- Teresa Daban Sanchez, Steven Symansky, Gian Milesi-Ferretti, Enrica Detragiache, and Gabriel Di Bella
- Published Date:
- November 2003
This appendix provides a brief survey of political economy arguments that explain deviations of fiscal policy conduct from a socially optimal bench-mark.1 The first question, of course, is: What is the “optimal” conduct of fiscal policy—that is, what is the appropriate benchmark? The neoclassical theory of fiscal policy (see Barro, 1979, 1989; Lucas and Stokey, 1983; Lucas, 1986) stresses the importance of achieving tax smoothing. Budget deficits should be used to cover temporary increases in government spending (for example, those due to a war) while tax rates should be kept constant to minimize distortions.2 This generally implies that the budget balance will be countercyclical. Keynesian models of aggregate demand management stress the importance of fiscal policy as a stabilizer: fiscal policy should be expansionary during recessions and contractionary during expansions in order to moderate business cycle fluctuations.
Fiscal Policy Biases
The political economy literature provides possible explanations as to why governments may systematically deviate from these principles of fiscal policy. We divide theoretical arguments into those implying a bias toward budget deficits and those implying a bias toward excess public spending. As we shall see, there is overlap between the two categories, since excess budget deficits can clearly be due to excess public spending.
Alesina and Perotti (1995) provide a useful classification of political economy models of fiscal policy. We shall focus primarily on three types: (i) models based on “fiscal illusion” with opportunistic policy-makers and naive voters, (ii) models of debt as a strategic variable, and (iii) models of distributional conflict.
The first class of models is in the spirit of the public choice literature: the key assumptions are that policymakers are opportunistic (that is, they care about electoral prospects, and not directly about private agents’ welfare) and use fiscal deficits to increase their electoral chances. Voters fail to understand the intertemporal budget constraint of the government—they overestimate the benefit of current expenditures and underestimate future tax burdens or both—and therefore do not “punish” politicians for fiscally irresponsible behavior. In this context, fiscal rules would be beneficial because they would constrain such fiscal irresponsibility.
The second strand of literature emphasizes that the stock of debt has an effect on the policy choices of future governments and can therefore be used to constrain its actions (Alesina and Tabellini, 1990; Tabellini and Alesina, 1990). In this context, a deficit bias can arise because different political parties, which face electoral uncertainty, have conflicting spending priorities. These factors imply that the current government does not fully internalize the cost of running budget deficits today, because the future spending that is going to be compressed may reflect the priorities of a different government. This deficit bias is increasing in the degree of political polarization (reflected in the difference between spending priorities) and in the degree of electoral uncertainty.3 In this class of models, parties before an election would agree on a balanced budget rule, but after the election the party in power prefers “discretion.”
A third strand of literature shows how conflict between different social groups (represented by parties, interest groups, coalition members) can delay the adoption of necessary policy measures, for example, spending cuts or tax increases to stem growth in public indebtedness caused by exogenous factors (Alesina and Drazen, 1991; Drazen and Grilli, 1993). Delays occur because groups cannot agree on burden-sharing for the necessary fiscal adjustment. These models predict that fragmented or divided governments and polarized societies would have more difficulty implementing fiscal adjustment than single-party governments and less polarized societies. Evidence presented in Roubini and Sachs (1989) and Grilli, Masciandaro, and Tabellini (1991) for OECD countries, and Poterba (1994) and Alt and Lowry (1994) for U.S. states, is consistent with these predictions.
A number of contributions closer to the political science literature study the overprovision of public projects (“pork barrel spending”) that can arise, for example, when programs have concentrated benefits and diffuse costs. One important factor in this strand of literature is the interaction between the organization of legislatures and fiscal decisions. In particular, one strand of the literature stresses the bias toward excess spending that can arise when representatives of geographically based constituencies fail to fully internalize the financing costs of projects yielding benefits to their constituency, because these costs are borne by taxpayers as a whole (see, for example, Weingast, Shepsle, and Johansen, 1981).4 Whether the spending bias will indeed cause excess spending depends on the rules that determine which projects will actually be undertaken. In the simplest case, in which each policymaker decides on the level of spending in his or her district and taxes are determined so as to balance the budget, the result will be a level of spending and taxation that is too high from society’s point of view.5
These models can be applied to the determination of public spending within a government, where each “spending” minister fails to fully internalize the costs of higher taxes to finance the spending imposed on society at large (see, for example, von Hagen and Harden, 1996). The bias is stronger the more decentralized the decision system, because of a common pool problem—everybody has to pay taxes, but only specific ministries and their constituents benefit from the spending. Kontopoulos and Perotti (1999) present evidence that countries with a larger number of spending ministers tend to have higher public spending. Finally, the model can be applied to spending decisions within a government coalition, implying that control on spending is more difficult the larger the number of parties in the coalition.
Implications for Fiscal Frameworks
“Biases” in the conduct of discretionary fiscal policy are a possible justification for the imposition of fiscal rules.6 In principle, the ideal rule would be state-contingent, allowing authorities flexibility to react to shocks while removing inherent bias toward excess fiscal imbalances. However, another view is that rules have to be simple in order to be verifiable, so that contingent rules leave the door open to manipulation. If rules are not state-contingent, a critical trade-off arises between the elimination of a policy bias and the need to retain policy flexibility, as in the literature on rules versus discretion in monetary policy formation (Kydland and Prescott, 1977; Barro and Gordon, 1983).7
Corsetti and Roubini (1997) explore these issues more formally. They present a simple model that extends Alesina and Tabellini (1990) in order to highlight the trade-off between deficit bias and margin for stabilization in the context of a closed or open economy. They first consider whether leaving the government a margin for stabilization policy (modeled as a “tax-smoothing” role) worsens the deficit bias. They conclude that it does not. An interesting result they obtain is that the political deficit bias is enhanced in an open economy. Since in their model there is no default risk, the government in an open economy faces an infinitely elastic supply of funds at the given world interest rate, in contrast to a closed economy. This implies that additional borrowing to finance more expenditure is not discouraged by higher interest costs.8 Clearly, the scope for fiscal rules depends on the relative intensity of the deficit bias and the need for tax smoothing.9
Dur and others (1997) show that a fiscal rule imposed to address a deficit bias problem may have undesirable effects on the composition of public spending, leading to suboptimally low public investment.
A number of studies examine the rationale for fiscal rules in a monetary union. Chari and Kehoe (1997) argue that fiscal constraints can be desirable where no monetary policy commitment is possible. This is because national fiscal authorities take into account the incentive of the central bank to partially monetize debt, but they do not internalize the costs of induced inflation on other member states. Beetsma and Uhlig (1999) study the rationale for a “stability pact” limiting fiscal imbalances in a monetary union, using a model in which politicians have a deficit bias and an incentive to erode debt through unexpected inflation.
The models of spending bias described in the previous section highlight how budgetary institutions can affect fiscal outcomes—for example, the spending bias can be reduced by a strong finance minister with agenda-setting powers, by negotiated spending targets for each ministry, or by setting an overall spending ceiling. Indeed, imposing a binding aggregate spending constraint forces agents bargaining over spending to fully internalize the resource cost of their bids.
1991, “Why Are Stabilizations Delayed?” American Economic Review, Vol. 82(December), pp. 1170–88.
1990, “A Positive Theory of Fiscal Deficits and Government Debt,” Review of Economic Studies, Vol. 57(July), pp. 403–14.
1995, “The Political Economy of Budget Deficits,” IMF StaffPapers No. 42 (Washington: International Monetary Fund).
1996, “Budget Deficits and Budget Institutions,” NBER WorkingPaper No. 5547 (Cambridge, Massachusetts: National Bureau of Economic Research).
1994, “Divided Government and Budget Deficits: Evidence from the States,” American Political Science Review, Vol. 88(December), pp. 811–28.
1987, “Fiscal Discipline in a Federal System: National Reform and the Experience of the States,” (Washington: United States Advisory Commission on Intergovernmental Relations).
1979, “On the Determination of the Public Debt,” Journal of Political Economy, Vol. 87(October), pp. 940–71.
1989, “The Neoclassical Approach to Fiscal Policy,” in Modern Business Cycle Theory,ed.Robert J. Barro (Cambridge, Massachusetts: Harvard University Press), pp. 178–235.
1983, “A Positive Theory of Monetary Policy in a Natural Rate Model,” Journal of Political Economy, Vol. 91(August), pp. 589–610.
1995, “Restraining Yourself: The Implications of Fiscal Rules for Economic Stabilization,” IMF Staff Papers, Vol. 42(March), pp. 32–48.
1995, “Do Credit Markets Discipline Sovereign Borrowers? Evidence from U.S. States,” Journal of Money, Credit and Banking, Vol. 27(November), Part 1, pp. 1047–59.
1999, “An Analysis of the Stability Pact,” Economic Journal, Vol. 109(October), pp. 546–71.
1996, “Balanced Budget Rules and Public Deficits: Evidence from the U.S. States,” Carnegie-Rochester Conference Series on Public Policy No. 45(December), pp. 13–76.
1993, “Excessive Deficits: Sense and Nonsense in the Treaty of Maastricht,” Economic Policy: A European Forum, Vol. 17(April), pp. 58–100.
1993, “Why Are Representative Democracies Fiscally Irresponsible?” Federal Reserve Bank of Minneapolis Staff Report No. 163(August).
