Elections, recession expectations and excessive debt: an unholy trinity

It is seen as a stylized fact that political budget cycles (PBCs) are context-conditional, i.e., they do not occur in all countries or under all circumstances. Early on it was argued that PBCs are more likely to appear in specific country groups, e.g., developing countries (Schuknecht 1996) or new democracies (Brender and Drazen 2005). The emphasis then shifted to country characteristics like fiscal intransparency (Alt and Lassen 2006) or the electoral system (Aidt and Mooney 2014). Veiga et al. (2017) confront several of those conditioning factors and find that media freedom is key in reducing the incidence of PBCs. Bohn and Veiga (2017) move the focus to economic conditions and present evidence showing that recessionary expectations reinforce the political budget cycle.

This paper deepens the analysis of the effects of economic conditions on PBCs. It argues that local public sectors (e.g., in countries, municipalities) with high stocks of debt may end up with larger primary deficits in election years than those with smaller initial debts when a recession is expected (and vice versa for expected booms). That prediction is relevant for two reasons. First, high-debt governments face recessions frequently. Second, the high deficit outcome may seem surprising because high-debt local governments are often pressured, if not obliged, to raise tax or other revenues, cut expenditures, or both, in order to produce primary surpluses or, at least, to reduce their primary deficits dramatically (for instance, in order to reach pre-set debt targets). During a recession, such actions may not be easy. It likewise may not be desirable; standard Keynesian countercyclical policies may be adopted to alleviate the macroeconomic consequences of the recession. However, efforts to improve primary balances should be at least as strong in the presence of high debt stocks as not. In fact, that is the (normal) government response to a high stock of debt in an expected recession in an off-election year. But why, then, is the primary deficit larger in high-debt governments when a recession is expected in an election year?

Our answer is very simple and we illustrate it in an opportunistic PBC model that incorporates boom and recession expectations. Our model shows that an opportunistic policymaker is immune to debt targets (including a potential reputational loss) when a recession is expected during an election year. Instead, such a policymaker is concerned about her electoral prospects, which improve if voters can be made to believe in her competence. Such beliefs, in turn, depend on whether the policymaker is able or not to raise public services provision or expenditures by more than what voters expect. If so, the larger primary budget deficit in a high-debt government (in an election year when a recession is expected) is due entirely to the fact that a government of a highly indebted public sector typically must impose higher tax rates than otherwise and, therefore, loses more tax revenue during a recession. To undo that loss, and still appear competent, an opportunistic policymaker of a high-debt government has to accept a larger primary deficit. The opposite argument holds for expected boom times; an opportunistic policymaker then can plan on using the larger tax revenues to reduce the stock of outstanding debt without compromising her reelection chances.

Our logic works when excessive debt coincides with higher tax rates. But that is not guaranteed. In fact, excessive debt may have been produced because tax rates were too low in the first place. Eventually, excessive-debt governments will have to impose high tax rates or cut spending drastically to tackle the debt problem. It may be difficult to judge whether a public sector is still in the rapid debt accumulation, low tax-rate phase or in the excessive debt, high tax-rate phase. That is so because it is not at all obvious what constitutes a high tax rate. At a country level, for instance, tax rates depend on specific factors like the development of the tax system, the cost of tax enforcement (which depends, for instance, on the share of the agricultural sector in total output), or the willingness and ability of policymakers to use seigniorage.¹ At a sub-national level, the institutions of public finance tend to be more coherent, i.e., tax rates and procedures for responding to excessive debt are much the same, especially if procedures are in place for dealing with the latter. The Portuguese municipal data employed in this paper satisfy those conditions. We do not have tax rate data for most of our sample period, but we discuss in Footnote 18 and show in the Online Appendix that public revenues tend to be larger in high, excessive-debt municipalities.

The empirical results, obtained for a sample composed of all Portuguese municipalities covering the 2002–2014 period, confirm the intuition that our model suggests robustly. Based on our regression results, we illustrate policy changes in election years over forecasted growth rates with plots of average marginal effects. Those marginal effect plots show larger primary budget deficits in high-debt municipalities during expected recession times and smaller primary deficits during expected booms (compared to low- debt municipalities). The difference rises for expectations of more serious recessions as well as for expectations of more pronounced booms.

