Abstract

A number of governments across the world have adopted fiscal policy rules, especially against the backdrop of worsening fiscal performances and rising debt levels. Recently, following the financial crisis, fiscal rules have been advocated to support fiscal consolidation efforts and to ensure long-term sustainability of government finances. This chapter empirically analyzes the impacts of fiscal rules on fiscal performance in microstates with a focus on the Caribbean, where fiscal consolidation has been a major challenge. Broadly, we address three questions. Are there fiscal rules in microstates in general, and in the Caribbean in particular? If the answer is yes, what types of rules exist and what are their characteristics? Is the existence of fiscal rules in microstates associated with improved fiscal performance?

A number of governments across the world have adopted fiscal policy rules, especially against the backdrop of worsening fiscal performances and rising debt levels. Recently, following the financial crisis, fiscal rules have been advocated to support fiscal consolidation efforts and to ensure long-term sustainability of government finances. This chapter empirically analyzes the impacts of fiscal rules on fiscal performance in microstates with a focus on the Caribbean, where fiscal consolidation has been a major challenge. Broadly, we address three questions. Are there fiscal rules in microstates in general, and in the Caribbean in particular? If the answer is yes, what types of rules exist and what are their characteristics? Is the existence of fiscal rules in microstates associated with improved fiscal performance?

We find ample evidence of the existence of fiscal rules in microstates. In total, 17 countries—equivalent to 40 percent of the microstate sample—have a fiscal rule of some kind (see Table 11.1). These rules are relatively new, about two decades old. Although the institutional coverage slightly favors the central government, the rules in place aim to address fiscal and debt sustainability concerns. Budget balance rules and debt rules constitute 90 percent of all these fiscal rules. The debt rules generally constrain the public-debt-to-GDP ratio to at most 70 percent. Our empirical results show that the presence of these fiscal rules in microstates does significantly influence fiscal performance. It suggests that by increasing discipline and credibility of fiscal policy, fiscal rules tend to bolster fiscal consolidation efforts and lower high debt levels in microstates, including the Caribbean countries.

Table 11.1

Fiscal Rules in Microstates

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Sources: Budina and others (2012); European Commission (2006).

BBR = Balance budget rule; DR = debt rule; ER = expenditure rule.

The rule ceased to exist following the global financial crisis.

In addition to the balance and debt rules that apply to the European Union, Luxembourg has national debt, balance, and expenditure rules.

The remainder of the chapter is organized as follows. First we describe the main types, characteristics, and roles of fiscal rules, followed by an analysis of the main characteristics of the rules in existence in microstates. The chapter then reviews the literature on fiscal policy rules. The last part of the chapter presents our empirical analysis of the rules’ impact on fiscal performance and discusses the results.

Fiscal Rules: Types, Characteristics, and Roles

In this chapter, we define a fiscal rule along the lines of Kopits and Symansky (1998)—that is, a permanent constraint on fiscal policy through simple numerical limits on indicators of fiscal performance. We focus on rules that impose specific, binding constraints on the government’s policy options. The rules under consideration may be fixed by legislation or by political agreement, as is usually the case at the national level. However, at the regional and international level, the rules are backed by a treaty.

Types

In terms of coverage, we are interested in rules that cover at least the central government. Thus, subnational rules are not included. Accordingly, the major fiscal rules include the following (see IMF, 2009; Kopits and Symansky, 1998; Schaechter and others, 2012):

  • Budget balance rules are usually specified as rules for either overall balance, structural balance or cyclically adjusted balance, or balance “over the cycle.” Set as a percentage of GDP, these rules (with the exception of primary balance and golden rules), aim at ensuring debt sustainability.1

  • Debt rules limit government borrowing and set explicit targets on the public-debt-to-GDP ratio.

  • Reserve rules limit the stock of total government liability in percent of GDP, or the stock of reserves of an extra-budgetary contingency fund (social security fund) in percent of annual benefits payments.