1997, “On the Need for Fiscal Constraints in a Monetary Union,” FederalReserve Bank of Minneapolis(September).
1991, “Fiscal Deficits, Public Debt and Government Solvency: Evidence from OECD Countries,” Journal of the Japanese and International Economies, Vol. 5, pp. 354–80.
1996, “European Versus American Perspectives on Balanced Budget Rules,” American Economic Review, Papers and Proceedings, Vol. 86 (May), pp. 408–13.
1997, “Politically Motivated Fiscal Deficits: Policy Issues in Closed and Open Economies,” Economics and Politics, Vol. 9(March), pp. 27–54.
2000, Political Economy in Macroeconomics (Princeton, New Jersey: Princeton University Press).
1993, “Benefits of Crises for Economic Reforms,” American Economic Review, Vol. 83(June), pp. 598–607.
1997, “The Effects of Fiscal Rules on Public Investment if Budget Deficits Are Politically Motivated” (unpublished).
1996, “Fiscal Restrictions and Monetary Union: Rationales, Repercussions, Reforms,” Empirica, Vol. 23, No. 1, pp. 3–23.
1991, “Political and Monetary Institutions and Public Financial Policies in the Industrial Countries,” Economic Policy, Vol. 13(October), pp. 341–92.
1999, “Government Fragmentation and Fiscal Outcomes: Evidence from OECD Countries,” in Fiscal Institutions and Fiscal Performance,ed.James Porterba von Hagen Jürgen (Chicago: University of Chicago Press, for National Bureau of Economic Research).
1977, “Rules Rather Than Discretion: the Inconsistency of Optimal Plans,” Journal of Political Economy, Vol. 85(June), pp. 473–91.
1999, “Budget Deficits and Redistributive Politics,” Review of Economic Studies, Vol. 66(October), pp. 909–28.
1986, “Principles of Fiscal and Monetary Policy,” Journal of Monetary Economics, Vol. 17(January), pp. 117–34.
1983, “Optimal Fiscal and Monetary Policy in an Economy without Capital,” Journal of Monetary Economics, Vol. 12(July), pp. 55–93.
1997, “Fiscal Rules and the Budget Process,” CEPR DiscussionPaper No. 1664 (London: Centre for Economic Policy Research).
1989, “Why a Stubborn Conservative Would Run a Deficit: Policy With Time-Inconsistent Preferences,” Quarterly Journal of Economics, Vol. 104(May), pp. 325–45.
1990, Macroeconomic Policy, Credibility and Politics (Chur, Switzerland and New York: Harwood Academic Publishers).
2001, Political Economics: Explaining Economic Policy (Cambridge, Massachusetts: MIT Press).
1994, “State Responses to Fiscal Crises: The Effects of Budgetary Institutions and Politics,” Journal of Political Economy, Vol. 102(August), pp. 799–821.
1995, “Balanced Budget Rules and Fiscal Policy: Evidence from the States,” National Tax Journal, Vol. 48(No. 3), pp. 329–36.
1989, “Political and Economic Determinants of Budget Deficits in the Industrial Democracies,” European Economic Review, Vol. 33(April), pp. 903–38.
1997, “Price Level Determinacy and Monetary Policy Under a Balanced-Budget Requirement,” Finance and Economics Discussion Series No. 1997-17 (Washington: Board of Governors of the Federal Reserve System, Division of Research and Statistics),April.
1990, “Voting on the Budget Deficit,” American Economic Review, Vol. 80(March), pp. 37–49.
1999, “A Model of Fiscal Deficits and Delayed Fiscal Reforms,” in Fiscal Institutions and Fiscal Performance,ed.James Poterba von Hagen Jürgen (Chicago: The University of Chicago Press, for National Bureau of Economic Research).
1991, “A Note on the Empirical Effectiveness of Formal Fiscal Restraints,” Journal of Public Economics, Vol. 44(March), pp. 199–210.
1996, “Budget Processes and Commitment to Fiscal Discipline,” IMF WorkingPaper No. 96/78 (Washington: International Monetary Fund).
The neoclassical theory of fiscal policy can offer precise normative insights under the maintained assumption that distributional considerations can be addressed by lump-sum transfers. In reality, however, fiscal policies are used to redistribute resources across heterogeneous political groups and individuals, raising the question of how to define an appropriate benchmark of “virtuous” fiscal behavior. Clearly this is an open question, but for the purpose of this discussion we shall take as given the desirability of reducing fiscal imbalances.
A different but related argument is made by Lizzeri (1999) in a game-theoretic model of redistributive politics. Uncertainty about the outcome of elections implies that voters cannot predict whether politicians will in the future choose to redistribute resources to them. Voters are therefore favorable to politicians who promise large current transfers, financing current expenditure through borrowing.
In Weingast, Shepsle, and Johansen (1981), projects also bring political benefits to the district in which they are undertaken.
When spending decisions do not entail approval for all projects (for example, when a minimum winning coalition decides on the projects to be undertaken), results are ambiguous and depend on the voting rule. In a dynamic setting, similar considerations can give rise to “excessive” fiscal deficits. Velasco (1999) emphasizes the bias in fiscal policy when government resources are “common property”; the tendency to run budget deficits arises from each group’s perceptions that the return on public savings is too low, because the rate of return is adjusted by what other groups will appropriate. This enhances the tendency to overspend. Chari and Cole (1993) show that a deficit bias can arise in the presence of political uncertainty, because accumulated government debt reduces the bias toward excess government spending, in a fashion similar to Persson and Svensson (1989) and Alesina and Tabellini (1990).
Some studies have examined the impact of rules in the absence of underlying distortion in the conduct of fiscal policy. For example, Schmitt-Grohe and Uribe (1997) show that in a neoclassical growth model a balanced budget rule can make expectations of higher tax rates self-fulfilling if the fiscal authority relies on changes in labor income tax rates to balance the budget. This happens because the expectation of high tax rates lowers labor supply and therefore output, forcing tax rates to be raised to balance the budget.
In the context of monetary policy, an inflation bias can result from a credibility problem in the relation between the policymaker and the private sector. In the case of fiscal rules, the relevant bias, as we have seen, can instead be determined by political and distributional factors; problems of time consistency can arise if current and future governments may have different preferences for social outcomes. Expectations over future electoral outcomes play an important role in shaping both policy decisions and voters’ electoral choices.
This point was frequently considered in the context of the Maastricht debate. Indeed, the move toward a common currency lowered borrowing costs for high-debt countries by removing inflation and exchange rate risk premiums on interest rates. However, Bayoumi, Goldstein, and Woglom (1995) find that U.S. states face a steeply rising supply curve for credit.
The nature of the trade-off between flexibility and deficit bias is apparent in empirical work on the link between statutory fiscal restraints and budgetary outcomes within U.S. states. Anderson (1987) and von Hagen (1991), among others, find that states with such restraints run smaller budget deficits, while Bayoumi and Eichengreen (1995) find that the countercyclical responsiveness of state budgets is significantly reduced by more stringent balanced budget rules.
This appendix describes the experience with fiscal rules in Australia, Canada, Finland, the Netherlands, New Zealand, Sweden, Switzerland, the United Kingdom, and the United States. For each country, the context in which the rules were adopted, their objectives, and their institutional basis will be reviewed; and where possible, an evaluation of the performance of the rules will be attempted. A broad definition of fiscal rules is adopted in order to cover both countries with specific multiyear numerical targets as their objectives (as in the case of deficit, debt, or expenditure rules) and countries where principles are specified according to which fiscal policy should be conducted.
Background. Poor fiscal performance over more than two decades, which led to a marked buildup in public debt, prompted the Australian authorities to adopt a new fiscal policy framework in the mid-1990s. The Charter of Budget Honesty Act, broadly similar to New Zealand’s Fiscal Responsibility Act, was set out in 1996 and enacted by Parliament in 1998. Its aim was to enhance fiscal discipline and raise public scrutiny of fiscal policy.
Institutional Arrangement. Under the Budget Honesty Act, the Commonwealth (federal) government must lay out its short-term fiscal objectives and targets, as well as its medium-term strategy in each annual budget. In doing so, the act establishes general principles for formulating sound fiscal policy; it requires that governments be explicit about their fiscal policy intentions and present comprehensive information on fiscal developments. Short-term fiscal targets are established in the budget law; but they must be consistent with the principles determined by the act, particularly the principle of fiscal balance over the course of the economic cycle.
Objectives. The objective of the Budget Honesty Act is to improve fiscal policy outcomes by requiring the government’s fiscal strategy to be based on principles of sound fiscal management and by facilitating public scrutiny of fiscal policy and performance. Moreover, it establishes that the government’s fiscal policy is to be directed at maintaining economic prosperity in a sustainable medium-term framework.1
Characteristics. Under the Budget Honesty Act, the government’s fiscal strategy is based on the following principles. First, financial risks must be managed prudently, including the general government debt maintained at prudent levels. Second, fiscal policy should help achieve adequate national saving and moderate cyclical fluctuations in economic activity, taking into account the economic risks and impact of those risks on the fiscal position. Third, spending and taxing policies should be consistent with a reasonable degree of stability and predictability in the level of the tax burden. Fourth, the integrity of the tax system should be maintained. And fifth, policy decisions should be fair from an intergenerational point of view.2
The act also provides for the publication of several fiscal reports. The government is required to release a fiscal strategy statement at or before the first budget. The statement is intended to increase public awareness of the fiscal strategy and to establish a benchmark for evaluating its conduct. Additionally, the act requires the government to release several reports—“Budget Economic and Fiscal Outlook,” “Mid-Year Economic and Fiscal Outlook,” and “Final Budget Outcome.” The treasurer also has to publicly release an intergenerational report every five years that assesses the sustainability of government policies for the next 40 years, including the financial implications of demographic change. The first report was issued with the 2002/03 budget in May 2002. To increase the transparency of the budget process in election years, the government must publish a pre-election economic and fiscal outlook. In addition, the prime minister or the leader of the opposition can request cost estimates of the administration’s electoral plans.
