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Finland: Selected Issues and Analytical Notes

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International Monetary Fund
Published Date:
August 2012
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VII. Analytical Note 7: Fiscal Rules In Perspective1

Fiscal rules can be beneficial for a number of reasons. First, they can help build buffers during economic expansions to be used when the cycle turns. Second, in an uncertain environment with volatile financial markets, fiscal rules can help build and maintain credible and sound medium-term public finances. Third, on the back of a fiscally costly recession and with a rapidly aging population, fiscal rules can be helpful in closing the sustainability gap. With the background of the 2008–09 crisis and the euro area debt turmoil, this note will discuss the strengths and weaknesses of Finland’s fiscal rules framework. In addition, simulations will show how fiscal balances would have developed in Finland and its peers had various fiscal rules been in place prior to the crisis.

A. Finland’s Fiscal Accounts and Recent Developments

1. Despite a sharp worsening during the 2008–09 crisis, the general government deficit in 2011 was among the lowest in the European Union. After a decade of surpluses on general government accounts, the more than 4 percent of GDP fiscal surplus in 2008 sharply turned around as revenues collapsed with the 8.4 percent real GDP decline in 2009. Nonetheless, due to a strong bounce back in economic activity in 2010, the deficit remained contained below the 3 percent of GDP Maastricht criteria. As the government stepped up fiscal consolidation in 2011, the deficit narrowed further and was well below the euro area average of more than 4 percent of GDP.

General Government Balances and Debt, 2011

(Percent of GDP)

Sources: World Economic Outlook and Fund staff calculations.

2. However, the existing fiscal framework has not prevented rapid public expenditure growth outside the central government. While the spending limits have served Finland well in containing central government spending, other subsectors of the general government have behaved quite differently (Figure 7.1). With the spending limit constraints, central government nominal expenditure growth remained contained at less than 2 percent per year during 1996–2008. However, nominal expenditures grew strongly in local governments, averaging more than 5½ percent per year. In particular, in addition to rising costs associated with general public services, local government spending on social protection and health care services has increased rapidly. Nonetheless, the local governments’ deficit has remained contained at less than 1 percent of GDP with the Local Government Act stipulating at least a balanced budget over four years.2 On the contrary, the central government deficit deteriorated sharply when the 2008–09 crisis hit, further worsening to 5.6 percent of GDP in 2010.

Figure 7.1.General Government and Subsectors, 1995–2011

Sources: Finnish Ministry of Finance, Statistics Finland, World Economic Outlook, and Fund staff calculations.

3. General government spending growth has also been rapid compared to other advanced European countries. During the last decade, annual average real expenditure growth in Finland has outpaced that in Denmark, Sweden, and the euro area (Figure 7.2). In fact, Finland has now outpaced the size of government in Sweden, where most indicators of compliance with the fiscal rules framework over-performed relative to the one percent surplus target3 (IMF, 2011a). Overall, the relatively rapid expenditure growth suggests that Finland has room to modify the current framework, in particular to avoid a build-up of vulnerabilities as the increase in aging costs becomes more pressing.

Figure 7.2.General Government Real Expenditure and Revenue, 1995–2011

Sources: World Economic Outlook and Fund staff calculations.

General Government Expenditure

(Percent of GDP)

Sources: World Economic Outlook and Fund staff calculations.

4. Recently, the euro area sovereign debt market turmoil has led to the decision to further strengthen national frameworks. At the end of the summer of 2011, the confidence crisis in the euro area escalated and spread to countries that previously had been untouched, while rising borrowing costs swiftly put pressure on public accounts. As a result, part of the outcome of the Euro Summit in October 2011 was a commitment by euro area countries to carry out additional measures: (i) adoption of structural balanced budget rules, preferably at the constitutional or equivalent level; (ii) reinforcement of national fiscal frameworks, not least by formulating national budgets based on independent growth forecasts; (iii) taking into account recommendations adopted at the EU level on the conduct of economic and budgetary policies; (iv) consultation of the Commission and Member States before adopting any major fiscal or economic policy reform plans with potential spillover effects; and (v) commitment to stick to the recommendations regarding the implementation of the Stability and Growth Pact (European Council, 2011a).

