Abstract

The preceding section suggests that appropriate rules-based fiscal policies could correct the deficit bias—often encountered with discretionary policies—and lead to improved economic performance. On the basis of limited experience, including the recent convergence toward the EMU reference value for deficits, it appears that adherence to fiscal rules can help moderate inflation and reduce interest rates, and thereby contribute to investment and growth. As noted above, in developing economies, rules that restrict government borrowing from domestic sources may, however, be associated with a significant buildup of external indebtedness. According to the experience of the U.S. states and stochastic simulations for the advanced economies, fiscal rules contribute only marginally to short-run variability in output provided they allow for the operation of automatic stabilizers. As with many adjustment episodes (including those relying on discretionary measures), fiscal rules often have been implemented through cuts in investment expenditures, tax increases, and various one-off measures, rather than through much-needed structural reform. Thus, the favorable effect of fiscal rules on growth has not been fully realized.

The preceding section suggests that appropriate rules-based fiscal policies could correct the deficit bias—often encountered with discretionary policies—and lead to improved economic performance. On the basis of limited experience, including the recent convergence toward the EMU reference value for deficits, it appears that adherence to fiscal rules can help moderate inflation and reduce interest rates, and thereby contribute to investment and growth. As noted above, in developing economies, rules that restrict government borrowing from domestic sources may, however, be associated with a significant buildup of external indebtedness. According to the experience of the U.S. states and stochastic simulations for the advanced economies, fiscal rules contribute only marginally to short-run variability in output provided they allow for the operation of automatic stabilizers. As with many adjustment episodes (including those relying on discretionary measures), fiscal rules often have been implemented through cuts in investment expenditures, tax increases, and various one-off measures, rather than through much-needed structural reform. Thus, the favorable effect of fiscal rules on growth has not been fully realized.

Nevertheless, as always, it is difficult to judge the counterfactual to fiscal rules. Since, in principle, the same results could have obtained with the implementation of sensible discretionary policy, the question that must be explored is why the latter occurred in so few cases. In an attempt to answer this, the present section discusses the political economy of fiscal rules and provides an outline of the desirable characteristics of a fiscal rule and the circumstances in which it should be adopted. The section concludes with an inquiry as to the scope for IMF involvement in this area.

Political Economy

Probably the most powerful argument for fiscal rules centers on their political economy aspects. According to this argument, democratically elected (especially coalition) governments have a built-in bias to deficits, and thereby toward redistributing income from future (mostly unborn) generations to the present generation of voters. Because of their sensitivity to electoral pressures, most of these governments are incapable of correcting the bias without a higher-order—possibly constitutional—constraint on fiscal policy.69 The difficulty they face in taking corrective action is, of course, exacerbated in countries with aging populations and rigid social entitlements.

Similarly, it can be argued that the potential benefits of fiscal rules over discretionary policies ensue from the credibility of lasting commitment to fiscal discipline or, in other words, from the time consistency of rules in the eyes of rational private decision makers.70 Enhanced credibility of the government (1) facilitates access to financial markets at a much lower cost for the government, as well as for all economic agents, and (2) ensures the support and confidence of the electorate. The upshot is likely to be a virtuous circle of sustained macroeconomic stability, sustained investment, and growth.

Setting statutory—preferably legal or constitutional—constraints on key fiscal performance indicators may be a necessary, but not sufficient, condition for the successful pursuit of a fiscal policy rule; that is, a formal rule, by itself, may not guarantee fiscal discipline (such a case being the Netherlands in the 1970s). For the rule to be effective and fully credible, it must be underpinned by a widely shared commitment, embraced over time by a succession of governments (of differing political persuasions), and observed as intended.71 Such commitment is usually either based on the memory of a past major financial crisis (as in Indonesia in the mid-1960s)72 or inspired by a future challenge (aging population in Switzerland) or goal (creating a common currency area under EMU), and must be repeatedly confirmed in various ways by the authorities.73 Without sufficient commitment, the authorities, in some cases with the implicit consent (collusion) of the legislature or the judiciary, may attempt to circumvent the rule through a variety of available means, most commonly by resorting to creative accounting schemes or by exploiting ambiguities in the institutional coverage of the rule.74 Conversely, without a formal fiscal rule, commitment alone may not ensure prudent policy action; a committed but weak government may need to invoke a fiscal rule for implementing certain unpopular, yet necessary, adjustment measures.