The Budget Honesty Act does not specify particular numerical targets, but it requires the government to set its operational targets on a three-year basis and publish them in the fiscal strategy statement. The 1999/2000 budget, which introduced accrual budgeting, contains the following short-term objectives: to maintain fiscal surpluses over the three-year projection period, to reduce the ratio of federal net debt to GDP to 10 percent in 2000/01, to not increase the tax burden, and to improve the federal net asset position over the medium and long term.
Evaluation. The new framework contributed to a significant turnaround in the federal fiscal position, which shifted from a deficit of about 4 percent of GDP (on a cash basis) in 1992/93 to a surplus of 2 percent of GDP in 1999/2000.3 Spending has increased only slightly, and the tax burden has remained constant. Moreover, transparency has improved through the new reporting requirements established in the act.
Background. In Canada, federal government debt fluctuated around 35—40 percent of GDP in the 1980s; but the decline in economic growth during the early 1990s led to dramatic increases in the deficit, which reached around 6 percent of GDP in 1993. By 1994, debt reached 70 percent of GDP. The authorities responded through legislated spending restraint beginning in 1992.
Institutional Arrangement. The Fiscal Spending Control Act of 1992 established a nominal expenditure limit for 1992-96. In addition, since 1994 the government introduced several policy rules that were not formally legislated.
Objectives. The main objectives of the act were to control public expenditure growth, reduce fiscal imbalances, and stop the increase in public debt. The nonlegislated policy rules were directed at minimizing the use of overly optimistic economic assumptions for budgeting, reducing public debt to cope with population-aging costs, increasing the planning horizon for public sector activities, and improving the transparency of public operations.
Characteristics. The Fiscal Spending Control Act set nominal limits on program spending (with the exception of self-financing programs) from 1991 to 1995.4 “Program spending” included all public expenditures except those associated with the service of debts, payments of employment insurance, expenditures related to the Farmer Protection Act, and expenditures arising from emergencies and payments in satisfaction of court judgments against the government. The expenditure limits were legislated and thus legally binding; therefore, the government was not permitted to present a budget proposal inconsistent with the established expenditure. Overspending in one year could be offset in the following two years, including the final year stipulated in the law. Additionally, spending could be increased in a year with unexpected revenues, or if spending during the previous year had not reached the limit.
Parallel to the Fiscal Spending Control Act, the government introduced a set of nonlegislated policy rules that complemented and enhanced the spending limit imposed by law. The practice of basing budget planning on economic assumptions that are consistently more cautious than private sector forecasts was introduced in 1994. Furthermore, two-year rolling deficit targets were adopted with the goal of balancing the budget and, as part of a pre-budget consultation process, midyear fiscal updates describing deficit targets and revised economic assumptions began to be published. In 1995, a contingency reserve was set up to finance forecasting errors and unpredictable events. If not needed in a given year, the reserve would be used to pay down the debt, as was indeed the case. In 1998, the government committed itself to a debt repayment plan implying balanced budgets the following two years (in the event, surpluses were achieved). A contingency reserve of Can$3 billion a year was to be used to pay down the debt.
In 2000, the government added a new element to its debt repayment plan. In addition to setting aside a contingency reserve, each fall it announces whether more of that year’s surplus than anticipated in the budget would be devoted to debt reduction. In the future, the effect of “prudent assumptions” on budget projections would be identified explicitly in order to facilitate the evaluation of the fiscal strategy. This implies that the public budget starts by establishing the degree of economic prudence required to cushion pressures on government finances, such as higher-than-expected interest rates or lower-than-forecast growth. This helps to ensure that the government meets its commitment to balanced budgets.5 Finally, the government announced its intention to move toward full accrual accounting in the budget and, in 2001, announced that its final audited financial statements for 2002/03 will be presented on a full accrual basis.
Evaluation. The Fiscal Spending Control Act was successful. Actual spending remained within limits in all years except 1993, when overspending offset underspending in the preceding fiscal year. Furthermore, the deficit of 5 percent of GDP in 1995 became a surplus of more than 1 percent of GDP by 1999. Although this improvement partially is cyclical, most of it reflects structural gains. Additionally, the ratio of net public debt to GDP was reduced from around 70 percent in 1995 to 52 percent in 2000.
Background. As a consequence of a severe recession and a banking crisis in the early 1990s, Finland’s fiscal accounts deteriorated markedly. Levels of public expenditures were around 30 percent of GDP in the 1970s and 45 percent of GDP in the mid-1980s. This ratio increased to around 60 percent in the early 1990s because of increases in welfare expenditures and bank support programs. Tax receipts did not keep pace with spending increases. Deficits peaked in 1993, with an imbalance of over 7 percent of GDP. The public debt ratio quadrupled from 1990 to 1993, from about 14 percent to about 56 percent of GDP. Forced by the evolution of the public accounts, a cabinet accord was reached to improve public finances.
Institutional Arrangement. The fiscal rule is a political understanding endorsed by the cabinet but not by parliament. As a result, only the first year of the multiyear program is legally binding, as it is reflected in the yearly budget law. In 1995, the new government extended the practices established in 1991, but it changed the planning horizon from three to four years. In 1999, the government coalition that had ruled the country since 1995 was reelected, and a new extension of the agreement was reached.
Objectives. The main objective of the original agreement was to reduce the public deficit and debt. The 1999 agreement extended the original objectives to include tax reduction. Other objectives stated in the budget laws are to: increase the autonomy of spending departments, improve the transparency and simplicity of public sector operations, maintain deficits and public debt ratios consistent with the Maastricht Treaty and the SGP, and gradually prepare the public finances for population aging.6 The 1999 agreement established the objective to keep the expenditure of the central government fixed in real terms at its 1999 level.
Characteristics. The basic fiscal rule is a multi-year expenditure ceiling on total central government spending measured in constant prices of the budget year, with a rolling four-year horizon. This rule is complemented with a balanced-budget rule for autonomous local governments and by strong regulation of the privately managed, social security funds. The real expenditure ceilings are set not only for total expenditure of the public sector but also for each ministry; they are binding, though supplementary budgets have been used on occasion to dispose of privatization revenues, resulting in minor deviations from the ceilings. Unemployment benefits, transfers to local governments, and social security funds—as well as interest on public debt—are included in the expenditure aggregate.
There is no contingency reserve in case of differences between ex ante projections and ex post outcomes. The expenditure ceiling must be met ex post, but projections for the remaining years can be adjusted to reflect unexpected changes in the economic scenario. To facilitate expenditure management, the introduction of the rules was accompanied by a move from line-item budgeting to lump-sum appropriations. To avoid inefficient spending of appropriations not used at the end of the year, transfers to the following year are allowed. The expenditure ceilings are projected in real terms and then converted to nominal terms at the time of the budget using specific price and cost deflators. Finally, performance targets are developed between ministries and their agencies to improve service provision. Ex post controls and auditing of spending budgets were also strengthened.
Evaluation. Since the introduction of the expenditure restraints in 1991, the central government has been able to keep its primary spending close to its 1992 real levels, resulting in a decline in the ratio of public expenditures to GDP from almost 60 percent in 1993 to around 45 percent in 2000. The fiscal deficit decreased from its peak in 1993 to 1.6 percent in 1997 and turned to consistent surpluses beginning in 1998. The debt to GDP ratio was stabilized and began to decrease after 1994. It is estimated that approximately 70 percent of this improvement was due to structural rather than cyclical factors (IMF, 1999). Although the main expenditure reductions were in transfers to the private sector and in public consumption, public investment suffered a more noticeable reduction in relative terms. Recently, Finland’s fiscal performance has been somewhat less impressive. Owing mostly to the election cycle, expenditures started to increase in real terms, contributing to above-target spending and a below-target surplus in the 2002 and 2003 budgets. This may point to certain weaknesses in the existing expenditure framework, in particular the lack of broad commitment by parliament and the government.
Background. The Netherlands has a long history of carefully planned fiscal policy. As early as the 1960s, the Dutch government adopted a Structural Fiscal Policy based on the principle that the budget deficit should be constant as a proportion of trend GDP.7 The system performed well until the early 1970s, when unrealistic forecasts about trend GDP increased expenditures far beyond actual revenues, resulting in a substantial increase in the fiscal deficit. By 1982, the general government deficit was around 7 percent of GDP. As a result of this situation, the government abandoned the previous fiscal policy and adopted a multiyear deficit reduction target. The new policy, however, was strongly procyclical, and the deficit reduction path had to be frequently revised. Despite these drawbacks, the fiscal deficit returned to more sustainable levels.
In 1994, the administration of Prime Minister Kok returned to a type of structural fiscal policy, though with a number of important differences. This fiscal framework (denominated Trend-Based Fiscal Policy) established medium-term ceilings for government expenditures and rules for the disposition of revenue shortfalls or overruns.8 Subsequent governments in 1998 and 2002 continued with the approach but introduced some modifications.
