We estimate the political economy determinants of budget deficit forecast errors. Since the adoption of the Stability Pact, Eurozone governments have manipulated forecasts before elections. The political orientation and the institutional design of governments also affects the quality of forecasts.Fiscal policy, Budget deficit, Forecast error, Electoral cycles

Andreas Stephan

Tilman Brück

English

Research Papers in Economics

 
 
 
 
Tilman Brück* 
Andreas Stephan** 
 
 
 
Do Eurozone Countries Cheat 
with their Budget Deficit Forecasts? 
 
Discussion Papers 
Berlin, August 2005  
*  Corresponding author: Tilman Brück, tbrueck@diw.de 
German Institute for Economic Research – DIW Berlin and Poverty Research Unit at 
Sussex (PRUS) 
 
**  European University Viadrina and German Institute for Economic Research – DIW Berlin  
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
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permission of DIW Berlin. 
 Do Eurozone Countries Cheat with their Budget Deficit Forecasts?
1 
2 
 
Tilman Brück 
German Institute for Economic Research (DIW Berlin) and Poverty Research Unit at 
Sussex (PRUS) 
 
and 
 
Andreas Stephan 
European University Viadrina and German Institute for Economic Research (DIW 
Berlin) 
 
 
24 May 2005 
 
JEL classifications: H62, H87, C23, C53, E62 
Keywords: fiscal policy, budget deficit, forecast error, electoral cycles 
 
 
 
Abstract 
We estimate the political economy determinants of budget deficit forecast errors. Since 
the adoption of the Stability Pact, Eurozone governments have manipulated forecasts 
before elections. The political orientation and the institutional design of governments 
also affects the quality of forecasts. 
                                                 
1 Corresponding author: Tilman Brück, German Institute for Economic Research (DIW Berlin), Königin-
Luise-Str. 5, 14195 Berlin, Germany, Tel: +49-30-89789-591, Fax: +49-30-89789-108, Email: 
tbrueck@diw.de. 
2 We thank Anne Brunila, Ulrich Fritsche, Chetan Ghate, Andrew Hughes Hallet, and Boriss Siliverstovs 
for helpful comments and Ina Yaneva for her excellent research assistance. The usual disclaimer applies. 
1  1. Introduction 
In this paper, we assess the political, electoral and institutional determinants of the 
quality of the budget deficit forecasts for Eurozone countries before and after the 
introduction of the Stability and Growth Pact (SGP). We also check if similar political 
economy considerations drive the quality of budget deficit forecasts in non-Eurozone 
economies. 
Under the SGP, the European Commission is charged with monitoring the fiscal 
position of each eurozone country and initiating fines for truants using raw data from 
national statistical agencies (Buti and van den Noord 2004). The SGP therefore creates 
incentives for “unobservable fiscal effort” (Beetsma and Jensen 2003) of a malign 
nature, “creative accounting” (Milesi-Ferretti 2003) or plain cheating with budget 
deficit forecasts prior to elections (Strauch et al 2004). 
Our paper makes three distinct contributions to the political economy analysis of fiscal 
policy. First, this is the first paper, to our knowledge, that proves the existence of 
cheating by eurozone governments (compared to other OECD governments) in 
reporting their budget deficits since the adoption of the SGP prior to elections. Second, 
we apply panel econometric techniques to the analysis of forecast errors of both 
eurozone and non-eurozone OECD economies, rather than only considering eurozone 
economies. Third, we use two forecasts per year which increases the subtlety of our 
political economy analysis. 
2. Hypotheses 
We conjecture that the SGP created incentives to induce “political forecast cycles” in 
Eurozone but not in non-Eurozone countries. As with political budget cycles, there may 
be electoral, partisan or institutional forecast cycles.  
2 In an electoral forecast cycle, a given election date determines a government’s spending 
and taxation plans and the corresponding information policy. For example, a 
government may increase spending prior to an election and hide the emerging budget 
deficit until after the election. We hypothesise that under the SGP forthcoming elections 
induce budget deficit forecast manipulations. 
In a partisan forecast cycle, cyclical behaviour derives from different preferences of the 
political parties and their respective voters. The political orientation of a government 
may affect the quality of its budget deficit forecasts. We hypothesise that left-wing 
(right-wing) governments pursue employment (price stability) at the expense of price 
stability (employment) which means that tax revenues are more (less) difficult to 
forecast. 
In an institutional forecast cycle, the institutions of governance create incentives for 
more or less truthful reporting of budget deficit forecasts, as is the case in institutional 
budget cycles. We hypothesise that moving to a coalition or minority government 
increases the incentive to cheat for two reasons. First, single-party and majority 
governments can afford to be unpopular if necessary and still hope to win elections 
later. Second, they can afford to openly favour their supporters without having to 
conceal such actions. 
3. Method 
Let   denote the deficit or surplus in period  . The deficit (or surplus) forecast error 
 (measured as share of GDP) is defined as predicted   in   for period   minus 
actual   in  , thus 
t y
, t
t
t1 e + y t t1 +
y t1 +
  t1 , t t1 , t t1 eyy + ++ = − . (1) 
3 Accordingly, an optimistic forecast (that is an underestimation of the deficit or an 
overestimation of the surplus) yields a positive value of the forecast error. 
A forecast should be unbiased, that is it should have a mean error of zero. Furthermore, 
a forecast should be rational, that is it should use all available information thus making 
it impossible to find any other variable which can be used to predict the error. 
A basic regression model for testing the rationality of forecasts with a panel of   
countries is 
N
  