5. The commitment to reform euro area member states’ fiscal framework will have direct implications for countries’ budgetary processes. In December 2011, further details were agreed. In particular, the European Council (2011b) agreed to a new Fiscal Compact, including that the annual structural deficit must not exceed 0.5 percent of nominal GDP. While fiscal frameworks in some countries already include some form of structural balance rules, several countries will have to make adjustments or amendments to these. For example, though over-the-cycle rules in principle target the medium-term structural balance, they also allow for temporary procyclical policy. In addition, some countries, including Finland, will need to set up independent fiscal councils to provide the macroeconomic framework for the budget formulation process. At the same time, while credible medium-term debt reduction plans remain a priority, countries must be careful not to jeopardize growth, in particular in light of a weak near-term outlook and prevailing downside risks. For Finland, however, staff estimates that due to the around 3 percent of GDP surplus in employment pension funds, a structural deficit limit of 0.5 percent of GDP has generally not been binding since euro adoption.

B. Spending Limits and Other Rules: the International and the Finnish Experience

6. Fiscal rules have been increasingly important across countries. The IMF (2009) found that, as of early 2009, 80 countries within the Fund membership had national and/or supranational fiscal rules in place that covered at a minimum central government. This is a sharp increase from only seven countries with fiscal rules in 1990. At the same time, many countries have moved from only one rule to a combination of rules in order to address sustainability objectives, and 18 percent of advanced countries had independent fiscal bodies assessing the budget.

7. Some countries within the European Union have seen substantial changes in their fiscal frameworks. Though some countries have strengthened their frameworks, the 2008–09 global financial crisis also resulted in some weakening. The United Kingdom suspended its golden and sustainable investment rules at the end of 2008 (IMF, 2010). In Finland, having performed comparatively well in relation to fiscal rules elsewhere in Europe before the crisis, the European Commission’s fiscal rules index weakened from 2007 to 2009—a period in which the target of reducing central government debt was abandoned and the government allowed an exemption from the central government deficit limit of 2½ percent of GDP—indicating that the fiscal goals were not apt for a crisis situation. The Netherlands and Sweden are examples of countries similar to Finland with strong fiscal frameworks as of 2010 (see Box 7.1 for additional information on fiscal rules in selected European countries).

Fiscal Rules Index, 2000–10

Sources: European Commission, May 2012, and Fund staff calculations.

http://ec.europa.eu/economy_finance/db_indicators/fiscal_governance/fiscal_rules/index_en.htm

Finland’s Fiscal Framework

8. The main pillar of the Finnish fiscal rules framework is the spending limits system but other targets are often also included. The current framework dates back to the reformed central government spending limits system, which was introduced in the context of the 2003–07 parliamentary term, albeit with some more recent modifications. Government Programs (GP) have typically also included other benchmarks such as targets on the central government balance and the debt ratio. For example, during the 2003–07 parliamentary term, the upper bound for the central government deficit was set at 2¾ percent of GDP, which was lowered to 2½ percent of GDP in the subsequent term. The current GP targets a central government deficit of no more than 1 percent of GDP by 2015 and that the central government debt-to-GDP ratio is put on a declining path (Box 7.2).

9. Though the spending limits have never been exceeded, additional targets have shown to be less significant. In particular, with the sharp contraction in revenue, the central government deficit limit was exceeded in both 2009 and 2010. And though the severity of the recession justified the departure from the deficit limit, it did also suggest a soft attitude toward the rule. Currently, staff estimates that the GP specified measures fall short of the 2015 central government deficit limit by about ½–1 percent of GDP. Albeit the GP states an annual review of the progress toward the targets, the lack of specific plans at this stage may jeopardize the credibility of the targets. In addition, existing fiscal rules have been rather ineffective at closing the sustainability gap, suggesting that a further strengthening of the system could be beneficial.

10. The Finnish spending limits focus on containing central government spending, leaving a substantial share of general government expenditure outside the ceilings. The central government spending limits are set in real terms for the four-year parliamentary term, allowing for annual adjustments in the nominal value due to price changes. According to the Finnish Ministry of Finance, the spending limits cover 37 percent of overall public spending and 75 percent of central government on-budget expenditure, compared to more than 50 percent of overall spending in Sweden (MoF, 2011). Spending outside the limits includes identified cyclical expenditure items, interest on central government debt, VAT expenditures, financial investments and expenditure, and local government expenditure. Importantly, the spending limits allowed full room for automatic stabilizers to work during the 2008–09 global financial crisis.

11. The Finnish spending limits are not required by the constitution but enjoy strong political support. Specifically, the spending limits are determined as part of the government coalition agreements. Nonetheless, their effectiveness in containing central government spending has added to political support for the rule, and Finnish governments have a strong track record in adhering to the system. However, adherence to the spending limits framework was not fully tested in the context of economic stimulus during the crisis as the stimulus measures were partly targeted on expenditure outside the spending limits as well as on the revenue side.

