Abstract

This paper has reviewed fiscal policy and the fiscal framework in four of the largest economies of the euro area—France, Germany, Italy, and Spain. As in many other advanced economies, the size of government and the public debt in these countries grew rapidly after the 1970s. Furthermore, fiscal policy was often conducted in a procyclical fashion. With the prospect of monetary union in the late 1990s, large deficits needed to be reined in. The Maastricht Treaty imposed well-defined rules on deficits and debt levels, which the four countries managed to meet after an often difficult consolidation process. Despite this progress, significant medium-term pressures on expenditures remain, with debt still large (especially in Italy), tax burdens heavy (less so in Spain), infrastructure needs foreseeable (particularly in Spain), and population aging ahead (more quickly in France). These challenges prompted the present reexamination of the fiscal framework in the four countries.

This paper has reviewed fiscal policy and the fiscal framework in four of the largest economies of the euro area—France, Germany, Italy, and Spain. As in many other advanced economies, the size of government and the public debt in these countries grew rapidly after the 1970s. Furthermore, fiscal policy was often conducted in a procyclical fashion. With the prospect of monetary union in the late 1990s, large deficits needed to be reined in. The Maastricht Treaty imposed well-defined rules on deficits and debt levels, which the four countries managed to meet after an often difficult consolidation process. Despite this progress, significant medium-term pressures on expenditures remain, with debt still large (especially in Italy), tax burdens heavy (less so in Spain), infrastructure needs foreseeable (particularly in Spain), and population aging ahead (more quickly in France). These challenges prompted the present reexamination of the fiscal framework in the four countries.

This paper has argued that adopting carefully designed multiyear fiscal rules may help consolidate fiscal discipline in the four countries, reducing deficit and spending biases (as underscored by the new political economy literature) and possibly reducing the procyclical character of fiscal policy. A frame-work encompassing a country-specific medium-term deficit or debt target (within the boundaries of the Maastricht Treaty and the SGP) and a spending rule is found to be preferable to a framework based on a budget balance rule, as it does not require discretionary measures to offset cyclical fluctuations in revenues. Provided that the spending aggregate used in the rule is appropriately defined, such a frame-work can be relatively easy to explain to the public, in contrast with one based on a cyclically adjusted budget balance.

For the framework to work, care must be taken to ensure compliance both ex ante (at the stage of the introduction of the yearly budget) and ex post (at the budget implementation stage). The former requires a clear political or legal commitment to the multiyear framework, precise definition of the rule, and accounting and reporting standards that limit “creative accounting.” The latter may require changing budget institutions to strengthen implementation. Margins of flexibility to deal with unpredictable circumstances are also useful to ensure compliance.

A successful fiscal framework should apply to the general government because this is the relevant economic concept and because shifting expenditure responsibilities to other levels of government could be used to circumvent the rules. Thus, the framework should address the issue of coordination among different levels of government. When subnational governments have considerable fiscal autonomy, fiscal rules may have to be complemented by an intergovernmental agreement. Such a pact would specify either a spending or a deficit rule on subnational governments, monitoring responsibilities, and sanctions for noncompliance.

Finally, when countries conduct fiscal policy in a well-established, credible, rules-based framework, the economic impact of discretionary fiscal policy measures may differ from a framework characterized by discretion. This is because agents’ expectations on how the measure will affect future fiscal policy are likely to depend on the rule, and these expectations affect behavior. This paper has provided a summary analysis of this important issue, but additional research, both theoretical and empirical, is needed.

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1

This problem has been widely studied theoretically and empirically in the political economy literature, which has analyzed how conflicts of interest are shaped by the political system and budget institutions (see Appendix I).

2

These frameworks exhibit considerable variety regarding the choice of target, degree of flexibility, and other characteristics. Most countries adopting rules in recent years have experienced substantial fiscal consolidation against a background of favorable economic conditions. Whether these rules can survive a downturn remains largely untested. Appendix II reviews selected country experiences.

