Economic Modelling 30 (2013) 7989

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Economic Modelling
journalhomepage:www.elsevier.com/locate/ecmod

Governments under influence: Country interactions in discretionary fiscal policy

a b c, d
Aurlie Cassette , Jrme Creel , Etienne Farvaque , Sonia Paty
a EQUIPPEUniversits de Lille, France
b OFCE and ESCP Europe, France
c EDEHN, Universit du Havre and Skema Business School, France
d GATE-LSEUniversit de Lyon 2 and CNRS, France
article info abstract

Article history: We investigate the interactions between countries, and their effect on the discretionary (i.e. the cyclically-adjusted and
Accepted 31 August 2012 interest-adjusted) components of national fiscal policies, observing and investigating the parts of public spending and tax
receipts over which governments retain full discretion. Our sample in-cludes 18 OECD countries for the period 1974 2008.
JEL classification: First, we construct a measure of a discretionary fiscal policy from the residual component in a VAR model. We then compute
E62
this measure for the full sample. Using these data, we next run estimations of the discretionary fiscal policy interactions among
H60
the countries in the sample. Our results show that public decisions are affected by interactions between neighbor countries,
H87
neighborhood being defined by economic leadership as well as geography. We found evidence of opportunis-tic behavior by
Keywords: OECD country governments in relation to discretionary public spending. Finally, our estima-tion results reveal the crucial
Fiscal policy leadership role played by the USA in relation to discretionary fiscal policy decisions in Europe.
Discretion
Interactions
VAR 2012 Elsevier B.V. All rights reserved.
Spatial econometrics

1. Introduction
The idea that public policies diffuse from one country to another is not
new. It is developed in the literature, e.g. in work on yardstick com-petition
(see Besley and Case, 1995), tax competition (see Wilson, 1999),
coordination issues (see Oudiz and Sachs, 1984, for a seminal contribution),
capital account policies (see Steiner, 2010), and in the political science
literature (see Gilardi, 2010, for a recent contribution). Although binding
fiscal rules and peer pressure have been studied ex-tensively (see, e.g.,
Hallerberg et al., 2009, for the European case), other means of diffusion of tax
and fiscal policies, i.e., imitation, have been rather overlooked. This paper
aims, therefore, to show that the tax and fiscal policies of one country have an
influence on those implemented in other countries.
The authors acknowledge financial support from the French National Research Agency
(grant ANRFRAL022). This paper has benefited from useful comments from a referee and
from Cristina Badarau-Semenescu, Lars Borge, Martial Foucault, Jean-Luc Gaffard, Marcel
Grard, Massimo Giuliodori, Jurgen von Hagen, Hakim Hammadou, Jrme Hricourt, Grgory
Levieuge, Ioana Moldovan, Edoardo di Porto, Laurence Rioux, David Wildasin, Blandine
Zimmer, participants in the Public Economics Day (Paris 1), the European Public Choice
Society 2010 meeting, the 44th Canadian Economics Association conference, Journes AFSE
2010, the 27th symposium on Money Banking and Finance Bordeaux 2010, AFSE Annual
Confer-ence 2010, the workshop on New issues on fiscal federalism and tax competition and
seminar participants in Bonn. The usual disclaimer applies.
Corresponding author.
E-mail address: etienne.farvaque@univ-lehavre.fr (E. Farvaque).
This paper aims to investigate the existence of these influences. First we
define a discretionary policy in order to study the behavioral interac-tions
between governments: only the part of public spending and/or tax receipts
over which governments retain full control can be used strate-gically in
response to the behavior of other governments.
We need to understand the structure of a discretionary fiscal policy.
Countries publish only one annual budget; however, budget supplements may
be applied in response say, to changes to welfare benefits, public employees'
wages following a new collective agree-ment, or new tax exemptions. The
implementation of supplements to annual budgets is common practice; they
may be included as part of the mid-year budget review but in most countries
can be proposed to the legislature at any time (see OECD, 2004). For
instance, in the UK, the end-of-the-year budget represents a substantial
revision to the Pre-Budget Report which is the basis for the UK annual
budget. The reasons for revisions include forecasting changes, not directly
attributable to policy decisions and the effects of discretionary changes which
do result from policy decisions. The OECD countries do not set a limit on
these supplements, although it is generally accepted that they should not be
too large (OECD, 2004). If the mid-year budgets and possible supplementary
budgets include dis-cretionary changes, this can affect the fiscal policy
outcome for the current fiscal year, even if only marginally. What matters is
that these changes cannot be entirely expected (and, at least, induce a re-
vision to expectations), meaning that discretionary policy measures, even in a
rational expectations setting, may have a lasting impact.

0264-9993/$ see front matter 2012 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.econmod.2012.08.032
80 A. Cassette et al. / Economic Modelling 30 (2013) 7989