C. The Effect of Fiscal Rules

12. Fiscal rules can help enhance the credibility of the government’s medium-term fiscal objective and thus buttress consolidation plans. In particular, fiscal rules can entrench fiscal discipline (Debrun and Kumar, 2007a). Also, the European Commission concluded that the strength and coverage of fiscal rules in EU countries were associated with an increased likelihood of successful fiscal consolidation, though the link is weak when considering expenditure rules only (EC, 2007). An IMF study found that on average during large adjustments, debt reduction was larger in countries with fiscal rules (IMF, 2009). In general, debt rules and various types of budget balance rules help move toward sustainability but do not constrain spending and, hence, the size of government. On the contrary, expenditure rules are helpful when the objective is to constrain the size of government, while economic stabilization can be supported also through balanced budget rules over the cycle. Therefore, the choice of rule depends to a large extent on the objectives and preferences of the government.

Properties of Different Types of Fiscal Rules Against Key Objectives 1/
Objectives
Type of fiscal ruleDebt sustainabilityEconomic stabilizationGovernment size
Overall balance++0
Primary balance+0
Cyclically adjusted balance++++0
Balanced budget over the cycle+++++0
Public debt-to-GDP ratio+++
Expenditure+++++
Revenue
Revenue ceilings++
Revenue floors++
Limits on revenue windfalls+++++
Source: IMF (2009).

Positive signs (+) indicate stronger property, negative signs (-) indicate weaker property, zeros (0) indicate neutral property with regard to objective.

Source: IMF (2009).

Positive signs (+) indicate stronger property, negative signs (-) indicate weaker property, zeros (0) indicate neutral property with regard to objective.

13. A structural balance rule could usefully complement an expenditure rule but is subject to several challenges. A structural balance rule allows automatic stabilizers to work by adjusting the required budget balance for the economic cycle. Not only will a structural balance rule be needed from the perspective of the new European Fiscal Compact, it can also help the economy on the right path in a decade with a rapidly aging population. At the same time, the expenditure limits can prevent an unintended long-term increase in the size of government. However, there are several challenges associated with the practical implementation of structural balance rules as estimating the output gap and, hence, the sustainability gap and the structural balance target is subject to considerable uncertainty. Therefore, forecasters should take the approach of using conservative estimates of potential output growth in order to avoid overestimating the structural balance during periods of rapid economic growth, which would tend to produce loser fiscal rules.

Simulating Hypothetical Budget Balances

14. To account for the difficulties in estimating potential output, the simulations in this note are based on several different structural balance rules. Specifically, in addition to an expenditure rule, the analysis covers four rules related to a cyclically adjusted budget balance target: a simple and an augmented structural balance rule and a simple and an augmented growth-based rule (Box 7.3). For simplicity, the focus is on general government finances, and the simulations produce hypothetical paths of the general government balance in percent of GDP for each of the various rules. This shows in a cross-country setting how different fiscal rules would have affected the fiscal balance and compares the simulated outcome of using each rule to the actual history.

15. The two structural balance rules require an estimate of the output gap. In the case of the simple structural balance rule, the actual budget balance under the rule arises from the target budget balance, b*, after adjusting for the output gap. In the baseline simulations, b* is set in order to reach a predetermined level of debt to GDP by a certain future data (see Box 7.3 and the appendix for details). The augmented version of the rule accounts additionally for the level of the budget balance ratio in the previous period, thereby accelerating the adjustment toward the target.

16. The growth rate rules target the structural balance but adjust for real GDP growth rather than the output gap during the adjustment period. Given the difficulty in obtaining accurate output gap estimates, this approach is a useful and simple alternative. After setting a medium-term balance target, the simple growth-based rule allows for deviations from the target when growth falls below the trend level of growth. However, without further adjustment, the rule would require a larger balance during times of a negative but closing output gap where growth would be temporarily high. Hence, an augmented form of the rule allows for a gradual adjustment toward the medium-term budget balance target. This has the advantage of allowing for countercyclical policy under the rule while being independent of contemporaneous potential output estimates.

17. The expenditure rule sets a ceiling for real expenditure. Expenditure rules can be very effective in reducing the tendency to increase public spending during periods of rapid growth (IMF, 2011b). For simplicity and cross-country comparison in the simulations, the rule is applied to general government spending and not only to certain parts of central government spending. The ceiling is set to grow with either long-term real GDP, estimated as the historical annual average growth rate over 1970–2002 or, alternatively, by applying the medium-term estimated potential growth rate from the growth rate rule above. It is then translated into nominal expenditure using the GDP deflator. As the rule does not set any limits on revenue, the simulations use actual revenue for computing the budget balance. In practice, if a country implements expenditure rules in combination with structural balance rules, it will be important that expenditure limits are set to comply consistently with the targets under the structural balance rule.