3

In Italy and Spain, a substantial fraction of expenditure reduction was the result of lower interest payments due to declining risk premiums on government securities.

4

See, for example, Alesina and Perotti (1995); IMF (1996); Alesina and Ardagna (1998); Perotti, Strauch, and von Hagen (1998); and von Hagen, Hughes Hallett, and Strauch (2001).

5

Countries with pegged exchange rates, such as France during the policy of the franc fort, may not lose a great deal if they join a union.

6

Moreover, rules can be designed to allow for some cyclical stabilization (see “Implications for the Choice of a Fiscal Rule,” below).

7

If trend growth in certain spending categories (such as entitlements) exceeds trend output growth, the fiscal impulse would tend to be negative even in the absence of discretionary policy measures. In addition, calculations of structurally adjusted balances are difficult, and different methodologies can give rise to very different results (Hagemann, 1999; Giorno and others, 1995). Such calculations also typically compute tax revenues using long-run elasticities. If short-run elasticities tend to be procyclical (with tax revenues growing faster than GDP during expansions and vice versa)—suggested for instance by Quinet and Mills (2001)—then the calculated structural balance will be too smooth, and the discretionary component will appear more countercyclical than it actually is.

8

If fiscal policy had been set randomly with respect to the cycle, for a sufficiently large number of observations the value of the index should be 50 percent.

9

These issues are explored for a wider set of countries and for alternative methodologies in “Cyclical Fiscal Policy Behavior in EU Countries,” a Selected Issues paper for the 2001 Euro Area Article IV Consultation (IMF, 2000). The results are broadly similar to those presented here.

10

These benchmarks are defined as the difference between the 3 percent reference value and the “cyclical safety margin.” The latter is obtained by multiplying the output gap for the cyclical sensitivity of the budget calculated using historical data (European Commission, 2000). The benchmarks are deficits of 1.6 percent of GDP for France and Italy, 1.4 percent for Spain, and 1.1 percent for Germany.

11

Wendorff (2001) uses a standard definition of investment to show that the rule was violated ex post in 19 out of the past 20 years at the level of the general government.

12

The law allows the central government and the social security fund a 12-year transitory period during which the general rule of balanced budget or surplus applies to their consolidated budget.

13

These figures are net of borrowing from a special government body that finances subnational governments by issuing postal bonds in the retail market (Cassa Depositi e Prestiti).

14

Before the Law of Budgetary Stability, the law did not envisage any sanction, so these restrictions have been violated on a number, of occasions (Viñuela, 2001).

15

Besides rules, economic policy researchers have also studied how changes in the budget process and fiscal transparency can improve the conduct of fiscal policy (von Hagen and Harden, 1996; Kopits and Craig, 1998; and Hemming and Kell, 2001).

16

A “rule” here means a numerical objective that is costly to violate because it is based on a legal obligation or a “reputational investment.” Typically, the framework specifies a mechanism to rein in deviations from the rule in a particular year. In contrast, a “target” is an objective that can be missed without triggering a sanction, automatic clawback, or loss of reputation.

17

Even with a rule on the budget balance, ensuring compliance ex post (that is, at the budget implementation stage) may not be straightforward. Mechanisms to prevent systematic deviations from the rule ex post need to be devised and implemented.

18

This drawback (though not the others) can be avoided by replacing the balance rule with a “golden rule.” The golden rule, however, introduces its own difficulties because current and capital expenditures are often hard to distinguish.

19

In Switzerland, in each budget expenditures are set equal to “structural revenues,” defined as projected revenues multiplied by the ratio of trend to projected output (Appendix II). This is close to targeting a zero structural balance.

20

The framework could also mandate that the stabilizers be allowed to operate by requiring that deviations of revenues from projections be used to reduce or increase the balance. However, for the stabilizers to operate correctly, revenue projections must be based on a realistic rather than a cautious scenario.

21

If cyclically sensitive items are excluded from the ceiling, however, these advantages would not materialize.

22

In Sweden, the rate of growth of total spending is set above that implied by the aggregation of the components, thereby creating a margin to adjust spending in midcourse. In practice, this margin has always been used for discretionary expenditures.

