Abstract

Against the backdrop of fiscal developments in recent decades, this section reviews the major arguments that have been put forth to adopt fiscal policy rules. It then discusses the institutional aspects of existing and proposed rules, the encompassing statutory instruments, the authority responsible for enforcing or monitoring compliance, and the actual means of enforcement.

Against the backdrop of fiscal developments in recent decades, this section reviews the major arguments that have been put forth to adopt fiscal policy rules. It then discusses the institutional aspects of existing and proposed rules, the encompassing statutory instruments, the authority responsible for enforcing or monitoring compliance, and the actual means of enforcement.

Rationale for Fiscal Rules

The rationale for fiscal policy rules needs to be examined mainly against the widespread deterioration in public finances, moderated by some attempts to reverse this trend through discretionary fiscal policy and by the recent adjustment in the run-up to EMU participation in the European Union (EU). These developments point to a twofold task: first, making a credible reduction in the fiscal deficit within a range that will stabilize the public debt ratio at a prudent level and, then, containing the debt ratio over the medium to long term. Broadly speaking, the task is to ensure fiscal discipline that contributes to price stability and is conducive to sustained economic growth. For this purpose, it is necessary to inquire whether this objective can be served better with continued efforts at discretionary correction in the context of annual budgets or medium-term adjustment plans, or, alternatively, with the design and implementation of economically sensible fiscal policy rules. As part of this inquiry, it is useful to review the specific arguments often advanced for adopting broad-based fiscal rules: macroeconomic stability; support of other financial policies, including other policy rules; sustainability of fiscal policy; avoidance of negative spillovers and adverse market reactions, especially within a common currency zone; and overall policy credibility.

The traditional rationale for fiscal policy rules is macroeconomic stability. In several Western European countries and Japan, the current budget balance rule was largely enacted to support the postwar macroeconomic stabilization; as this goal was accomplished, the rules were relaxed or abandoned.19 Although applied to a less comprehensive indicator of fiscal imbalance, limits or prohibition on government borrowing from all domestic sources (as in Indonesia) and particularly from the central bank (especially useful in some developing and transition economies) was seen as contributing to stability by removing a major source of base-money creation and thus of inflationary pressures. Against this consideration, there is concern that a rule, especially in the form of a strict balanced-budget requirement, might impair the short-run stabilization and tax-smoothing roles of fiscal policy. In this sense, a judicious mix of discretionary fiscal and monetary policies guided by targets for macro-economic performance—namely, low inflation and external balance—can be viewed as conceptually superior to fiscal rules. As noted earlier, however, the superiority of discretionary fiscal policy has not always been corroborated in practice. Moreover, often the lack of adequate fiscal discipline has reduced the countercyclical role of fiscal policy to the point of rendering it procyclical.20 If applied flexibly, fiscal rules may be seen as restoring at least a moderate countercyclical role through the operation of automatic stabilizers, rather than as constraining fiscal policymaking. In these circumstances, given the politically induced deficit bias of many governments, appropriate fiscal rules constitute a second-best solution.21

A fiscal policy rule can assist other financial policies, especially the utilization of monetary instruments, in pursuing the stabilization goal. It has been suggested (for example, in connection with EMU and the Stability and Growth Pact) that a rule that reduces budget deficits—while allowing the automatic stabilizers to work—tends to lessen the burden on monetary policy.22 By the same token, the case for fiscal discipline through fiscal rules is usually strengthened in the presence of other policy rules; specifically, certain monetary or exchange rate rules impose an implicit constraint on government deficits.23 However, an excessively rigid balanced-budget rule (such as the proposed U.S. constitutional amendment) could overburden the stabilization role of monetary policy.24

Much of the recent interest in fiscal rules has been prompted by the need to achieve or maintain long-run fiscal sustainability. In fact, the main objective of fiscal rules introduced in New Zealand and proposed in Switzerland and Japan has been to consolidate gains from earlier discretionary adjustment and to prevent a potential future increase in public indebtedness associated, for instance, with the prospective aging of the population. Similarly, rules intended for containing the public debt—possibly including a measure of unfunded contingent liabilities—relative to GDP under a certain threshold can contribute to a fair distribution of fiscal benefits and burdens across generations.25 More immediately, such rules should help moderate real interest rates in financial markets, ease crowding out of private investment, and reduce income redistribution from wage earners to interest earners.