t 1,it i t k k,it it
k
ex
i1 ,, N ;t1 ,, T ;k1 ,, p
+ =µ +λ + β +ε
===
,
;
∑
KKK
 (2) 
where   denotes country-specific (intercepts) and  i µ t λ  time-specific effects,   a r e    
factors potentially predicting the forecast error, and 
k,it x p
it ε  represents iid random noise with 
variance  . 
2
i σ
The unbiasedness of countries’ forecasts implies  i 0 µ =  for all  . The rationality of 
forecasts furthermore implies  . 
i
tk 0 λ= β=
Due to groupwise heteroscedasticity of error variances in (2), we employ Weighted 
Least Squares (WLS) for the estimations, where weights are proportional to the 
reciprocals of country-specific error variances obtained from residuals of a first step 
OLS regression. 
4. Data 
Each Spring and Autumn, the European Commission publishes budget deficit forecasts 
of each member state for the subsequent calendar year (European Commission 1995-
2004), which yields two observations for each year for the dependent variable defined in 
equation (1). To calculate the budget deficit forecast error, we use the first estimate of 
the actual budget deficits as published in the same source.  
4 We calculate the following political variables (Armingeon et al 2004, Europa 
Publications 1996-2003): 
(i)  the number of months till the next legislative election, 
(ii) the political orientation of a government as indicated by the election manifestos of 
the government parties and ranging from very left-wing (negative values) to very 
right-wing (positive values) orientations, 
(iii)a binary variable indicating coalition governments (which take the value one), and 
(iv) a binary variable indicating minority governments (which take the value one). 
In addition, we define a binary variable taking the value one if a country has joined the 
stability and growth pact (that is if it is a eurozone country after 1997). 
To control for the effects of unobserved macro-economic shocks, we include the GDP 
forecast error as an explanatory variable. We include as an additional independent 
variable the error from the Spring forecast in the estimation of the Autumn forecast 
error. With rational forecasts, we would not expect a correlation of forecast errors 
across years. 
The dataset covers 17 eurozone and non-eurozone countries (EU-15, Japan and the 
USA) and bi-annual forecasts for these countries published by the Commission from 
1995 to 2003. Due to missing values, 249 observations are available in total. 
The political orientation of parties is only available till 1998 and extrapolated for 
subsequent governments based on the latest available election manifestos. For the 
compilation of the political variables, the publication dates of the Commission Spring 
and Autumn forecasts served as cut-off dates.  
5 5. Results 
Table 1 shows that there are no significant differences in biases of forecast errors 
between Eurozone and non-Eurozone economies. 
We first estimate a model where the coefficients on the political variables can be 
different for eurozone and non-eurozone countries (model I). We then restrict the 
sample to the eurozone countries and then test the effects of the political variables 
before and after the adoption of the SGP (model II). 
Both models fit very well, taking into consideration that rational forecasts should not be 
correlated with any further variable (table 2). We find that the error of the Spring 
forecasts has predictive power for the Autumn forecast error in all models. Macro-
economic shocks, captured by the GDP forecast error variable, are positively correlated 
with the deficit forecast errors, which is not surprising. The country fixed effects are 
