Fiscal performance under inflation and inflation surprises: evidence from fiscal reaction functions for the euro area

This paper estimates fiscal reaction functions to examine the importance of inflation and inflation surprises for fiscal outcomes in the euro area countries, covering the first 12 countries to join the euro area. The effect of HICP inflation on the primary fiscal balance in per cent of GDP is positive, and statistically and economically significant. The positive effect stems from both the revenue side, particularly direct taxes and indirect taxes, and the expenditure side, particularly primary current expenditures. The effects of HICP inflation on the primary balance and other fiscal outcomes appear in large part to stem from inflation surprises, which arise when inflation differs from the inflation forecasts available for preparing budgets. The effects of inflation on the various fiscal outcome do not appear to exhibit noticeable non-linearities.