18. The rules differ in how the budget balance is affected in case of macroeconomic shocks. The adjacent text chart shows how the budget balance is affected by a growth shock under various structural balance rules (see appendix for details), where growth at time t-1 is set equal to real GDP growth in 2010. The rules are then assumed to be implemented in period t+1 when an adverse growth shock hits. The simple structural balance rule provides the slowest adjustment to the long-run surplus target, while the augmented growth rule allows for some degree of cyclicality during the downturn but then enacts more rapid adjustment.

Responses of Rules to a Large Adverse Growth Shock 1/

(Hypothetical budget balances, percent of GDP)

Sources: World Economic Outlook and Fund staff calculations.

1/ At t-1, potential real GDP growth, g*, is set equal to actual real GDP growth, g, in 2010, and it is assumed that real GDP, y, in 2010 equals potential real GDP, y*.

Simulation Results

19. The simulations suggest substantial cross-country differences in performance relative to the rules in recent years. The simulations assume the implementation of the rule in 2003 when Finland’s spending limits system was revised. Hence, actual data in 2002 for the respective countries are used as initial conditions, and the budget balance is computed over time assuming each of the rules one by one had been in place over the horizon. Until 2009, Finland’s budgetary stance fell within the range given by the various rules (Figure 7.3). However, after the global economic and financial crisis, the budget balance fell below that implied by all the rules. The budget balance in the Netherlands, which has seen a similar deterioration, declined markedly below that implied by the various budget balance rules. On the contrary, Sweden’s actual budget balance has fared well relative to what the rules would imply. In particular, the expenditure rules for Sweden would by themselves have implied a more lax fiscal stance than the actual balance provided.

Figure 7.3.The Impact of Fiscal Rules, 2002–11

(General government balance, percent of GDP)
(General government balance, percent of GDP)

Sources: World Economic Outlook and Fund staff calculations.

20. The recent Finnish budget balance developments are most closely associated with rules that target a relatively low medium-term balance. In order to explore the sensitivity of the results for Finland, Figure 7.4 shows the development of the budget balance under different assumptions for the medium-term budget balance target. Indeed, several rules tend to generate a path for the budget balance similar to the actual historical developments when the budget target is set at a relatively low level. For example, the fiscal balance under the augmented growth-based rule follows closely that of the actual fiscal balance when the budget balance target is set at 1.5 percent of GDP or lower. However, this level is well below the 4 percent of GDP surplus, which the Ministry of Finance has estimated as required for long-term sustainability of public finances (MoF, 2012).

Figure 7.4.Finland: Sensitivity Analysis. Budget Target, 2002–11

(General government actual and hypothetical balances, percent of GDP)

Sources: World Economic Outlook and Fund staff calculations. See the appendix for detailed assumptions.

21. The effect of the various rules is also sensitive to the degree of counter-cyclical policy. For example, the rules above allow only for the automatic stabilizers to work (for Finland: a = 0.48). However, during the crisis, the government undertook substantial fiscal stimulus. Hence, to allow for more active countercyclical policy, the semi-elasticity, a, in the structural balance and growth-based rules is allowed to vary. Figure 7.5 shows the paths for the simulated budget balance under different assumptions for the parameter a, and for varying the parameter e in the case of the augmented growth-based rule. Indeed, as a approaches 1, the fiscal balance worsens further in 2009, consistent with fiscal stimulus—the Ministry of Finance estimates that more than 1½ percent of GDP in fiscal stimulus measures were provided in 2009 and 2010.

Figure 7.5.Finland: Sensitivity Analysis. Cyclicality, 2002–11

(General government actual and hypothetical balances, percent of GDP)

Sources: World Economic Outlook and Fund staff calculations. See the appendix for detailed assumptions.

D. Improving the Finnish Fiscal Framework

22. The current Government Program incorporates several Ministry of Finance recommendations to improve the spending limits framework. For example, as recommended by the Ministry of Finance Spending Limits Working Group, the noncyclically sensitive central government contribution to expenditure arising from the National Pension Act is now included under the ceilings. In addition, the GP includes a formal commitment not to use tax subsidies to circumvent the spending limits, and the spending limits are neutral with regard to changes between tax subsidies and expenditure of equal magnitude. Nevertheless, some shortcomings persist.

