>[0.070]***|0.07<br>[0.060]|
|Lagged General Government Expense Growth|0.02|0.13|0.01|0.19|
||[0.058]|[0.079]|[0.087]|[0.086]**|
|Constant|0.00<br>[0.009]|0.01<br>[0.004]***|||
|Observations|817|432|810|418|
|R-squared|0.089|0.078|||
|Number of Countries|40|18|40|18|
|Country Fixed Effect|Yes|Yes|Yes|Yes|
|Adjusted R-squared|||0.036|0.052|
|**First Stage IV Estimates**|||First Stage|First Stage|
|Trade Weighted Growth * Exp|||1.18<br>[.03]***|1.27<br>[.02]***|
|Trade Weighted Growth * Rec|||1.35<br>[.03]***|1.43<br>[.04]***|
|**Underidentification - Weak Identification - Weak**|**Instruments Tes**|**ts**|||
|LM test statistic for underidentification|||92.65|35.91|
|p-value of underidentification LM statistic (Anderso|n or Kleibergen-P|aap)|0|2.07e-09|
|F statistic for weak identification (Cragg-Donald or|Kleibergen-Paap)||1008|856.6|
|Anderson-Rubin chi-sqared test of significance of e|ndogenous regress|ors|15.59|28.69|
|p-value of Anderson-Rubin chi-sqared test of endog|enous regressors||0.000411|5.89e-07|

Source: Authors’ calculations based on World Economic Outlook database 2019.

Robust standard errors in brackets.*** p<0.01, ** p<0.05, * p<0.1.Underidentification tests. Ho: matrix of reduced form coefficients has rank=K1-1 -underidentified. Ha: matrix has rank=K1-identified. Weak identification test. Ho: equation is weakly identified. Weak-instrument-robust inference. Tests of joint significance of endogenous regressors B1 in main equation. Ho: B1=0 and overidentifying restrictions are valid.
# **Table A4. Changes in Revenue Growth Across the Business Cycle on Compensation to Employees: Elasticities from Fixed Effects and IV Regressions for Emerging and Advanced Economies**

|VARIABLES|(1)<br>Emerging<br>economies -<br>FE|(2)<br>Advanced<br>economies -<br>FE|(3)<br>Emerging<br>economies -<br>IV|(4)<br>Advanced<br>economies -<br>IV|
|---|---|---|---|---|
|Revenue Growth * Exp|0.28<br>[0.121]**|0.32<br>[0.094]***|0.74<br>[0.167]***|0.34<br>[0.090]***|
|Revenue Growth * Rec|-0.07|0.06|0.10|-0.18|
||[0.149]|[0.110]|[0.220]|[0.152]|
|Lagged Compensation to Employees Growth|-0.04|0.26|-0.06|0.30|
||[0.093]|[0.068]***|[0.083]|[0.130]**|
|Lagged General Government Expense Growth|0.09|0.05|0.08|0.01|
||[0.039]**|[0.079]|[0.051]|[0.056]|
|Constant|0.04<br>[0.004]***|0.01<br>[0.001]***|||
|Observations|864|432|857|418|
|R-squared|0.045|0.162|||
|Number of Countries|42|18|42|18|
|Country Fixed Effect|Yes|Yes|Yes|Yes|
|Adjusted R-squared|||-0.200|0.090|
|**First Stage IV Estimates**|||**First Stage **|**First Stage **|
|Trade Weighted Growth * Exp|||1.45<br>[.2]***|1.3<br>[.08]***|
|Trade Weighted Growth * Rec|||1.68<br>[.24]***|1.39<br>[.15]***|
|**Underidentification - Weak Identification - W**|**eak Instrume**|**nts Tests**|||
|LM test statistic for underidentification|||43.97|30.51|
|p-value of underidentification LM statistic (And<br>F statistic for weak identification (Cragg-Donald|erson or Kleibe<br>or Kleibergen|rgen-Paap)<br>-Paap)|0<br>29.28|3.33e-08<br>52.01|
|Anderson-Rubin chi-sqared test of significance|of endogenous r|egressors|39.88|13.91|
|p-value of Anderson-Rubin chi-sqared test of en|dogenous regre|ssors|2.19e-09|0.000952|

Source: Authors’ calculations based on World Economic Outlook database 2019.

Robust standard errors in brackets.*** p<0.01, ** p<0.05, * p<0.1.Underidentification tests. Ho: matrix of reduced form coefficients has rank=K1-1 -underidentified. Ha: matrix has rank=K1-identified. Weak identification test. Ho: equation is weakly identified. Weak-instrument-robust inference. Tests of joint significance of endogenous regressors B1 in main equation. Ho: B1=0 and overidentifying restrictions are valid.
# **Table A5. Changes in Revenue Growth Across the Business Cycle on Goods and Services: Elasticities from Fixed Effects and IV Regressions for Emerging and Advanced Economies**

|VARIABLES|(1)<br>Emerging<br>economies -<br>FE|(2)<br>Advanced<br>economies -<br>FE|(3)<br>Emerging<br>economies -<br>IV|(4)<br>Advanced<br>economies -<br>IV|
|---|---|---|---|---|
|Revenue Growth * Exp|0.37<br>[0.106]***|0.47<br>[0.108]***|1.32<br>[0.484]***|0.63<br>[0.133]***|
|Revenue Growth * Rec|-0.22<br>[0.164]|-0.18<br>[0.099]*|-0.06<br>[0.397]|-0.50<br>[0.189]***|
|Lagged Goods and Services Growth|-0.20|0.15|-0.24|0.09|
||[0.102]*|[0.086]|[0.076]***|[0.061]|
|Lagged General Government Expense Growth|0.03|0.09|-0.02|0.14|
||[0.060]|[0.074]|[0.100]|[0.086]|
|Constant|0.04<br>[0.006]***|0.01<br>[0.002]***|||
|Observations|808|432|801|418|
|R-squared|0.050|0.092|||
|Number of Countries|40|18|40|18|
|Country Fixed Effect|Yes|Yes|Yes|Yes|
|Adjusted R-squared|||-0.202|0.028|
|**First Stage IV Estimates**|||**First Stage **|**First Stage **|
|Trade Weighted Growth * Exp|||1.41<br>[.2]***|1.33<br>[.08]***|
|Trade Weighted Growth * Rec|||1.77<br>[.29]***|1.36<br>[.15]***|
|**Underidentification - Weak Identification - We**|**ak Instruments**|**Tests**|||
|LM test statistic for underidentification|||44.93|29.74|
|p-value of underidentification LM statistic (Ander|son or Kleiberge|n-Paap)|0|4.95e-08|
|F statistic for weak identification (Cragg-Donald o|r Kleibergen-Paa|p)|23.97|47.36|
|Anderson-Rubin chi-sqared test of significance of<br>p-value of Anderson-Rubin chi-sqared test of endo|endogenous regr<br> genous regressor|essors<br>s|15.45<br>0.000442|28.69<br>5.89e-07|

Source: Authors’ calculations based on World Economic Outlook database 2019.

Robust standard errors in brackets.*** p<0.01, ** p<0.05, * p<0.1.Underidentification tests. Ho: matrix of reduced form coefficients has rank=K1-1 -underidentified. Ha: matrix has rank=K1-identified. Weak identification test. Ho: equation is weakly identified. Weak-instrument-robust inference. Tests of joint significance of endogenous regressors B1 in main equation. Ho: B1=0 and overidentifying restrictions are valid.
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