Co-movement of public sector tax revenues in the EMU: Evidence from a dynamic factor analysis

The ratio between public sector tax revenues and GDP is one of several measures of government size. This paper uses a dynamic factor analysis to show that the co-movement of public sector tax revenue in the Euro area appears to be driven by an unobserved common factor. This may be attributed partially to a response at the global business cycle or due to EU treaties. However, we detect the presence of a latent factor(s) that also affect this behavior. Our empirical analysis uses yearly data for the period 1970-2016 for the European Monetary Union (EMU) consisting of 19 member countries. By introducing a measure of the EMU-19 business cycle as a control variable in the model, we can partial out the effect of the common business cycle for the EMU-19. We highlight this common pattern in a Dynamic Factor (DF) model as grounds for seeking a satisfactory explanation. Due to its unobservable nature, the best we can do at the present is to estimate its magnitude without definitively stating what it represents.

A major question emerging from the financial crisis of 2008 is how to stimulate economic growth while restoring a country’s fiscal health in the presence of this commonality feature of co-movement. It is important to maintain the fiscal space (public finance flexibility) for sovereign nations in the EMU-19. This is especially relevant to the Euro area due to its dismal economic growth prospects coupled with high levels of public sector debt and unsustainable fiscal policies. Debt and slow economic growth in conjunction with the unidentified commonality factor underscore the importance of understanding the potential effects the growth of government (increasing the ratio of public sector tax revenues) has on economic growth and the fiscal space trade-offs which these conflicting goals entail. A further concern is the effect of stabilization policies (public finance tax and spending mechanisms) on the ratio between public sector tax revenues in the context of changes to interest rates and the money supply. Such fiscal structural reforms hold the potential to enhance the prospects for economic growth and debt reduction through use of automatic stabilizers, labor market reforms, which reduce labor taxes and social security contributions. Yet attention must be given to the effects on specific groups such as the elderly and youth which might be adversely affected by policies.