Historically, fiscal rules have been utilized at various levels of government for the avoidance of negative spillovers within a federation, confederation, or currency area.26 A fiscal rule restraining subnational government deficits prevents externalities from fiscal misbehavior in one jurisdiction from being transmitted, through credit downgrading and concomitantly higher interest charges, to other subnational jurisdictions and to the national government—with the stabilization function generally to be exercised at the national or federal level. This argument has been applied to member countries of a confederation-cum-monetary union (as in the case of EMU)—the argument being stronger, the larger the weight of each member’s budget in relation to the confederation or supranational budget.27 Also, it is relevant, perhaps to a lesser extent, to all countries in the international economy.28 The rationale for preventing the accumulation of deficits at lower levels of government (such as through the rules adopted in most U.S. states) is compounded by the potential interest risk premium on debt at those levels in the absence of an explicit or implicit bailout commitment by the national (or supranational) government.29 Conversely, it is feared that profligate fiscal policies at lower jurisdictions generate pressures for a bailout that the common (supranational) monetary authority may find difficult to resist.30

A fiscal rule can be useful for ensuring the credibility of government policy over time. Stated differently, a major advantage of rules-based policies over a discretionary approach is time consistency.31 This is crucial in countries with a track record characterized by wide swings: periods of poor fiscal performance alternating with market-imposed adjustments, followed again by unsustainable deficit spending, and so forth. To gain the lasting confidence of financial markets, households, and enterprises, governments may need to subject themselves to permanent constraints on deficits, borrowing, or debt.32 As an example, in Costa Rica, the balanced-budget rule has been proposed with a view to eliminating deficits caused by the electoral cycle.33 More generally, given the considerable danger in postponed adjustment, such a rule may be helpful when the electorate is prone to overlook—under the so-called fiscal illusion—the consequences of a deterioration in sustainability or when creditors may not accurately judge default risk in lending to sovereign borrowers. In fact, an upgrading or downgrading by international credit-rating agencies tend to take place with a considerable lag, following either a substantial improvement or a substantial deterioration in performance indicators. In brief, fiscal rules can help reduce or remove the influence of short-run political expediency that leads to a deficit bias,34 especially in an environment where policymakers are exposed periodically (especially before elections) to strong, often conflicting, pressures to relax the fiscal stance.

In practice, it may be difficult to attain sustainability, to avoid negative spillovers, or to gain policy credibility, with or without a fiscal rule, in the absence of a sufficiently widespread perception of the need for enforcing fiscal discipline. Yet a country experiencing extraordinary fiscal stress in the midst of a major financial crisis may have no alternative but to submit to a fiscal rule to restore policy credibility. Particularly once the initial adjustment has been completed, a well-designed rule may be useful in preventing reversion to failed discretionary policies. Less often, such a rule may be perceived as necessary to avert a future deterioration in fiscal performance, in view of, say, future demographic pressures under a generous system of entitlements. In either case, essentially the rule represents the constraint that, under a discretionary regime, would be imposed—probably at a much higher cost—by financial markets. In these circumstances, a well-designed fiscal rule (Section IV) may prove to be an effective proxy for the discipline sought by a far-sighted electorate.

Institutional Arrangements

Statutory Basis

The statutory basis of existing and proposed fiscal rules can be found in a variety of instruments: constitution, law, regulation, policy guideline, or international treaty. The instrument selected by a given country is largely a function of custom, legal precedent, or convention. Although a constitutional provision or amendment would be expected to carry much greater weight than a law or a policy guideline, the latter may in fact be equally or even more binding.

To illustrate the point, in Germany, for both the federal and most Lander governments, the balanced-budget rule is stipulated in the constitution and confirmed in the respective budget laws. Similarly, the fiscal rules proposed in Costa Rica, Switzerland, and the United States require passage of a constitutional amendment. The majority of U.S. states with fiscal rules have some constitutional requirement (approved through a state referendum) to balance the budget, whereas the others rely on legislation enacted at the state level. Yet, while in most U.S. states fiscal rules are strictly enforced, in Germany they often are not realized and rarely attract a judicial challenge.

Among the countries that follow the legislative approach, New Zealand’s Fiscal Responsibility Act of 1994 requires the government to abide by principles of responsible fiscal management, including maintenance of a balanced operating budget. These principles allow for some flexibility in implementation but are subject to strict standards of transparency.35 Although all rules, including those prescribed by legislation, are intended to apply strictly and permanently—over successive governments—they are, in practice, open to some interpretation and conceivably can be revised, suspended, or repealed through subsequent legislative action. In Japan, for example, the Public Finance Law of 1947, which limits the issuance of government bonds (“construction” bonds) to finance public investment, has been overridden through legislation every year since 1975 to allow the issuance of bonds for the general financing of budget deficits. However, the present government intends to reinstate the original legislation.36 At the subnational government level, in the first half of the 1990s, the majority of Canadian provinces and territories enacted legislation requiring budget balance or limiting the deficit.

