eThesis - Kauppakorkeakoulun sähköiset gradut

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The sustainability of public finances is currently a hot topic in economic policy debate. This is because of the on-going sovereign debt crises in Europe and the long-term public spending pressures caused by the impeding demographic change in developed countries. This thesis examines some of the approaches that have been used to assess the public finance sustainability in the literature. Also, theoretical criteria for sustainability are examined. The study is conducted by a way of literature review.

There is no consensus among economists about the correct theoretical criterion for public finance sustainability. Rather, each approach to assess sustainability introduces its own, sometimes differing, definitions. Government’s inter-temporal budget constraint (IBC) is the most commonly used theoretical criterion for sustainability. We find that it is not theoretically waterproof and even invalid in some cases. We suggest an alternative criterion from the literature, Bohn’s model-based sustainability, to be used in place of the IBC in theoretical settings.

In the thesis, six different approaches to assess public finance sustainability are examined. These are: summary indicators of sustainability, econometric tests, Value-at-Risk framework, fiscal limits and fiscal space, general equilibrium models and generational accounting. Each approach is described and analysed based on research found in the literature.

Summary indicators are the most commonly used practical tool used in sustainability assessments. They are based on projections of future public debt and give the budgetary adjustment required to satisfy the IBC or reach a target debt level. Econometric tests are statistical tests for various theoretical sustainability criteria that can be used to determine whether a given criterion holds in the data. Value-at-Risk framework uses stochastic simulations of the public sector balance sheet to study the degree of public sector solvency. It gives an estimate of a probability distribution for government’s future net asset position. Fiscal limits and fiscal space attempt to estimate a public debt ceiling for a country based on assumed constraints to government’s fiscal policies. General equilibrium models are detailed large-scale frameworks which assess sustainability based on comprehensive modelling of the whole economy. Generational accounting analyses sustainability by comparing the net tax burden of current and future generations.

We analyse the strengths and weaknesses of each of the approaches and tentatively compare them with each other. We find that each approach has its uses. Approaches should be viewed as complementary. Availability of data and modelling resources, goals of the analysis and other case-specific constraints affect relative suitability of the approaches in different situations. From purely theoretical perspective, general equilibrium models and the Value-at-Risk approach appear most attractive. We conclude that theoretical accuracy of the models doesn’t guarantee the accuracy of the future forecasts and thus sustainability estimates.