Abstract

To identify some of the shortcomings that fiscal rules may seek to address, this section provides an overview of how fiscal policy has been conducted in recent years in the countries under consideration. It also examines the institutional context in which such policies are formulated.

Fiscal Policy in Practice: An Overview

To identify some of the shortcomings that fiscal rules may seek to address, this section provides an overview of how fiscal policy has been conducted in recent years in the countries under consideration. It also examines the institutional context in which such policies are formulated.

Fiscal Consolidation in the 1990s

Fiscal deficits and public debt grew throughout much of the postwar period in most industrial countries under the pressure of rising public expenditure, a trend that began to reverse after 1992 (IMF, 2001). The improvement in the government financial position was fairly universal, with Japan being a notable exception. However, as shown in Figure 2.1, the largest turnaround was probably in a group of mainly English-speaking industrial countries (Australia, Canada, New Zealand, the United Kingdom, and the United States), where relatively fast economic growth also facilitated the process of consolidation. Fiscal adjustment in advanced countries was based especially on expenditure restraint, though tax increases played a larger role in the euro area—particularly in France and Germany (Figure 2.2).3

Figure 2.1.
Figure 2.1.

Government Revenue, Expenditure, and Debt

(In percent of GDP; revenue and expenditure, left scale; debt, right scale)

Source: OECD Analytical and Economic Databases (UMTS receipts are excluded from revenue and disbursement).1 This group includes Australia, Canada, New Zealand, United Kingdom, and United States.

A number of studies argue that fiscal consolidation associated with expenditure restraint, particularly reductions in primary current expenditure, has proved more durable historically.4Figure 2.2 indicates that the adjustment effort on transfers and subsidies has been relatively modest or nonexistent in the four countries covered in this study. Furthermore, in contrast with Anglophone countries (and with the possible exception of Spain), spending on goods and services remained near historical highs at the end of the decade. It is also troubling that reduced capital outlays accompanied the decline in expenditure ratios in the euro area, although this may partly reflect privatization. The consolidation was helped by an increase in revenues, which further raised the already high tax burden (Figure 2.3). In the four countries under study, the tendency has been to reduce direct taxes and social security contributions and rely more heavily on indirect taxes.

Figure 2.2.
Figure 2.2.

Composition of Expenditures

(In percent of GDP)

Source: OECD Analytical and Economic Databases (UMTS receipts are excluded).1 This group includes Australia, Canada, New Zealand, United Kingdom, and United States.
Figure 2.3.
Figure 2.3.

Composition of Revenue

(In percent of GDP)

Source: OECD Analytical and Economic Databases (UMTS receipts are excluded).1 This group includes Australia, Canada, New Zealand, United Kingdom, and United States.

All in all, the fiscal consolidation necessary for the four countries to qualify for the European Monetary Union (EMU) was a major achievement but also a difficult process. While several temporary tax increases were enacted, primary current expenditure reduction was limited, raising questions about the durability of the improvements in the public accounts.

The Current Fiscal Position and the Medium-Term Outlook

After the inception of EMU in 1999, further progress in fiscal adjustment was made, but this was supported by favorable cyclical conditions that yielded revenue overperformance. Structural progress was limited, as became evident once the cycle turned in 2001-02 (Table 2.1). Looking ahead, however, debt levels remain high, and in Italy very high. Despite recent tax relief, the tax burden (except in Spain) remains higher than in other industrial countries (Table 2.2). The taxation of labor remains particularly heavy because of large social security contributions (Table 2.3). In Spain, the need to upgrade infrastructure is expected to put upward pressure on government expenditures in the medium term.

Table 2.1.

General Government Balance and Debt, 2001–02

(In percent of GDP)

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Sources: Eurostat; and World Economic Outlook database.
Table 2.2.

Total Tax Revenue, 2000

(In percent of GDP)

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Source: Organization for Economic Cooperation and Development (OECD).
Table 2.3.

Total Tax Wedge, Including Employer’s Social Security Contributions for Married Worker with Two Children

(Average rate in percent)

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Source: OECD.

In the medium and long term, population aging is expected to raise the financial burden of pensions and health care, although the timing differs with demography in the four countries (Table 2.4). Further pension and health-care reform and policies to foster employment and growth can ease the pressure on the budget; however, the need to safeguard pensioners’ standard of living and growing preference for a shorter work life suggest that reforms alone may not eliminate the problem. Thus, the net asset position of the four public sectors needs to improve in order to make room for additional spending without compromising sustainability.