  • Expenditure rules set permanent limits on total, primary, or current spending in absolute terms, growth rates, or in percent of GDP. When combined with debt or balanced budget rules, expenditure rules can serve as operational guidance for fiscal consolidation.

  • Revenue rules are aimed at boosting revenue collection or preventing an excessive tax burden and therefore set ceilings or floors on revenues.

Characteristics

What is an ideal fiscal rule? While recognizing that it is impractically impossible to have a fiscal rule that possesses all desirable characteristics, Box 11.1 summarizes the recommendations of Kopits and Symansky (1998) on the features of an ideal fiscal rule. Some studies have argued that an ideal fiscal rule is one that is transparent, flexible, and implementable (Guichard and others, 2007; and Price, 2010). In addition, Ahrend, Catte and Price, 2006, argue that the adequacy of institutions as well as rules is essential.

Roles and Design

Why are fiscal rules needed? The overarching reason is to address deficit bias—correcting distorted incentives and containing pressures to overspend, especially when times are good, thereby ensuring fiscal responsibility and debt sustainability (Schaechter and others, 2012; IMF, 2009). There are four additional roles, as highlighted by Kopits and Symansky (1998) and Kennedy and Robbins (2003): (1) to ensure macroeconomic stability; (2) to support other financial policies; (3) to minimize negative externalities; and (4) to ensure credibility of fiscal policy.2

Policy credibility is important, especially when financial market confidence is in doubt. When such doubt arises, as argued by IMF (2009), a fiscal rule can help raise the credibility in the context of government’s medium-term fiscal strategy. However, Chowdhury and Islam (2012) express the concern that rule-based policymaking may pose a risk to both democracy and development. They fear that by removing discretion from politicians, fiscal rules could undermine accountability, especially in new democracies, leading them to wonder whether credibility should be a matter for financial markets rather than for the electorate.

Desirable Characteristics of a Fiscal Rule

  • A fiscal rule should be well defined to avoid ambiguity and ineffective implementation. This requires clarity about the indicator being constrained, the institutional coverage, and specific escape clauses, if any.

  • It should be transparent in relation to government fiscal operations, including accounting, forecasting and institutional arrangement. It should avoid a misrepresentation of the true timing and magnitude of future fiscal obligations, especially contingent liabilities.

  • It should be adequate with respect to the specified proximate goal. For example, debt sustainability would require a rule expressing debt as a nondecreasing percentage of GDP, or a minimum primary balance in percentage of GDP.

  • A fiscal rule should be internally consistent with other fiscal rules in place, as well as with other macroeconomic policies. For example, a fixed nominal exchange rate anchor should be accompanied by an explicit restriction on the monetization of budget deficits.

  • It should be simple to apply. This enhances the understanding of the general public and the parliament, and therefore draws large consensus.

  • A fiscal rule should be flexible to accommodate exogenous shocks. An example is when the central bank’s advances to the government are subject to specified limits and full repayment during the year. In recent times, escape clauses provide some form of flexibility to respond to uncertainties relating to a recession, adverse economic development, banking system bailout, and natural disaster.

  • It should be enforceable by incorporating penalties for noncompliance and authorities for enforcement. The consequences for noncompliance—judicial, financial, and reputational—should be agreed upon by all parties. Implementation should be within the control of government. A case has been made for an independent fiscal council to monitor compliance.

  • A rule should be supported by efficient policy actions, including by engaging in more fundamental fiscal reforms to restore public finances to sustainable levels.

Source: Kopits and Symansky (1998).

A key concern addressed in the literature is whether fiscal rules are in fact effective. There is a general concern that rules might reduce fiscal policy flexibility. For example, they tend to create incentives to artificially achieve targets by adopting dubious accounting practices, thereby reducing the transparency of government budgets (Milesi-Ferretti, 2000; von Hagen and Wolff, 2006; Larch and Turini, 2011; Basdevant, 2012). As Irwin (2012) discusses, governments under pressure to reduce fiscal deficits can be tempted to replace spending cuts or tax increases with accounting devices that give the illusion of change without its substance, or that make a change look larger than the actual situation. However, how much of this creative accounting would occur would depend on the reputation cost to the government and the economic cost of adhering to the rule (von Hagen and Wolff, 2006). Effectiveness is enhanced when rules have regulatory or political support (Wyplosz, 2012).