jointly significant in all models. In particular, Greece and the US have high positive and 
Luxembourg and Belgium high negative coefficients, indicating that these countries 
systematically under- and overestimate their budget deficits, respectively. 
The regression analysis suggests the following about our hypotheses. First, the 
introduction of the SGP led to the eurozone governments issuing biased budget 
definition forecasts prior to elections. While this effect is present only for the Eurozone 
countries (model I), model II in fact demonstrates that the effect became significant with 
the introduction of the SGP. 
Second, governments moving to the right (left) make more pessimistic (optimistic) 
forecasts (model I). Model II again demonstrates that the introduction of the SGP made 
this effect significant for eurozone economies. 
Third, coalition governments in eurozone economies do not make unbiased budget 
deficit forecasts (model I), either before or after the adoption of the SGP (model II). In 
6 contrast, minority governments in eurozone countries only have made overtly optimistic 
forecasts since the introduction of the SGP (model II). 
Our findings extend the empirical literature on political budget cycles to the case of 
political forecast cycles. In contrast to the literature, we find that contracts like the SGP 
do have an impact on European fiscal choices (Andrikopoulos et al 2004). Governments 
faced extra incentives to mislead their electorates. In comparison to the ambiguous 
results provided by Strauch et al (2004), we present strong evidence on the existence of 
electoral cycles due to the introduction of the SGP. 
6. Conclusion 
Our analysis demonstrates the existence of political forecast cycles in Eurozone 
economies after the adoption of the Stability and Growth Pact. The Pact creates 
incentives for governments to mislead their electorates about budget deficit forecasts, 
especially in the run up to elections. The finding calls into question the strong reliance 
of the Pact on budget deficit forecasts as a key fiscal indicator. 
Bibliography 
Andrikopoulos, A., I. Loizides and K. Prodromidis (2004). “Fiscal Policy and Political 
Business Cycles in the EU.” European Journal of Political Economy. 20: 125-52. 
Armingeon, K., P. Leimgruber, M. Beyeler and S. Menegale (2004). Comparative 
Political Data Set 1960-2002. Berne: Institute of Political Science, University of 
Berne. 
Beetsma, R. and H. Jensen (2003). “Contingent Deficit Sanctions and Moral Hazard 
with a Stability Pact.” Journal of International Economics. 61: 187-208. 
Buti, M. and P. van den Noord (2004). “Fiscal Policy in EMU: Rules, Discretion and 
Political Incentives.” Economic Papers European Commission. 
Europa Publications (1996-2003). Europa World Year Book. London. 
European Commission (1995-2004). European Economy. Brussels. 
7 Milesi-Ferretti, G. M. (2003). “Good, Bad or Ugly? On the Effects of Fiscal Rules with 
Creative Accounting.” Journal of Public Economics. 88: 377-94. 
Strauch, R., M. Hallerberg and J. von Hagen (2004). "Budgetary Forecasts in Europe - 
the Track Record of Stability and Convergence Programmes." ECB Working 
Paper Series. Frankfurt. 
von Hagen, J. (2003). "Fiscal Discipline and Growth in Euroland: Experiences with the 
Stability and Growth Pact." ZEI Working Paper. Bonn. 
8 9 
Table 1: Descriptive Statistics for Deficit Forecast Errors 
Country  No. Obs. Mean  Std. Dev.
Eurozone countries before 1998  47  -1.002  1.006 
Eurozone countries after 1997  134  -0.015  1.616 
Non-Eurozone countries  68  0.135  1.866 
All countries  249  -0.160  1.643 
 