Assessing these measures is not
straightforward. Various attempts
have been made to extract or reveal
discretionary fiscal measures (see,
e.g., Beetsma and Giuliodori,
2010a; Blanchard and Perotti, 2002;
Mountford and Uhlig, 2009; Ramey
and Shapiro, 1998; Romer and
1 neighbors' spending. These results
Romer, 2010). We review these
briefly in Section 2. However, apart
from the two studies by Beetsma
and Giuliodori (2010a,b), the issue
of external influences on the
adoption of the new policy
measures is not explored and most
work focuses on only one country.
The scope of the present study is
much broader.
Our study of external influences
on the design of discretionary fis-cal
policy provides two contributions to
the literature. First, we define a
measure of discretionary fiscal
policy for 18 OECD countries for
the period 19742008. We compute
a discretionary (i.e., a cyclically-
and interest-adjusted) measure of
public spending, and a discretionary
(i.e., a cyclically-adjusted) measure
of tax receipts. Second, we use
spatial econometrics to measure
country interactions in discretionary
tax or fiscal policy. Although spatial
econometrics is used in the
empirical literature to measure
strategic interactions among local
governments, very few studies
investigate public policy
interdependencies at the
(inter-)national level. We consider
several weight matrices and various
political variables not identified in
the first step but which may
contribute to explain why countries
imitate each other. Our approach
suggests a new way of approaching
the problem by combining two well
established methodologies from
different fields.
Our results show that there are
interactions among our sample
countries and that the closer the
countries involved, the more im-
portant are these interactions.
Closeness is defined as similar
relative per capita GDP or close
geographic location. We find also
that political cycles are influential;
we show that OECD country
governments dem-onstrate
opportunistic behavior in relation to
discretionary public spending. Also,
estimation results confirm the
crucial role of the USA as a leader
in relation to discretionary public
decisions in Europe.
The paper is structured as
follows. Section 2 briefly reviews
the related literature. Section 3
describes the empirical
methodology, and defines and
computes our measure of
discretionary fiscal policy. Sections
4 and 5 present the estimation
results and Section 6 con-cludes the
paper.
2. Related literature
The literature on fiscal policy
and its determinants and
consequences is abundant but
consists mainly of two strands:
macro-founded studies and micro-
founded studies.
In the macroeconomic work,
only a few papers address the mea-
surement and determinants of
reciprocal influences in
discretionary fiscal policy.
Giuliodori and Beetsma (2008)
analyze the inter-dependence of
budget deficits among European
Union (EU) countries, using real-
time data. They find some evidence
of fiscal policy inter-dependence,
with the fiscal plans of the large
countries affecting the fiscal plans
of smaller ones, but not vice versa.
However, they focus only on fiscal
plans i.e., measures announced ex
ante by EU govern-ments which
require them to internalize how they
will abide by the rules of the
Stability and Growth Pact.
2
Although fiscal plans to ad-dress
European recommendations are
included in discretionary fiscal
policies, these policies can include
other elements. Governments may
modify their fiscal policies during a
particular year without their being
justified by fiscal obedience to a
European rule: ex post data
1 See Beetsma and Giuliodori (2010b) for
a review of discretionary fiscal policy which
highlights estimates in an open economy
framework. Exchange rates and cur-rent
accounts are beyond the scope of the present
contribution.
2 Giuliodori and Beetsma (2008) use
OECD forecasts in order to avoid recurring
to fiscal forecasts possibly manipulated by
governments. However, as Giuliodori and
Beetsma (2008) acknowledge, given that
OECD figures come from government
institu-tions, OECD forecasts are influenced
by politics: economic forecasts can be
expected to abide ex ante by the rules of the
Stability and Growth Pact.
states (Baicker, 2005; Case et al.,
would be necessary to reveal such a 1993; Figlio et al., 1999; Redoano,
modification. Moreover, the scope 2007). For instance, Case et al.
for discretionary fiscal interactions (1993) estimate the effect of a
may extend beyond the EU area. state's spending on that of its
Beetsma and Giuliodori (2010a) neighbors using a spatial lag model.
make use of real-time data for the They find that states' per capita
OECD countries, but focus on expenditures are positively and
changes to domestic fiscal plans signifi-cantly correlated with their
driven by changes in cyclical
conditions, rather than on external are confirmed by Figlio et al.
interactions. (1999), who check the existence of
spillovers in welfare spending.
Agnello and Cimadomo (2012) Baicker (2005) finds that each dollar
investigate the revenue aspects of of state spend-ing causes spending
the government budgets of EU in neighboring states to increase by
countries in relation to discretionary between 37 cents and 88 cents.
policy and whether discretionary Finally, Redoano (2007) estimates
reaction functions for taxes and
measures are implemented as a re-
action to economic fluctuations. public expenditure, aggregated and
disaggregated, using a dataset of
They show that legislated changes
countries for the period 19851995.
to taxes and social security
She finds that govern-ments behave
contributions respond to the
strategically with respect to those
business cycle in a strongly pro-
expenditures that are more directly
cyclical way. However, their
comparable, such as expenditures in
measure of discretion-ary fiscal
education: a country's education
policy considers only revenue (our
expenditure increases by over 40
measure is more com-prehensive),
cents for a $1 increase in spending
and their sample is of EU countries
on education by neighbor countries.
while our sample of OECD
However, to our knowledge, all
countries is much larger.
these papers use broad measures for
spending and gross fiscal data; we
Neely and Rapach (2009)
believe that to properly investigate
analyze co-movements in four
the interactions between countries,
measures of budget surpluses, for
it is necessary to isolate the part that
18 OECD countries in 19802008
is the sole responsibility of policy
within a dynamic latent factor
makers, i.e., the discretionary part
model. They show that the world
of public spending and tax receipts.
factor in national budget surpluses
declined substantially in the 1980s
and then rose throughout most of
the 1990s reaching a peak in 2000
3. The empirical methodology
that was followed by decline. They
show that this world factor explains
This section first presents the
a substantial portion of the
spatial method and then describes
variability in budget surpluses
the construction of the dependent
across countries. Although they
variables, i.e., the discretionary
document a common trend, their
public policy impulses.
modeling strategy does not allow
them to verify whether this com-
3.1. Assessing fiscal policy
mon trend is in fact driven by some
interactions among OECD countries
of their sample countries' influ-ence.
It also does not allow them to
Strategic interactions among
investigate the determinants of the
governments have been a central
interrelations exhibited. In the
issue in public finance theory since
present study we examine discre-
the early 1990s (see the survey by
tionary fiscal policy (and not on
Wilson, 1999). More recently,
aggregates that may be subject to
spatial econometric techniques have
other influences such as
been used to estimate inter-
generalization of the welfare state,
governmental interaction models
along the lines of the case in
(see Brueckner, 2003; Revelli,
Lindbeck, 2008), and deepen the
analysis by uncovering the origins 2005).
Building on the spatial
of reciprocal national influences. econometric method
developed
The micro strand in the
literature focuses on spending
interactions among countries or
A. Cassette et al. / Economic Modelling 30 (2013) 7989 81

by Anselin (1988), the model
includes the spatially lagged
dependent variable:
u
CA;i
Wu
CA;j
Xi t i t
i t
with ij
1 and imposes a smooth distance
k;t k;t ; and m is a vector of the i.i.d. error
; decay with weights wij, given by
CA, i
where uk ,t is the discretionary
(cyclically-adjusted, CA) spending
(or tax receipts) of the i=1, N
countries, X is the set of exogenous
national socio-economic
characteristics, i is a country fixed
effect, t is a period fixed effect and
is a vector of i.i.d. error terms.
In this spatially lagged model,
W is a weight matrix that assigns
neighbors to each country
(according to the definition below);
CA, i
the spatial lagged variable Wuk ,t
is a weighted average of all other
coun-tries' fiscal policies, is the
spatial autoregressive coefficient,
that gives the sign and the intensity
of the impact of neighboring fiscal
policies on one country's public
decisions.
A negative implies that
expenditure spillovers explain the
spatial correlation between
countries' decisions (Brueckner,
2003; Revelli, 2005). When is
positive, a form of imitation
(mimicking, i.e., fiscal competition
or yardstick competition) explains
the ob-served interaction. For
example, in the presence of tax base
mobility, a government's fiscal
policy may affect the budget
constraints of other governments,
through capital migration (Wilson,
1999). This is the assumption of
fiscal competition for mobile
resources. In yard-stick competition
theory, information on the fiscal
policy of neighbor governments acts
as a yardstick for the electorate in
any given coun-try. As a result, any
country's citizens will compare the
performance of their own
policymakers to that of neighboring
ones, triggering electoral reprisals.
This encourages mimicking
behavior by govern-ments to avoid
stigmatization and secure reelection
(Besley and Case, 1995; Salmon,
1987).
Finally, a spatial auto-
correlation pattern may simply
reflect com-mon shocks affecting
public policy, or the omission of
variables (such as country
characteristics) that are spatially
dependent (Manski, 1993). In this
case, we have a spatial
autoregressive process in the error
term, or a spatial error model:
u
CA;i
Xi t i t i t and i t geographical
Wj; t mi t 2 k;t ; ; ; ;
Euclidean
where is the spatial correlation
coefficient, W is a weight matrix
terms.
Turning to the estimation
techniques, Anselin (1988) shows
that, due to endogeneity bias,
ordinary least square (OLS)
produces incon-sistent estimators
when estimating spatial lag and
spatial error models. However,
instrumental variables (IV) or
maximum likelihood (ML)
estimation methods lead to
consistent estimators (Brueckner,
2003; Elhorst, 2003).
If spatial error dependence is
ignored, estimations can give false
evi-dence of strategic interaction.
We can use ML to deal with this
problem since ML takes account of
both spatial lag and error models,
however, this method, which is
implemented by Case et al. (1993),
is computa-tionally challenging
(Brueckner, 2003). The IV method,
however, yields consistent estimates
even with spatial error dependence.
Therefore, we run all the
estimations using the generalized
spatial two-stage least squares
(GS2SLS) method including both
the spatial lag and error models.
Arraiz et al. (2010) show that this
procedure produces consis-tent
estimates when disturbances are
heteroskedastic, and provides
simulation evidence that the ML
estimator produces inconsistent esti-
mates in that case.
The weight matrix, denoted W,
defines the structure of the inter-
action, the neighborhood among
countries. Since an a priori defini-
tion of interaction might arbitrarily
influence the estimations results, we
test the robustness of our fiscal
policy interaction model using
various criteria i.e., different weight
matrices.
Empirical studies testing for
fiscal competition, yardstick
competi-tion or spillover effects
when neighborhood is a central
feature, tradi-tionally use weight
matrices based on geographical
distance or simple
people (over 65 years) in the
contiguity. In line with the empirical population, based on the European
literature, we choose a common Commission AMECO (Annual
definition of Macro-Economic) database.
neighborhood based on the
Although a positive sign is usually
dis-tance between
3 expected since they are expected to
countries (dij). This scheme is reflect higher needs from these
DIST
given by the weight matrix W 5
particular population groups, we
believe that these macroeconomic
covariates should not be significant
1/dij when i is different from j (and
given our measures of discretion.
wij = 0 otherwise). We nevertheless deliberately
A second set of matrices is based include them to confirm that our
4
on economic criteria. We con- public policy dependent variables
sider the case where countries
measure discretion.
follow an economic leader, the latter
being defined by its per capita GDP.
GDPL
The matrix W assigns higher
weights to countries j with higher A second group of control
GDP per capita: wij = GDPj/jGDPj variables includes political data
if i is different from j, and 0 collected from the Database of
otherwise. This allows us to assess Political Institutions (DPI, see Beck
size effects. Trade flows between et al., 2001). Left is a dummy
countries may also promote variable for the country's political
mimicking behavior. Similar to preference. It takes the value 1 if the
TRADE
W , country i is closer to chief executive of country i in year t
country j than to country k if the belongs to a left-wing party, and 0
share of trade with j is higher than otherwise. We introduce dummies
the share of trade with k in the total
for the electoral cycle. Election year
trade of the country i.
(t) is a dummy variable that takes
It is a convention in the
the value 1 if there is a legislative
empirical spatial literature that all
election in year t. Election year t1
these weight matrices are
(resp. t + 1) is a dummy variable
standardized so that the elements of
that takes the value 1 for the year
each row sum to 1. Also, we need to
before/after a legislative election,
include some control variables in
and zero otherwise. If there is a
our model to reflect the impact of
trend towards an opportunistic
differences in the socio-economic
political business cycle during the
and political factors grouped within
legis-lature, we will observe higher
the vector X in Eq. (1). Following
discretionary public spending and
the empirical literature, we include
lower tax receipts in the year
some explanatory variables that
preceding the election and in the
might affect fiscal policies.
election year.
However, we do not expect an
important impact from these
Thirteen of the countries in our
variables on the validation of a
sample are members of the EU. We
former step of the empirical
introduce three dummies for EU
procedure. It should be noted also
membership, Eurozone membership
that a matrix based on GDP per
and respect of the Stability and
capita is not considered in this step
Growth Pact (SGP) respectively.
because this variable is already
included in the former step of the
estimation procedure (see below).
3 Geodesic distances are calculated
following the great circle formula, which
uses the geographic coordinates of capital
Our data set includes the 18 cities (CEPII data base).
4 See Case et al. (1993) and Baicker
OECD countries (Australia, Austria,
(2005), for a discussion of these matrices,
Belgium, Canada, Germany, defin-ing similarities between countries in
terms of income, population, etc.
Denmark, Spain, Finland, France,
5 The variable old people is designed to
United Kingdom, Greece, Ireland,
capture the demand for social services by
Italy, Japan, Netherlands, Norway, older members of the electorate. This
segment of the population constitutes an
Sweden and the United States),
interest group with growing political power,
considered over a period of 34 years and this variable is expected to be positively
(19752008). Descriptive statistics relat-ed to the size of the government.
are shown in Table 1.
The first group of control
variables, in line with the literature,
is a set of socio-demographic
variables, such as unemployment
rate, population density, and shares
of young people (under 14) and old
82 A. Cassette et al. / Economic Modelling 30 (2013) 7989