Our results extend the discussion of context-conditionality for political budget cycles. The evidence shows that excessive debt, if paired with high tax rates, produces even stronger PBCs during recessionary periods. It captures an important mechanism with significant policy implications. In particular, the findings say that it may even be counterproductive to prescribe harsh medicine (higher tax rates), if the excessive-debt government faces frequent elections during recessionary periods. Another interpretation relates to the role of fiscal constraints in the emergence of political budget cycles. Streb et al. (2009) discuss checks and balances that serve as institutional constraints for reducing political budget cycles. This paper argues that the existence of small public debts are by themselves constraints that limit political budget cycles (at least during recessionary periods).

We emphasize recessions and excessive debt as conditioning factors herein, but other conditionalities likewise may play roles (see reviews by Franzese 2002; de Haan and Klomp 2013). First, we focus on the aggregate level of fiscal policy in terms of the primary deficit, but not on particular types of expenditures.² In a robustness test, we also present results for total expenditures and fiscal revenues. Footnote 19 explains why such evidence provides clues in the direction of the results we obtain for primary deficits. Second and consequently, we do not account for fiscal ideologies. Given that we find a significant PBC effect, no overall fiscal conservatism arguably is evident, as suggested by Pelzman (1992).³ We can, however, not exclude the possibility that the PBC effect occurs because policymakers manipulate certain types of expenditures (which we do not distinguish in the paper) in favor of some key groups of voters.

Our theoretical model likewise does not distinguish between different types of expenditures or voters. It presupposes that voters do not behave as fiscal conservatives, either because they do not want to or because budgetary manipulation is so effective that it overcompensates any fiscally conservative predisposition. The opportunistic political budget cycle model we use implicitly assumes that voters, rational or not, actually can be made to believe in the competence of incumbent policymakers. It was Rogoff and Sibert’s (1988) and Rogoff’s (1990) idea that utility-maximising voters should be concerned only about the competence of the policymaker chosen for governing after the elections. If competence shocks are persistent (usually modelled as MA(1) shocks), the task of voters becomes one of competence extraction in deciding for whom to vote. However, even rational voters can be fooled in the presence of informational asymmetry. In Rogoff’s world, politicians observe their own competence skills before voters do; hence, we obtain a signalling model. In the Lohmann (1998) and Shi and Svensson (2006) world, some part of the electorate is uninformed or has some other handicap; in Bohn and Veiga (2017), it is inertial growth perceptions. It is important, however, that politicians cannot observe their own competence shocks. No signalling is thus possible; instead, the incumbent will exert some hidden effort to manipulate the outcome of the elections. Our model is in the latter pure moral-hazard tradition.

The paper is structured as follows. Section 2 lays out the model. Indications of the solution and the main results can be found in Sect. 3. Section 4 describes the data, the institutional setting, and the empirical model. Section 5 presents empirical evidence (including the results of robustness tests) providing support for the main implications of the theoretical model. Section 6 concludes.

The model combines elements from Lohmann (1998), Shi and Svensson (2006) and Bohn and Veiga (2017). It captures an economy with n voters and two opportunistic candidates, an incumbent and a challenger, who compete for holding office every alternate period. Each agent’s expected utility depends on the discounted present value of expected per-period utilities which, in turn, consist of additively separable economic and political utilities (\(\beta \) is the discount factor; E is the expectations operator). In each period, voters derive utility from consumption c (\(u(c_{s}))\), which has the standard concavity properties, from local public goods L and from political utility \(\theta ^{i}z_{s}\) (with weight \(\alpha \)). Voter i’s ideological preference or personal sympathy, \(\theta ^i\), is distributed uniformly over the interval [− 1,1]; z indicates who is in power (\(z_{s}=-\frac{1}{2}\), if a is in power; \(z_{s}=\frac{1}{2}\), if b is in power; without limiting the generality of the analysis we call a the incumbent and b the challenger). If her favorite candidate is in power, voter i receives positive political utility; political utility is smaller for more moderate voters, i.e., voters with weaker views on the candidates’ competencies. Voters vote prospectively in that they choose the candidate who can deliver the highest expected utility in the future. More moderate voters might, therefore, vote for the “wrong” candidate, if they are compensated by higher economic utility. The voters’ utility function is:The candidates’ economic utility is the same as the voters’. However, candidates receive a political (dis-)utility only if they are in office: an ego rent and a potential reputation loss, if they also were responsible for missing pre-set debt target \(B^{*}_{s-1}\) (see further down) in the previous year:Everybody’s expected consumption depends on expected after-tax income:where \(\tau _s\) is the tax rate. Period-specific expected growth factor shock \(\epsilon _s\) captures the deviation from trend (or previous period or potential) output \({\bar{y}}\) which is normalized to 1; \(\epsilon _s>1\) is an expected boom; and \(\epsilon _s<1\) is an expected recession.

