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STU 03-04 : Special Topic - The effects of an oil price shock on the Belgian economy and public finances [Short Term Update 03-04]

The recovery of Belgian GDP started by mid-2003, driven by an improvement of the worldwide business cycle, which persisted during the first half of this year. As a result, GDP growth should accelerate to 2.4% in 2004 and 2.5% in 2005, after a modest increase of only 1.3% in 2003.

Economic growth in 2004 should be more balanced than in 2003, when it was boosted entirely by domestic demand and net exports contributed negatively. In 2004 net exports should make a positive contribution of 0.4% to economic growth and hence become the driving force behind the pick up in growth. Growth of final national demand should accelerate to 2% this year, from 1.7% in 2003. Next year's economic growth will depend on final national demand. The sharp rise in investment, in particular, will cause an acceleration in national demand of up to 2.6% in 2005. Combined with strong export growth, this implies a speeding up of imports, resulting in a zero contribution of net exports to economic growth next year.

After a net gain of 2,300 persons in 2003, employment should show an average annual rise of respectively 17,700 and 31,700 persons in 2004 and 2005. The unemployment rate should mark its third consecutive rise this year and only decline marginally in 2005.

The decrease in underlying inflation from 2% last year, to 1.6% in 2004 and 1.5% in 2005 will be more than compensated for by the recent oil price rises, resulting in headline inflation of 2.1% in 2004 and 2% in 2005.

The price of oil has risen sharply over the course of recent months. In this context of persistently high oil prices, the FPB’s Hermes macro-econometric model has been used to investigate the effects of an oil price shock on the Belgian economy and the public finances. The results of the simulation of a permanent 20 percent rise in the price of crude oil show that the Belgian economy would be affected negatively, with real GDP falling by up to 0.17 percent, private consumption by up to 0.32 percent, and consumer prices rising by up to 0.46 percent. The country’s public finances are equally negatively affected, as the recessionary impact on output and inflationary price effects combine to produce a stronger rise in government spending than in tax income. At the same time, the oil price shock tends to shift the weight of the overall tax burden more heavily towards household income and expenditure on private consumption.

The macro-economic effects on the Belgian economy

The 20 percent rise in oil prices has a direct effect on Belgian import prices, as well as on the volume of effective foreign demand for Belgian exports. In the first year the rise in oil prices leads to a 1.09 percent rise in total import prices relative to the baseline scenario. Import prices then continue to rise, before falling back to a 0.96 percent rise in the medium term. The rise in import prices leads to higher domestic inflation, reducing real household disposable income and corporate real profit margins. The oil price shock also has a direct real effect on the Belgian export volume. Indeed, as the oil price shock develops and impacts the global economy, it also produces recessive effects on the other main importers of oil, which are among Belgium’s foremost trading partners. One first result is a drop in domestic demand from Belgium’s trading partners, including their demand for imports from Belgium. The rise in their domestic inflation is assumed, however, to be only partly passed on to their own export prices for non-energy goods and services, as they attempt to maintain their overall competitiveness. The global effects of the oil price shock reduce Belgian exports by 0.31 percent in the first year and by 0.10 percent in the medium term.

The rise in import prices feeds Belgian domestic inflation, as the oil price shock trickles down through the production price and into the price to private consumers. The consumer prices rise by 0.27 percent immediately, then continues to rise and reaches 0.46 percent in the medium term. Rising consumer price inflation reduces household real disposable income, and this fall in household purchasing power leads to a fall in private consumption. The oil price shock affects the components of private consumption in various ways. The demand for fuel and power falls only slightly on impact, but the effect becomes more pronounced over time. The initial fall in demand for personal transportation and its related equipment is much more abrupt, but diminishes over time. Purchased transportation increases after the rise in oil prices, as the price of this component rises only modestly.

This note describes the general trend as well as the main phenomena that are at play: a consumer preference for services when their purchasing power increases and an intense international competition leading to further productivity gains and specialisation.

Firms’ profits also feel the squeeze from the higher energy price, which immediately raises their production costs. At the same time, rising prices reduce private consumption and lead to a reduction in GDP. The loss in GDP and rising inflation initially lead firms to cut employment, further reducing household income. At the same time, the inflationary shock causes a rise in the health index, to which nominal wages and various public transfers to households are indexed. The automatic indexation mechanism tends to limit the fall in real household wage income, putting further pressure on firms’ overall production costs, and leading to further employment losses. The initial drop in employment and labour productivity then tend to temper demands for nominal wage increases, pushing real wage costs down. In t+7, the oil price shock leads to no significant effect on either total employment or nominal wage costs, although real per capita wage costs fall by 0.42 percent. The price shock has a relatively balanced effect on the distribution of income, as household real disposable income drops by 0.43 percent, and corporate gross profits decline by 0.47 percent. Overall, Belgian constant price GDP falls by 0.17 percent in the first year of the shock, and the decline stabilises at 0.11 percent in the medium term.

Effects on Belgian public finances

The world oil price shock also has adverse effects on Belgium’s public finances. Taxes on corporate income go down by no more than 0.05 percent of GDP, following the decline in corporate gross profit margins due to the higher cost of intermediate inputs and higher unit labour costs. Initially, taxes on household incomes and social security contributions rise by 0.05 percent and 0.04 percent of GDP respectively, due to the indexation of nominal wages and the fall in the GDP deflator. While the rise in oil prices leads to declining real income for both households and the corporate sector, the rise in inflation also skews the weight of income taxes towards households. As the average tax rate on household income is higher than the average corporate tax rate, this produces an autonomous rise in the overall tax burden on income, which then boosts government revenue.

The oil price shock’s recessionary effect on private consumption tends to reduce tax revenue related to consumption, especially income from excise duties on energy products. When taken together, however, total receipts from VAT and excise duties tend to rise as a percentage of GDP, albeit marginally. This limited though positive effect on consumption tax receipts stems from the rise in consumer prices, which compensates for the decline in the volume of real consumer spending, and from the relatively faster rise in consumer prices than the price of GDP. Notwithstanding the positive effects of inflation on tax receipts, the recessionary effects of the oil price shock limit the overall rise in current government receipts to somewhat below 0.10 percent of GDP. On the whole, the rise in world oil prices produces a slight shift in the fiscal burden, away from the relatively more exposed corporate sector and toward both household income and household private consumption expenditure.

The oil price shock leads to a rise in total public expenditure of about 0.28 percent of GDP in the medium term. This rise in spending is due to higher social security outlays, rising public sector consumption, and the rise in the interest rate charges on public sector debt.

The adverse inflationary shock raises the public sector net borrowing requirement by about 0.16 percent of GDP in the first year and, as public spending rises, the borrowing requirement rises to 0.25 percent of GDP in t+7. [More in the publication ...]

STU 3-04 was finalised on 4 October 2004.

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