Table 1
Descriptive statistics.
Sources
Unemployment AMECO
rate
Young people AMECO
Old people AMECO
Population AMECO
density
Election year DPI
Left DPI
EU membership European Commission
Eurozone European Commission
membership
SGP European Commission and
AMECO
AMECO: database of the European
Commission, Economic and
Financial affairs. DPI: Database of
Political Institutions, World Bank.
Belonging to the EU and the
Eurozone take the value 1 if the
country i in year t belongs
respectively to the EU and to the
Eurozone, and zero otherwise. SGP
takes the value 1 if the EU country
i's deficit does not respect the SGP
in year t, and zero otherwise. There
will be a negative (positive) sign for
this parameter if the SGP is a
constraint on or a disciplining
device for the manipulation of
discretionary spending (taxes) in
EU countries experimenting with
high deficits. A positive (negative)
sign will emphasize the
ineffectiveness of the disciplining
device for discretionary spending
(taxes).
3.2. Measuring discretion in fiscal
policy
We next explain a former step of
the estimation procedure that has
permitted to measure our dependent
variables, the discretionary public
policy impulses on taxes and
spending.
It is acknowledged that macro-
fiscal data are distorted by various
influences that make it difficult to
extract their discretionary part,
which importantly is the part in the
sole control of policymakers, and
for which they can be held
6
accountable by citizens.
In order to extract discretionary
fiscal stances, we need to make
adjustments to the interactions with
other policies (central banks' and
foreign policymakers' decisions)
and adjustments to business-related
cyclical variations. This allows us to
relate discretionary fiscal policy in
one country to its counterpart in
another country and to in-vestigate
the existence of a causal
relationship and whether discre-
tionary interactions (if they exist)
change with political closeness,
geographical closeness, and good
and bad times, etc. We can examine
also where these interactions occur
(in relation to countries' public
spending and/or between to
countries' tax policies).
We use an approach related to
that in Blanchard and Perotti
(2002), which uses structural VARs
to extract the discretionary part of
fiscal policy in a dynamic and
atheoretical model in which they
assume that GDP reacts sluggishly
7
to fiscal policy shocks. In its
6 Recall that the focus here is on policy
design rather than policy effectiveness.
7 Other approaches for measuring the
discretionary part of fiscal policy include a
narrative one (Romer and Romer, 2010) and
Mountford and Uhlig's (2009) method. The
former is appealing because it relates to
real-time and real discretionary fiscal
episodes, but gathering information of the
same kind and quality for 18 countries is a
difficult methodological task. The latter
approach identifies fiscal shocks using a
VAR model with sign restrictions on the
dynamics of the fiscal variables, and
imposes orthogonality on a business cycle
shock and a monetary policy shock.
Although the au-thors claim that the
identifying assumptions are close to
minimal, the identification procedure
requires certain assumptions, including co-
movement of consumption, GDP and non-
residential investment for 4 quarters
following the shock to characterize
automatic stabilizers. Conversely, it could be
argued that the latter should apply if a shock
on consumption or a shock on non-
residential investment occurs, not because
both variables co-move.
simplest form, the identification of
fiscal policy shocks depends
substantially on the computed
elasticities of pairs of the dependent
variables, a process that does not
require any types of restrictions.
Because the method can be made
automatically systematic, it can be
applied to many countries. Recent
applications to, e.g., France (Biau
and Girard, 2005), the UK (Creel et
al., 2009), and the Euro area as a
whole (Burriel et al., 2010) testify
to this property, making the method
very appealing. Using this
methodology, we provide a com-
parative assessment for 18 OECD
countries.
The method used to obtain
adjusted fiscal data that characterize
the discretionary part of gross fiscal
data is as follows. We obtained
discretionary public spending and
tax receipts data for 18 OECD
coun-tries, for the period 1974 to
2008. Gross annual data were taken
from the OECD database. Our
public spending data are not free of
net inter-est because for a few
countries net-of-interest spending
data were missing. We can adjust
spending data for long-run interest
rates except in the case of Greece
where, for the entire period, only
short-run interest rate data are
available.
For each country we estimate a
single VAR model. Let g, , , r and
y denote, respectively, government
spending, tax revenues, consumer
inflation, long-term interest rate, and
GDP growth. Public finance
variables are expressed as
percentages of GDP; all variables
are expressed in percentages. Let Y t
and Ut respectively denote the
vector of the endogenous variables
and of the reduced-form residuals of
the VAR. The reduced form VAR
can be written as:
Yt AL Yt1 Ut
where Yt = [gt, t, yt, t, rt] and Ut
= [ug,t, u,t, uy,t, u,t, ur,t]. A(L) is
the L-year lag operator. Based on
the usual tests (Akaike information
cri-terion, Schwartz information
criterion), the optimal lag has been
set at 3 for all countries. With the
exceptions of Greece, Italy and the
UK, where Johansen cointegration
tests point to the existence of one
cointegration equation (at 1%) for
each country, the remaining (15)
countries show no significant
cointegration relation. A VECM is
not required for these 15 countries;
for the other three, and for the sake
of comparison with the remaining
15, we decided not to implement a
VECM experiment.
We first exploit a canonical VAR
model, but the residuals are not
informative about the response of
the endogenous variables to shocks:
they are only estimation errors.
Hence, in order to extract the
discretionary parts of fiscal data
public spending and tax receipts
we need to isolate the structural part
of the respective canonical residual.
While the canonical residual of, say,
tax receipts collects information on
all unexpected movements of that
variable, the corresponding
structural residual is obtained by
eliminating all the instantaneous
feedback mechanisms triggered by
evolutions of the other endogenous
variables.
The identification method
consists of isolating structural
residuals according to the following
procedure. Following Blanchard
and Perotti (2002), we begin with
by writing the reduced form
canonical residuals of the two fiscal
policy variables as linear
combinations of the structural and
automatic components:
u u u u e
g;t g;y y;t g; ;t g;r r;t g;t
u u u u e
;t ;y y;t ; ;t ;r r;t ;t
where eg,t and e,t are the structural
shocks to the two fiscal policy
variables. The first three terms on
the RHS of each equation in block
(3) capture the automatic responses
of fiscal policy to a change in GDP
growth, inflation, and interest rate
(the elasticities, denoted by ). The
last term captures the structural
policy component, which will be
interpreted as the discretionary
component.
Elasticities
(,y,g,y,g,,,,g,r,,r) are
computed as estimations of the log
change of the variable public
spending or tax receipts on
A. Cassette et al. / Economic Modelling 30 (2013) 7989 83
 y