Institutional Arrangement. Trend-Based Fiscal Policy established in 1994 was the result of a political agreement among the three parties forming the first Kok coalition for the four years of the legislature. The coalition was committed to implementing the rules as established. As in Finland, the only ceilings that were legally binding were those in the current year budget.
Objectives. The fiscal framework adopted in 1994 and continued in 1998 and 2002 aimed at introducing transparent and orderly decision making in the budgetary process, increasing efficiency and improving financial control of public sector activities, reducing the ratio of structural government spending to GDP, and permitting a more effective use of the public budget as a countercyclical tool in order to stabilize GDP around its potential. Finally, the fiscal framework was intended to strengthen the budgetary process.
Characteristics. The budgetary framework of 1994 established specific expenditure ceilings in constant prices for central government spending, social security, and health care on a four-year basis based on cautious economic assumptions (that is, a projection of real GDP growth of 2¼ percent, which is below trend growth during the last 15 years).9 The cautious assumptions implied that the probability of windfalls was greater than the probability of setbacks, which facilitated an orderly execution of the budget. The agreement also established that expenditure overruns had to be redressed within the spending category in which the excess occurred. In the case of lower than planned expenditures, the difference had to be used to reduce the public deficit or taxes or both. Nonrecurrent revenues, such as those generated by privatization, were excluded. Revenue windfalls or setbacks could be absorbed by the deficit (thus allowing for the operation of automatic stabilizers) or used for tax cuts.
Under the new coalition agreement adopted in 1998 by the second Kok administration, expenditure undershoots in one category could be used to cover overruns elsewhere, but this rule was tightened again in the 2002 agreement, when transfers were allowed only in exceptional circumstances.10 Also, in 1998 a reserve of 0.25 percent of budgeted expenditure was created to cover public sector wage-bill overruns and to carry over spending, which can be advanced from or postponed to the following year in an amount equal to that percentage. In addition, another small reserve was established to face unforeseen expenditures. On the revenue side, if the budget deficit was less than ¾ percent of GDP, half of the revenue overshoot had to be used to reduce the deficit and half to cut taxes; while if the budget deficit exceeded ¾ percent of GDP, 75 percent of the excess had to be used to reduce deficit and the rest to cut taxes. In the case of revenue undershoots and if the budget deficit was larger than 2¼ percent of GDP, half of the undershoot would go to the deficit and the other half would be covered with higher taxes. Conversely, if the budget deficit was lower than 2¼ percent of GDP, the percentages would be changed to 75 percent and 25 percent, respectively. The 2002 coalition agreement modified the rules for allocating revenue setbacks and overruns; specifically, automatic stabilizers on the revenue side would be allowed to operate as long as the surplus stayed between zero and 2¼ percent of GDP, although in case of surpluses of above 1 percent of GDP the cabinet was given the option of granting tax relief of up to ⋶ 1 billion. Beyond these budgetary thresholds, the cabinet would have to introduce corrective measures.
As an implementation issue, when a new budget is drawn up the estimated revenue is compared with forecasts made at the time of the coalition agreement. This comparison indicates, for a given year, the extent of overshoots or setbacks. The situation is not reviewed during the course of the year. Deviations from ex ante estimations go entirely to the fiscal result. The provisions on the revenue side make clear a central feature of the Dutch budgetary framework—strict separation of expenditure and revenue planning and, therefore, the intended impossibility for revenue windfalls or setbacks to generate changes in expenditures.11 Since the expenditure ceilings are expressed in constant prices, the projected GDP deflator (the expenditure deflator since 2002) is used to convert them into nominal amounts. There is a midyear supplementary budget that allows for a final adjustment in the projected GDP deflator. After that, changes in the deflator are not reflected in nominal spending ceilings.
Evaluation. Under the budget framework established by the two Kok administrations, Dutch public accounts improved substantially; and both public spending and the tax burden were reduced. The fiscal deficit of 4.2 percent of GDP in 1995 became a surplus of 1.5 percent of GDP in 2000, while the gross public debt to GDP ratio was reduced to 56.1 percent in 2000 from more than 75 percent in 1995. As in the other countries, however, a favorable position in the business cycle also contributed to these outcomes; and by 2002 a deficit had reemerged. The use of a cautious economic scenario and the unexpectedly strong economic growth produced large revenue windfalls during the second Kok administration, which should have resulted in large tax cuts according to the rules. In order not to further stimulate the economy, tax cuts remained below what would be implied by the rules for the distribution of the revenues windfalls. The spending rules, on the other hand, remained binding.
Background. By and large, fiscal management was orderly in New Zealand during the 1960s and early 1970s. Government expenditure was around 30 percent of GDP and the public budget was close to balance. However, during most of the 1970s and 1980s, tax revenues lagged spending growth, with the latter being led by increasing transfers, higher debt service caused by persistent fiscal deficits, and higher interest rates following financial liberalization. By the early 1990s, government spending had reached 40 percent of GDP. Debt peaked at 74.5 percent of GDP in 1987, from levels of around 40 percent of GDP in the mid-1970s. As a consequence of the poor fiscal performance, New Zealand’s debt rating was downgraded in the early 1990s, increasing the cost of financing the continuing fiscal imbalances.
In this context, the authorities began a process of institutional reform. First, the government enacted laws that changed the way the public sector was managed from a microeconomic perspective, with the objective of increasing efficiency in the provision of public services. Second, the autonomy of the central bank was guaranteed by law and its main objective—price stability—was made explicit. Finally, parliament enacted a law modifying how public policy was managed from a macroeconomic perspective. The government also established principles, procedures, and goals for budget administration.
Institutional Arrangement. The fiscal rules are contained in the Fiscal Responsibility Control Act, which became effective in July 1994. Earlier reforms, intended to increase the efficiency of the public sector as a provider of services, were contained in the State-Owned Enterprises Act of 1986 and the State Sector Act of 1988. Both laws adopted private sector procedures for the management and evaluation of public sector services. Additionally, the Public Finance Act of 1989 reformed the budgetary appropriation and reporting process, granting chief executive powers and responsibilities to officials in relation to fiscal management and imposing reporting requirements for departments and the government as a whole; it also changed the basis for appropriation from inputs to services (that is, outputs) and from a cash basis to an accrual basis. It is worth emphasizing that the Fiscal Responsibility Control Act reflected a process that began well before 1994. The principles contained in the act constitute the current budget policy guidelines for New Zealand.
Objectives. The Fiscal Responsibility Control Act aims at improving fiscal policy by specifying principles of responsible fiscal management and strengthening reporting requirements to achieve more transparent decision making by the government. The law also intends to increase accountability by promoting a more informed public debate about fiscal policy, and it facilitates the independent assessment of fiscal policies.
Characteristics. Provisions of the Fiscal Responsibility Control Act can be grouped in two areas. The first establishes five principles of responsible management: to reduce public debt by achieving operating surpluses every year until prudent levels are reached; to maintain public debt at prudent levels by ensuring that, on average, total operating expenses do not exceed total operating revenues over a reasonable period of time; to achieve levels of public sector net worth that can provide a buffer against adverse shocks; to prudently recognize and take reasonable steps to manage the risks facing the public sector; and to pursue policies that are consistent with reasonable predictability (that is, avoiding surprises about future tax rates).
In addition to these principles, the second area of provisions requires two new publications stating the intentions and objectives for fiscal policy: an annual budget policy statement to be published by the end of March and a fiscal strategy report to be published at the time of the budget around May. The budget policy statement must include the government’s broad strategic priorities for the upcoming budget, its fiscal intentions for the next three years, and its long-term fiscal policy objectives. The government must also make clear the consistency of its plans and objectives with the principles of responsible fiscal management set out in the act. In turn, the fiscal strategy report analyzes the consistency between the economic and fiscal projections included in the budget and the government’s short-term fiscal plans set out in the most recently published budget policy statement. Where those plans have changed, the government must provide an explanation.
In addition to the budget policy statement and fiscal strategy report, the act requires a substantial array of publications throughout the year, including three-year economic and fiscal updates to be published on budget night and in December; a three-year economic and fiscal update to be published, depending on circumstances, 14 to 42 days prior to any general election; and a current-year fiscal update to be published with the supplementary estimates toward the end of each financial year. The reports are to be made using Generally Accepted Accounting Practice and on an accrual basis. In the case of differences between ex ante and ex post outcomes, no formal sanctions are established. The government can depart from the principles, but reasons for the departure and when and how it expects to return to them must be stated explicitly.
In addition, nonlegislated fiscal practices concerning expenditure management have been introduced. These involve giving spending departments fixed nominal baselines, which can be adjusted for demographic or demand-driven changes. Until fiscal year 2002/03, any changes or new initiatives within the three-year parliamentary cycle had to be met from a fund called Fiscal Provision, which limited the amount available for new spending. In the 2002 budget this set of practices was replaced by an explicit medium-term framework, which becomes operational in 2003/04. The medium-term objective is to achieve an average operating surplus over the cycle sufficient to cover contributions to the New Zealand Superannuation Fund (covering old-age pensions) and ensure that gross public debt remains below 30 percent of GDP. Short-term operating and investment expenditure plans will have to be consistent with these objectives and regularly adjusted in line with the fiscal outlook.