In view of the above limitations, there is renewed emphasis among policymakers and researchers on the design and monitoring aspects.3 IMF (2009) notes that fiscal rules are effective only when credible punishment for noncompliance is in place. In the context of the United States, Bernanke (2010) proposes that an effective rule must be sufficiently ambitious to address the underlying problem. It should focus on variables that the legislature can control directly and should have widespread political commitment and public support. In the context of the European Union, Marneffe and others (2011) propose that the effectiveness of rules can be enhanced when they are framed within a medium-term economic management framework. Basdevant (2012) makes a similar point, that the time horizon over which a fiscal target should be met is crucial, especially in providing flexibility.

In designing expenditure rules, Ljungman (2008) suggests that they should exhibit comprehensiveness and have an inflation adjustment, a mechanism to manage expenditure fluctuation, a time horizon, a clear numerical definition, and a legislative requirement. Chowdhury and Islam (2012) insist that since macroeconomic stability is not a sufficient condition for economic growth, the design of fiscal rules should therefore include a growth objective.

Other essential supporting requirements include adequate fiscal institutions, independent fiscal councils and fiscal responsibility laws. This is in recognition that fiscal rules alone are not the solution to ensuring fiscal discipline. Indeed, Wyplosz (2012, 2005); and European Commission, (2006) argue that rules and institutions should not be considered as substitutes but rather as complementary. In particular, Wyplosz (2012) notes that both fiscal rules and institutions can never be adequately contingent—in the face of an unforeseen event, rules are often too rigid while fiscal institutions may be too flexible. The belief is that independent fiscal councils could enhance the credibility of fiscal rules by monitoring their implementation. However, in the absence of formal rules, fiscal frameworks could ensure fiscal discipline, provided that they have transparent and credible strategies backed by proper fiscal institutions.

Main Characteristics of Fiscal Rules in Microstates

To answer the question of whether there exist fiscal rules in microstates, we explore the existence and the main features of fiscal policy rules in a sample of these countries. For this purpose, microstates are defined as countries with populations of less than 2 million.4 By this definition, we identify 42 microstates, many of which are islands, including eight in the Caribbean. In several respects, microstates are different from other countries, in the sense that they possess unique features that have implications for fiscal policy (See Worrell, 2013; and Chapter 10 of this book).

There is ample evidence of the existence of fiscal rules in microstates. In total, 17 countries, equivalent to 40 percent of our sample, have at least a fiscal rule. With the exception of four countries—namely, Cabo Verde, Iceland, Jamaica, and Mauritius—all belong to an economic or monetary union.5 The rules came into force through international treaties, acts of parliaments, coalition agreements, and political commitments.

Origins and Institutional Coverage

The rules are relatively new, about two decades old. As members of the EU, Luxembourg and Malta, have the earliest rules dating back to 1992. However, before joining the EU, Luxembourg had national debt and expenditure rules. In the ECCU, the rules came into force in 1998. Those in WAEMU and the Central African Economic and Monetary Community (CEMAC) have existed since the early 2000s. Most recently, Jamaica and Namibia adopted fiscal rules.

The institutional coverage of these fiscal rules centers on the general government and the central government (see Figure 11.1). The coverage is important, especially for fiscal consolidation, as the size of fiscal consolidation has tended to be significantly larger when national or supranational rules have been in place (IMF, 2009). In the present study, the coverage is slightly in favor of the central government. Rules in the EU and the ECCU cover the general government, while those in WAEMU and CEMAC relate to the central government. Meanwhile, national rules in Botswana, Cabo Verde, Iceland, Luxembourg, and Namibia mostly cover the central government.

