Be on your guard! Cyclically adjusted budget deficit
Cyclically adjusted budget deficit (CAB) is a concept widely cited and used in evaluating fiscal situations. The key idea behind it is to separate temporary and/or non-discretionary effects on budget deficit from the underlying balance and/or effects of discretionary measures of fiscal policy. Computation of CAB is based on identification of the potential level of economic variables. In this paper, it is demonstrated that composition matters in the case of both real and nominal variables. The European Commission and the European Central Bank have each proposed methods for measuring CAB, but these are not fully capable of satisfying all requirements. Besides, results show that aggregated and disaggregated approaches provide different estimations, to the benefit of the latter. The paper presents an alternative method, able to incorporate the advantages of both approaches. Combining output gap from production function and constrained multivariate HP filter induces a theoretically motivated disaggregated approach that also exploits the implication of production-function parameterization. Taking into account the nominal features, for example, nominal elements of the tax code or deflators directly affected by the government, the more precise definition of discretionary measures became also important.
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