How Sensitive is the Public Budget Balance to Cyclical Fluctuations in the EU?

This paper discusses the fiscal behaviour of EU countries in 1972-1999. It attempts to find out how deficits adjust to changes in interest rates and output growth by examining the hypothesis that the reaction of deficits to output growth is non-linear: relatively small in "good times" and quite substantial in depressions. This hypothesis is tested using pooled cross-country data for 14 EU countries. All test results give support for the hypothesis, which suggests that nonlinearity is an essential ingredient of the fiscal policy transmission mechanism. The paper also discusses some explanations and policy implications of this finding. It is also found that overall deficits are quite sensitive to output fluctuations. This result appears to be quite robust in terms of different model specifications and estimation methods. The sensitiveness seems to be related to the size of the public sector.