Table 2.4.

Pension Expenditure Projections

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Source: Economic Policy Committee, ECOFIN.

Assumed to be 5 percentage points lower than in the central scenario by 2050.

Assumed to fall to between 3 and 5 percent by 2050.

Assumed to be 1 percentage point lower than in the central scenario.

Fiscal Policy and the Business Cycle

An important characteristic of fiscal policy is its potential role as a tool to stabilize aggregate demand shocks. This role is arguably more important in countries belonging to a monetary union, where monetary policy is set to respond to area-wide developments and not to country-specific shocks.5 In Western Europe, inflexible labor markets may also reinforce the need for countercyclical policies. A criticism levied at fiscal rules is that, by limiting discretion, they take away an important instrument of macroeconomic stabilization and may even cause fiscal policy to be procyclical. In practice, however, this loss may not be so important if, under discretion, fiscal policy tends not to be used for stabilization.6 For instance, there may be a tendency to introduce new spending programs during cyclical upturns when budgetary resources are more easily available, resulting in a procyclical fiscal stance. In this case, fiscal rules that limit spending or the deficit may actually reduce procyclicality. In addition, by making fiscal policy more stable and predictable, fiscal rules may reduce a source of shocks to aggregate demand.

To shed some light on these issues, this section briefly explores fiscal policy over the cycle in the four countries. Figure 2.4 plots an indicator of the cyclical situation (the output gap) against two indicators of the fiscal policy stance, the change in the overall balance and the change in the structural primary balance (the fiscal “impulse”). According to this definition, a positive impulse corresponds to an improvement in the structural balance, and hence to a discretionary fiscal contraction. The period examined ends at the start of the EMU fiscal consolidation, when fiscal policy was arguably no longer free to react to the cycle. If fiscal policy is countercyclical, periods of negative output gap should be accompanied by a deteriorating fiscal balance and vice versa. A deteriorating balance may reflect the operation of automatic stabilizers or discretionary measures. The fiscal impulse is used as a proxy of the discretionary components of fiscal policy, although this measure has well-known shortcomings.7 Accordingly, if during a recession the deficit is widening but the structural primary balance improves, then discretionary intervention partly offsets the automatic stabilizers and vice versa.

Figure 2.4.
Figure 2.4.

Fiscal Policy and the Cycle

(In percent of GDP)

Source: OECD.Note: The impulse is defined as the change in the structural primary balance.

In the four countries, fiscal policy was not consistently countercyclical (Figure 2.4). While deficits typically widened at the beginning of a downturn, thus presumably helping to cushion the effects of the adverse shock, the impulse often became contractionary as the recession continued. Likewise, the fiscal accounts often did not improve substantially during expansions, as higher-than-normal revenues were spent or used for tax cuts. Table 2.5 summarizes some of the information in Figure 2.4. In every country, the fiscal impulse is negatively correlated with the output gap, suggesting overall procyclicality, except in Spain, where the correlation is close to zero. The negative correlation is even stronger when the output gap is lagged, suggesting that procyclicality is not explained by delays in learning about the structural position. An alternative measure of procyclicality is the fraction of observations for which the output gap and the impulse have opposite signs. This fraction is above 50 percent in all four countries, confirming the procyclical nature of fiscal policy.8

Table 2.5.

Fiscal Policy and the Cycle Before the Maastricht Treaty

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Sources: OECD; and IMF staff calculations.

Percentage of years in which output gap and change in the primary structural balance had different signs.

Percentage of periods with positive output gap in which primary structural balance deteriorated.

Percentage of periods with negative output gap in which the primary structural balance improved.

Interestingly, the four countries found it especially difficult to save the cyclical component of the improvement in the balance during expansions (Table 2.5).9 However, why was fiscal policy so seldom countercyclical? One possible answer is that policy-makers deliberately avoided finetuning because output gaps are difficult to gauge and fiscal policy effects are delayed. In addition, monetary policy was available to smooth the cycle, especially in the early years when substantial capital controls were still in place. These considerations, however, at best explain a neutral, not a procyclical, fiscal impulse. Fiscal tightening in the late phase of a downturn may be caused by the deficit becoming unsustainable (economically or politically) after rising sharply early on, thus forcing a discretionary contraction (Artis and Buti, 2000). This would suggest that to conduct countercyclical fiscal policy a comfortable budgetary margin is needed during normal times. Fiscal policy may turn expansionary during upturns because policymakers tend to be overly optimistic (or just myopic) and fail to recognize that the fiscal improvements during cyclical upswings are temporary. In addition, political economy arguments underscore the difficulty of standing up to pressures from spending ministries or organized interest groups who want to share the growth dividend during good times, when budgetary resources are available (Tornell and Lane, 1999).