Indonesia and the Netherlands provide examples of rules based on policy guidelines. In Indonesia, the fiscal rule is contained in the Guidelines for State Policy. Although these guidelines are not formally backed by law, they have been followed by the ministry of finance in the formulation and execution of the budget. In the Netherlands, the structural deficit ceiling, which was introduced as a policy norm in 1961, was abandoned in 1974 after a number of nontransparent recalculations were made partly to accommodate a widening budget deficit.37 Under a more recent approach, introduced in 1995, the Netherlands is pursuing a similar rule to meet the EMU deficit reference value in a transparent manner.38

Limits on, or prohibition of, central bank credits to governments are usually stated in the central bank statutes. An exception is the United Kingdom, where the prohibition is based on tradition. In the CFA franc zone, the limit is reinforced by an international treaty. Similarly, under the Maastricht Treaty, participation in EMU requires EU member countries to abstain from direct central bank financing of government, to meet the budget deficit ceiling—while targeting a balance or surplus over the medium term—and to show satisfactory progress toward the debt reference value. Although, in principle, EU members that are not able to fulfill these fiscal criteria are not eligible to participate in EMU (Stage 3), the treaty allows considerable scope for judgment in the application of the reference value on debt.

More specialized rules targeting the accumulation of a minimum level of contingency reserves in an insurance-based extrabudgetary fund are usually supported by a policy guideline or legislation. In the United States, the target ratio of public pension reserves to annual benefits has been set by the Board of Trustees of the Social Security Trust Funds, which is fully accountable to the public; in Canada, the target ratio is prescribed under the Canadian Pension Plan Act. In Chile, the contingency reserve requirement under the Copper Compensatory Fund was formally enacted in 1986.

Authority

Enforcement of restrictions on central bank financing of budget deficits usually rests with the central bank or, in some cases, with the department or agency in charge of budget execution, under the authority of the ministry of finance. More generally, a higher competent authority, possibly independent of the executive branch, acts as a referee or renders judgment to determine compliance with fiscal policy rules. In countries where national or subnational rules are incorporated in the constitution, stewardship is normally entrusted to the supreme court at the national or subnational jurisdiction.

On the other hand, in Indonesia and New Zealand, both enforcement and monitoring of the rules have been exercised quite effectively by the ministry of finance within the executive branch. Moreover, in New Zealand, a high degree of transparency is ensured by a formal requirement, which is binding on both the minister of finance and the secretary to the treasury.39 By contrast, in the Netherlands, the government consistently failed to enforce the former structural deficit ceiling. In the United States, responsibility for compliance with the reserve rule lies with the Social Security Administration, under the authority of the Board of Trustees of the Social Security Trust Funds, which is directly responsible to Congress. In Chile, oversight of the Copper Compensation Fund is exercised jointly by the central bank, the state-owned copper corporation (CODELCO), the treasury, and the budget office of the ministry of finance.

Surveillance over convergence to, and observance of, the Maastricht Treaty criteria is to be assumed by the EU Council of Ministers—on the basis of monitoring by the European Commission—which meets periodically for this purpose. In the CFA franc zone, authority over borrowing limits is vested in the two regional central banks, namely, the Banque Centrale des Etats de I’Afrique de I’Ouest (BCEAO) and Banque des Etats de I’Afrique Centrale (BEAC). In most countries, judgment over observance of limits on central bank credit to government rests in principle with the courts.

These examples indicate that, depending on the specific circumstances and tradition of a given country, fiscal rules can be enforced effectively even by an entity close to, or within, the government. Nevertheless, a certain degree of independence for the supervisory body is desirable to ensure adherence to the rules. Also, the more complex a set of rules, the greater the need for a technically competent supervisory authority.40

Method of Implementation

A key question determining implementation is whether the rule must be complied with merely ex ante, that is, at the time of budget approval, or also ex post, during the budget execution. Obviously, although the first step is always a necessary condition, only the second step can be sufficient to ensure compliance. Moreover, assuming that major aggregates—budget balance, financing, or expenditure levels—in the enacted budget are consistent with the rule, there are three essential elements of implementation: availability of automatic or discretionary contingency measures during budget execution; provision for safeguards or escape clauses (or unintended loopholes); and effectiveness of sanctions for non-compliance with the rule.