Evaluation. New Zealand’s fiscal position improved substantially during the 1990s, but the direct contribution of the present fiscal framework has to be weighed against the cyclical improvements. Nevertheless, most estimates indicate a clear shift toward lower structural public deficits during the second half of the 1990s. Furthermore, by requiring all levels of government to be explicit about their short-term intentions and long-term objectives, the Fiscal Responsibility Control Act establishes a more transparent framework for annual budget decisions.
Background. Fiscal adjustment and the implementation of fiscal rules in Sweden came after a period of high fiscal deficits and a substantial increase in the public debt to GDP ratio in the early 1990s. This fiscal deterioration was partly caused by the severe recession and banking crisis of the early 1990s. The government elected in September 1994 faced a fiscal deficit of 10.5 percent of GDP and a ratio of public expenditures to GDP of about 65 percent. Gross public debt as a proportion of GDP almost doubled between 1990 and 1994, reaching almost 75 percent of GDP. The government reacted by issuing a consolidation program during the winter of 1994-95. The program included measures equivalent to 7.5 percent of GDP to be implemented in 1995-98. In 1996, the consolidation program was augmented to yield additional savings of around 0.5 percent of GDP.
Institutional Arrangement. To consolidate the achievements of 1994–96, the government introduced a fiscal rule, approved in 1996 and implemented in 1997, to complement and augment previous parliamentary resolutions and government guidelines. In 1993, the government strengthened financial control over its agencies. In 1994, the parliament established government budgetary planning on a four-year basis. In 1995, expenditure ceilings for the public sector were introduced.
Objectives. The rules aim at achieving the government’s long-term goal of a budget surplus of 2 percent of GDP over the cycle to prepare the public finances for population aging. This goal is intended to need no further tax increases. The consolidation measures were in part guided by the Maastricht criteria for convergence to EMU.12
Characteristics. Work on the public sector budget starts more than a year before the relevant fiscal year.13 In December, the ministry of finance reports to the government on the forecast of economic trends, which is made on a realistic (rather than prudent) basis. This is used as input for the Spring Fiscal Policy Bill, which the government presents to the parliament no later than April 15. Budgetary planning is made on a rolling three-year basis based on economic forecasts reviewed by both the parliament and the government. The basic fiscal targets are a binding nominal ceiling for central government expenditure and the general government net borrowing. The Spring Fiscal Policy Bill contains the government’s forecast for revenues and expenditures and the allocation of total spending among 27 expenditure areas. The document also contains a supplementary budget with proposed changes in appropriations for the current year.14 The expenditure areas exclude pension costs and interest payments. The latter are excluded as being beyond public sector control.15 As a result, the expenditure ceiling covers approximately two-thirds of total expenditure.
Since the ceiling is set in nominal terms and on a three-year rolling basis, the government’s Spring Fiscal Policy Bill includes updates of expected price movements, as well as the projected expenditure ceiling for the new third year. In order to create room for forecast errors, the ceiling is set at a slightly higher level than the sum of the expenditure items included. This “budget margin” serves to accommodate differences between ex ante projections and ex post outcomes without having to change the expenditure ceiling. In the Budget Bill of 1997, when the expenditure ceilings were first set, the budgetary margins for the period 1997-99 were established at 1.5, 2.0, and 2.5 percent of total expenditures, respectively. In practice, the margins have been used to finance discretionary increases in public expenditures.
The Spring Fiscal Policy Bill constitutes the basis for the budget bill submitted to the parliament by September 20. When the parliament receives the bill, it decides in two stages. First, it approves the global expenditure ceiling, the expenditure ceiling for each area, and changes in taxes. After decisions are made, no further changes in the ceilings are allowed. In the second stage, parliamentary committees decide how the expenditure in each area is to be allocated to the individual appropriations. The final budget bill has to be approved by mid-December.
After approval, ministries monitor the expenditures on a monthly basis. In August, there is an interim report on the first half of the year and an assessment on the use of appropriations for the rest of the year. The government must inform the parliament of substantial deviations from the expenditure ceilings, including reasons for such deviations. As mentioned, the government can propose necessary amendments to the current budget by means of a supplementary budget to be presented with the Spring Fiscal Policy Bill. Any overruns have to be financed by reducing other areas of spending, though the differences between ex ante and ex post outcomes are not formally sanctioned. In the case of limited expenditure overruns, a borrowing possibility is allowed, but the amount borrowed is automatically deducted from the budget appropriation of the following year. Finally, the National Audit Office carries out annual audits and efficiency audits. The annual audit examines whether an agency’s annual report gives a true picture of its financial situation and performance, while the efficiency audit concentrates on how government activity is carried out. The audit office presents its observations by April 1.
Evaluation. Even though the rules have been in place only since 1997, it is clear that results are positive. Although favorable economic growth has also contributed to this outcome, government expenditure as a percentage of GDP decreased to below 53 percent of GDP in 2002 from around 60 percent in 1996. The fiscal balance has shown steady surpluses since 1998. The gross public debt to GDP ratio is forecast to decrease to below 51 percent of GDP in 2003, from a level of 74 percent of GDP in 1996.
Background. During the 1980s, the Swiss authorities were able to manage its fiscal accounts prudently, which resulted in public debt to GDP ratios substantially below those of other European countries. In the first half of the 1990s the Swiss economy experienced a protracted recession, which reduced the annual average growth rate of GDP from 1.8 percent in 1970-90 to zero in 1990-96. As a result, spending growth—fueled by raising pensions and health care costs—outstripped revenue growth, and deficits appeared. The situation worsened as unemployment rose from below 1 percent of the labor force to over 5 percent. The public debt as a percentage of GDP increased from 31 percent in 1990 to a peak of 54.5 percent in 1998, especially because of an increase in the debt of the federal government.
Institutional Arrangement. In 1998, a constitutional amendment established the obligation to balance the federal budget by 2001.16 In order to achieve this goal, the authorities cut military spending and the railroad budget, and increased social security payments by the cantons. The recovery of the economy in 1999–2000 allowed the Swiss government to balance the budget one year earlier than planned. In 2000, the government proposed another constitutional amendment that introduced rules to control the fiscal accounts of the federal government in all stages of the business cycle. The rules were approved by public referendum in 2001 and became applicable in 2003.
Objectives. The Swiss fiscal rule aims at preventing structural deficits in the federal budget and allowing scope for countercyclical fiscal policy.
Characteristics. The fiscal rule proposed in the constitutional amendment imposes a ceiling on federal government expenditure (including capital expenditure but excluding net lending to the unemployment insurance fund) according to the following formula:
where is the projected, or ex ante, one-year-ahead ceiling on federal expenditures; Et denotes the expectation operator at time t; Rt+1 is one-year-ahead revenue; and Ct+1 describes the cyclical position of the economy. The latter is defined as,
where YTt+1 denotes one-year-ahead trend real GDP and Yt+1 is the one-year-ahead real GDP; thus, Ct+1 > 1 if the economy is below trend and Ct+1 < 1 if the economy is in a period of expansion. Equation (1) implies a level of expenditures that depends on projected fiscal revenues and on the position of the economy in the cycle. Thus, if the economy is expected to be below trend, expenditures are allowed to exceed revenues and vice versa, allowing for the fiscal position to move countercyclically. As a consequence of these mechanics, the federal budget is expected to be in equilibrium over the cycle. Thus, the fiscal rule is approximately a rule on the cyclically adjusted balance.17
The Swiss fiscal rule is intended to hold also ex post, that is, at the execution stage. However, equation (1) relies on projections that sometimes may be inaccurate. To address this problem, the proposed fiscal rule creates a fictional account, where Aj denotes deviations from the original (ex ante) budget balance. This fictional account is credited in case of an unexpected surplus (At+1>0) and debited in the case of an unanticipated deficit (At+1<0).18 If the fund exceeds 6 percent of total expenditures or 0.6 percent of GDP, the authorities must bring it back below the threshold within three years.
Supplementary budgets can be introduced in midyear, but if they violate the fiscal rule they have to be approved by a qualified majority in both chambers of the parliament.19 This provision adds flexibility to the rules in the event of exceptional circumstances, although the law does not specify what these circumstances might be.
Evaluation. The introduction of the rule in a period of structural deficits has made compliance difficult—in particular, as a sharp adjustment would be required in 2004 to abide by the rule. Technical implementation problems have also emerged. For instance, a revenue elasticity of 1 was assumed, which, ex post, turned out to be too low; also, some revenue components were particularly erratic. Another problem with the Swiss rule is that it covers only the relatively small federal budget.
Background. The United Kingdom’s fiscal policy was highly volatile during the 1970s, with deficits averaging around 3.3 percent of GDP from 1979 to 1996 and reaching over 4 percent of GDP in 1997. When the authorities attempted to control the budget deficit, fiscal policy turned procyclical, with the main burden of the adjustments falling on public investment. This bias against capital investment resulted in underinvestment in public assets and in formation below that in other G-7 countries. In this context, in 1997 the authorities introduced a new framework, including measures to ensure a clear separation between monetary and fiscal policy.
Institutional Arrangement. The fiscal framework introduced in 1997, the Code for Fiscal Stability, is a set of principles and guidelines that received statutory backing through the Finance Act of 1998. Thus, it also binds future governments.