the contemporary log change of Our method introduces some Table 2

either GDP, inflation, or the interest new elements to that proposed by Elasticities. d
8 Blanchard and Perotti (2002). Since i
rate. g,y g,r g, f
we include inflation and interest
Australia 0.03 0.05
a 0.0001 f
Next, the canonical residuals are rates (as in Perotti, 2004), we can a e
Austria 0.04 0.03 0.02
corrected for GDP growth (the adjust the fiscal variables for a wide Belgium 0.04 0.005 0.003r
array of macroeconomic shocks. e
automatic stabilizers), inflation, and Canada 0.04 0.004 0.00003
a n
interest rate variations, in order to Under the assumption that long- Germany 0.03 0.03 0.009
t
a a
term and short term interest rates Denmark 0.02 0.02 0.004
extract the respective discretionary a a
Spain 0.08 0.04 0.03
parts of spending and tax vari-ables. are related along the yield curve, the Finland 0.03 a
0.03
0.03 f
We can then define the cyclically- adjustment to fiscal data can be France 0.02 0.007 0.002r
adjusted (CA) public spend-ing and interpreted as involving correc-tion UK 0.05 0.09 0.008o
a
tax receipts as their respective for changes in monetary policy. In Greece 0.09 0.02 0.002m
a
relation to adjustments to for-eign Ireland 0.04 0.12 0.007
canonical residuals net of the effects a
Italy 0.06 0.0003 0.02
of the other contemporaneous fiscal policies, the spatial a a
0
Japan 0.02 0.02 0.004.
endogenous variables, hence: econometric method we implement Nld. 0.04 0.009 0.0005
below is a novelty in the literature Norway 0.04 0.04
a
0.01
a
a a
on the discretionary components of Sweden 0.01 0.04 0.002 The values of the elasticities are
CA
ug ;tug;t g;yuy;t g; u;t g;r u fiscal policy. USA 0.04 0.04
a
0.01
a
reported in Table 2. The picture is
CA
u ;tu;t ;yuy;t ; u;t ;r u S relatively diverse for the different
o countries. Note that the sign of sole
u
r elasticity, g,y, is always negative
As a consequence, without 8 Two other computation methodologies c and is statistically significant for
are possible. First, taking all taxes into ac- e
theoretical priors, estimations errors most countries. Other elasticities
count (from income to social contributions), s
of the canonical VAR are adjusted we could compute a weighted average of tax : testify to variations among coun-
for changes in the macroeconomic elasticities where the weights would depend tries in terms of degrees of
environment. The ensuing structural on the respective contribution of taxes to tax indexation and tax structures. The
revenues. Second, as in Blanchard and O
component can be interpreted as E con-temporaneous impact of long
Perotti (2002), overall tax elasticity to GDP
discretionary because it is related could be a weighted average of the product C term interest rates on public
D spending often is not statistically
neither to the other endogenous of the elasticity of each tax to its own base
and the elasticity of its tax base to GDP. The ,
variables nor to their unexpected significant. This is not surprising as
methodology used in this paper is the
variations. simplest to perform uniformly for a large
one would expect relative inertia of
a
Although we use the method sample of countries. total public spending vis--vis short
u
proposed by Blanchard and Perotti 9 Blanchard and Perotti (2002) identify t term change in the nominal long
(2002), the present elaboration does one structural residual e.g. the public h term interest rate, so that no clear
spending one as the canonical one. It is o
not completely endorse their iden- pattern emerges which, at first
then possible to regress the second canonical r
tification strategy. In addition to residual on tax receipts on the first one, glance, makes the disclosure of
s
introducing automatic responses to and to identify the new residual as the sec- ' inter-actions between countries ever
macroeconomic shocks in the ond structural residualon tax receipts. In more challenging. Beyond these
their robustness checks, Blanchard and
adjusted residuals of public c
differentiated underlying forces
Perotti (2002) also reverse the identification
spending and tax receipts, assumption: the canonical residual of a behind public spending and tax re-
Blanchard and Perotti (2002) adjust spending is regressed on the structural l ceipts behaviors, it is worth
public spending (tax receipts) for residual of tax receipts to identify the c studying whether political or
structural residual of spending, where the u
the instantaneous interaction with l
institutional determinants, like
structural residual of tax receipts is identical
tax receipts (public spending). to its ca-nonical residual. a yardstick competition, opportunistic
Nevertheless, their identification t behavior, or fiscal limits in the vein
methodology requires one of these 10 This avoids entering into the unresolved i of the Stability and Growth Pact,
discussion on the best fiscal framework, in o
two potential interactions to be fixed n
can trigger comparable fiscal
this case, for a sample of 18 countries over
9 behaviors.
at zero. However, this as-sumption 40 years. However, we cannot completely s
avoid this strategic issue: although we fix all .
requires taking a stand in the debate
contemporaneous interactions to zero, we do
over two competing the-ories: so only at the macroeconomic stage of the
Spend & Tax or Tax & Spend empirical procedure; in the spatial stage, we
a Before that, three issues with
public finance frameworks (see conduct an analysis of the strategic our dataset need to be acknowl-
Musgrave, 1966), depending on interactions across tax or fiscal policies.
: edged and discussed. First, the use
which variable must be constrained of annual data may seem at odds
by the other when designing policy N
with some papers, like Blanchard
action. Within the VAR model, a o and Perotti (2002) which make use
first case arises where public t of quarterly data. However,
spending is left free to affect taxes quarterly public finance data are,
but not the reverse. In a second s more often than not, interpolations
case, tax receipts are left free to t of yearly data (see Perotti, 2004, for
a
affect public spending but not the a discussion and Giuliodori and
t
reverse. Because there are no a i Beetsma and Giuliodori, 2010b, for
priori reasons to consider that one s a clear statement justifying the use
of these frameworks is better than t of annual data). It was thus im-
i
the other for all the countries under possible to find truly quarterly data
c
review at any one time, we do not a for all the countries under study
use this method for identifying the l over the whole sample period.
11
10 l
structural components.
Second, it can be argued that there
is no reason to fix the
contemporaneous interaction
between taxes and spending to zero.
The use of Generalized Impulse
Response Func-tions (GIRFs, see
Pesaran and Shin, 1998) can be
considered as an ad-equate tool to
overcome such a potential problem
of identifying restriction. Without
identifying restrictions, the use of
GIRFs permit-ted to extract the
VAR residuals of public spending
and tax receipts that we compared
to the discretionary fiscal stances
that our method delivers. It turns
out that, on average for the whole
sample period and the whole range
of countries, the correlation for
spending between our method and
GIRF is equal to .8 and is even
stronger for tax re-ceipts with a
correlation of .9. Hence both
methods give very similar
outcomes. However, the statistical
properties of residuals from GIRF
are weaker than with our method.
For spending and receipts, in all the
countries we cover, the mean and
standard deviation of GIRF

