Growing interest in fiscal policy rules is in part attributable to the deterioration in fiscal performance, the so-called deficit bias, experienced for more than two decades by a large part of the IMF membership. In many countries the deterioration recently has been reversed—in a number of cases, as part of the convergence toward meeting fiscal rules. Still, some advanced economies face a major task in managing a sustainable fiscal policy over the medium to long run, given uncertainties in the macroeconomic outlook, structural rigidities, and the aging of populations. Equally worrisome are the prospects for developing and transition economies, as continued vulnerability to macroeconomic imbalances prevents realization of their full growth potential, especially in the absence of predictable and sound fiscal policies. In the light of these considerations, in its September 1996 Declaration on Partnership for Sustainable Global Growth, the Interim Committee of the Board of Governors of the International Monetary Fund attached particular importance to “achieving budget balance and strengthened fiscal discipline in a multi-year framework” (IMF, 1996b, p. xii).
This paper addresses a number of major questions. What are fiscal policy rules? What are the principal benefits and drawbacks associated with various fiscal rules, particularly compared with alternative approaches to fiscal adjustment? Can fiscal rules contribute to long-run sustainability and welfare without sacrificing short-run stabilization? If so, what characteristics of fiscal rules make this contribution most effective? And in what circumstances and contexts, if any, should the IMF encourage its member countries to adopt fiscal rules? In an attempt to answer these and related questions, the paper ultimately seeks to identify sensible fiscal policy rules that can succeed, if chosen by a member country or a group of countries, as an alternative to discretionary fiscal policies.
At the outset, we should note that fiscal policy rules tend to be more heterogeneous and complex than monetary and exchange rate rules. Fiscal rules vary considerably across countries in terms of the target variable, institutional coverage, and method of implementation. Although this paper refers to the theoretical literature on the subject, it does not pretend to settle the academic debate over the broader question of policy rules versus discretion. Equally, on the basis of the arguments presented and the relatively limited experience with rules, this paper cannot provide a categorical endorsement (or rejection) of fiscal rules over discretionary practices. Rather, the objective is simply to shed light on the usefulness and advantages of implementing—under appropriate circumstances—fiscal rules endowed with certain characteristics.
Anticipating the discussion of the desirable rule characteristics, transparency stands out as probably the most important attribute in determining the usefulness of such rules.1 In general, clarity in institutional arrangements, measurement, and analysis is a critical element for the formulation and implementation of successful fiscal policy. A hardening of budget constraints, through limits on government deficits or borrowing—whether imposed through a rule or on a discretionary basis—may in fact induce nontransparent practices. Accordingly, application of a fiscal rule without an explicit mandate to maintain transparency is likely to lead to circumvention and distortions, which ultimately erode the effectiveness of the rule. By the same token, transparent implementation of a well-designed and credible medium-term fiscal adjustment program can be highly effective in securing fiscal discipline.
The remainder of this section presents a relatively broad definition of fiscal policy rules (illustrated with examples from a survey of rules provided in Appendix I) and a brief discussion of past fiscal developments that serves as background to the rest of the paper. Section II reviews the arguments often advocated in the literature and used by various countries for adopting rules, followed by a discussion of institutional aspects of fiscal rules. Section III examines the likely economic consequences of fiscal rules, on the basis of actual experience with existing rules and of simulations of proposed rules (discussed in detail in Appendices II and III) for major industrial countries. Building on the preceding sections, Section IV discusses the political economy of rules, outlines the key desirable characteristics of fiscal rules, and explores the implications of the analysis for IMF advice to member countries. The final section summarizes the main findings.