Objectives. The fiscal framework intends to achieve multiple objectives. In addition to meeting the government’s microeconomic objectives related to the efficiency and effectiveness of taxation and spending, in the short term it aims at supporting monetary policy—where possible—through the automatic stabilizers that smooth fluctuations in aggregate demand and—where prudent and sensible—through discretional changes in the public accounts. Over the long term, the fiscal framework intends to ensure sound public finances and a fair allocation of taxation both within and across generations. It avoids unsustainable increases in public debt by balancing current expenditures with current revenues over the cycle. In this way, the new fiscal framework aims at removing the bias against capital spending.
Characteristics. The Code for Fiscal Stability is based on three pillars: a set of fiscal policy principles, two fiscal rules, and specific reporting and auditing requirements.
The five principles are: transparency in the setting of objectives and implementation of fiscal policy and in the publication of public accounts; stability in the fiscal policymaking process and in how fiscal policy affects the economy; responsibility in the management of public finances; fairness, including a fair treatment among different generations; and efficiency in the design and implementation of policy and in managing both sides of the public sector balance sheet.
Two general rules accord with these principles. The first, the golden rule, specifies that the government will borrow only to invest. The second, the Sustainable Investment Rule, establishes that the public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level.20
These fiscal rules provide benchmarks against which the performance of fiscal policy can be judged. In this sense, the U.K. fiscal framework is similar to that of New Zealand, with the determination of specific targets left to the current authorities.21 Accordingly, the government can permanently or temporarily change its objectives and rules of operation, providing that the new objectives and rules are in accord with the principles stated in the code and that the government specifies reasons for departing from previous goals. In the case of temporary changes, the government has to state when it will return to the previous objectives and rules.22
The code also specifies reporting and auditing requirements. It mandates the publication of a pre-budget report to encourage debate on the proposals under consideration for the budget; a financial statement and budget report to disclose the key budget decisions and the short-term and fiscal outlook; an economic and fiscal strategy report outlining the government’s long-term goals, its strategies for the future, and progress toward meeting its fiscal objectives; and a debt management report outlining the government’s debt management plans. Furthermore, the government has to publish its economic and fiscal projections, including estimates of the cyclically adjusted fiscal position and long-term projections; and it has to assess the sustainability of policies, including disclosure and quantification, where possible, of decisions and circumstances that could have a material impact on the economic and fiscal outlook.
All reports have to be drawn up using best practice accounting methods, and they have to be referred to the Treasury Committee of Parliament, ensuring that the general public will have full access. The National Audit Office audits changes in key assumptions and conventions on which fiscal projections are based. The code does not include provisions for formal sanctions; thus, enforcement is based on reputational considerations, supported by the rigorous reporting requirements.
To support the fiscal framework, the government has implemented a new regime for planning and controlling spending.23 This regime establishes that all spending departments will have Departmental Expenditure Limits, which will be set in nominal terms for three years on a two-year rolling basis. The expenditure limits are only adjusted if inflation forecasts differ significantly from the original projections. Unspent funds can be carried over to the next year, but overruns are not allowed. Departmental Expenditure Limits cover most noncyclical primary expenditure, approximately half of total expenditures, and they include central government transfers to local governments.
Expenditures that are not subject to multiyear limits are subject to annual scrutiny as part of the budget process and are referred to as Annually Managed Expenditure. Current and capital expenditures are treated separately in order to be consistent with the golden rule established in the code. The ceiling on annually managed expenditure is only binding for the current budget year. It includes a contingency reserve in order to deal with changing circumstances.
Evaluation. Following the introduction of the new framework, fiscal accounts improved markedly, with the public debt to GDP ratio declining from 43.7 percent in 1996 to 31.5 percent in 2001. At the same time, the general balance switched from a deficit of 4.4 percent of GDP in 1996 to a surplus of 0.9 percent of GDP in 2001. Over the same period, the structural balance also improved, suggesting that part of the fiscal improvement was not attributable to the positive position of the U.K. economy in the business cycle. Although fiscal balances weakened in 2002, they remained consistent with the fiscal rules. The public debt to GDP ratio edged up to 31.9 percent in 2002, and the general government balance deteriorated by about 2 percentage points (from a surplus of 0.9 percent in 2001 to an estimated deficit of 1.2 percent of GDP in 2002). Meanwhile, the structural balance turned from a surplus of 0.5 percent in 2001 to a deficit of 1.2 percent in 2002, reflecting mainly an increased spending on education, health, and transportation, and a loss of corporate tax revenues.
Background. During 1950–75, the public debt to GDP ratio declined continuously, while the budget deficit remained low.24 In 1975, however, public expenditures began to increase rapidly, mainly due to expanding entitlement programs. Initially, the deficits were partly covered by growing tax revenues, as high inflation moved individuals into higher income tax brackets. However, the introduction of inflation indexing in the tax code, tax relief introduced through the Economic Recovery Tax of 1981, increases in defense spending, and an adverse cyclical position resulted in a substantial increase in the public deficit, which reached more than 6 percent of GDP in 1983. After the mid-1980s, the deficit was reduced thanks to stronger economic activity and to several legislative initiatives, but the mild recession of the early 1990s resulted in a new increase in the budget deficit. All in all, the public debt to GDP ratio rose from approximately 25 percent in the early 1970s to just under 45 percent in the early 1990s.
Institutional Arrangement. The United States has long experience with fiscal rules.25 Recent rules were introduced through a series of laws enacted since the mid-1980s. The Balanced Budget and Emergency Deficit Control Act of 1985, known as Gramm-Rudman-Hollings I, specified annual deficit targets through 1991. This was followed in 1987 by the Balanced Budget and Emergency Deficit Control Reaffirmation Act, also known as Gramm-Rudman-Hollings II, which revised the deficit targets established in 1985 and extended them through 1993. In 1990, as part of a major deficit reduction package, the congress approved the Budget Enforcement Act of 1990, which replaced the deficit targets with expenditures ceilings, or caps, and established a “pay-as-you-go” system (PAYGO) for the period 1990–95. The act also established guidelines on how baseline budget projections were to be made. In 1993, the Omnibus Budget Reconciliation Act extended the provisions of the 1990 law until 1998.26 The Budget Enforcement Act of 1997 extended again the provisions of the 1990 law until 2002. The provisions were not extended after their expiration in September 2002, but the 2004 budget proposes their extension for two more years.
Objectives. The goal of Gramm-Rudman-Hollings I and II was to increase fiscal discipline by reducing the public deficit and to control the increase in the public debt. The Budget Enforcement Acts (1990 and 1997) shared the objective of controlling the fiscal deficit and the public debt, but changed the fiscal framework used to achieve the goals.
Characteristics. Gramm-Rudman-Hollings I specified declining nominal targets for the budget deficit, ending with budgetary equilibrium in 1991. The targets were to be enforced by uniform percentage reductions in selected mandatory and most discretionary spending programs. However, this was ruled unconstitutional because its implementation violated the separation of powers. In 1990, because of unexpected expenditures arising from the war with Iraq and a major flood, and faced with the prospect of substantial expenditure cuts (over 30 percent in some programs, including defense), the president and the congress agreed to postpone balancing the budget until 1993, as specified in Gramm-Rudman-Hollings II. This triggered a change in the fiscal framework, which the 1990 Budget Enforcement Act reflects.
The 1990 Budget Enforcement Act changed the main control variable from the budget deficit to expenditure.27 It defined categories of discretionary spending and established nominal caps for them for the period 1990-95. Discretionary outlays were defined as those controlled by the annual appropriation process. Currently, discretionary expenditure represents about one-third of total public outlays. The caps could accommodate emergencies and other circumstances. When initially enacted, there were three separate caps, covering defense spending, international spending, and non-defense domestic spending. The 1993 amendment introduced a single cap for 1994-96. Under the Budget Enforcement Act of 1997, separate caps were established for defense spending and non-defense discretionary spending for the period 1997-99, while a new cap for 1997-2000 was established for a category of outlays called Violent Crime Reduction. In the 2001 budget bill, there was again only one cap for all discretionary spending.
In addition to the nominal caps, the Budget Enforcement Act of 1990 introduced the PAYGO system for revenues and direct spending. Direct spending included entitlement programs established through legislation. For these programs, outlays were determined not by annual appropriations but by eligibility criteria and benefit formulas specific to each. Under the PAYGO system, all changes in taxes and in direct spending had to be deficit neutral over one- and five-year horizons. The PAYGO system did not require congressional action if revenues fell or outlays grew because of changing economic conditions or changing technical assumptions. Additionally, it was enforced one year at a time, implying that no carryover was to be permitted.
Both the nominal caps on discretionary spending and the PAYGO system were enforced by the threat of sequestration. The required sequestrations were to be identified by the Congressional Budget Office and the Office of Management and Budget (OMB) and enforced by the president based on the OMB estimates.28 The sequestration process was characterized by three stages, resulting in three different reports—a preview report, an update report, and a final report—which had to be based on consistent economic and technical assumptions. Sequestration could be suspended in the event of a declaration of war or passage of a joint resolution by Congress triggered by a Congressional Budget Office report indicating that economic growth was likely to slow below a defined threshold rate. In practice, however, appropriations have been deemed “emergencies” to skirt PAYGO provisions. The law also introduced new budget-related reporting, such as the President’s Budget Review.