11
The exception was the USA. We
compared our annual dataset with the
interpolated yearly-equivalent quarterly data
obtained with the same identification
procedure. The correlations between both
are equal to 0.32 and 0.58 for public
spending and tax re-ceipts, respectively.
84 A. Cassette et al. / Economic Modelling 30 (2013) 7989

Table 3a
Estimation resultsdiscretionary spending (GS2SLS estimations).
Weight matrix GDP
W leader
WDIST WTRADE
Dependent Spending Spending Spending Spending Spending Spending
variable GIRF GIRF GIRF
W*Y (rho) b c c c a a
0.588 0.849 0. 880 0.884 0.176 0.370
(.231) (0.154) (.089) (0.081) (0.233) (0.359)
Unemployment rate 0.004 0.002 0.006 0.002 0.005 0.007
(0.101) (0.011) (0.009) (0.010) (0.010) (0.012)
Young people 0.005 0.008 0.011 0.016 0.004 0.014
(0.015) (0.017) (0.012) (0.014) (0.016) (0.020)
Old people 0.005 0.001 0.005 0.004 0.005 0.007
(0.020) (0.023) (0.019) (0.022) (0.020) (0.020)
Population density 0.0001 0.0008 0.0001 0.0001 0.0001 0.0005
(0.0004) (0.0005) (0.0004) (0.0005) (0.0004) (0.0005)
Election year (t) c c c c c c
0.200 0.182 0.183 0.161 0.202 0.193
(0.073) (0.086) (0.069) (0.082) (0.073) (0.085)
Election year (t+ 1) a a b a a a
0.124 0.104 0.141 0.129 0.048 0.151
(0.069) (0.081) (0.061) (0.073) (0.070) (0.081)
Election year (t1) 0.044 0.141 0.027 0.022 0.048 0.016
(0.069) (0.086) (1.52) (0.074) (0.068) (0.016)
Left a a a a a a
0.129 0.141 0.101 0.091 0.125 0.119
(0.073) (0.086) (0.062) (0.077) (0.073) (0.083)
Left*Coal 0.021 0.073 0.006 0.016 0.007 0.036
(0.090) (0.106) (0.084) (0.100) (0.090) (0.103)
EU membership 0.032 0.021 0.019 0.023 0.048 0.064
(0.079) (0.093) (0.081) (0.095) (0.081) (0.101)
Eurozone membership 0.043 0.069 0.043 0.044 0.052 0.090
(0.087) (0.099) (0.068) (0.084) (0.105) (0.159)
SGP a a b a b c
0.159 0.162 0.178 0.281 0.213 0.359
(0.095) (0.108) (0.074) (0.088) (0.103) (0.130)
Lambda 0.007 0.079 c c a a
1.311 1.241 0.328 0.702
Notes: 612 observations. Standard errors in parentheses.
Lambda is the spatial error coefficient.
a Significant at the 10% level.
b Significant at the 5% level.
c Significant at the 1% level.

Table 3b
Estimation resultsdiscretionary tax receipts (GS2SLS estimations).
Weight matrix GDP
W leader
WDIST WTRADE
Dependent variable TR TR TR TR TR TR
GIRF GIRF GIRF
W*Y b b a b b b
1.000 0.989 0.886 0.892 0.946 0.956
(0.091) (0.099) (0.061) (0.067) (0.108) (0.118)
Unemployment rate 0.004 0.005 0.009 0.006 0.003 0.009
(0.008) (0.009) (0.008) (0.009) (0.008) (0.009)
Young people 0.003 0.002 0.001 0.004 0.003 0.004
(0.011) (0.013) (0.011) (0.013) (0.011) (0.013)
Old people 0.001 0.006 0.006 0.0002 0.006 0.001
(0.018) (0.20) (0.018) (0.020) (0.017) (0.019)
Population density 0.0001 0.0001 0.0001 0.0001 0.0001 0.0001
(0.0003) (0.0004) (0.0004) (0.0004) (0.0004) (0.0004)
Election year (t) 0.066 0.079 0.111 0.110 0.091 0.097
(0.066) (0.074) (0.066) (0.075) (0.065) (0.072)
Election year (t+ 1) 0.084 0.069 0.023 0.014 0.017 0.016
(0.062) (0.070) (0.057) (0.063) (0.060) (0.067)
Election year (t1) 0.017 0.013 0.090 0.108 0.007 0.033
(0.062) (0.070) (0.057) (0.064) (0.061) (0.067)
Left 0.018 0.027 0.052 0.073 0.051 0.061
(0.066) (0.074) (0.056) (0.064) (0.062) (0.069)
Left*Coal 0.008 0.024 0.008 0.036 0.042 0 .015
(0.082) (0.092) (0.079) (0.088) (0.079) (0.088)
EU membership 0.011 0.010 0.057 0.063 0.017 0.010
(0.071) (0.074) (0.075) (0.084) (0.067) (0.075)
Eurozone membership 0.028 0.024 0.087 0.093 0.049 0.060
(0.061) (0.092) (0.065) (0.072) (0.058) (0.063)
SGP 0.002 0.012 0.002 0.025 0.004 0.028
(0.070) (0.079) (0.077) (0.090) (0.073) (0.085)
Lambda 0.780 0.702 1.1423 1.491 0.644 0.688
a Significant at the 5% level.
b Significant at the 1% level.
A. Cassette et al. / Economic Modelling 30 (2013) 7989 85