Table 2: Regression Results (Weighted Least Squares) 
Dependent variable: 
Deficit forecast error   
 
Model I 
(all countries)   
Model II 
(Eurozone countries) 
Independent variable  Estimate  t-value   Estimate  t-value 
Spring forecast error  0.140  2.08**    0.125  1.68* 
GDP forecast error  0.284  4.05***    0.270  3.62*** 
Months till election         
  non-Eurozone  -0.001 -0.05  1995-1997 -0.006 -0.69 
  Eurozone  -0.014 -3.39***  1998-2003 -0.016 -3.29*** 
Political orientation       
  non-Eurozone  -0.012 -1.18  1995-1997 -0.009 -0.73 
  Eurozone  -0.013 -1.71*  1998-2003 -0.016 -1.82* 
Coalition government       
  non-Eurozone 0.133  0.11  1995-1997 2.049  3.03*** 
  Eurozone  0.746 2.15**  1998-2003 0.761 2.25** 
Minority government       
  non-Eurozone -0.377  -0.37  1995-1997 0.980  1.55 
  Eurozone 0.515 1.06  1998-2003 1.762  3.01*** 
Austria -0.146  -0.27    0.033  0.06 
Belgium -0.714  -1.66*    -0.601  -1.37 
Denmark 0.680  0.30       
Finland  -0.529 -1.08    -0.416 -0.88 
France  0.252 0.62    0.399 0.93 
Germany -0.025  -0.06    0.114  0.26 
Greece 0.869  1.66*    1.409  2.92*** 
Ireland 0.185  0.23    -0.594  -0.74 
Italy  0.107 0.23    0.279 0.58 
Japan 1.201  0.97       
Luxembourg  -1.839 -3.26***    -1.717 -3.03*** 
Netherlands  -0.455 -1.04    -0.315 -0.71 
Portugal  0.233 0.50    0.305 0.66 
Spain -0.053  -0.18    0.125  0.41 
Sweden -0.341  -0.28       
United Kingdom  0.564  1.11       
USA 2.274  2.48**       
1995 -0.565  -1.78*    -1.905  -2.90*** 
1996  -0.876 -3.37***    -2.451 -3.72*** 
1997  -0.899 -2.98***    -2.510 -3.65*** 
1998  -0.860 -3.27***    -1.117 -3.97*** 
1999  -1.385 -5.01***    -1.671 -5.54*** 
2000  -0.466 -1.57    -0.406 -1.31 
2001  0.380 1.35    0.259 0.88 
2002 0.237  0.84    -0.020  -0.07 
R² 0.6166    0.6681 
Obs. 249    181 
Test for unbiasedness
a 71.0***    51.0*** 
 
Statistically significant coefficients are indicated by *, **, and *** at 10, 5, and 1 percent level, respectively. 
 
aSignificance of country effects 

Budgetary Forecasts in Europe -the Track Record of Stability and Convergence Programmes.&quot; ECB Working Paper Series.

Comparative Political Data Set 1960-2002.

Contingent Deficit Sanctions and Moral Hazard with a Stability Pact.”

Fiscal Discipline and Growth in Euroland: Experiences with the Stability and Growth Pact.&quot; ZEI Working Paper.

Good, Bad or Ugly? On the Effects of Fiscal Rules with Creative Accounting.”

Do Eurozone Countries Cheat with Their Budget Deficit Forecasts?

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Do Eurozone Countries Cheat with Their Budget Deficit Forecasts?

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