After 2008 many countries started to revise their fiscal rules, mostly to address weaknesses that had emerged with the Global Financial Crisis. Experience so far with second-generation fiscal rules shows that the effectiveness of fiscal rules at promoting prudent fiscal policies and at supporting long-term fiscal objectives depends crucially on their design. Given its importance, what principles should guide the design of fiscal rules?
To begin with, fiscal rules should be designed with a holistic view of the fiscal framework. This is because fiscal rules are one component of such framework and the quality of their design cannot be improved in isolation from the quality of the overall framework. A well-designed fiscal framework should have three elements: a clear long-term objective, an explicit fiscal anchor that guides fiscal policy over the medium term, and a fiscal rule that guides fiscal policy over the short term.
The long-term objective should primarily include fiscal sustainability and should be determined considering the long-term challenges and opportunities that the economy faces. For all countries this means that the desirable amount of long-run savings (or debt) should be consistent with the implications that these challenges and opportunities have for the budget. For resource-rich countries this also implies determining how much of current resource income should be saved and transferred to future generations, including whether this inter-generational transfer should happen by building financial assets or through the economic dividends of investing in infrastructure and increasing the stock of physical capital.
The medium-term anchor should be set as limit on a stock variable (assets, debt, net debt, net worth) and it should help close the gap between the desired long-run fiscal position, and the one implied by current policies. The anchor should not determine fiscal policy in the short-run because the dynamics of stock variables depend on factors that are not fully under the control of the authorities, and because adopting counter-cyclical policies (a desirable feature of fiscal policy) implies a temporary increase in debt or a decline in assets.
The anchor should be set prudently, at a level that allows reaching the long-term objectives under most of the adverse scenarios that the economy might face. For resource-rich countries the volatility of resource prices amplifies the spectrum and unpredictability of adverse scenarios. For these countries, the best way to shield the budget (and, through the budget, the economy) from the volatility of resource prices is to build a buffer that allows financing a gradual adjustment to a permanent (or temporary, but large) loss in resource revenue. The buffer can be built either through assets or by keeping debt at a low level.
The size of the buffer depends on two factors. The first is the tolerance for the depth of the annual adjustment, which would have to be set based on economic considerations, including the effect of fiscal consolidation on economic activity. The other factor is risk aversion. To one extreme, with zero tolerance for risk, the buffer should be large enough to allow smoothing the adjustment to the most extreme event: a large permanent loss of resource revenues. In this case the buffer should be large enough to finance the part of spending that remains to be adjusted, for the time that it will take to absorb the entire loss of revenues. With some tolerance for risk, the government would like to cover the adjustment to all but the worst possible revenue losses. In this case, a risk-based approach that considers the entire risk profile of resource revenues can be adopted to estimate the buffer.
The fiscal rule should be set as a lasting numerical limit on a quantifiable fiscal aggregate or indicator of fiscal policy. The rule should be binding for the annual budget and be set on a flow variable that is under the direct control of policymakers. However, the rule should not be treated as a target for fiscal policy; rather, it should be thought of as the perimeter within which policy discretion can be exercised.
The limit(s) imposed by the rule should be set consistent with the medium-term anchor and the structural parameters of the economy. Also, in case more than one limit constrain different variables, these limits should be set coherently with one another, to avoid both contradictory overlaps (which leaves the choice to pick and choose the limit with which to comply), and overly-constraining fiscal policy (which could lead to sub-optimal policies). In any case, the system of fiscal rules (if more than one is present) should be parsimonious.
Correction mechanisms and transitional arrangement can reinforce the link between short-run policies and the medium term anchor, strengthening the credibility of the rule. Correction mechanisms are provisions that pre-determine how fiscal policy should respond in the short run to deviations of stock variables from the anchor. Correction mechanisms enforce credibility because they give further insurance that fiscal policy will remain anchored over the medium-term. Transitional arrangements determine instead a path that bridges the current fiscal position to the one established by the rule. These arrangements support the credibility of the rule when the immediate implementation of the rule implies unrealistic adjustments.
A well-designed fiscal rule should be flexible, but flexibility should not lead to complexity. Escape clauses strike this balance by pre-establishing the conditions, modality, and duration of deviations from the rule in case exceptional circumstances materialize.
Finally, rules should be complied with, which is more likely to happen if compliance mechanisms are based on incentives rather than enforcement, that is by raising the costs of noncompliance and by creating more tangible benefits for compliance. For example, raising the reputational costs of noncompliance (by subjecting compliance to the scrutiny of independent monitoring bodies such as fiscal councils, and by fostering debate in Congress) appears more promising than imposing sanctions for non-compliance.