The Institutional Context

The Fiscal Framework

In joining the European Monetary Union, the four countries under consideration committed themselves to prudent fiscal policy. The Maastricht Treaty specifies that countries must keep general government deficits within 3 percent of GDP, except for exceptional and temporary reasons, and that gross general government debt must be below 60 percent of GDP. Countries joining EMU with debt above that threshold must first make substantial progress in reducing debt. Countries that violate the Maastricht Treaty ceilings may be subject to pecuniary sanctions. Subsequent council regulations and resolutions have further strengthened the treaty by committing members to a fiscal position “close to balance or in surplus” in the medium term, and by establishing monitoring procedures (the Stability and Growth Pact, SGP). The “close to balance or in surplus” target should provide enough room for the balance to deteriorate during a downturn without exceeding the 3 percent threshold, and it has been interpreted as applying to the cyclically adjusted fiscal balance (see, for instance, Artis and Buti, 2000). The commission has attempted to quantify the former concept by calculating “minimum benchmarks” based on each member’s past history.10

As part of the monitoring mechanism, every year countries present to the ECOFIN Council their fiscal policy plans for the following four years (the Stability Programs). The council issues an opinion on whether the plans are consistent with the SGP and, more generally, with principles of sound public finance. These programs contain only indicative targets and sometimes few specifics—for instance, they may not specify how the path of the balance breaks down between revenues and expenditures. In contrast with the deficit and debt ceilings of the Maastricht Treaty, there is no process to sanction deviations from the “close to balance or in surplus” target. Within the boundaries of the Maastricht Treaty and of the Stability and Growth Pact, a country can set fiscal policy according to its own national framework.

In Germany, the federal government and many of the regional governments are constitutionally obligated to adhere to the “golden rule,” that borrowing should only finance capital expenditures. However, the rule has imposed little budgetary discipline because it is usually applied ex ante rather than ex post. In addition, investment at the federal level is broadly defined, including financial as well as nonfinancial assets and excluding privatization and depreciation. It excludes special funds and can be suspended if the government determines that the economy is not operating at the “national equilibrium.”11 More recently, German stability programs have undertaken to keep annual nominal spending growth at or below 2 percent at the level of the general government. However, rules to deal with spending overruns are not specified.

Stability programs in France set out multiyear rates of increase of real expenditure for the general government and each of its components (central government, social security, and local authorities). In practice, multiyear expenditure growth targets are not treated as binding, however, especially not on a year-by-year basis, and overruns have not been generally clawed back.

In Italy, no fiscal rules exist other than the SGP. In Spain, the Law of Budget Stability introduced in 2003 shifted fiscal policymaking toward a rules-based model. Under the law, all levels of government must formulate, approve, and execute a budget in balance or in surplus.12 If exceptional circumstances preclude a balanced budget, they must explain the reasons, identify the responsible revenue or expenditure items, and formulate a medium-term fiscal adjustment program with corrective actions. In addition, the cabinet sets fiscal targets for each level of government and imposes limits on central government expenditures for a three-year period. A contingent liability fund equal to 2 percent of the maximum central government expenditures provides some flexibility. The accounting standard is ESA-95. All public entities, including public enterprises, have to formulate a multiyear budget. The ministry of finance monitors whether the law is being respected at all levels of government. Finally, the law establishes that if the EMU deficit or debt ceilings are breached, the cost of the sanctions are to be distributed among levels of government according to their respective contributions to the breach.

Relationships Among Levels of Government

Excluding intergovernmental transfers, expenditure by the federal government in Germany is smaller than that of the subnational governments (the regions, Länder, and communes, Gemeinden). In principle, subnational governments have ample autonomy, as the constitution stipulates that public services are to be decentralized. However, expenditure policies are often determined at the central level, with lower levels of government in charge of the execution. The Länder have complete autonomy to borrow while the Gemeinden can only borrow with the approval of the Länder. Länder deficits averaged about 1 percent of GDP in the 1990s, the highest level for subnational governments in the European Union. An advisory intergovernmental council, the Finanzplanungsrat, coordinates fiscal policy across levels of government. A more detailed discussion of fiscal policy coordination across levels of government is provided in Appendix III.