The government’s budget constraint relates primary deficit \(D_s\) to the provision of (local) public goods \(L_s\). It takes into account expected tax revenue \(\tau _s \epsilon _s\) and the government’s competence \(\eta _{s}^{j}\) (see further down):Excessive-debt municipalities are obliged to reduce their debts by a certain percentage every year and may have to impose a particularly high tax rate to do so. Low-debt municipalities do not face such requirements. In a continuous setting, we capture budget dynamics with two continuous functions. Every municipality’s yearly (period-specific) debt target \(B^{*}_s\) (which depends on the initial level of debt \(B_{t-1}\)) isWe assume that the municipality’s tax rate \(\tau _s\) is predetermined and—as argued before—also depends on the initial level of debt \(B_{t-1}\), too:Given the interest payment on the inherited debt level \(B_{s-1}\) from the previous period, and, possibly, debt reduction from \(B_{s-1}\) to target level \(B^{*}_s\) the government normally would be obliged to produce a primary surplus. Let’s call it the primary surplus requirement (component 1) which would imply \(D_s<0\) and require spending cuts. However, the government may choose to disregard the rules, especially in an election year, and maximize with respect to the second component, the freely choosable deficit \(D^{free}_s\).As in Rogoff (1990), government competence is modelled as an MA(1) process. However, Shi and Svensson (2006) suggested that there new tasks always arise that do not allow candidates to know their own competencies \(\eta _{s}^{j}\) in advance:Shocks \(\mu _{t}^j\) are random variables with mean 0 and distribution function \(F[\mu _{t}^j]=F[\bullet ]\). For simplicity, density function \(f[\mu _{t}^j]=f[\bullet ]=F^{\prime }[\bullet ]\) is assumed to be bell-shaped, but more general specifications also would be possible. Inserting Eqs. (6) to (8) into budget constraint (4) we obtain:The timing of events is presented in Table 1. Elections take place in alternating periods. At the beginning of election period t, voters and incumbent a observe the realizations of last period’s skills shock \(\mu _{t-1}^a\) and predetermined current period tax rate \(\tau _t\). The incumbent also observes (period-specific) debt target \(B_t^{*}\) and growth shock \(\epsilon _t\) which allow her to decide on the optimal level of freely choosable deficit \(D^{free}_t\).⁴ On that basis, the government chooses the primary deficit level \(D_t\), thereby providing quantity \(L_t\) of local public goods. Voters observe \(L_t\) and form expectations of skills shock, \(\widehat{\mu _t^a}\), which is, however, affected by their expectations of the growth shock, \(\widehat{\epsilon _t}\), and of the primary deficit, \(\widehat{D_t}\). Voters base their decisions on whether to vote for the incumbent on \(\widehat{\mu _t^a}\) because period t skills affect the incumbent’s competence in providing local public goods in (\(t+1\)). Note that voters’ expectations of the incumbent’s competence can be mistaken for two reasons: (1) they may not be able to fully anticipate the incumbent’s deficit policy; and (2) they may not be able to anticipate fully an imminent economic slump or boom.

In period (\(t+1\)), the winner of the election receives ego rent X. Policy in (\(t+1\)) no longer depends on voting, though; hence, either policymaker (a or b) will repay the costly debt to the extent possible, thereby cutting the provision of local public goods.⁵ Voters anticipate that response, but can do nothing to prevent it. Note also that the voting decision in election period t does not extend to considering expected utility in \(t+2\) because the MA(1) nature of the competence process makes incumbent and challenger indistinguishable then. Policymakers likewise do not account for \(t+2\) in solving their optimization problem when determining the optimal level of \(D^{free}_t\) because they cannot influence their own utility or boost their reelection chances in \(t+2\). Hence, the model can be split into cycles of two periods consisting of election period t and off-election period (\(t+1\)).