Evaluation. The Gramm-Rudman-Hollings laws did not produce the targeted decline in deficits because of mistakes in estimating the potential rate of growth of GDP and flaws in the determination of the targets. As a result, the sequestrations required to achieve the goals proved to be unworkably large. In contrast, the Budget Enforcement Act of 1990 and its subsequent modifications in 1993 and 1997 established more realistic targets, so fiscal restraint was more easily maintained. Nonetheless, an important part of the improvement in fiscal accounts during the 1990s was due to the favorable position of the U.S. economy in the business cycle (about 40 percent, according to the Congressional Budget Office).
In addition, the effectiveness of the rules waned after surpluses emerged in 1998 (Kell, 2002). A variety of mechanisms were used to circumvent spending limits—for example, emergency appropriations (excluded from the Budget Enforcement Act caps) and advance appropriations. In addition, in 2001 “scorecards,” tallying the cumulative effects of legislation on the budget balance for a given year, were set to zero through legislation, thereby avoiding the required corrective measures or the triggering of sequestration.
The Australian population is relatively young, so population aging is of less concern than in other OECD countries.
The financial risks identified in the charter include those arising from excessive net debt, commercial risks arising from ownership of public trading enterprises and public financial enterprises, and risks arising from erosion of the tax base and from the management of assets and liabilities.
The fiscal year runs from July 1 to June 30.
The Article 10 established that Parliament should consider extending the law by 1994. As legislation was not deemed necessary to further control spending, the act was not extended beyond 1995.
For the 2000 budget, prudence was set at $1 billion in 2000/01 and $2 billion in 2001/02 (“Economic and Fiscal Update,” 1999).
Short-term economic stabilization is not a specific objective; however, the government has established that tax reductions have to take into consideration the position of the economy in the business cycle.
In the context of this discussion, potential and trend GDP are considered equivalent concepts.
In introducing this budgetary policy, the minister of finance followed the advice of the Study Group of Budgetary Margin, which is composed by the highest-rank civil servants of the financial and economic ministries, an executive director of the central bank, and the director of the Netherlands Bureau for Economic Policy Analysis. This group also devised the fiscal policy followed by the Netherlands during the 1960s and 1970s.
Central government spending includes interest on public debt and excludes local government spending and a fund for infrastructure investment. In addition, it is net of nontax and nonpremium revenues.
The Balkenende cabinet formed in July 2002 fell in the fall of the same year, so the 2002 coalition agreement was short lived.
This is known in the Netherlands as the Zalm rule, after the finance minister of the two Kok governments.
However, according to the Rome Agreement of 1992, Sweden is an observer member of the European Union and does not participate in EMU.
The public sector in Sweden includes the central, local, and regional governments as well as fiscal agencies.
Compared with the previous process, the ministry of finance has more powers in drawing up the budget.
There is an indicative ceiling for general government expenditures, which includes estimated local government expenditure. It is only indicative because local governments have the right to decide on their own levels of expenditure. However, local government expenditure is primarily affected by central government grants and. tax revenues, so the indicative ceiling is actually binding. Additionally, as of 2000, the parliament decided that municipalities and county councils must present budgets with ex ante surpluses.
Budget “balance” was defined as, at most, a deficit of 2 percent of total revenues.
The procedure to compute the output gap ensures that this objective is met. In this regard, the authorities have proposed the use of the Hodrick-Prescott filter, but this is not legislated and the government is open to other methods.
In the formula for Ft, []ϊ denotes the first period of application of the fiscal rule and t denotes the current period.
The fiscal rule is considered to be complied with if modified expenditures exceed the ceiling by, at most, 0.5 percent.
To avoid loopholes, the definition of “public investment” is that used in the System of National Accounts.
The current authorities, for example, have specified a sustainable level of net public debt to GDP ratio to be 40 percent.
The rules of operation are related to government practice and are not specified in the code.
It should be noted that the supporting expenditure framework is not established in the Code for Fiscal Stability.
The discussion that follows refers to the federal government only.
According to Peach (2001), the first law incorporating a provision that can be interpreted as a “fiscal rule” was enacted in 1917. This law, the Liberty Bond Act, established a statutory limit on the gross indebtedness of the federal government. Its intent was to simplify the procedure for issuing bonds, since before the law individual bond issues had to be approved by Congress. In the 1980s and 1990s, the need to raise the federal debt ceiling motivated deficit reduction legislation. Additionally, the Congressional Budget and Impoundment Control Act of 1974 established the current congressional budget process, with the creation of the House and Senate Budget Committees and the Congressional Budget Office.
In 1996, Congress approved the Line Item Veto Act, which granted the president the authority to cancel selected categories of spending and tax provisions over the period 1997-2004. However, this act was declared unconstitutional by the U.S. Supreme Court and was therefore abolished.
It additionally placed the sequester “trigger” in the hands of the director of the Office of Management and Budget.
According to Peach (2001), only one very modest sequestration has occurred since the enactment of the law.
In the run-up to the European Monetary Union, an intense debate took place in Germany on the design of an Internal Stability Pact (ISP). Agreement, however, was stalled by major differences in needs and economic strength among Länder and by constitutional problems.2 Following the ECOFIN Council’s recommendation to the German authorities to agree upon an ISP,3 the responsibilities of the Financial Planning Council were reinforced and Article 51(a) of the General Budget Law was modified. The new draft of Article 51, which was to have come into force January 1, 2005, specifies that all levels of governments will be responsible for avoiding the excessive deficit procedure (Article 104 of the EU Treaty) and proclaims the overall aim of deficit reduction to meet the close-to-balance target of the SGP. In particular, Article 51(a) establishes that for all levels of governments the Financial Planning Council will issue recommendations on budgetary policies, discuss the consistency of budgetary developments with Article 104 of the EU Treaty and the SGP, and will make recommendations in case of deviations. In response to the Commission’s recommendation to the Council (January 30, 2002) to issue an early warning to Germany, the implementation date of Article 51(a) was carried forward to July 1, 2002. These legal modifications strengthen the rules beyond the previous framework; however, the lack of sanctions for governments not complying with the Financial Planning Council’s recommendations could jeopardize their effectiveness in practice.
In 1999, Italy introduced an ISP requiring regional and local governments to reduce their deficits and debt.5Deficit was defined as the difference between total revenues net of state transfers and total expenditures net of investment and interest payments (on a cash basis). The three-year total adjustment was divided among the different levels of subnational governments—regions, provinces, and municipalities—in proportion to their respective levels of total expenditure. Within each level, fiscal adjustment was allocated in proportion to primary current expenditure in the previous year. Accordingly, even a government already running a surplus had to contribute to the effort. The previous ceiling on debt service payments (no more than 25 percent of own revenues) remained in place. Finally, the ISP established that if Italy were sanctioned under the Maastricht Treaty, the fines would be levied on the entities failing to meet their targets in proportion to the overshoot for which they were responsible. These sanctions were not credible because they could result in excessive penalties for subnational governments.
In 1999, only half of the fiscal consolidation projected in the ISP was achieved. The pact was therefore modified in late 1999. First, a more ambitious target was set for subnational governments for 2000. Second, overall balance was defined to include receipts from the sale of real estate assets as part of public revenues. Third, subnational governments meeting the objectives of the ISP would be granted a reduction in the interest on their outstanding debts to the Cassa Depositi e Prestiti.6 For 2000, it appears that local governments complied with these revised targets, while the regions breached their deficit ceilings.
For the fiscal year 2001, it was established that the targeted balance could not worsen by more than 3 percent from 1999. Successive ISP modifications were adopted to constrain the increase in planned current spending by Ordinary Statute Regions and municipalities in 2002 and with the budget law for 2003—for example, establishing that municipalities’ deficits should be no worse than 2001 levels.
Following the publication of the March 1992 Convergence Program for Spain in 1991, the central and regional governments agreed to the so-called Budget Consolidation Scenarios (BCSs) for 1992-96. Based on bilateral negotiations, this agreement specified the maximum deficit and debt for each region. These programs were publicly announced and became the main coordination tool for budgetary and debt policies of the central and regional governments. Because of the 1992-96 recession, no region complied, but the scenario represented a turning point in the evolution of regional debt (Viñuela, 2001). The BCSs were revised in March 1995, following revision of the convergence program in July 1994, and again in 1998 with the approval of the first stability program. While the former agreements were respected, the deficit and debt levels specified in the previous agreement are unknown to the public, and no transparent sanctioning mechanism exists. Therefore, it is impossible to assess compliance. The Law of Budgetary Stability, first implemented in 2003, requires that all levels of government formulate, approve, and execute a budget in balance or in surplus. It strengthens reporting requirements, especially at the regional level. This law is expected to ensure that decentralized public finances will not jeopardize the central government’s consolidation objective, as well as greater transparency of each region’s contribution.