Fiscal Policy Rules Defined
For the purposes of this paper, a fiscal policy rule is defined, in a macroeconomic context, as a permanent constraint on fiscal policy, typically defined in terms of an indicator of overall fiscal performance. The rules under consideration cover summary fiscal indicators, such as the government budget deficit, borrowing, debt, or major components thereof—often expressed as a numerical ceiling or target, in proportion to gross domestic product (GDP) (Box 1).2
Besides consisting of restrictions on the overall budget balance, government borrowing, or public debt (as envisaged under Economic and Monetary Union (EMU) for example), fiscal rules may encompass key subsets of these aggregates, including the current budget balance—that is, permitting borrowing only for investment (as applied with regard to subnational governments in Germany and the United States). Also, in the absence of sufficiently developed domestic financial markets or given limited access to external sources of financing, prohibition on domestic borrowing (as in Indonesia) and restrictions on borrowing from the central bank (as in CFA franc zone member countries) may impose a severe constraint on the budget deficit and thus serve as fiscal rules (Table 1). Specialized rules imposed on the level or allocation of certain categories of government expenditure or revenue, though potentially useful in their own right, are beyond the scope of this paper.
Selected Countries: Fiscal Policy Rules
Source: Appendix I.
Including Stability and Growth Pact and pertinent European Council Regulations.
Selected Countries: Fiscal Policy Rules
| Target or Ceiling | Effective Period | Statutory Instrument | Government Level | Penalty for Noncompliance | |
|---|---|---|---|---|---|
| Netherlands | Structural deficit limit | 1961–74 | Government policy | Central government | Reputational |
| European Union members | Medium-term overall balance Yearly deficit limit 3 percent of GDP) | Since 1997 | International treaty1(Stage 3 of EMU) | General government | Reputational Financial (from 1999) |
| United States | Yearly overall balance | Proposal | Constitutional amendment | Federal government | Judicial |
| Costa Rica | Yearly deficit limit (1 percent of GDP) | Proposal | Constitutional amendment | Public sector | Judicial |
| Switzerland | Cyclically adjusted balance | Proposal | Constitutional amendment | Federal government | Reputational |
| New Zealand | Medium-term operating balance | Since 1994 | Legal provision | Public sector | Reputational |
| Germany | Yearly current balance | Since 1949 | Constitutional amendment | Federal and subnational governments | Judicial |
| Japan | Yearly current balance | 1946–75 and proposed from 2003 | Legal provision | Central government | Judicial |
| United States | Yearly current balance | Various | Constitutional amendment | Subnational governments | Judicial |
| Canada | Overall balance or deficit limit | Since 1993 | Legal provision | Subnational governments | Judicial |
| Indonesia | No domestic borrowing | Since 1967 | Government policy | General government | Reputational |
| European Union members | No borrowing from central bank | Since 1994 | International treaty (Stage 2 of EMU) | General government | Judicial |
| Argentina, Canada Chile, Ecuador, Hungary, Japan, Peru, United States | No borrowing from central bank | Various | Various | General government | Judicial |
| CFA franc zone members | Borrowing from central bank limited to 20 percent of last year’s revenue | Since 1973 | International treaty | General government | Financial |
| Brazil, Egypt, Morocco, Philippines, Slovak Republic | Borrowing from central bank limited as fixed proportion of last year’s revenue | Various | Various | General government | Judicial or reputational |
| European Union members | Gross debt limit (60 percent of GDP) | Since 1997 | International treaty (Stage 3 of EMU) | General government | Judicial |
Source: Appendix I.
Including Stability and Growth Pact and pertinent European Council Regulations.
