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Heterogeneous Effects of Fiscal Consolidation on Firms' Balance Sheets

Periodic Reporting for period 1 - FLASH (Heterogeneous Effects of Fiscal Consolidation on Firms' Balance Sheets)

Reporting period: 2017-09-01 to 2019-08-31

What is the problem/issue being addressed?
Despite major and sustained fiscal adjustments made in recent years to bring debt down to safer levels in the face of a weak recovery, many OECD countries still need substantial fiscal consolidation to put public finances back on a sustainable path. The design of fiscal adjustments and its macroeconomic effect has been extensively investigated in the literature. However, existing studies have focused on aggregate level data and have failed to consider the heterogeneous effects that fiscal consolidation might have on the economic performance of the business sector. Project FLASH aims to evaluate the short-term effects of fiscal consolidation on the real and financial activities of firms of different characteristics. FLASH provides novel empirical evidence on the transmission of fiscal shocks to the firm's employment, investment, and balance sheets. In addition, FLASH evaluates how firms with different characteristics respond to changes in average versus marginal tax rates.

Why is it important for society?
A credible fiscal adjustment strategy would be expected to consider the business sector response. Project FLASH highlights the important role of financial frictions in determining the impact of fiscal consolidation on firms' performance. Because financial frictions affect differently firms of different sizes, the effects of fiscal consolidation are likely to be heterogeneous across firms. An important policy implication of FLASH is about how best to design fiscal consolidation for small and large firms as well as for financially constrained and unconstrained firms.

What are the overall objectives?
Using CompNet and Compustat datasets, narrative identification and MTR's simulation, and Panel VARX methods, the overall objectives of FLASH are twofold: (1) to develop a research programme in the design, implementation and evaluation of fiscal consolidations plans and investigate the relative importance of tax increases on Firms' balance sheets, and (2) to explain the possible mechanisms that drive differential responses by small and large firms to fiscal adjustments.

The project has achieved most of its objectives and milestones for the period, with relatively minor deviations.
The work plan of project FLASH was divided into 5 work packages. WP1 provides an extensive literature review and familiarization with fiscal consolidation policies in the euro area and US corporate taxation. WP2 involves data management of a new dataset based on the Competitiveness Research Network (CompNet) micro-level database, and Compustat data. WP3 is on training and analyses of econometrics and policy evaluation techniques. WP4 represents the core of the project and provides the main findings on the impact of fiscal consolidation on the real and financial activities across small and large firms. WP5 involves the dissemination of results.

1.2.1 Work Package 1: Literature review and familiarization with fiscal consolidation policies in the euro area. Through an extensive reading of papers and related reports, we defined flexible working arrangements into:
• Using existing narratively identified exogenous fiscal adjustments instead of using changes in the cyclically-adjusted primary balance (CAPB) to measure discretionary changes in fiscal policy.
• Using a Panel VARX model to estimate heterogeneous effects of fiscal consolidation on firms' balance sheets, instead of using the conventional approach such as: Panel SVAR models, Local Projection Techniques, 2SLS and Truncated Moving Average (MA) representation.
• Using growth rates of series instead of using the level variables or first-differenced variables.
• Using sectoral level data (2-digit NACE classification) for six EU countries (BE, DK, DU, FI, FR and IT).
• Distinguish between small and large firms based on the number of employees. In addition, distinguish between financial constraint and unconstraint firms based on conventional measures.

1.2.2 Work package 2: Data management of CompNET and Compustat datasets. Regarding CompNET data, we used the size and distinguished between small and large firms based on the number of employees. We also used two measures of financial constraints provided in the data (ICC and IFC indicators). Regarding Compustat data, we sorted firms into financially constrained and unconstrained using annual payout ratio, debt ratings, paper ratings, and Kaplan-Zingales index.

1.2.3 Work package 3: Training and analyses of econometrics and policy evaluation techniques. To further strengthen my time-series analysis and macroeconometric skills, I received training in econometrics and identification methods, at a recognized state-of-the-art facility, and benefited from the expertise of the research advisory team. I attended several training courses on econometrics and policy evaluation techniques and could incorporate and apply them to data analyses and applications.

1.2.4 Work package 4: Applications and results.
FLASH provides novel empirical evidence on the transmission of fiscal shocks to the firm's balance sheets. We find that tax-based fiscal consolidations lower firm-level employment and investment but raise labor productivity. We find that fiscal consolidations lower investment by small and financially constrained firms mostly. In addition, FLASH provides empirical evidence that constrained firms are significantly more responsive to ATRs than unconstrained firms, which are relatively more sensitive to MTRs. An important practical implication of project FLASH could be of interest to many different parties, such as institutional investors, corporate managers, policymakers and university scholars to evaluate the impact of changes in different tax rates on corporate decisions, in particular when the financial market is under stress.

1.2.5 Work package 5: Dissemination of results, including conferences, workshops, seminars, meetings and the elaboration of research papers for submission to journals. Project results were also presented in various situations and for different types of audiences. We organized a fiscal policy workshop to share findings of this project with researchers from both academia and industry. We brought toget
Project FLASH had a significant impact on a range of groups outside the academic research community, including policy institutions, independent fiscal councils, non-governmental organizations, and the public. We used a variety of methods to ensure that these groups are reached and have the opportunity to engage with this research. This project provides recommendations to fiscal policy administrations to design effective programs, catering to different sized firms in a way, which promotes a strong economic performance.

Two years under the Marie Skłodowska-Curie fellowship provided me a great opportunity to extend my research horizon and helped consolidate my career development. It expanded my theoretical and empirical time-series analysis skills. Furthermore, through training courses, at a recognized state-of-the-art facility, I am able to incorporate and apply my skills to data analyses and applications. Although I was working under the supervision of an experienced and devoted team, I had the opportunity to explore my own research questions and developed an independent research agenda.
Fiscal Policy Workshop - Dinner
Fiscal Policy Workshop
Fiscal Policy Workshop - Program
Fiscal Policy Workshop - Rana Sajedi (Bank of England)
Fiscal Policy Workshop - Paulo Santos Monteiro (University of York)
Fiscal Policy Workshop - Nicolò Maffei Faccioli (ECB)
Fiscal Policy Workshop - Carlo Favero (Bocconi University)