Given the timing of events and the reasoning for splitting the analysis into two-period election cycles the solution is found by studying the incumbent’s utility maximization over the cycle, including the election period t and off-election period (\(t+1\)). Whether the incumbent receives an ego rent in period (\(t+1\)) depends on the probability of being elected which, in turn, depends on her election year choice of the optimal level of deficit \(D_t\), which ultimately depends on the choice of freely choosable deficit \(D^{free}_t\). The logic of the model’s solution is explained here, but details are provided in the Online Supplementary Material. Voters base their voting decisions in period t on a comparison of utilities to be expected from the incumbent and the challenger in period (\(t+1\)). The utility expected from the provision of local public goods in (\(t+1\)) is affected by the policymakers’ competence (\(\eta ^j_{t+1}=\mu ^j_{t+1}+\mu ^j_{t}\)) and individuals’ expectations thereof. Since competence is an MA(1) process, incumbent a’s period t choice of \(D^{free}_t\) affects what voters expect of the incumbent’s competence in period (\(t+1\)), whereas nothing is known about the challenger. In Online Appendix A we derive a (in our opinion, realistic) condition for a voter to vote for the incumbent, which already was hinted at when explaining Eq. (1). If the voter shares the incumbent’s ideology and the incumbent is expected to do at least an equally good job (\(E_{t}^i[\mu _t^a] \ge E_{t}^i[\mu _t^b]=0\)) or if the voter has a different ideology (though not too far on the other side of the political spectrum) and the incumbent does a great job, then the voter will vote for the incumbent:On that basis, the individual’s probability of voting for the incumbent can be derived (see the end of Online Appendix A). The probability that the incumbent wins the election is, therefore:Voters extract government competence \(\mu _t^a\) by relying on the public budget constraint (9). True competence is:Voters can observe the level of local public goods \(L_{t}\), the tax rate \(\tau _t\), and previous period competence \(\mu _{t-1}^a\). Their perception of government competence is, however, also affected by their expectations of growth and the government’s budget deficit policy. Using Eq. 13 (see Online Appendix B) the perception of competence \(E_{t}[\mu _t^a]\) can be expressed as:Note that voters overestimate the incumbent’s competence (\(\widehat{\mu _t^a}>0\)), if the government can raise the primary deficit above what is expected by voters. This is the standard manipulation argument. However, if voters think the recession is less severe than it actually is, they underestimate the incumbent’s competence.

Let us now rewrite the incumbent’s probability of winning (12):If we assumed rational expectations, no manipulation is possible in equilibrium and the probability of winning cannot be increased (despite the government’s best efforts in doing so, as seen in first-order condition 17). Under other behavioral assumptions for voters’ expectations, the probability of winning can be affected by the incumbent’s choice. For the core result of the paper it does not matter whether the winning probability can be affected or not. We, therefore, take an agnostic point of view at this stage, but will discuss the effect of voters’ assumptions when discussing Lemma 1 and Proposition 1 further down.

The incumbent’s two-period maximization problem can now be written as follows (see end of Online Appendix B and Appendix C; \(X_s\) is held constant and discount factor \(\beta \) is set to 1 because it is irrelevant for the qualitative properties of the results):The first-order condition (FOC) determines the government’s optimal choosable deficit \({D_t^{free}}^{*}\) (because the second order condition for an optimum is satisfied):The FOC is staightforward. The interest rate (which is the net marginal loss from incurring a deficit) must be equal to the net marginal gain from increasing the chances of winning. The latter is the net benefit for the government (ego rent minus reputation loss) times the marginal increase in winning chances owing to the increase in voter-perceived governmental competence caused by the increase in deficit-financed public goods.

As the FOC defines the equilibrium for any expected growth rate \(\epsilon _t\), we can now study the effect of (reduced or aggravated) boom or recessionary expectations:

The lemma says that a countercyclical policy effect materializes in election years. An opportunistic government will compensate for the tax revenue shortfall during the recession by an equal increase in the budget deficit. Conversely, an opportunistic government can reduce the deficit by the amount of additional tax revenue. The motivation is clear, the government does not give voters reason to believe that it would not be able to provide the same quantity of public goods with or without a recession or a boom. Recall that the optimal choice of public goods and, hence, of the deficit already is elevated as indicated by the first-order condition. The lemma says only that the government does not want to provoke a reduction in its competence as perceived by voters.