To be fully credible, a fiscal rule must pass two tests: it must have a track record of satisfactory compliance and it must be supported by well-specified future policy measures, including, if necessary, deep structural reforms. At present, there are relatively few cases (mainly some U.S. states) that meet the first test, besides the widely adopted prohibition of central bank financing of government deficits. The second test has yet to be passed in many countries that have enacted fiscal rules.

Adherence to fiscal rules over the medium to long run would often be problematic unless major structural reforms were undertaken, most importantly in the area of mandatory social entitlement programs.75 As reflected in the present value of net unfunded liabilities of social security systems,76 population aging, combined with rising health care costs, poses for some advanced economies a formidable burden for future compliance with fiscal rules. To realize fully the credibility gains from fiscal policy rules in these countries, it is essential to create an early consensus for reforming public pensions and health care programs and to initiate implementation of these reforms, rather than to rely on one-off or cosmetic steps to launch the rule while postponing the actual adjustment.

Characteristics of a Model Fiscal Rule

The foregoing assessment of existing and proposed rules implies the principal characteristics of a model fiscal policy rule or set of rules. Ideally, a fiscal rule should be well defined, transparent, adequate, consistent, simple, flexible, enforceable, and efficient. In any case, the rule should, preferably, be fully adopted following a process of convergence.

A fiscal rule should be well defined as to the indicator to be constrained, the institutional coverage, and specific escape clauses, in order to avoid ambiguities and ineffective enforcement. On these grounds, for example, a rule defined in terms of the overall balance is preferable to one aimed at the current balance (requiring balance between current revenue and current expenditure), as investment expenditure suffers from both conceptual and measurement weaknesses. Also, limitations in the institutional coverage of the government budget—excluding off-budget operations and the cost of quasi-fiscal activities of public enterprises—are an invitation to leakages. It is for this reason, for instance, that the proposed deficit ceiling in Costa Rica is intended to cover the entire public sector. As an exception, however, it may be desirable to exclude social security funds from a balanced-budget rule (as it was implemented in Japan) to ensure the accumulation of surpluses to cover future contingent liabilities. Finally, the circumstances for invoking escape clauses need to be defined as precisely as possible in advance. Attempts at specifying the circumstances that permit noncompliance with the statutory limits on budget deficits have been made in the Stability and Growth Pact and in the proposed Swiss and U.S. constitutional amendments.

An essential characteristic of a durable fiscal rule is transparency in government operations, including accounting, forecasting, and institutional arrangements.77 Opaque fiscal policy intentions and recourse to creative accounting or misrepresentation of the true magnitude and timing of future fiscal obligations—usually in the form of commitments and contingent liabilities—are likely to undermine the rule and the popular support that it requires. Among the countries that set a target or ceiling on the budget balance, New Zealand stands out as having the most transparent approach—with emphasis on accountability for fiscal performance—and the most likely to command the support of the electorate.

Fiscal rules should be adequate with respect to the specified proximate goal. If the goal is to reduce the inflation rate and the extraction of revenue from seigniorage, the rule should, as is done in many countries, restrict government access to central bank financing or, as in Indonesia, prohibit domestic borrowing altogether. However, if, in addition, the objective is to avoid a buildup of external debt, then the constraint should be imposed on the budget balance as a whole. Alternatively, sustainability of the public debt–GDP ratio would require a rule expressed as a maximum and nonincreasing debt ratio—or, more precisely, as a minimum primary surplus, in proportion to GDP, that is equivalent to or larger than the projected difference between the interest rate and the growth rate in the economy.