23

In this respect, a general price index is preferable to sector-specific deflators because the latter are more difficult to forecast accurately, although differences between government expenditure deflators and the general index would lead to ex post deviation from the real spending path. Of course, a nominal rule does not address this problem either.

24

Differences between actual and expected inflation may result in violations of real expenditure ceilings ex post. To minimize this risk, ceilings can be revised in midyear to reflect updated inflation projections.

25

In Sweden, interest expenditures are excluded; in the Netherlands, they are included.

26

Bohn and Inman (1996) show that rules requiring that the budget be balanced in U.S. states are associated with lower deficits only if the requirement has to hold also ex post. Under the EMU, the Stability and Growth Pact sets union-wide fiscal rules, enforced by the Council of Ministers. The expenditure rules and the overall balance/debt targets, discussed above, would likely be subject to national compliance procedures—although they would doubtless be reflected in countries’ stability programs and discussed by fellow members of the union.

27

In Japan, the golden rule has been often violated by using supplementary budgets, as the latter are not subject to the rule. An example of a broadly successful set of rules to ensure budget implementation is the U.S. Budget Enforcement Act of 1990 (see Appendix II).

28

Budget implementation, however, should allow for the deficit to increase if revenues turn out to be smaller owing to lower-than-expected growth, consistent with the operation of the automatic stabilizers on the revenue side.

29

The budget expenditure execution process, including the stages and levels of control, are discussed in detail in von Hagen and Harden (1994) and Potter and Diamond (1999).

30

Also, a rule fixing the maximum yearly growth rate of spending rather than its level would complicate verification, as revisions in the outturn for the initial year change realized growth rates. Ceilings on levels also ensure that overruns in one year are automatically clawed back in the next.

31

On creative accounting and fiscal rules, see Milesi-Ferretti (2000).

32

Pisauro (2001) argues that the decentralization of revenue and expenditure responsibilities may cause a bias toward higher expenditures and deficits if subnational governments expect to be bailed out by the central government in case of insolvency. In addition, when expenditures are financed through shared taxes, “common pool” problems may arise.

33

This agreement could be called an Internal Stability Pact (ISP), although this term can be confusing if understood as a scheme to implement the SGP. A brief survey of ISPs in euro-area countries is provided in Appendix III.

34

Transfers could be based on trend output or trend tax revenues, or on parameters such as population. In order to avoid procyclical offsets at the central level, transfers would be excluded from the expenditure aggregate targeted.

35

Traditional Keynesian effects, such as the expansionary effect of higher government spending and lower taxes on liquidity-constrained individuals when output is demand-determined, would not be systematically different under the two regimes.

36

If a strict balanced budget rule is in place, any spending shock must be matched by an immediate decline in other expenditures or by an increase in taxes, so it is not meaningful to talk about the “effectiveness” of fiscal policy. The only exception would be a case in which for exogenous reasons, say, revenue is higher than forecast, so there would be room for increased public spending. If so, the assessment of the expansionary effect would depend on whether the revenue shock is perceived as temporary or permanent and as leading to lower future taxes or higher future spending.

37

Allowing for an impact of fiscal policy on the supply side, for example through the labor supply decision, would introduce considerable complications. On the one hand, an increase in government spending would reduce the resources available to the private sector for consumption, and hence stimulate labor supply (the income effect). On the other hand, the increase in distortionary taxes needed to finance the additional government expenditure would reduce labor supply (the substitution effect). Hence the overall impact on labor supply would be ambiguous. Clearly, changes in capital income taxes would have output effects through their impact on rates of return, making tax cuts more expansionary and tax increases more contractionary.

38

The hypothesis of a small open economy pins down the domestic interest rate irrespective of fiscal policy shocks. See Barro (1989) for an analysis of temporary and permanent shocks to government purchases in a closed economy.

39

In endogenous growth models higher tax rates on labor or capital income reduce the rate of return and the rate of growth.

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