Maneuvering Public Finance: The Consequences of Government’s Diminishing Fiscal Room on Governments’ Spending Choices

This article explores the effects of a reduction of the fiscal room to manoeuvre on public finance in advanced democracies. I show that while advanced democracies’ tax revenues stagnated or declined since the 1990s, spending commitments, especially social spending on health care and pensions, are on the rise. New social risks, concomitant with the transition to a post-industrial society have grown, while old industrial social risks remain important. This increases demand for risk protection, which creates an upward pressure on public social spending. Hence, the fiscal room to manoeuvre (measured as tax revenues minus social spending and debt service as percentage of GDP) is decreasing in most OECD countries. This article uses error correction models to evaluate the long-term and short-term impacts of a decreasing fiscal room to manoeuvre on government spending on different types of public policies in 22 advanced democracies. It shows that a smaller fiscal room to manoeuvre is associated with higher debt levels, lower public investment in infrastructure and gross fixed capital formation, higher non-tax revenues like user fees and higher private social spending. These effects are significant in the long term, while short-term effects tend to be insignificant. Surprisingly, a smaller fiscal room to manoeuvre is associated with higher levels of social investment, suggesting that countries with high levels of social investments tend to maintain tighter budget constraints. The results are robust to changes in the measurement of the fiscal room to manoeuvre.