residuals are always superior to the
mean and standard deviation
obtained with our method. Thus, we
give preference to our method and
limit the use of discretionary
stances obtained with GIRFs to a
ro-bustness check of our main
outcomes. Third, we already
acknowl-edged that other methods
had been used in the literature to
extract discretionary stances (i.e.
Mountford and Uhlig, 2009; Romer
and Romer, 2010). Though we
praise the simplicity of applying our
meth-od to a wide range of
countries, we compare the
discretionary parts of tax receipts in
the USA with earlier estimations.
Discretionary stances are fully
consistent whatever the
identification procedure used.
12
4. Results
Our estimation strategy is as
follows. First, we estimate model
(1) using OLS without taking
account of the potential influence of
the fiscal policies set by other
countries. Because serial correlation
in panel data models biases the
standard errors and causes the
results to be less efficient, we
performed a Wooldridge (2002) test
to identify potential serial
correlation in the idiosyncratic error
term. No correla-tion was observed.
We next estimate the full model
(1). The dependent variable is our
CA
first step u residual, considering
the influence of the other countries'
policies (weighted spending
decisions or tax receipts) using the
GS2SLS method developed by
Arraiz et al. (2010). We estimate the
spa-tial lag parameter (denoted for
CA
W*u ) and the spatial error
parameter (denoted ). Estimation
results for discretionary spending
decisions and tax receipts are
presented in Tables 3a and 3b
respectively.
The estimates in Tables 3a and
3b show that the sign of the coeffi-
cient associated with neighboring
OECD countries' decisions on dis-
cretionary public expenditures and
tax receipts are significant and
positive. These results confirm the
existence of fiscal policy
interactions for all weighting
schemes based on either
geographical proximity or economic
leadership. This implies that
geographically close countries tend
to imitate each other when defining
their discretionary fiscal pol-icy
(public spending and tax receipts).
Countries also closely mimic their
main trade partners and economic
leaders in the OECD: the coef-
ficients are all close to 1. It is
interesting that the coefficients of
the three weight matrices are very
similar (although the trade matrix is
barely significant for spending, but
strongly so for tax receipts). As this
result cannot be attributed to a
similarity of contexts (taken into
account in the first step of the
estimation procedure), we interpret
this as showing that the estimation
results may be hiding different types
of interactions. Strategic interaction,
linked to yardstick compari-son or
tax competition may be the leading
mechanism, something we
investigate further in the next
section.
In relation to the estimation
results associated with the other
explan-atory variables, none of the
parameters associated with the
traditional variables, such as
unemployment and demographic
variables, is signifi-cant for either
type of public policy. This is further
confirmation that our measure of
discretionary fiscal policy really
13
measures discretion.
Among the political variables,
there are two important results for
public spending. First, the dummy
variables associated with an elec-
tion year indicates opportunistic use
of (i.e., an increase in) discre-
tionary public spending in the year
of the election. This is strong
evidence of a political budgetary
cycle for discretionary public
expen-diture. This result contrasts
with Brender and Drazen's (2005,
2007) findings of a political deficit
cycle in a large cross-section
between 74 and 106 countries, a
result that is driven by the
experience of new democracies.
Our sample contains mature
democracies only. Although our
results reaffirm the presence of
opportunistic cycles in older
democracies, it
12 A comparative graph is available upon
request.
13 Recall also that taxes and spendings are
not in (per capita) real terms but in per-cent
of GDP.
should nevertheless be remembered
that our measure of fiscal policy
draws on discretionary fiscal policy,
whereas Brender and Drazen (2005,
2007) use an overall deficit i.e., the
difference between receipts and
14
expenditures.
Second, we find evidence of
ideological effects on discretionary
spending decisions: the coefficient
of political affiliation (Left) for the
chief executive is significant and
negative. Left-wing chief execu-
tives seem to set lower discretionary
public expenditures than right-wing
chief executives. As shown by the
coefficient of the variable Left*Coal
(where Coal stands for coalition),
this result is not driven by the fact
that Left-wing governments are
more often than their Right-wing
counterpart, members of a ruling
coalition, a claim often found in the
literature. The empirical results for
the relationship between partisan
politics and public finance, drawing
on a panel of advanced economies,
generally are mixed (see Cusack,
1999, for a survey). Our result
would be consistent with debt being
used strate-gically la Persson and
Svensson (1989), and which, to our
knowl-edge, has not been observed
earlier. If an incumbent government
is afraid of not being reelected, it
might decide to increase overall
public spending, hence feeding debt
growth. Newly elected governments
have no choice but to reduce
spending whatever the economic
condi-tions: thus discretionary
public spending will fall. Our
results support this hypothesis when
the incumbent government is on the
Right and the newly elected one is
Left wing.
The remaining explanatory
variables for socio-demographic
fea-tures (unemployment rate,
young people, old people, and
population densities) and European
characteristics (EU and Eurozone
member-ship) have the expected
signs although they are never
significant. This again confirms that
it is only the discretionary
components of fiscal policy that are
present in our dependent variables
(i.e., the first step has purged the
fiscal data, and our measure
correctly esti-mates discretionary
impulses). The only significant
explanatory vari-able is the SGP
dummy, which has a positive sign in
the discretionary public spending
equation, but consistently negative
in the discretion-ary tax revenues
equation although it is not
statistically significant. We interpret
this result as showing that the EU
fiscal framework is not effective at
prompting a corrective effect when
public deficits in the EU are above
the SGP threshold. The disciplining
device of the SGP is not working.
This result complements the study
by Fats and Mihov (2003),
showing that once countries fall
below a 3% threshold, the
incentives to go further (towards the
final objective of close to balance or
surplus budgets) are much weaker
and countries reduce their efforts.
Finally, as a robustness check, it
is worth mentioning that results
obtained using discretionary stances
extracted with GIRFs are consis-
tent with the ones obtained with our
preferred method. In contrast with
our first results, interactions are
magnified if GIRF-obtained dis-
cretionary public spending is used;
the influence of the SGP is also
stronger, whereas the opportunistic
behavior is somewhat lessened;
finally, interactions with GIRF-
obtained discretionary tax receipts
are almost similar. Hence, the
choice of the discretionary dataset
does not bias the results.
5. Further results
Here we investigate the source
of interdependence in national dis-
cretionary fiscal policies (5.1) and
check whether belonging to the EU
matters (5.2).
14
The result may also be due to an
incumbent effect or to the election of a new
polit-ical team. We believe that further
estimations are needed to distinguish
between these effects. However, as the
purpose of the present paper is not to
investigate the effect of the political agenda
on discretionary public policy, we do not
develop this issue further here.
86 A. Cassette et al. / Economic Modelling 30 (2013) 7989

Table 4
Source of the interactions in the OECD (ML estimations).

Dependent variable Spending Tax receipts

Weight matrix WD GDP US leader WD GDP US leader
W leader WTRADE W leader WTRADE
ELECT*W*Y c c c c c c c c
0.30 0.25 0.16 0.29 0.43 0.48 0.24 0.35
(3.21) (3.27) (3.20) (4.35) (4.97) (7.15) (5.37) (5.48)
(1ELECT)*W*Y a b a a a a a a
0.29 0.28 0.14 0.20 0.21 0.04 0.03 0.10
(1.80) (2.35) (1.75) (1.84) (1.36) (0.37) (0.46) (0.95)
Unemployment rate 0.01 0.01 0.02 0.01 0.003 0.005 0.004 0.002
(1.28) (1.23) (1.35) (1.21) (0.31) (0.48) (0.37) (0.19)
Young people 0.02 0.02 0.03 0.02 0.003 0.002 0.004 0.004
(1.21) (1.39) (1.43) (1.37) (0.20) (0.10) (0.24) (0.20)
Old people 0.01 0.02 0.02 0.01 0.0006 0.0007 0.0007 0.002
(0.64) (0.70) (0.68) (0.64) (0.02) (0.03) (0.027) (0.07)
Population density 0.0001 0.0001 0.0002 0.0002 0.0001 0.0008 -0.0003 0.0001
(0.30) (0.31) (0.38) (0.34) (0.32) (0.14) (0.06) (0.29)
Election year (t) b c b c 0.11 0.09 0.09 -0.10
0.19 0.20 0.20 0.19
(2.55) (2.60) (2.56) (2.58) (1.49) (1.26) (1.17) (1.34)
Election year (t+ 1) 0.03 0.04 0.04 0.04 0.02 0.009 0.009 0.01
(0.54) (0.65) (0.64) (0.56) (0.33) (0.13) (0.13) (0.18)
Election year (t1) a 0.11 0.11 a 0.05 0.06 0.06 0.05
0.12 0.13
(1.74) (1.51) (1.49) (1.81) (0.72) (0.84) (0.83) (0.76)
Left a a a a 0.04 0.04 0.04 0.04
0.14 0.16 0.15 0.13
Left*Coal (1.88) (1.94) (1.93) (1.75) (0.60) (0.57) (0.60) (0.61)
0.04 0.05 0.04 0.03 0.03 0.03 0.01 0.02
(0.38) (0.47) (0.43) (0.28) (0.34) (0.28) (0.13) (0.27)
EU membership 0.0005 0.02 0.003 0.006 0.05 0.07 0.07 0.06
(0.005) (0.17) (0.03) (0.05) (0.57) (0.69) (0.71) (0.60)
Eurozone membership 0.06 0.04 0.05 0.07 0.08 0.08 0.08 0.10
(0.74) (0.46) (0.60) (0.81) (0.90) (0.95) (0.96) (1.16)
SGP a b b b 0.09 0.11 0.14 0.12
0.18 0.19 0.19 0.19
(1.92) (2.07) (2.01) (2.06) (1.07) (1.18) (1.51) (1.38)
c c a
Wald test rho 0.007 0.04 0.02 0.08 0.22 0.44 0.27 0.25
(0.03) (0.25) (0.26) (0.63) (1.15) (3.25) (3.23) (1.84)
Log likelihood 633.9 636.1 637.7 632.6 621.6 622.2 627.9 623.7

Notes: 612 observations. Spatial fixed effects are included.

a Significant at the 10% level.
b Significant at the 5% level.
c Significant at the 1% level.

