The Effects of Inflation on Public Finances
TheEffectsofInflationonPublicFinances DanielGarcia-MaciaWP/23/93 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2023 MAY ©2023InternationalMonetaryFundWP/23/93 IMFWorkingPaper FiscalAffairsDepartment TheEffectsofInflationonPublicFinancesPreparedbyDanielGarcia-Macia* AuthorizedfordistributionbyPauloMedasMay2023 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:Doesinflationhelpimprovepublicfinances?Thispaperdocumentsthedynamicresponsesoffiscalvariablestoaninflationshock,usingbothquarterlyandannualpaneldataforabroadsetofeconomies.Inflationshocksareestimatedtoimprovefiscalbalancestemporarily,asnominalrevenuestrackinflationclosely,whilenominalprimaryexpenditurestakelongertocatchup.InflationspikesalsoleadtoapersistentreductionindebttoGDPratios,bothduetotheprimarybalanceimprovementandthenominalGDPdenominatorchannel.However,debtonlyfallswithinflationsurprises—risesininflationexpectationsdonotimprovedebtdynamics,suggestinglimitstodebtdebasementstrategies.Theresultsarerobusttousingvariousinflationmeasuresandinstrumentalvariables. RECOMMENDEDCITATION:Garcia-Macia,Daniel.2023.“TheEffectsofInflationonPublicFinances”IMFWorkingPaper2023/93,InternationalMonetaryFund,Washington,DC. JELClassificationNumbers: E31,E6,H6 Keywords: Inflation;fiscalbalance;publicdebt Author’sE-MailAddress: dgarciamacia@imf.org *ThemainresultsinthispaperarepresentedinChapter2oftheApril2023FiscalMonitor,ledbyMarcosPoplawski-RibeiroandCarlosGonçalves,undertheguidanceofVitorGaspar,PaoloMauro,andPauloMedas.ThepaperalsobenefitedfromcommentsbySakaiAndo,MyrvinAnthony,AlbertoBehar,OlivierBlanchard,YongquanCao,DevrimDemirel,KarenDynan,OlamideHarrison,OlivierJeanne,JeongDaeLee,JamesMcHugh,PrachiMishra,AnhNguyen,NikhilPatel,AdrianPeralta-Alva,RobertoPerrelli,AdamPosen,JohnRalyea,andotherseminarparticipants.ZhonghaoWeiprovidedoutstandingresearchassistance.Dataandcodesareavailableuponrequest. WORKINGPAPERS TheEffectsofInflationonPublicFinances PreparedbyDanielGarcia-Macia Contents I.Introduction3 II.EmpiricalApproach5 III.Data6 IV.Results8 V.Robustness16 VI.Conclusions18References20 FIGURES 1.InitialGainsinFiscalBalancesfromCPIInflationShocks,AEs,1999:Q1-2019:Q411 2.InitialGainsinFiscalBalancesfromCPIInflationShocks,Sub-Items,AEs,1999:Q1-2019:Q412 3.Responsetoa1PercentagePointGDPDeflatorGrowthShock,1962-201913 4.Responsetoa1PercentagePointGDPDeflatorGrowthShock,AEsvsEMs,1962-201914 5.Responsetoa1PercentagePointGDPDeflatorShock,byFXregime,1962-201914 6.DebtReactiontoSurprisevs.ExpectedGDPDeflatorGrowthSpikes,1992-201915 7.ResponseofDebttoa1PercentagePointGDPDeflatorShock,AEs16 8.ResponseofOverallBalancetoa1PercentagePointGDPDeflatorShock,1962-201917 TABLES 1.ListofCountriesintheQuarterlyandAnnualSamples.7 2.SummaryStatistics.8 3.IVFirst-StageRegressionResults,CPIInflation,1999-20199 4.ImpactofCPIInflationSpikesinInitialQuarter,1999:Q1-2019:Q411 5.ImpactofCPIInflationSpikesontheOverallBalanceintheInitialQuarter,1999:Q1-2019:Q417 6.Impactofa1PercentagePointInflationSpikeonDebtbyYear4,1962–201918 I.Introduction Thesharpinflationupsurgeaffectingmostcountriessince2021broughttotheforequestionsabouttheimpactsofinflationthroughouttheeconomy.Akeydimensionishowinflationaffectsfiscalsustainabilityandredistributesresourcesbetweenthepublicandprivatesectors,asreflectedinthedynamicsofgovernmentdeficitsanddebt. Intheory,inflationcanaffectpublicfinancesthroughmultiplechannels(Dynan,2022,CBO,2022a).Ittendstoexpandtaxbasesinnominalterms,boostingnominaltaxrevenue,butcanalsoraisethecostofgovernmentexpenditure,mostdirectlyforbudgetitemsthatareautomaticallyindexedtoinflation.Moreover,theassociatedincreaseinnominalGDPtendstoreducedeficitanddebtratios.Overtime,policiesmayalsoreacttoinflation,includingthroughdiscretionaryfiscalmeasures(e.g.,subsidiesandtaxcutstoalleviatecost-of-livingimpacts),ormonetarypolicytightening,pushingupgovernmentborrowingcosts.Thus,inflationcanimpacttaxpayers,civilservants,pensioners,beneficiariesofgovernmentprograms,governmentsuppliers,andbondholdersinvariousforms. Thispaperestimatestheneteffectsofinflationonfiscalvariablesovertime,usingpaneldataforabroadsetofeconomiesandtimeperiod.Itfindsthatinflationshocksimprovefiscalbalancestemporarily,asnominalrevenuesrisewithinflationfasterthannominalexpenditures.TheyalsoleadtoapersistentreductionindebttoGDPratios,bothduetoprimarybalanceimprovementsandnominalGDPdenominatorincreases.However,debtonlyfallswithinflationsurgesthatcomeasasurprise—risesininflationexpectationsdonotimprovedebtdynamics. Theestimationisbasedonlocalprojectionsoffiscalvariablesafterinflationshocks,withinflationmeasuredaseitherCPIorGDPdeflatorchanges