Concerning the initial question, with the exception of mostly subnational jurisdictions (some U.S. states and all German Lander) where the rule can be met simply by approval of a balanced current budget (that is, legislative enactment), virtually all rules also require actual implementation. Usually, ex ante compliance with the rule implies that the legislative debate and action affect the composition of expenditures but not the aggregates subject to the rule.41 Once the budget is enacted, the authorities must focus, in the course of the fiscal year, on implementing the budget, keeping within the limits consistent with the rule, and availing themselves of the budget control and execution techniques at their disposal. Alternatively, they may attempt to resort to formal or informal escape clauses or safeguards to avoid breaching those limits.

Among existing rules, only some U.S. states are known to prescribe automatic contingency measures—such as uniform expenditure cuts or imposition of, say, a surtax—in response to an unexpected revenue loss or expenditure overrun.42 Under a variant of the rule proposed in Switzerland, the Federal Council would be authorized to cut various subsidies in order to prevent an excess deficit. However, under certain rules, including those setting limits on deficit financing, there is scope for bypassing the rule through alternative channels. For example, Indonesia’s rule permits recourse to extrabudgetary operations. Some U.S. states allow for carryover of spending authorizations to the following fiscal year. Less formally, a no-borrowing rule—if tantamount to a cash budget balance rule—could induce a government to invoke cash limits or to sequester funds, accompanied by a buildup of arrears.

To strengthen their effectiveness, fiscal policy rules should be specified insofar as possible in terms of accrual-based recording and in reference to the general government (as done under EMU), or to the entire public sector when necessary to capture widespread quasi-fiscal activities (as in Costa Rica). Under the excessive deficit procedure of EMU, as indicated above, adherence to the deficit and debt limits will be subject to EU Council surveillance. If warranted, the Council may initiate waivers for any deficits in excess of the ceiling; such waivers, granted in “exceptional circumstances,” would require a numerical test of a recession or judgment by a qualified majority in the Council. Of course, EMU and the Stability and Growth Pact may be buttressed with specific rules at the national level in each EU member country (as in the Netherlands). Normally, such national rules need to prescribe internal procedures, including the nature and timing of contingency measures and the circumstances that would trigger their implementation—whether automatically or through a supplementary budget.43 In Switzerland, the proposed constitutional amendments would contain contingency measures for compliance as well as escape clauses that permit fiscal policy to respond to large unfavorable shocks. By contrast, in Germany and Costa Rica, actual and proposed rules fail to specify the circumstances and the escape clauses that allow deviation from the basic rule. In the United States, under the proposed constitutional amendment, deficits would be permitted only in extreme situations.44 Unlike in most other countries, where the fiscal rules leave some latitude for circumvention or creative accounting, in New Zealand the scope for such practices has been minimized.45

The final deterrent for noncompliance consists of a set of financial, judicial, or reputational penalties for nonobservance. The penalty can take the form of a reduced ceiling—in the amount of the excess in the preceding year—in the fiscal year that follows, as practiced in some U.S. states. In the context of an international treaty, the government may be penalized financially. The Maastricht Treaty provides, in principle, scope for the imposition of financial sanctions for the violation of EMU reference values on deficits or debt. Whereas in practice no such penalties are envisaged for noncompliance with the debt reference value, the Stability and Growth Pact imposes financial sanctions for excesses above the deficit reference value. Each percentage point of excess deficit above the 3 percent of GDP reference value would oblige the transgressing EU member country to make an interest-free deposit of up to ½ of 1 percent of GDP if the excess were not corrected by the following year—unless the excess is attributable to “exceptional circumstances.”46 Failure to take corrective action over a two-year period would convert the deposit into a transfer to the EU budget. In one Canadian province (Manitoba) the law provides for a penalty, consisting of cuts in cabinet members‘ salaries, in the event of budget deficits that are not caused by exogenous shocks. In the CFA franc zone, similar financial penalties are applicable for any excess over the limit on central bank advances to the government. In many other cases, violation of fiscal rules may entail an unfavorable court decision on the noncomplying government, at the national or subnational level.

Quite apart from any financial or judicial penalties, noncompliance usually entails loss of prestige by the government before the electorate and financial markets. In New Zealand, for example, noncompliance carries a reputational penalty for the transgressing government. In the EU, the failure of member governments to meet the EMU reference value for the public debt ratio would result in a reputational cost. Likewise, in Switzerland, nonobservance of the proposed constitutional amendments would be accompanied by a loss in prestige for the government.47

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