Estimating the structural deficit and sustainability of public finances in Czechia

• Thesis title in Czech: Odhad strukturálního deficitu a udržitelnosti českých veřejných financí
• Thesis title in English: Estimating the structural deficit and sustainability of public finances in Czechia
• Key words: strukturální deficit, udržitelnost veřejných financí v České republice
• English key words: structural deficit, sustainability, public finances in Czechia
• Academic year of topic announcement: 2022/2023
• Thesis type: Bachelor's thesis
• Thesis language: angličtina
• Department: Institute of Economic Studies (23-IES)
• Supervisor: prof. Petr Janský, Ph.D.
• Author: hidden - assigned by the advisor
• Date of registration: 18.06.2023
• Date of assignment: 18.06.2023

References

TÓTH, Máté. A multivariate unobserved components model to estimate potential output in the euro
area: a production function based approach. 2021.

Jooste, Charl, et al. Fiscal sustainability and the fiscal reaction function for South Africa. International
Monetary Fund, 2011.

Futtwiler, S. T. (2007). Interest rates and fiscal sustainability. Journal of Economic Issues, 41(4), 1003-1042.

Bodmer, F., & Geier, A. (2005). Estimates for the Structural Deficit in Switzerland, 2002 to 2007. OECD Journal on Budgeting, 4(2), 77-100.

The 2021 Ageing Report: Economic and Budgetary Projections for the EU Member States (2019-2070)

Konvergenční program České republiky

Preliminary scope of work

Stav českých veřejných financí označují ekonomové za neudržitelný, zatímco politici tvrdí
víceméně opak. Navzdory posledním událostem, které drasticky změnily svět i financování
České republiky, se ve své práci pokouším odhadnout strukturální deficit a udržitelnost našich
veřejných financí s využitím nejnovějších dat a metodik. Má práce se snaží vnést více světla
do problematiky udržitelnosti českých veřejných financí a předložit další argumenty,
představit české veřejné finance v co nejširším kontextu a s využitím srovnatelných, stejnou
metodikou podložených dat, stejně jako různých přístupů a úhlů, ze kterých lze na veřejný
sektor nahlížet. Jsou předpokládaná opatření schopna vyřešit problém rostoucích deficitů? Je
udržitelnost českých veřejných deficitů skutečně ohrožena? Jak měřit udržitelnost veřejných
financí? Co určuje chování deficitů a výše dluhu v evropském kontextu? To vše jsou otázky,
na které se pokusím odpovědět.

Preliminary scope of work in English

The position of Czech public finances has been pronounced unsustainable by economists,
while politicians claim more or less the opposite. In spite of the latest events that drastically
changed the world and Czech Republic financing, my work attempts to estimate the structural
deficit and sustainability of our public finances with the newest data and methodologies. My
work attempts to shed more light on Czech public finances sustainability and to present
further arguments, presenting Czech public finances in the widest context possible and using
comparable, same methodology-based data, as well as different approaches and angles the
public sector can be looked upon. Are the measures envisioned able to solve the problem of
growing deficits? Is the sustainability of Czech public deficits really threatened? How to
measure the sustainability of public finances? What determines the behavior of deficits and
debt levels in the European context? These are all the questions I will try to answer.

Methodology:
To compute the structural deficit, I will apply the Production Function Approach. This entails
estimating the potential output of the Czech economy utilizing a Cobb-Douglas production
function as Tóth (2021) suggests, which correlates output with inputs such as labor, capital,
and total factor productivity. The output gap defined as the disparity between actual and
potential output is calculated upon determining the potential output. This, in turn, facilitates
the estimation of the structural deficit.
I will employ the Fiscal Reaction Function Approach to evaluate public finance sustainability.
This involves constructing a time series regression model that associates the primary budget
balance with public debt and other explanatory variables. This method sheds light on the Czech government's response to alterations in public debt, a critical aspect of evaluating the
sustainability of public finances. I will use the methodology used in a paper from the IMF.

1. Fiscal Reaction Function
I will start by specifying the fiscal reaction function. This relates the primary balance/GDP
ratio to the one-period lagged public debt/GDP ratio, controlling for other influences. The
actual behavior of the government is studied by estimating a fiscal reaction function.
2. Stationarity and Model Estimation
Next, I will address the problem of possible non-stationarity in the data from three angles:
First, estimate the fiscal reaction function using OLS, VAR, and GMM as if the data were
stationary. Second, I will estimate the fiscal reaction function as State-Space and TAR models
assuming non-linearities in behavior. Third, I will treat the debt/GDP ratio and the primary
balance/GDP data as if the data are non-stationary and estimate a Vector Error-Correction
model (VECM).
3. Error Correction Term
In the case of a VECM, I do not estimate the fiscal reaction function directly, but rather a
model containing short-run dynamics, with the fiscal reaction function then derived from the
short-run dynamics.
4. Long-Run Relationship
I will include the output gap in the short-run dynamics of the model, catering for the
possibility that fiscal policy might react to the business cycle. The fiscal reaction to the
debt/GDP position is captured by the error correction term, which represents the response of
B/Y to deviations from the long-run relationship.
5. Parameter Estimation

By following this approach, I can effectively analyze how the government reacts to its debt
burden and assess the sustainability of public finances. This methodology will help in
understanding whether the government is attempting to stabilize its debt ratio at the realized
level in the previous period, and how fiscal policy might react to the business cycle.

Data
Public debt/GDP data for the Czech Republic can be found in the IMF database and represents national government debt. Primary balance data will be also obtained from IMF. Furthermore, the Fiscal reaction function also includes the output gap, which is constructed in two ways, first with a Hodrick-Prescott filter and secondly with a Kalman filter. Total factor productivity data will be used from Our World in data. Labor data will be used from WorldBank. Data regarding the capital will be used from ČSÚ.