A closely related criterion is for a set of fiscal rules to be consistent internally, as well as with other macroeconomic policies or policy rules. A fixed nominal exchange rate should be accompanied by an explicit restriction on monetizing budget deficits. Similarly, a currency board arrangement implicitly imposes a limitation on domestic bank financing of budget deficits. The EMU fiscal reference values for debt and deficits are numerically consistent under certain reasonable macroeconomic assumptions.78

Rules should be characterized by simplicity to enhance their appeal to the legislature and to the public.79 This partly explains the strong political support for the proposed balanced-budget constitutional amendment in the United States, as compared, for example, with the Netherlands’ structural deficit limit, which was derived from periodically updated estimates of the output gap. Similarly, prohibition is superior to limits on central bank financing of budget deficits because the latter requires fine-tuning specific numerical ceilings, usually determined as a proportion of lagged government revenue or expenditure.

Rules must be flexible to accommodate exogenous shocks beyond the control of the authorities. Flexibility can be obtained with balanced-budget rules defined over a medium-term horizon by requiring a structural or cyclically adjusted balance, thus permitting explicitly short-run cyclical deviations from balance, through the operation of automatic stabilizers. Such broadly defined rules were followed in the Netherlands, adopted in New Zealand, envisaged under the Stability and Growth Pact (constrained by the deficit reference value), and proposed in Switzerland.80 In a different context, central bank advances to the government during the year (and subject to full repayment by the end of the year) provide some flexibility under a rule prohibiting government access to central bank credit.

A fiscal rule should be enforceable. Country experience indicates that institutional arrangements, including penalties, vary widely across countries without a clear pattern as to which arrangement is the most effective. An implication is the need for constitutional or legal statutes, possibly accompanied by penalties for noncompliance and authority for enforcement, that are most appropriate for each country. The consequences of noncompliance, whether in the form of financial, judicial, or reputational sanctions, should be clearly agreed upon. Needless to say, implementation of the rule must be within the control of the government. However, there is a case for appointing an independent authority—a role that can be assumed ultimately by the courts—to be responsible for monitoring compliance with the rule and with the underlying accounting and procedural standards.

Most rules cannot last for long unless they are supported by efficient policy actions. A balanced-budget target can be met at a given time through recourse to one-off measures, such as those recently introduced by some EU member countries to converge to the EMU reference values. However, these should be regarded only as temporary stopgap measures, allowing time for the preparation and implementation of more fundamental reforms to ensure continued adherence to the rule in the future. From this perspective, as suggested above, a fiscal rule may be viewed as a catalyst for fiscal reforms that would be necessary anyway to ensure sustainability.

None of the rules reviewed in this paper combines fully all desirable attributes, partly because of the inevitable trade-offs among some of them. For example, the more flexible a rule, the less likely it is to be simple, as illustrated by various structural or cyclically adjusted balanced-budget rules. More generally, the credibility of a rule is likely to be stronger in the case of a simple, transparent, consistent, and enforceable rule. In addition, as with other rules-based policies, there is a distinct trade-off between credibility and flexibility.81 Indeed, at the limit, a highly flexible rule borders on discretion. Subject to these caveats, the approach adopted by New Zealand and by EMU participants, as well as the rules under consideration in Switzerland, all seem to display most of the above characteristics. The case of New Zealand is remarkable for its high degree of transparency and flexibility, perhaps at some cost in enforcement capacity and simplicity. Although in several EU member countries the EMU fiscal reference values have been pursued with less efficient policy measures, they are carefully defined, adequate, and consistent, yet sufficiently simple, flexible, and enforceable. On the other hand, the main advantage of the U.S. constitutional amendment is its simplicity, while lacking above all sufficient flexibility.