Long-Term Sustainability

23. One shortcoming of the Finnish fiscal rules relates to the absence of explicit consideration of the sustainability gap. Hence, improvement in the rules should aim at closing the sustainability gap. It is important at the same time that any fiscal rule for Finland be sufficiently flexible to allow the automatic stabilizers to work. Setting a near-term target for the overall central government balance is too constraining during severe economic downturns. To strengthen the framework, the authorities could therefore consider extending the horizon for the spending limits to include a four-year rolling window as in Sweden or an augmented growth-based balance rule as suggested in the simulations. In addition, the anticipated increase in expenditure related to population aging suggests that a rule that targets a medium- to long-term balance consistent with debt sustainability would be desirable. With the recent stress in the euro area related to market concerns about debt sustainability, a strengthening of the system in this direction will also serve as an additional positive signal to markets. In the short term, however, it will be important that any rule implies a structural balance outcome in accordance with the European Fiscal Compact. However, given the surplus in employment pension funds, a goal of closing the sustainability gap would likely coincide with a structural balance well above the Fiscal Compact deficit limit.

Local Government Spending

24. Another shortcoming relates to the coverage of the spending limits, which leaves substantial room for expansion. For example, as recommended by the Ministry of Finance working group on the Spending Limits System (MoF, 2011), consideration could be given to bring the central government’s off-budget funds into budget finances and then encompass them within the spending limits. But even more importantly, the rapid expenditure growth in local governments suggests these should be covered in a strengthened framework. To accomplish this, the authorities could move toward a spending limits framework for the local government sector, in particular with a focus on basic municipal services. An alternative approach includes medium-term expenditure ceilings at the municipal level. However, as each municipality mainly considers its individual tax revenue, this would require substantial guidance and coordination from the central government level in order to lead to a consistent framework for the local government sector as a whole.

25. Local government obligations include general social spending. Local governments are responsible for the majority of public social and health care spending as well as education expenditure, with the exception of spending related to universities. Hence, with the rapidly aging population and its associated upward pressure on expenditure related to health and social care, improving the local government revenue and expenditure framework is becoming particularly pressing.

26. A complement to including local governments under the spending limits is to smooth their revenue stream to strengthen long-term planning. Though changes to the framework should address the main fiscal challenge for local governments, namely how to contain expenditure growth, improving the revenue base can indirectly strengthen expenditure restraint through better ability to plan. Local government revenue derives from the municipal income tax (close to 50 percent of total revenue), corporate tax, real-estate tax, central government transfers, and operating income. The income and corporate taxes are highly cyclical in nature. Hence, with strong revenue growth during economic expansions, expenditures are likely to fluctuate procyclically, leading to the necessity of difficult spending cuts when the cycle turns. Hence, a larger role for a more stable revenue source such as real estate taxes could indirectly help spending restraint. In fact, property taxes in percent of GDP in Finland are low in international comparison (OECD, 2010). Additionally, corporate tax revenue and associated cyclical fluctuations could be transferred to the central government and substituted for a cyclically adjusted and more predictable transfer from the central government to the municipalities.

Local Government Finances, 2006–11

(Nominal, annual percent change, unless otherwise indicated)

Sources: Finland Ministry of Finance and Fund staff calculations.

27. Any reform of the fiscal framework for local governments should also address the deteriorating productivity. Total productivity in local governments has been on a declining trend over the last decade with the productivity decline averaging 1 percent per year during 2003–08. According to Ministry of Finance estimates (MoF, 2010), addressing this decline can greatly contribute to closing the sustainability gap. To this end, additional mergers of municipalities that lead to a larger population base for basic services would pave the way for efficiency improvements. This can help concentrate a high level of expertise, benefitting people also in low density areas.

Local Government Productivity, 2001–08

(Annual percent change)

Sources: Statistics Finland and Fund staff calculations.

Additional Factors that Can Help Obtain the Goals

28. To limit procyclical policy under the rule, additional fiscal space should be used for debt payoff rather than fiscal stimulus. For example, in order to maintain the net asset position, revenue from the sale of shares should be used for debt payoffs and not for additional spending as currently allowed in the GP. In addition, the GP implicitly allows for pro-cyclical fiscal policy above and beyond the spending limits in the case of revenue windfall or expenditure shortfalls following faster-than-projected growth and a “clear reduction in the central government debt-to-GDP ratio before 2015.”

29. The Finnish fiscal framework could benefit from an independent fiscal council. In general, such a council could provide macroeconomic forecasts for budgeting and assess the adequacy of the spending limits set by the government to avoid a fiscal stance that is too lax or based on overly optimistic economic forecasts. In addition, it could contribute to greater transparency and credibility (Council of the European Union, 2010). Even without evidence of overly optimistic macroeconomic forecasts in the Ministry of Finance, an independent fiscal council of high intellectual capacity and credentials could improve the transparency of the budgetary process, provide a separate calculation of the sustainability gap, assess the appropriateness of the GP goals and targets, and monitor progress toward the targets during the government term. An independent fiscal council could also analyze the macro framework with a greater focus on risk analysis and the effects of potential downside scenarios. The independence, credibility, and high-level capacity of a fiscal council, however, should be its cornerstones. In this respect, the OECD highlights the case of Sweden where, though the agency is under the Ministry of Finance, its independence and credibility are assured by the stellar reputation of its mainly academic members (OECD, 2010).