Figure 11.1
Figure 11.1

Coverage of Fiscal Rules in Microstates Sample

(Percent of total rules)

Source: Author’s calculations.

Supranational rules are usually not complemented with national rules. With the exception of Luxembourg, all other members of economic or monetary unions do not have national rules. Under the reformed Stability and Growth Pact, the EU encourages national governments to adopt additional domestic rules to bolster commitment to the rules in place at the EU level (European Commission, 2006). Indeed, Luxembourg has three such rules covering budget balance, expenditure, and debt, framed within a multi-annual context. The budget balance rule is legislated on and covers social security and is monitored by the Ministry of Social Security. Both the expenditure and debt rules cover the central government.

Debt, Expenditure, and Budget Balance Rules

Debt Ceilings

Broadly, the fiscal rules aim to address fiscal and debt sustainability concerns. Currently, the public-debt-to-GDP ratio in more than half of the countries exceeds the generally accepted prudent threshold of 60 percent (Figure 11.2). The need to address fiscal and debt concerns is reflected in the types of rules in place. In the context of a monetary and economic union, another objective is to prevent fiscal policy inconsistency with the needs of the union. In particular, budget balance and debt rules constitute 90 percent of the rules in existence, with expenditure rules accounting for the remaining 10 percent (Figure 11.3), excluding those in Jamaica and the EU that limit an expenditure subcomponent, such as wages and salaries. No country has a revenue rule.

Figure 11.2
Figure 11.2

Public-Debt-to-GDP Ratios by Country, 2012

(Percent)

Source: Author’s calculations.
Figure 11.3
Figure 11.3

Number of Fiscal Rules in Microstates Sample

Source: Author’s calculations.

The debt rules mostly constrain the public-debt-to-GDP ratio to at most 70 percent (Table 11.2). The debt ceilings are 70 percent of GDP in WAEMU and CEMAC, and 60 percent of GDP for Cabo Verde, Mauritius, and the EU countries. Of note, Mauritius proposes to lower its public debt further to 50 percent of GDP by 2018 and to hold it under that ceiling subsequently. For the ECCU countries, the target is to reduce the debt-to-GDP ratio to 60 percent by 2020. To achieve this objective, the ECCU member countries are required to set annual debt targets. In Namibia, reflecting the already low debt level, the ceiling is lower at 25–30 percent. Jamaica targets a debt reduction to 100 percent of GDP by March 2016 from its current level of around 140 percent. Botswana does not have a debt rule.

Table 11.2

Numerical Limits in Fiscal Rules, Selected Microstates and Currency Unions

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Source: Budina and others (2012).Note: CEMAC = the Central African Economic and Monetary Community; ECCU = the Eastern Caribbean Currency Union; EU = the European Union; WAEMU = the West African Economic and Monetary Union.

The basic fiscal balance is defined as total revenue net of grants less total expenditure net of foreign-financed capital spending. Two new supplementary criteria, the basic structural fiscal balance and the non-oil basic structural fiscal balance were introduced in 2008.

The primary expenditure rule excludes unemployment benefits and discretionary revenue increases, and when the excessive deficit procedure (EDP) is not in force.

A debt ceiling of 50 percent of GDP to start in 2018.

Expenditure

Expenditure rules target the growth rate of public expenditure, or the aggregate relative to GDP. At 40 percent of GDP, the expenditure ceiling in Botswana is the highest among the countries covered, while it is 30 percent of GDP in Namibia. In addition, Botswana has a “golden rule,” which requires that 30 percent of total expenditure should be channeled to development activities, including in the health and education sectors. Cabo Verde has a cap on domestic borrowing, equivalent to 3 percent of GDP. Jamaica aims to reduce the wages-to-GDP ratio to 9 percent by 2016. Recently, the EU introduced a new expenditure benchmark in the context of the fiscal compact, requiring that annual growth of primary expenditures, excluding unemployment benefits and discretionary revenue increases, should not exceed long-term nominal GDP growth. The benchmark affects countries that are not in an excessive deficit procedure; that is, those whose overall deficits are less than 3 percent of GDP.