There have been a number of cases where, almost immediately following a severe financial crisis, governments have introduced a rules-based regime, including a fiscal rule, to restore severely eroded credibility. Although necessary under the circumstances, such an approach is far from ideal, in view of the likely difficulty of supporting the durability of the rule with a set of structural reforms built on broad popular consensus. By and large, it is preferable to prepare well in advance for the adoption of a fiscal rule through a carefully mapped out convergence plan. Such gradual implementation, for example, is being followed in Switzerland and Japan, where the authorities have set a budget target (balance or deficit limit) to be met in the context of a medium-term adjustment plan, prior to formal introduction of the rule. Similarly, New Zealand had followed a successful discretionary fiscal adjustment path, netting budget surpluses, over several years before enacting the rule. Somewhat less satisfactory was the recent experience of a number of EU members, where convergence to participation in EMU has been aimed at barely meeting the deficit reference value rather than the medium-term balanced-budget target specified in the Stability and Growth Pact.82 Broadly speaking, these examples suggest that a fiscal rule with many of the above characteristics could be most effective after discretionary policy has been successful at restoring or achieving fiscal discipline. Again, however, discretionary action during convergence should, to the extent possible, consist mainly of structural reforms that will ensure the durability of the rule.

Implications for IMF Involvement

Potentially useful lessons can be derived from the experience with, or from the likely future prospects for, fiscal policy rules in a number of IMF member countries. Some of these lessons relate to IMF involvement in fiscal policy issues through surveillance, as well as financial or technical assistance. Generally, in line with its concern for fiscal discipline, the IMF has supported fiscal policy rules adopted by member countries as long as such rules broadly conform with the foregoing characteristics of a model fiscal rule. Recently, for example, through Article IV consultation discussions with EU members, the World Economic Outlook (WEO) exercise, and consideration of special Executive Board papers, the IMF has closely monitored and encouraged convergence toward the fiscal criteria under EMU. At the same time, it has alerted the authorities to the risks involved if certain fundamental conditions for EMU participation are not in place or if automatic stabilizers are not allowed to work in the short run. Also, for instance, in the Article IV consultation discussions with Switzerland, the IMF has expressed support for the constitutional amendments under consideration.

In the context of stand-by arrangements, member countries have been encouraged to maintain or approach fiscal balance, with a view to abiding by the implicit fiscal rule under currency board arrangements (Argentina and Estonia) or in preparation for an explicit fiscal rule (Costa Rica). More often, the IMF has advocated limiting budget deficit financing to nonbank sources and, in particular, prohibiting the recourse to central bank financing.

Although on a relatively modest scale, technical assistance in public debt management provided by the IMF’s Fiscal Affairs and Monetary and Exchange Affairs Departments has included recommendations for diversifying budget deficit financing to nonbank sources and phasing out financing from bank sources. In a few cases, member countries have asked the Fiscal Affairs Department to review an existing fiscal policy rule and suggest improvements.

In general, advice in this area is guided primarily by the premise that the pursuit of fiscal rectitude, aimed at underpinning sustained growth, is likely to be more beneficial to the member country in question and the rest of the world than attempts to engage in short-run international coordination of fiscal policies—through fine-tuned discretionary action—at the risk of sacrificing the country‘s long-run sustainability.83 In this context, if a country chooses to adopt a fiscal policy rule, the IMF seeks to provide a balanced and realistic assessment while raising the authorities‘ awareness of the potential downside associated with either noncompliance or compliance through one-off measures. Above all, it is necessary to stress the importance of following a well-designed rule (with the characteristics outlined above), both in letter and in spirit. Absent the appropriate conditions, the authorities are usually encouraged to introduce a credible medium-term fiscal adjustment program. Only upon satisfactory performance under such an adjustment program or as part of a comprehensive and consistent set of macroeconomic policy initiatives—with or without support by the IMF—should the option of introducing a rule be seriously considered by the authorities. If possible, as suggested above, a formal rule should be implemented following a successful discretionary adjustment.84

The IMF‘s Fiscal Affairs Department, if requested, stands ready to comment on the design and operation of fiscal policy rules. The appropriate vehicle for the latter is technical assistance in macroeconomic fiscal management, which is already being provided to some member countries. In addition, assistance can be provided to help design or review rules for subnational governments in the context of improving the assignment of revenue and expenditure among different levels of government. Assistance in enhancing the effective operation of rules, including improving the budget process and the transparency of government accounts, is also available.

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