E. Concluding Remarks

30. In general, when improving the Finnish fiscal framework, some aspects are particularly desirable. First, a premium should be given to clarity and simplicity as well as communication and evaluation. For example, too many targets could create inherent conflicts. Second, the implementation of a new rule should be associated with a clearly specified transition phase in order to avoid too rapid adjustment toward the appropriate long-run requirement under the rule. For example, a swift closing of the structural balance gap could lead to a large consolidation need at a time of an already negative output gap. Lastly, while ensuring fiscal sustainability, fiscal rules should also be supportive of countercyclical policy such as, for example, is the case for structural budget balance rules.

Box 7.1.Fiscal Rules in Europe

The Netherlands. The coalition agreement commits the government to budgetary rules at the beginning of the term. Revenues and expenditures are strictly separated. Expenditure ceilings are set in real terms for four years, adjusted for actual price and wage inflation, and cover central government, the social security and labor market sector, and the health care sector, with separate ceilings for each of the three areas. The real revenue framework allows for full automatic stabilization. The coalition agreement includes a medium-term budget balance path, which will require corrective action if deviation from the path is larger than 1 percent of GDP. The Netherlands Bureau for Economic Policy Analysis (CPB) provides independent macroeconomic projections for the government period and monitors the fiscal framework.

Sweden. The framework consists of a general government surplus target of 1 percent of GDP over the cycle; 4-year rolling nominal expenditure limits for central government and the old-age pension system; and a constraint that local governments cannot budget with a deficit—an ex post deficit must be corrected within three years. An independent Fiscal Policy Council assesses whether fiscal policy objectives are being achieved, evaluates economic development in a long-run perspective, and monitors and evaluates the quality of the government’s forecasts, including the underlying models.

Switzerland. The debt-brake rule sets central government expenditure ceilings, which aim at balancing the budget over the cycle. They are set annually as one-year ahead ex-ante ceilings that correspond to predicted revenues, adjusted for cyclical factors. Deviations of actual spending outcomes from ceilings are accumulated in a notional account. If the negative balance in that account exceeds 6 percent of expenditures, corrective measures sufficient to reduce the balance below this level within three years is required by law. An escape clause allows Parliament to approve deviations from the rule in exceptional circumstances.

Germany. In 2011, Germany introduced rules for both federal and state governments. The rule limits the federal structural deficit at 0.35 percent of GDP from 2016 (the end of the transition period) and allows for an escape clause that can be invoked by parliament in case of natural disasters or extraordinary emergency situations. The independent Council of Economic Experts issues an annual report with the current economic situation and associated forecasts, and the Joint Economic Forecast reports twice a year on economic developments.

Austria. 4-year rolling fixed nominal spending limit that covers about ¾ of budget expenditure. Cyclical expenditure is covered by a variable ceiling. Unused funds at the end of each year can be carried forward to future years. An independent research council (Austrian Institute of Economic Research – WIFO) delivers economic forecasts for budget planning, and the Government Debt Committee issues annual recommendations to the government on fiscal sustainability. In November 2011, the Austria Cabinet signed off on a draft law to introduce a constitutional debt limit into their fiscal policy framework. The law includes a debt brake to cut the debt level to 60 percent of GDP by 2020. Similar to the German rule, the aim is to keep the structural deficit below 0.35 percent of GDP as of 2017. A two-thirds majority in parliament is required to include the debt-brake rule into the constitution.

Box 7.2.Expenditure Limits and the 2012–15 Government Program

According to the Government Program for the 2012–5 parliamentary term, the spending limits will continue as an important part of the Finnish fiscal framework.

“Any margin created under the spending limits through price adjustments and revenue from the auctioning of emissions rights can be allocated to the repayment of debts and to meeting the strategic objectives set out in the Government Programme.”

“The Government is committed to undertake further adjustment measures if indications are that the central government debt-to-GDP ratio is not shrinking and if the central government deficit shows signs of settling at over 1% of GDP. The Government will annually monitor the achievement of these central government objectives and where necessary implement conditional measures that will be applied in equal proportions. The conditional measures include the additional freezing and adjustment of central government expenditure and transfers to local government, further tax increases and the trimming of tax deductions.

