Since the early 1970s, fiscal deficits and rising public debt have been ubiquitous features of government budgetary positions. Indeed, in aggregate, fiscal balances of both industrial and developing economies have been negative in each of the past 30 years, with an average deficit of about 3 percent of GDP a year for both groups (Figure 1.1). In recent years, an improvement in the overall fiscal positions in the industrial economies during the economic and financial market boom in the 1990s was quickly reversed thereafter. In many developing economies, although there has been a welcome turnaround in budgetary positions over the last 4 years, this reflects in large part cyclical factors, higher commodity prices, and a benign global financial market environment. 1
Mr. Xavier Debrun, Mr. David Hauner, and Manmohan S. Kumar
Economic analysis has long recognized that policymakers, particularly in the fiscal domain, act quite rationally according to specific incentives, including reelection concerns, pressures from interest groups and constituencies, and the need to honor specific pledges or commitments. Growing evidence of fiscal indiscipline and procyclicality has prompted a debate on the likely distortions causing and arising from such behavior, and on effective ways to correct policymakers’ incentives in a socially beneficial way. This chapter examines how distorted incentives may undermine a judicious use of fiscal discretion, and explores how fiscal frameworks could improve fiscal behavior and outcomes.
Although some debate on the feasibility and effectiveness of fiscal policy in stabilizing output fluctuations continues, there is little disagreement that, as a rule, policy should not be procyclical. The standard Keynesian approach suggests that fiscal policy should act in a stabilizing manner, while within the neoclassical paradigm, tax-smoothing models imply that fiscal policy should remain neutral over the business cycle. Even in a Ricardian framework, where a reduction in taxes or an increase in spending leads to an equivalent rise in private sector saving, policy would not be expected to be procyclical.
Since political economy factors are an important determinant of procyclicality of policies, measures to contain the misuse of fiscal policy discretion can be beneficial. The scope of fiscal frameworks designed to attain this varies widely across countries. In some countries, economic, political, and legal factors will be more conducive to rules-based arrangements, putting explicit constraints on policy choices. In others, institutions may more effectively transmit public pressure to decision makers through a system of checks and balances. History may also play a role, with countries that have experienced fiscal crises possibly more inclined to opt for hard rules. Overall, there is a range of options to constrain discretion: from broadly defined good practices leaving ample room for interpretation to tighter setups, based on hard numerical rules or even delegation of policy-related mandates. 1
The search for more comprehensive institutional arrangements to improve fiscal policy outcomes intensified during the last decade. Analogous to the monetary policy debate, while discussions initially centered on the general issue of rules versus discretion, more recently they have turned into a search for broader institutional arrangements that would help ensure the desired fiscal policy outcomes. Recognizing the limited scope for improvement that stand-alone fiscal rules can provide, and the frequent lack of immediate results from enhanced transparency alone, fiscal responsibility laws (FRLs) have been enacted in many countries as permanent institutional devices aiming to promote fiscal discipline in a credible, predictable, and transparent manner. New Zealand was at the forefront of these reforms, adopting an FRL in 1994. More recently, FRLs have been implemented in several countries in Latin America, Europe, and Asia.