The countries of Latin America and the Caribbean (LAC) have joined the global trend of adopting rules-based macrofiscal frameworks. The adoption of fiscal rules began with Brazil and Argentina in 2000, and most of the countries in the region have followed suit. To date, 14 countries in the region have adopted fiscal rules.
However, the presence of fiscal rules is not sufficient, in and of itself, to achieve fiscal sustainability. Experience, within and outside of the region, shows that the design of fiscal rules is a key factor in their effectiveness. More specifically, fiscal rules must have the following features in order to be effective: (i) broad institutional coverage; (ii) a sound legal base; (iii) compliance mechanisms; and (iv) flexibility in addressing shocks. The presence of these factors is essential in explaining the contribution of the rules to fiscal consolidation and in accounting for their uneven levels of performance in the region (Ardanaz et al., forthcoming).
Recent experiences in Mexico and Colombia illustrate the challenges of having adequately and effectively designed fiscal rules. From 2006 until 2014, Mexico had a balanced budget rule, which proved to be ineffective as a result of the following factors (Barreix and Corrales, forthcoming): (i) increasing exceptions to the definitions of balance; (ii) excessive use of escape clauses; and (iii) weaknesses in fiscal management leading to an ongoing practice of underbudgeting. As a result, debt between 2006 and 2014 increased from less than 30 percent of GDP to approximately 45 percent of GDP. Against this backdrop, the Mexican government amended its fiscal rule to address some of these weaknesses (i) through the use of the broadest measurement of the balance as a fiscal target; and (ii) by moving towards a balanced budget rule through the use of a structural expenditure rule. Although the amendment represented significant progress, a number of challenges have yet to be addressed before the escape clause can be more precisely defined.
Colombia introduced a structural balance rule in 2014 with support from an Independent Fiscal Council. While it would seem that Colombia is using a sound design for the rule, problems in estimating structural revenue deriving from oil have led to constant revisions of the balance targets that have undermined the credibility of the rule (Barreix and Corrales, forthcoming). Along with the open-ended escape clauses, this factor has led to increases in debt from 36 percent to 46 percent of GDP since the rule was introduced. This rise in debt is associated with the downgrading of Colombia’s credit rating in 2017.
An additional topic of particular importance in the current context of fiscal adjustment in the region is the importance of flexibility in the fiscal rules. While LAC countries have undertaken a fiscal consolidation process, most of this adjustment applies to capital expenditure. The question is therefore whether fiscal rules can protect investment expenditure in times of fiscal adjustment. Ardanaz et al. demonstrate that more flexible rules that include clearly-defined escape clauses, cyclically-adjusted balances, or investment-friendly rules are capable of protecting capital expenditure during periods of fiscal adjustment.
In summary, fiscal rules have the potential to be a valuable instrument in achieving sustainable fiscal policy. However, design and compliance mechanisms are more important than the fiscal rule itself. Rules having broad coverage, sound compliance institutions and mechanisms, and a flexible approach in addressing shocks are more likely to be effective.
References
Ardanaz, M., E. Cavallo, A. Izquierdo, and J. Puig. Forthcoming. Growth friendly fiscal rules? Understanding the link between rule based fiscal frameworks and public investment. Inter-American Development Bank (IDB), Mimeo.
Barreix, A. and L. F. Corrales, Reglas fiscales resilientes en América Latina [Resilient fiscal rules in Latin America], IDB, forthcoming.