The need for additional expenditure and tax adjustments will be reviewed annually starting from the 2013–2016 central government spending limits decision. If there is a clear reduction in the central government debt-to-GDP ratio before 2015, no more than 30% of the improved fiscal position can be assigned to additional expenditure in line with the Government’s strategic objectives.”

“The Government makes a commitment to observe the spending rule set out in the Government Programme and the first spending limits decision based on that rule. The measures announced in the Government Programme will be implemented during the parliamentary term in line with the spending limits. The spending rule is designed to ensure a prudent and long-term spending policy that promotes economic stability.

The Government observes that central government expenditure as specified in the spending limits is EUR 1,215.5 million less in 2015 than the figure recorded in the technical spending limits on 23 March 2011 (EUR 40,699 billion). In addition to structural adjustments, the overall spending limits level will be revised to reflect changes in price levels.

EUR 200 million will be earmarked annually for supplementary budget needs. If annual expenditure falls below the spending limits even after supplementary budgets, the difference, up to a maximum of EUR 200 million, can be spent the following year on one-off expenditure items, spending limits notwithstanding.

If economic growth is faster than anticipated, the increased revenue and decreased expenditure will primarily be used to reduce central government debt. If there is a clear reduction in the central government debt-to-GDP ratio before 2015, no more than 30% of the improved fiscal position can be assigned to additional expenditure in line with the Government’s strategic objectives.

If annual revenue from the sale of shares exceeds EUR 400 million, a maximum of EUR 150 million of the excess can be spent on one-off, infrastructure and skills investments that promote sustainable growth.

Central government revenue from the auctioning of emissions rights can be allocated to one-off climate change and development cooperation expenditure, spending limits notwithstanding. The Government will not use tax subsidies to circumvent the spending limits in any way that clashes with the purpose of the spending rule. The spending limits are neutral with regard to changes between tax subsidies and expenditure of equal magnitude. The spending limits carry no restrictions on the re-budgeting of expenditure, on changes to the timing of expenditure items or on refunds or compensation of revenue collected at an unjustifiably high level during the parliamentary term.

The Government will review the overall situation in transport infrastructure before taking any decisions on new transport projects. The aim is to maintain a steady rate of transport route construction and stable funding from one year to the next, giving due consideration to trends in civil engineering costs. The review will take account of the economic impact of any proposed projects as well as their employment, emissions and regional policy implications.

The central government contribution to pension expenditure incurred by the Social Insurance Institution under the National Pensions Act will be brought under the spending limits system.

The following items are excluded from the spending limits:

  • unemployment security expenditure, the central government contribution to the cost of basic social assistance, pay security and housing allowances; however expenditure effects resulting from changes to the criteria for these items are included in the spending limits;

  • debt interest payments;

  • any compensation payable to other tax recipients as a result of tax changes made by central government (including social insurance contributions);

  • expenditure corresponding to technically transmitted payments and external funding contributions;

  • expenditure corresponding to revenue from betting and lottery, totalisator betting and transferred earnings from the Slot Machine Association;

  • financial investment expenditure;

  • appropriations for VAT expenditure. “

Source: Government Program (2011), English language version.

Box 7.3.Structural Balance and Expenditure Rules

Simple medium-term balance rules

There are a number of ways to specify a structural balance rule (IMF, 2009). What they all have in common is that they target the fiscal balance, adjusted for cyclical fluctuations.1

Structural balance rule

The simplest structural balance rule included here can be expressed as:

Here, bt denotes the overall fiscal balance in year t, b* is the medium-term structural balance target, a is the semi-elasticity of the budget balance with respect to the output gap, ytgap. The baseline value of a is set at 0.48 for Finland, which Girouard and Andre (2005) estimated as the overall cyclical sensitivity of the budget to the economic cycle. Hence, this value of a allows automatic stabilizer to work fully. Detailed assumptions for the countries considered can be found in the appendix.

Growth-based rule

An alternative relationship uses the growth rate of real GDP, gt, relative to the steady-state growth rate, g*, in place of the output gap:

bt = b* + a(gt - g*), a > 0.

This allows reactions to the growth rate rather than the level of GDP but could lead to procyclicality during times of rapid growth and a negative output gap.

Augmented medium-term balance rules

Augmented rules that account for the speed of adjustment can address the inherent cyclicality in the simple rules by either accelerating or delaying the adjustment to the target.

Augmented structural balance rule

In the output gap form above, this would be modified to

Here, c is the speed of correction to the deviation in the overall balance in the previous year from the target. It reduces the allowed deviation of the overall balance from the target and accelerates the adjustment, while still allowing for some degree of countercyclicality.