In 1995, the federal, state (Länder,) and local governments agreed to achieve budget balance primarily through expenditure reductions. During subsequent negotiations on the intergovernmental transfer system in 1997, they agreed on the maximum deficit that each would incur. The federal government was assigned a deficit of 2.7 percent and the Länder and local governments were assigned 0.3 percent of GDP. In the 1998 Austrian Stability Pact, all levels agreed to internally allocate the Maastricht Treaty deficit limit mainly on the basis of population. This internal stability pact also established committees to monitor and report public finance performance. Moreover, the pact established proportional contribution of the federal government and Länder to the sanction payment in the case of an excessive deficit. Local governments in any Länder collectively share the responsibility for the deficit; their contribution to sanction payments would be deducted from their share of federal revenues. Länder and local governments would be allowed to partially assign their permissible deficit to other entities. No sanctions were established for noncompliance with the deficit ceiling. In 2000, the domestic stability pact was amended through 2004. Länders will target an average budget surplus over the period of no less than 0.75 percent of GDP, with allowable temporary underruns of⊟0.15 percent of GDP. Local governments should balance their budgets over the period with allowable temporary overruns of 0.1 percent of GDP. The monitoring and enforcement system includes fines subject to unanimous decision of all interested parties.8
In Belgium, the general government consists of two bodies: the so-called Entity I, which includes the federal government and the social security system, and the Entity II, which includes communities, regions, and the provinces and communes. There are three communities (Flemish, French, and German-speaking) and three regions (Flanders, Wallonia, and the Brussels-Capital), referred to as the federated entities. Communities and regions are financially autonomous. They are financed mainly through shared taxes, which are centrally collected and then allocated according to parameters fixed by law. In theory, communities and regions can impose their own taxes and issue debt, but in practice the federal government retains responsibility for the majority of decisions concerning taxes. Borrowing by communities and regions requires federal authorization. Provinces and communes are financed through regional grants and local taxes.
Cooperation agreements under the national Stability Program set permissible fiscal targets for the federal and the other levels of government. In 1994, the federal government and the communities and regions reached a first cooperation agreement. Subsequent intergovernmental agreements covered 1996-99, 1999-2002, and 2001-05. These agreements established permissible Entity I and Entity II deficit targets according to the recommendations of the High Council of Finance, which is also in charge of monitoring and reporting on compliance. The cooperation agreement does not include formal sanctioning procedures for deviations from permissible deficits. However, the federal government can restrict the borrowing of communities and regions for up to two years upon recommendation of the High Council of Finance once regions involved have been consulted. To date, this mechanism has not been invoked.
Federal Ministry of Finance,2003, Austrian Stability Program,Vienna(March).
2001, “Fiscal Federalism and the Stability and Growth Pact: A Difficult Union,” in Fiscal Rules, Proceeding of the Research Department Public Finance Workshop on Fiscal Rules. (Rome: Banca d’Italia).
ECOFIN Council Opinion, 1999, “Stability Program of Germany, 1998 to 2002,” Official Journal,C 124(May5),p. 0003.
European Commission, 2003, Public Finance in EMU, 2003, Directorate-General for Economic and Financial Affairs (Luxembourg: Office for Official Publications of the European Communities).
International Monetary Fund, 2003, “Belgium: Selected Issues.” IMF Country Report No. 03/50 (Washington).
1997, “Control of Sub-national Government Borrowing,” in Fiscal Federalism in Theory and Practice,ed.Ter-Minassian Teresa (Washington: International Monetary Fund).
1997, Fiscal Federalism in Theory and Practice (Washington: International Monetary Fund).ed.,
2001, “Fiscal Decentralization in Spain,” Conference on Fiscal Decentralization,Washington,International Monetary Fund.
2001, “Budgetary Consolidation in EMU,” CEPR Economic Paper No. 148 (London: Centre for Economic Policy Research),March.
This section draws on Wendorff (2001).
The first contentious issue was the federal government’s proposal to enshrine the ISP in a federal act. Some Länder considered a constitutional amendment or “federal treaty” appropriate, but others supported a case-by-case arrangement. Another contentious issue was the federal proposal for a 50/50 distribution of the 3 percent of GDP deficit ceiling between the central government and the Länder, while the Länder demanded 60/40 on the grounds that the federal government could better absorb unexpected shocks. The federal government and some Länder supported a distribution of deficit ceilings within each level of government based on population size. However, the Eastern Länder insisted that the fiscal deficits also be considered. Finally, the federal government proposed an allocation of sanctions in accordance with each level of government’s responsibility, while the Länder argued that the German constitution prohibited the imposition of this heavy financial burden.
See ECOFIN Council Opinion (1999).
See Balassone and Franco (2001) for a more detailed discussion.
In the early 1990s, Italy began to decentralize—from subnational governments’ revenues consisting basically of conditional transfers from the central government, to subnational revenues based on own or shared taxes. Before the ISP, the limits on subnational governments’ borrowing were set by a golden rule with an indirect ceiling (debt service not to exceed 25 percent of own revenues). Frequently, however, the central government provided unlimited year-end coverage of deficits—in the health and transport sectors, for instance.
Cassa Depositi e Prestiti is a public institution that finances subnational governments. This incentive was undermined by the recent decision to grant all regions an unconditional reduction in the interest rate.
In 2002 and 2003, the expenditure for flood-related aid was exempted from sanctions.
This appendix briefly reviews the effects of expenditure and tax shocks on aggregate demand, comparing outcomes in the presence of credible fiscal rules to outcomes in fiscal policy from the absence of such constraints.
Temporary Spending Shock
With a binding spending rule, shocks leading to higher expenditures are ruled out by assumption, so we will focus on a spending rule that limits the amount of spending increases over the economic cycle. In the presence of such a rule, an increase in public sector spending would be perceived as temporary. In a neoclassical framework—for example, Ahmed (1986) and Barro (1989)—this would entail, other things being equal, a small or no adjustment of private sector spending, and therefore an increase in external borrowing (a current account deficit).
Consider now the case of a discretionary fiscal regime. In this case, the increase in spending may be perceived as being more persistent, because the government is not required to adjust future spending in line with the fiscal rule and because the government has a spending bias by assumption. Given the bound of the intertemporal budget constraint, private agents will anticipate an increase in the future tax burden and adjust their current consumption behavior accordingly. If all else is the same, this implies a smaller or no increase in aggregate demand and a smaller current account deficit.
Finally, consider a rule on the cyclically adjusted budget balance. In this case, the spending shock could be offset through lower future spending or higher future taxation. We have already analyzed the former case. In the latter case, the effects would be more similar to those occurring under discretion, but the fact of tax increases sooner rather than later would tend to reduce further private sector demand. Given the assumed excess spending bias, private agents may attribute a higher probability to a future tax increase rather than a spending cut. This would imply an outcome similar to the one unexpected under discretion.
A Temporary Shock to Tax Rates
In analyzing the impact of an unexpected reduction in tax rates, the key issue is again whether the public expects the government to meet its intertemporal budget constraint through higher future taxes or lower future government expenditure. Given the assumption of an excess spending bias, assume the former. In the presence of a cyclically adjusted budget rule, the perceived “temporariness” of the tax cut would imply no impact on private sector consumption if consumers are fully Ricardian, or a very modest one if they have a discount rate higher than the rate of interest.
Under a discretionary regime, if the tax cut is perceived as lasting for a longer period, the response of private sector consumption may be stronger.1
In the presence of a spending rule, there would be no constraints on whether the adjustment will take place through lower future spending or higher future taxes, and therefore the impact would be the same as in the discretionary case.
Permanent Spending Reductions
Suppose that the government announces and implements a reduction in government expenditure, announcing that this reduction will be permanent. In the presence of a spending rule, private agents may find the announcement credible. This would lead them to increase private consumption.
Under discretion, private agents may consider that lower spending may not be sustained. This would imply a smaller increase in private consumption than in the presence of a rule, and hence lower aggregate demand.
In the presence of a balanced budget rule, agents will not be sure as to whether there will be permanently lower spending, and hence lower taxes as in the case of a spending rule, or only a temporary decline in spending. The effect may therefore be similar to the one under discretion.
Permanent Reduction in Tax Rates
In the presence of a budget rule, an announced permanent tax rate reduction would also imply lower government spending. This would lead to higher private consumption.2
Conversely, under discretion, agents may expect a more limited reduction in spending (and hence a future increase in tax rates) and would therefore increase private consumption by less.
Under a spending rule, a permanent reduction in tax rates would be credible if the rule in question is consistent with it. In this case, the effects would be the same as under a budget rule.
A number of studies have examined whether the cyclical response of the budget to shocks depends on different types of fiscal rules in U.S. states, and the implications for macroeconomic volatility. Bayoumi and Eichengreen (1995) find evidence that the response of the budget to macroeconomic shocks is weaker under tighter budget rules, but Alesina and Bayoumi (1996) find no evidence of higher output volatility under more stringent fiscal rules. Kopits and Symansky (1998) use stochastic simulations to show that, based on the historical covariance of shocks, tight fiscal rules increase output variability.
If the public expects an expenditure reduction (for example, if there is a deficit bias but not an excess spending bias), the private sector will expect it to occur sooner under a budget rule because the rule constrains the budget balance. In this case, the tax cut would stimulate an increase in private consumption, which is larger under a rule than under discretion.
With distortionary taxes, the reduction in tax rates would tend to stimulate labor supply, while the reduction in spending would tend to increase leisure because of a positive wealth effect. The net effect on production would be ambiguous.
1986, “Temporary and Permanent Government Spending in an Open Economy: Some Evidence from the United Kingdom,” Journal of Monetary Economics, Vol. 17,March, pp. 197–224.
1996, “The Costs and Benefits of Fiscal Rules: Evidence from U.S. States,” NBER Working Paper Series No. 5614 (Cambridge, Massachusetts: National Bureau for Economic Research).
1989, “The Neoclassical Approach to Fiscal Policy,” in Modern Business Cycle Theory,ed.J. Barro Robert (Oxford: Basil Blackwell).
1995, “Restraining Yourself: The Implications of Fiscal Rules for Economic Stabilization,” Staff Papers, International Monetary Fund Vol. 42,March, pp. 32–48.
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