Dynamic panel analysis of the EU's fiscal reaction function with threshold effects

Abstract

This study contributes to the ongoing reform of the EU's economic governance, particularly about fiscal performance. We opt for a fiscal reaction function of the cyclically adjusted primary balance. Given concerns over underlying endogeneity and heterogeneity across countries we employ a threshold dynamic analysis. The findings confirm that the fiscal policy in the EU has been procyclical overall. However, we identify two regimes of output gap. Fiscal policy has been countercyclical for EU member states in the higher output gap regime while EU member states follow a procyclical fiscal policy in the lower regime. We reveal also that the endogenous debt-to-GDP ratio threshold is at 75.6% for the EU and 78.7% for the Euro area, which notably exceeds the EU Treaty's reference value of 60%. Fiscal rules and fiscal councils mitigate procyclical fiscal policies, being more effective for low debt countries. In terms of policy implications, the identified fiscal thresholds and variability across countries warrant a higher degree of fiscal coordination in the EU, particularly in the Euro area.