Augmented growth-based rule

In the growth rate form, the adjusted rule would instead read

bt = b* a(gt - g*) + e(bt-1 - b*), a > 0, 0 < e < 1.

Here, e is the speed of correction to the deviation in the overall balance in the previous year from the target. As the adjustment back to the target is delayed, the procyclicality of the rule is reduced.

Expenditure rule

An expenditure rule can be stipulated in either nominal or real terms. While several countries may not have a specific formula that formally defines the rule, one way to do this is to link expenditure growth to a prudent level of medium-term growth. In this note, we define the expenditure rule in real terms and compute expenditure growth at time t, xt, under the rule as:

xt = μ . g*,

where μ is a proportionality parameter that can be set in line with the targeted budget balance. For the present analysis, μ = 1 to allow for cross-country comparison. Hence, the rule does not correct for potential existing imbalances in the starting year.

1 We follow the approach for the UK in IMF (2010) to determine the structural balance target, b*. In particular, following Escolano (2010), with an initial debt ratio, d0, and a target, d*N, to be reached N periods later, the constant overall balance, b*, which can obtain that target can be computed asbN*=γ(1+γ)((1+γ)N1)((1+γ)NdN*d0),where γ is the long-run growth rate of nominal GDP. Alternatively, the constant overall balance, b*, that leads the actual debt ratio to asymptotically converge to the target debt ratio, d*, as N goes to infinity (if γ is positive) can be expressed asb*=γ(1+γ)d*.
F. References
Appendix 7.1. Assumptions Underlying the Fiscal Rule Simulations

Baseline parameters

The structural balance target for each of the four countries is set to lower the 2002 level of general government debt by 20 percentage points of GDP in N = 10 years. In turn, this leads to budget targets that are similar to recently announced policies. The long-run nominal GDP growth rate is computed as the sum of the average annual real GDP growth during 1970–2002 and an assumed long-run inflation rate of 2 percent. Specifically, we assume the targets for the general government balances are as follows:

Finland: The 2002 general government gross debt was D0 = 41.5 percent of GDP. Following the methodology in Box 7.3, the constant headline balance that can lower this level by 20 percentage points of GDP in 10 years yields b* = 0.5 percent of GDP. For comparison, if the Government Program target of a 1 percent of GDP deficit in central government was to be reached in 2015, IMF staff projects a corresponding general government budget balance of about 1 percent of GDP.

Netherlands: D0 = 50.5 percent of GDP. b* = 0.2 percent of GDP. For comparison, the 2010 Coalition Agreement states the government will seek the prospect of a balanced budget by 2015 and, thus, comfortably comply with the Stability and Growth Pact (CA, 2010).

Sweden: D0 = 52.5 percent of GDP. b* = 0.3 percent of GDP. For comparison, the fiscal framework includes a general government surplus target of 1 percent of GDP.

Germany: D0 = 60.7 percent of GDP. b* = -0.1 percent of GDP. For comparison, the central government structural deficit must not exceed 0.35 percent of GDP by 2016, while the states must not run a structural deficit by 2020.

Growth shock

The baseline growth rate in time t-1 is set equal to the actual rate in 2010 and kept constant thereafter. In the shock scenario, the shock happens at time t+1 when real GDP growth drops by four standard deviations (computed based on growth during 1996–2008) and the rules are implemented. The output gap is then set to close over time.

t-1tt+1t+2t+3t+4t+5t+6t+7t+8t+9
Growth assumptions
Baseline3.73.73.73.73.73.73.73.73.73.73.7
Shock3.73.7−3.12.07.05.85.55.04.03.93.7
Output gap assumptions
Baseline00000000000
Shock00−6.5−8.1−5.2−3.3−1.7−0.5−0.200

The parameters are set at the baseline values above and the constant potential growth rate, g*, is put at the 2010 growth rate. The output gap is assumed to be closed at t-1. Each rule is applied from t+1 and onward.

Prepared by Lone Christiansen.

“If the balance sheet of the current year is not estimated to show accumulated surplus, the financial plan must be in balance or show a surplus during the planning period of maximum four years. If the deficit of the balance sheet cannot be covered during the planning period, decisions shall be made in connection with the preparation of the financial plan, on the specified actions to be taken (action plan) to cover the deficit during a coverage period (coverage obligation) separately agreed upon by the council.” (http://www.kuntaportaali.org/k_perussivu.asp?path=1;161;279;280;37558;60393;60415).

Only the backward looking 10-year net lending average was marginally below the 1 percent surplus target in 2010.

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