5.1. Interpreting the interactions among OECD fiscal policies
In moving from theory to empirics, it is necessary to identify the
theoretical model generating the observed spatial pattern, i.e., to dif-ferentiate
among alternative theoretical explanations for fiscal inter-actions among
governments. We are particularly interested in the sources of interdependence
in national discretionary fiscal policies. As Redoano (2007) emphasizes, the
coefficient associated with the interaction term is not negative, so our results
do not point to the ex-istence of spillovers caused by free riding behaviors.
However, we want to find out whether the positive interaction coefficient
stems from fiscal competition or yardstick competition.
To distinguish between fiscal competition and yardstick competi-tion, we
need to check whether the spatial effect is stronger in an election year.
Yardstick competition occurs when citizens compare the fiscal and spending
decisions made by the incumbent government with those made by their
neighbors' policy makers (Besley and Case, 1995; Salmon, 1987). In this
context, policy-makers will be more concerned about neighbor incumbents in
election periods, and strate-gic interactions are likely to be stronger at such
times. Tax competi-tion, in theory, is not driven by political agendas. A
straightforward way of testing the yardstick versus the tax competition
hypotheses is to use variables for the election cycle (Elhorst and Frret, 2009;
Redoano, 2007). We interact the weighted average discretionary pol-icy of
neighbors (Yj,t) with an election dummy (D) and estimate two interaction
coefficients, one for the year of election (1) and one for the rest of the period
(2). We thus exploit a two-regime spatial lag model:
In line with Elhorst and Frret (2009), we use a ML estimator to deal with
15
this specific model. The results are reported in Table 4. We find no
significant difference in the interactions related to discre-tionary spending.
However, the coefficient of spatial interaction shows highly significant
differences for the discretionary tax receipts. OECD countries mimic the
discretionary revenues of the economic leaders (all GDP leaders or only the
US). Thus, the yardstick competi-tion hypothesis cannot be rejected for
discretionary tax receipts. In-terestingly, the coefficient related to the US
leadership is inferior to the ones relative to the matrix using the whole set of
countries (GDP leaders). This shows that the US is clearly a leading economy,
but that its leadership is shared with other OECD countries. An inter-pretation
of this result could be related to the intensity of competition between
countries to attract mobile capital bases, either attracted by favorable tax
regimes or by the better quality of infrastructure (pro-vided deficits are
directed towards growth-enhancing expenditures). This interpretation does not
contradict the yardstick hypothesis, but would point to the fact that the
competition could be more intensely felt in election years.
5.2. Does belonging to the EU matter?
Since 13 of the countries in our sample are members of the EU, we
16
estimate Eq. (2) on a subsample of European countries. The
15 Unfortunately, GS2SLS estimator is not available when estimating a two regime spatial lag
model. However, previous studies show that the interactions are not driven by common shocks.

16 Since these countries did not join the EU at the same time, we include a dummy for EU membership.
CA ;i CA ;j CA ;j
u k;t 1DWu k;t 21 DWu k;t Xi;t i t i;t 5
 A. Cassette et al. / Economic Modelling 30 (2013) 7989 87

Table 5a
Estimation resultsdiscretionary spending for EU13 (GS2SLS estimations).
Weight matrix GDP US leader
W leader
WDIST WTRADE
Dependent variable Spending Spending Spending Spending Spending Spending GIRF Spending Spending GIRF
GIRF GIRF
W*Y (rho) a c c c c c c c
0.737 0.889 1.038 0.968 0.144 0.191 0.894 1.013
(0.243) (0.223) (.083) (0.072) (0.064) (0.064) (0.200) (0.160)
Unemployment rate 0.001 0.001 0.005 0.002 0.016 0.005 0.003 0.005
(0.011) (0.013) (0.008) (0.010) (0.015) (0.018) (0.010) (0.012)
Young people 0.001 0.004 0.003 0.010 0.0007 0.024 0.004 0.011
(0.017) (0.021) (0.011) (0.014) (0.023) (0.028) (0.016) (0.018)
Old people 0.010 0.009 0.008 0.003 0.062 0.057 0.008 0.006
(0.027) (0.032) (0.021) (0.027) (0.047) (0.056) (0.026) (0.031)
Population density 0.0001 0.0001 0.0001 0.0001 0.001 0.0007 0.0001 0.0005
(0.0005) (0.0006) (0.0005) (0.0005) (0.005) 0.006 (0.0005) (0.0006)
Election year (t) b c c c c c c c
0.307 0.291 0.277 0.304 0.335 0.337 0.322 0.314
(0.087) (0.103) (0.065) (0.081) (0.092) (0.110) (0.083) (0.098)
Election year (t+ 1) 0.113 0.110 0.143 0.144 0.115 0.124 0.149 0.141
(0.080) (0.100) (0.062) (0.079) (0.089) (0.107) (0.082) (0.096)
Election year (t1) 0.025 0.021 0.008 0.026 0.035 0.025 0.014 0.034
(0.085) (0.100) (0.066) (0.081) (0.089) (0.107) (0.082) (0.097)
Left 0.040 0.011 0.025 0.046 0.075 0.044 0.008 0.032
(0.093) (0.109) (0.090) (0.108) (0.107) (0.127) (0.092) (0.107)
Left*Coal 0.038 0.049 0.066 0.062 0.061 0.062 0.062 0.061
(0.108) (0.127) (0.090) (0.113) (0.128) (0.152) (0.107) (0.124)
EU membership 0.001 0.022 0.016 0.012 0.048 0.083 0.003 0.027
(0.108) (0.128) (0.107) (0.127) (0.144) (0.172) (0.107) (0.125)
Eurozone membership 0.055 0.065 0.052 0.021 0.177 0.261 0.075 0.052
(0.092) (0.116) (0.048) (0.066) (0.139) (0.166) (0.074) (0.091)
SGP 0.120 0.145 0.153 0.116 0.256 0.472 0.133 0.191
(0.101) (0.123) (0.042) (0.057) (0.109) (0.130) (0.085) (0.101)
Lambda 0.048 0.158 2.166
c
1.66
c 0.076 0.041 0.401 0.296

Notes: 442 observations. Standard errors in parentheses.

a Significant at the 10% level.
b Significant at the 5% level.
c Significant at the 1% level.

Table 5b
Estimation resultsdiscretionary tax receipts for EU13 (GS2SLS estimations).
Weight matrix GDP US leader
W leader
WDIST WTRADE
Dependent variable TR TR TR TR TR TR TR TR
GIRF GIRF GIRF GIRF
W*Y a c b c c c c c
1.05 1.028 0.925 0.934 0.371 0.304 1.122 1.085
(0.110) (0.17) (0.039) (0.039) (0.068) (0.067) (0.158) (0.159)
Unemployment rate 0.005 0.006 0.001 0.006 0.004 0.003 0.001 0.006
(0.009) (0.010) (0.008) (0.008) (0.015) (0.175) (0.010) (0.011)
Young people 0.003 0.003 0.007 0.004 0.010 0.001 0.009 0.004
(0.014) (0.016) (0.009) (0.009) (0.023) (0.026) (0.014) (0.016)
Old people 0.004 0.003 0.017 0.012 0.016 0.007 0.017 0.010
(0.026) (0.030) (0.019) (0.020) (0.046) (0.052) (0.025) (0.028)
Population density 0.0001 0.0002 0.0001 0.0006 0.0001 0.002 0.0001 0.0002
(0.0004) (0.0005) (0.0005) (0.0008) (0.0005) (0.006) (0.0005) (0.0005)
Election year (t) 0.078 0.053 c c 0.121 0.115 0.092 0.073
0.073 0.065
(0.079) (0.089) (0.036) (0.025) (0.090) (0.102) (0.079) (0.090)
Election year (t+ 1) 0.091 0.088 0.003 0.004 0.092 0.116 0.087 0.097
(0.078) (0.089) (0.035) (0.029) (0.087) (0.099) (0.079) (0.090)
Election year (t1) 0.021 0.001 0.021 0.033 0.014 0.45 0.042 0.007
(0.077) (0.087) (0.036) (0.025) (0.087) (0.099) (0.079) (0.089)
Left 0.111 0.117 0.114 0.103 0.112 0.119 0.098 0.100
(0.090) (0.102) (0.071) (0.055) (0.104) (0.118) (0.089) (0.101)
Left*Coal 0.040 0.011 0.076 0.028 0.006 0.062 0.040 0.028
(0.103) (0.116) (0.068) (0.055) (0.125) (0.142) (0.103) (0.117)
EU membership 0.008 0.026 0.113 0.137 0.124 0.160 0.066 0.095
(0.099) (0.112) (0.103) (0.151) (0.141) (0.160) (0.106) (0.120)
Eurozone membership 0.021 0.006 b b 0.140 0.191 0.061 0.067
0.076 0.069
(0.068) (0.077) (0.033) (0.029) (0.136) (0.154) (0.068) (0.077)
SGP 0.006 0.005 0.009 0.031 0.092 0.117 0.010 0.021
(0.075) (0.084) (0.034) (0.035) (0.107) (0.122) (0.081) (0.093)
Lambda c c c c 0.036 0.002 b b
0.642 0.731 4.634 12.41 0.576 0.636
(0.246) (0.232) (1.522) (1.793) (0.258) (0.255)