In France, local governments remain relatively small, with total expenditure and revenue accounting for about 10 percent of GDP (Table 2.6). They operate under a “golden rule” mandating that current receipts must equal current expenditures. Receipts come from various local taxes (some of which are also locally controlled) and from central budget transfers on the order of 30 percent of local government budgetary receipts. The traditionally centralized French state is expected to further decentralize with implementation of the current government’s reform plans. As a first step, a constitutional amendment approved in March 2003 recognizes regions as legal administrative entities. The law allows the central government to experiment with devolving functions to local governments. In turn, local governments can experiment by modifying laws and regulations pertaining to these functions. Also, the law establishes local authorities’ right to receive any type of tax revenue, including shared national taxes, and set tax rates and the tax base for local levies within the limits of the law. A redistribution mechanism to reduce inequalities across regions is also envisaged.

Table 2.6.

Structure of the General Government in 2000

(In percent of GDP)

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Sources: IMF, Government Finance Statistics database; and IMF staff calculations.

Includes transfers to other levels of government. Central government data include social security.

In Germany and Spain, state governments and municipalities on an unconsolidated basis.

Includes transfers from other levels of government.

In Italy, there are three levels of local government—region, province, and municipality. There are 15 “ordinary statute” and 5 “special statute” regions, the latter having greater autonomy. For revenue, regions rely on taxes such as the IRAP (a tax on regional value added) and on government transfers. Special statute regions receive a substantial share of national tax revenue from that region. The ongoing process of fiscal decentralization has recently increased the share of taxes earmarked for local authorities. Tax revenues reached 43.6 percent of total local authorities’ receipts in 2001, up from 25 percent in 1995. The ability to borrow has increased apace, with local authorities’ public debt rising from 2.4 percent of GDP in 1995 to 3.4 percent of GDP in 2001.13 In particular, local authorities face problems in controlling health care expenditure, and recent attempts at discipline through an internal stability pact have not been very successful (see Appendix III). To address these problems, the government adopted a set of measures in August-September 2001 to strengthen regional expenditure control, particularly in the health area. Other revisions to the internal stability pact were introduced with the 2003 budget law.

In Spain, two regional governments have almost full fiscal autonomy (régimen foral), while the other 15 have more limited fiscal autonomy (régimen común). Regional governments have direct access to financial markets subject to several restrictions, which have been reinforced by the application of the Law of Budgetary Stability to the regions.14 The Council for Fiscal and Financial Policy, chaired by the Ministry of Finance and consisting of representatives of the regions, is responsible for coordinating regions’ economy policies and negotiating the financial arrangements between the régimen comên regions and the central government. In 2001, the central government and the régimen comên regions negotiated a financial arrangement of indefinite duration starting in 2002 to replace the previous five-year arrangements. The new arrangement encompasses all expenditures (previously health expenditure was financed separately), makes regions less dependent on guaranteed transfers from the central government (because regions receive a larger share of national tax revenues), grants tax powers to regions, and includes an equalization fund to ensure the solidarity of the system.

Finally, social security funds carry out important areas of government activity in all four countries. Large social security funds tend to be closely integrated with central government in Germany, Italy, and Spain. In France, they are jointly managed by the central government and the social partners, though the distinction among the activities of the central government and the social security funds has increasingly blurred.

Implications for the Choice of a Fiscal Rule

The four countries under consideration have made substantial progress toward fiscal consolidation since the mid-1990s, but several challenges and risks remain. First, public debt remains close to or above the Maastricht reference level of 60 percent of GDP, while (with the exception of Spain) structural fiscal balances are not yet near the “close to balance or in surplus” guideline of the SGP. Also with the exception of Spain, the burden of taxation (especially on labor) remains high relative to other OECD countries, while in the medium term population aging and health care costs will impose a substantial burden on the public sector. Given these challenges, the same processes that led to large spending and large deficits before 1992 could result in unduly rapid growth of current expenditure, raising the issue of whether a budget close to balance or the desired decline in the tax burden can be achieved.

The deficit and debt ceiling of the Maastricht Treaty and the SGP framework safeguard against excessive relaxation of the fiscal stance, and within this framework, specific fiscal rules tailored to the needs and preferences of each country could provide additional discipline and accountability. The next section explores how such rules can be designed. The design of rules in a decentralized system, a special concern in Germany, Italy, and Spain, is also addressed.

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