Lemma 1 can be illustrated in a stylized situation. Figure 1 captures a balanced budget situation, if output is at trend level. Situations to the left produce a budget deficit, those to the right a budget surplus. This is so because we assume that revenues are given by an upward-sloping straight line, which is determined purely by economic activity. For simplicity, no countercyclical (Keynesian) response to recessions is undertaken. Government expenditures do not respond to output; the government can change expenditures only discretionarily. Given that set-up, Lemma 1 simply says that an opportunistic government that expects a recession will not content itself with the “Normal PBC” (light [green] arrow) because it expects a revenue shortfall of the size of the dark [green] arrow. It will, therefore, plan on compensating for the revenue shortfall by increasing the deficit so that the no-recession level of manipulated government services can be provided despite the expected economic downturn (in order to appear competent). The extent of manipulation overall will be the sum of both arrows.

It is important to note that the result of precisely compensating for the tax revenue shortfall was obtained on the basis of given voter expectations for growth, \({\widehat{\epsilon }}_t\), and deficit, \(\widehat{D_t}\). If, for instance, voters were to expect a less severe recession than the government does, then the government would think that it will be harder to convince voters of its competence. Hence, the manipulation and the countercyclical policy effect would be strengthened. If, however, voters believed that the government would raise the deficit by less than the tax revenue shortfall, then it actually would be possible for an opportunistic government to increase the deficit by less. Hence, less manipulation would suffice and the countercyclical policy effect would be reduced. Analogous arguments could be made for expected booms. The factors determining the magnitude of the countercyclical policy effect already were studied by Bohn and Veiga (2017).

The focus of this paper is on how the countercyclical policy effect is influenced by the pre-existing debt level:

The proposition says that opportunistic policymakers in governments with high initial stocks of debt will choose larger deficits in expected recessions and smaller deficits in expected booms compared to governments with lower debt levels, when they face an election. The proposition is a direct result of the countercyclical policy effect derived in Lemma 1, together with Eq. (6), which is, admittedly, a simple, but also a very plausible assumption, namely that tax rates are higher in high-debt entities. Even if the countercyclical policy effect were reduced for one of the aforementioned reasons, Proposition 1 still would hold. It captures the testable prediction that very indebted governments manipulate fiscal policy, in particular the primary budget deficit, more than governments with lower initial debt levels.

Proposition 1 can be illustrated in an analogous way. Figure 2 compares the situation of a low-debt and an excessive-debt municipality. The low-debt municipality is identical to the municipality of Fig. 1; thin lines and a normal text font are used. Our stylized excessive-debt municipality is different in two respects (fat lines and italicized text [all in red] are used). First, the government revenue line is steeper and above the line for the low-debt municipality. Second, at trend output a primary surplus is assumed to be used for debt repayment (for simplicity, we assume no debt repayment in the low-debt municipality). In normal times, the excessive-debt municipality likewise would experience a “Normal PBC” (light [textured] arrow with thick borders) at trend output. However, the expected revenue shortfall in case of a recession is much larger (dark [textured] arrow with thick borders). In order to appear competent, the no-recession level of manipulated government services must be provided despite the expected downturn. Hence, an excessive-debt municipality must increase the primary budget deficit by more than a low-debt municipality. The opportunistic countercyclical policy effect is thus larger.⁶

This section describes the data, the institutional setting for Portuguese municipalities, and the empirical model.

Here, we present empirical results to test Lemma 1 and Proposition 1 of the theoretical model; we also discuss an array of robustness tests.

The goal of this paper was to show that it makes sense for policymakers of highly indebted local governments (e.g., countries, municipalities) facing an election to raise the primary budget deficit beyond what policymakers dealing with a smaller stock of debt will do, when faced with a recession (and vice versa for a boom). When tax rates are higher in high-debt entities, the tax revenue shortfall is more significant, but opportunistic policymakers will try to compensate for it in order to avoid giving the impression of being incompetent. We obtain robust support from our empirical investigation of Portuguese municipalities that recessions, elections, and high debt form an unholy trinity. That combination is shown to apply specifically to Portuguese municipalities, but the theoretical model illustrates that the underlying mechanism is more generally relevant.

Our finding is important because high-debt governments often face recessions and are thus tempted to manipulate fiscal policy more when elections are on the horizon. Such behavior may be particularly relevant for high-debt countries, because they often face both recessions and more frequent elections at the same time. Clear policy conclusions can be drawn from the theoretical mechanism we suggest. Rules and obligations for the government may not help much. Effective deficit and thus debt reduction may work only if voters can be made fully aware of the (expected) economic conditions; and if their expectations of government expenditures and services provisions can be lowered sufficiently. Such awareness reduces the magnitude of the competence-pretence game the government has to play.