Selected Countries: Fiscal Policy Rules
| Target or Ceiling | Effective Period | Statutory Instrument | Government Level | Penalty for Noncompliance | |
|---|---|---|---|---|---|
| Netherlands | Structural deficit limit | 1961–74 | Government policy | Central government | Reputational |
| European Union members | Medium-term overall balance Yearly deficit limit 3 percent of GDP) | Since 1997 | International treaty1(Stage 3 of EMU) | General government | Reputational Financial (from 1999) |
| United States | Yearly overall balance | Proposal | Constitutional amendment | Federal government | Judicial |
| Costa Rica | Yearly deficit limit (1 percent of GDP) | Proposal | Constitutional amendment | Public sector | Judicial |
| Switzerland | Cyclically adjusted balance | Proposal | Constitutional amendment | Federal government | Reputational |
| New Zealand | Medium-term operating balance | Since 1994 | Legal provision | Public sector | Reputational |
| Germany | Yearly current balance | Since 1949 | Constitutional amendment | Federal and subnational governments | Judicial |
| Japan | Yearly current balance | 1946–75 and proposed from 2003 | Legal provision | Central government | Judicial |
| United States | Yearly current balance | Various | Constitutional amendment | Subnational governments | Judicial |
| Canada | Overall balance or deficit limit | Since 1993 | Legal provision | Subnational governments | Judicial |
| Indonesia | No domestic borrowing | Since 1967 | Government policy | General government | Reputational |
| European Union members | No borrowing from central bank | Since 1994 | International treaty (Stage 2 of EMU) | General government | Judicial |
| Argentina, Canada Chile, Ecuador, Hungary, Japan, Peru, United States | No borrowing from central bank | Various | Various | General government | Judicial |
| CFA franc zone members | Borrowing from central bank limited to 20 percent of last year’s revenue | Since 1973 | International treaty | General government | Financial |
| Brazil, Egypt, Morocco, Philippines, Slovak Republic | Borrowing from central bank limited as fixed proportion of last year’s revenue | Various | Various | General government | Judicial or reputational |
| European Union members | Gross debt limit (60 percent of GDP) | Since 1997 | International treaty (Stage 3 of EMU) | General government | Judicial |
Source: Appendix I.
Including Stability and Growth Pact and pertinent European Council Regulations.
A critical feature of a fiscal rule is that—regardless of the statutory instrument (international treaty, constitutional amendment, legal provision, or policy guideline) or local terminology3—it is intended for application on a permanent basis by successive governments in a given country, at the national or subnational levels. For a policy rule to be credible, it must involve commitment over a reasonably long period of time.4 Thus, constraints that when adopted were meant to apply indefinitely can be viewed as rules, even if eventually they were abandoned or suspended. In this sense, for example, both the former structural deficit ceiling in the Netherlands and the former limitation on government borrowing to finance capital expenditures in Japan qualify as rules.5 By contrast, budget deficit ceilings or targets specified in the context of a fiscal adjustment program over a preannounced period of time—including one-year or multiyear IMF-supported programs—cannot be regarded as fiscal rules.
Major Types of Fiscal Policy Rules
Balanced-budget or deficit rules
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Balance between overall revenue and expenditure (that is, prohibition on government borrowing); or limit on government deficit as a proportion of GDP.
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Balance between structural (or cyclically adjusted) revenue and expenditure; or limit on structural (or cyclically adjusted) deficit as a proportion of GDP.
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Balance between current revenue and current expenditure (that is, borrowing permitted only to finance capital expenditure).
Borrowing rules
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Prohibition on government borrowing from domestic sources.
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Prohibition on government borrowing from central bank; or limit on such borrowing as a proportion of past government revenue or expenditure.
Debt or reserve rules
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Limit on stock of gross (or net) government liabilities as a proportion of GDP.
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Target stock of reserves of extrabudgetary contingency funds (such as social security funds) as a proportion of annual benefit payments.
Much like other rules-based policies,6 fiscal rules can be defined in terms of the degree of stringency, precision, and enforcement of the statutory instrument. A narrow definition would require both ex ante (budget approval) and ex post (budget execution) compliance, subject to tangible penalties. Examples include the current budget balance in some U.S. states, the reference value for the budget deficit under EMU, and the borrowing limits in the CFA franc zone; in all these cases, ex post noncompliance carries judicial or financial sanctions.7 A broader definition also encompasses cases of mere ex ante compliance (such as the current budget balance in Germany and in the remaining U.S. states) and those with some latitude in interpretation (for example, the former structural deficit ceiling in the Netherlands, the medium-term operating balance in New Zealand, the medium-term overall balance under the EMU Stability and Growth Pact, and the proposed cyclically adjusted balance in Switzerland), accompanied by reputational sanctions for noncompliance.