Notes: 442 observations. Standard errors in parentheses.

a Significant at the 10% level.
b Significant at the 5% level.
c Significant at the 1% level.
88 A. Cassette et al. / Economic Modelling 30 (2013) 7989

Table 6
Interactions in the OECD (ML estimations).

Dependent variable Spending Tax receipts

Weight matrix WD GDP US leader WD GDP US leader
W leader WTRADE W leader WTRADE
EU*W*Y c b cc c b c c b
0.40 0.25 0.16 0.28 0.30 0.28 0.21 0.17
(3.09) (2.41) (2.79) (3.85) (2.45) (3.13) (3.59) (2.22)
(1EU)*W*Y b c c c c c b c
0.23 0.27 0.14 0.23 0.40 0.41 0.12 0.37
(2.42) (3.12) (2.87) (3.00) (4.65) (5.44) (2.46) (5.17)
Unemployment rate 0.01 0.01 0.01 0.01 0.003 0.004 0.002 0.002
(1.19) (1.24) (1.34) (1.19) (0.29) (0.39) (0.24) (0.16)
Young people 0.02 0.02 0.02 0.02 0.004 0.001 0.003 0.003
(1.22) (1.38) (1.30) (1.39) (0.23) (0.08) (0.20) (0.17)
Old people 0.02 0.02 0.02 0.02 0.00004 0.001 0.001 0.0009
(0.65) (0.69) (0.67) (0.67) (0.001) (0.06) (0.06) (0.03)
Population density 0.0001 0.0001 0.0002 0.0002 0.0002 0.0001 0.0001 0.0001
(0.30) (0.31) (0.34) (0.36) (0.31) (0.20) (0.21) (0.27)
Election year (t) c c b c 0.11 0.10 0.10 0.10
0.20 0.20 0.19 0.19
(2.60) (2.60) (2.54) (2.58) (1.52) (1.41) (1.36) (1.41)
Election year (t+ 1) 0.03 0.05 0.05 0.04 0.02 0.01 0.02 0.01
(0.52) (0.65) (0.70) (0.56) (0.33) (0.22) (0.30) (0.24)
Election year (t1) a 0.10 0.10 a 0.05 0.06 0.05 0.05
0.12 0.13
(1.77) (1.51) (1.47) (1.79) (0.73) (0.84) (0.70) (0.77)
Left a a a a 0.04 0.05 0.05 0.05
0.14 0.15 0.15 0.13
(1.87) (1.94) (1.93) (1.75) (0.63) (0.68) (0.71) (0.68)
Left*Coal 0.03 0.05 0.05 0.03 0.03 0.03 0.008 0.03
(0.37) (0.48) (0.50) (0.28) (0.35) (0.31) (0.08) (0.30)
EU membership 0.005 0.02 0.01 0.007 0.06 0.07 0.08 0.06
(0.05) (0.17) (0.11) (0.07) (0.56) (0.72) (0.78) (0.63)
Eurozone membership 0.06 0.04 0.05 0.07 0.08 0.09 0.10 0.09
(0.70) (0.45) (0.54) (0.77) (0.86) (1.01) (1.15) (1.06)
SGP b b b b 0.09 0.10 0.14 0.12
0.18 0.19 0.20 0.19
(1.98) (2.05) (2.13) (2.10) (1.03) (1.14) (1.52) (1.33)
a
Wald test rho 0.16 0.02 0.02 0.05 0.09 0.13 0.09 0.20
(0.96) (013) (0.27) (0.48) (0.60) (1.00) (1.12) (1.84)
Log likelihood 633.5 636.1 636.8 632.7 622.1 624.2 630.0 623.6

Notes: 612 observations. Spatial fixed effects are included. T-Student in parentheses.
a Significant at the 10% level.
b Significant at the 5% level.
c Significant at the 1% level.

estimation results in Tables 5a and 5b, confirm the robustness of the results in
Tables 3a and 3b; the political cycle coefficients are stronger for the sample of
EU countries than for the whole sample. The coeffi-cient of the SGP dummy
is very robust to different specifications of the weight matrices and the
different samples. Note also that the es-timation results confirm the crucial
role of the US as a leader in terms of discretionary public decisionsamong
the sample of European countries and the whole sample. This result confirms
the increased dependencies among countries.
Another way to test whether EU membership matters for in-terdependence
among fiscal policy decisions, is to include in the full sample two interaction
coefficients for whether the country i belongs to the EU or not. On the one
hand, EU membership may cause more interdependence in these countries'
decisions since these countries have fewer policy tools to compete with other
Euro-pean countries. As Redoano (2007) states: they move in a similar
competitive and institutional environment and are subject to similar budget
and political constraints, moreover policy makers have more occasions to
meet and discuss formally or informally their plans. On the other hand, non-
EU members may engage in more compet-itive behavior.
We estimate Eq. (5) on the full sample, including a dummy D that is equal
to 1 for EU membership and 0 otherwise. Among the 18 coun-tries in our
dataset 8 were EU members at the beginning of the period and 13 were
members at the end of the period. Table 6 shows that the degree of interaction
is the same, whether the country is a member or is not a member of EU. This
result is obtained for both measures of discretionary policy. We consider this
subset of results as confirming the preceding ones, revealing the strong
influence of each country on
its neighbor, even if the leaders (and especially the US) are stronger players in
the game.
6. Conclusion
Although spatial econometrics is commonly used to measure stra-tegic
interactions among local governments, the literature investi-gating state
public policy interdependences is small. Our paper tries to fill the gap by
extracting the relevant component of policy choices at national state level, i.e.,
the discretionary part of these choices.
We investigated the relationship between the discretionary com-ponents of
fiscal policies, for a sample of 18 OECD countries, during the period 1974
2008. In a first step, we built two indicators of dis-cretionary fiscal policy,
considered as residual components of a VAR model: one for public spending,
and one for tax receipts. In a second step we estimated discretionary fiscal
policy interactions among these countries, using spatial econometrics.
Our results confirm the existence of strong interactions among neighbor
countries' public decisions (neighborhood being defined by economic as well
as geographic proximity). We found evidence of opportunistic behavior by
OECD countries' governments in relation to discretionary public spending,
and this behavior was even stronger for the sub-sample of European countries.
Finally, our estimation results confirmed the important role of the US as a
leader in terms of EU countries' discretionary public decisions.
We believe that this study could be extended in various
ways, including a deeper investigation of the role of political
variables in the setting of discretionary expenditures and tax
receipts. It may be interesting also to introduce measures of
exchange rates,
A. Cassette et al. / Economic Modelling 30 (2013) 7989 89

competitiveness, or current account
balances, as policy-makers could
want to react to variations in these
variables.
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