There are borderline cases that in principle can be viewed as fiscal rules, such as the provisions for reducing the public debt-GDP ratio to a reference value at a satisfactory pace (under EMU) or to a prudent level while achieving an adequate level of net worth (New Zealand). These provisions may be open to considerable judgment and involve mainly reputational sanctions for noncompliance. Given the significant scope for interpretation, it is debatable whether they qualify as fiscal rules.8
The primary focus of this paper is on fiscal policy rules, as distinct from the procedural rules that can be found in many countries to ensure the execution of either discretionary or rules-based policies. Procedural rules include automatic contingency measures, such as across-the-board cuts in noninterest spending (usually, but not always, excluding transfers under mandatory programs), cash limits, sequestration of funds, or imposition of a surtax.9 These or other measures, specified in advance, are triggered during the fiscal year if actual budget implementation (in terms of expenditure or revenue performance) deviates from budget forecasts, whether in the context of an annual or a multiyear program or pursuant to a fiscal policy rule. A fiscal policy rule that incorporates such contingency measures is called a contingent policy rule.10
Background
To understand the current interest in fiscal policy rules, it is useful to recapitulate the broad fiscal trends in major groups of countries. Except for the past few years, the period since the 1970s—following the breakdown of the Bretton Woods system—has seen a rise in the share of government in economic activity in the advanced economies and widening fiscal imbalances: the strong rise in government outlays was not matched by a commensurate improvement in revenue performance.11 The diverging structural trends in government revenue and expenditure, in combination with a fiscal policy stance guided by the short-run stabilization goal, reflected a largely asymmetrical demand management: budget deficits that emerged during recessions were not fully offset by equivalent surpluses during economic expansions.12
Fiscal developments in the developing economies were characterized by far larger fluctuations. While upward pressures on government spending were, for the most part, just as intense as in the advanced economies, the limits to taxation set in at a much lower level—given a relatively larger informal sector and lower administrative capacity. In addition, in the developing regions, expenditure programs and tax revenues were subject to large swings, reflecting terms-of-trade shocks as well as the relatively short decision-making horizon of unstable governments, compounded by rapid shifts in investor confidence. These developments led to a highly volatile and pro-cyclical fiscal policy stance.13
Faced with widening fiscal imbalances, from the mid-1980s onward, a number of countries launched medium-term fiscal adjustment plans;14 these met with success in only some cases, however.15 Among the advanced economies, the adjustment has been sustained in recent years largely as part of the convergence toward a balanced-budget position under actual (in New Zealand and the European Union) or proposed (in Japan, Switzerland, and the United States) fiscal rules. In developing economies, fiscal adjustment—often undertaken, in the context of an IMF-supported program, following an external payments crisis—has usually included a blend of structural fiscal reform and financial and trade liberalization. But in many cases, as market access was restored, the commitment to consolidating the initial gains from the adjustment vanished and a new crisis emerged, requiring an adjustment effort even tougher than the previous one.16 Taken as a whole, however, these countries have managed to reduce their fiscal deficits in recent years.
As they embarked on a market-oriented transition in the early 1990s, the former centrally planned economies underwent considerable fiscal stress. Owing to the collapse of output, waves of privatization, lack of administrative resources, and growth of the informal sector, tax revenue fell dramatically. Meanwhile, the need for government expenditure in building infrastructure and social safety nets and in supporting enterprise and bank restructuring was only partially financed by savings from sizable cuts in price subsidies. In some cases, fiscal imbalances were exacerbated by large, inherited debt-service obligations—in part carried outside the budgetary accounts. More recently, an increasing number of transition economies have made progress in reducing their fiscal deficits and achieving some policy credibility.17
Fiscal developments over the past two decades can be summarized by four observations. First, many countries experienced a deficit bias, reflected in the steady deterioration in public finances; a recent reversal, in a number of cases, is mainly attributable to convergence under fiscal rules. Second, efforts to arrest this deterioration with short- or medium-term discretionary action have succeeded in relatively few countries. Third, contrary to previously held conventional wisdom—largely derived from Keynesian tradition—fiscal adjustment, if underpinned by structural reform, need not induce a recession.18 And, fourth, a critical ingredient to successful adjustment is prolonged commitment to fiscal discipline.