Budget Balance

The budget balance rules differ across countries. In the ECCU, the overall deficit of 3 percent of GDP, initially agreed by member countries in 1998, was abandoned in 2006, perhaps reflecting an inability to cope with exogenous shocks. In 2009, however, member governments agreed to set annual primary balance targets in the context of the ECCU Eight Point Growth and Stability Agenda. For EU members, the overall deficit target of 3 percent of GDP came into force in 1992, with subsequent reforms in 2011 and 2012.6 In Jamaica, fiscal balance should be nil by end-march 2016.

Escape Clauses

Few countries have escape clauses (see Table 11.3). Typically, escape clauses provide some form of flexibility to respond to exceptional circumstances, including economic recession and natural disasters. Whereever they exist, it is suggested that escape clauses should be well specified to avoid ambiguity about the potential trigger events. In Botswana, the Public Debt Management Act embeds the cases to which the debt rule will not apply: (1) natural disasters or other emergencies requiring exceptional expenditure; (2) cases where a large investment project in the public sector is considered by the cabinet to be timely and prudent; and (3) general economic slow-downs requiring fiscal stimulus. At the same time, the Act further stipulates that increases in the debt-to-GDP ratio should not exceed one percent relative to the previous year. Similar to Botswana, the applicable act in Jamaica specifies that the fiscal targets may also be exceeded on the grounds of national security, national emergency, or other such exceptional grounds as the Minister of Finance may determine. Escape clauses relating to adverse economic shocks are embedded in the fiscal rules of the EU and the WAEMU and apply to the respective member countries covered in this chapter.

Table 11.3

Countries with Escape Clauses

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Source: Budina and others (2012).

The escape clause is only applicable at the European Union level.

Formal enforcement procedures are generally limited, although the implementation of rules appears adequately monitored, especially by an independent body outside the government. This is the case for the ECCU, EU, and WAEMU countries, unlike their counterparts. Constitutional rules that are enforced by an independent body appear to be most effective (Kennedy and Robbins, 2003).

The Literature on Fiscal Policy Rules

Several studies have adopted statistical and econometric techniques to investigate the role of fiscal rules in determining fiscal performance or budgetary outcomes. In the simplest cases, a simple correlation of an index of fiscal rules with measures of fiscal performance provides some preliminary guidance on the impact of fiscal rules. Generally, the empirical literature establishes a link between fiscal rules and budgetary outcomes.

In the context of successful fiscal consolidation and debt reduction, empirical evidence associates the presence of fiscal rules with stronger fiscal performance (Schaechter and others, 2012; IMF, 2009; Guichard and others, 2007; Poterba, 1994; Kennedy and Robbins, 2003). In a large sample of member countries of the Organization for Economic Co-operation and Development, the G-20, and the EU, several large fiscal adjustments and debt reduction episodes were found to be supported by fiscal rules (IMF, 2009). Nevertheless, as noted by some studies (IMF, 2009; von Hagen, 2006; Schaechter and others, 2012; Gollwitzer, 2011; Debrun and others, 2008), the interpretation of results regarding impact calls for caution, because the analyses could reflect the effects of omitted variables and other determinants of fiscal behavior, such as political institutions, which, according to Poterba (1994) and Stein, Talvi, and Grisanti (1999), are important. Estimates by Debrun and others (2008) indicate that fiscal rules have a positive and statistically significant impact on budget balances. The relationship between fiscal rules and budgetary outcomes is robust to the possibility of omitted variables and to the definition of the government balance. Reverse causation did not appear as a source of concern.

Lessons from the EU reveal that the coverage, design, and strength of fiscal rules, as well the quality of budgetary procedures, promote fiscal consolidation (Larch and Turrini, 2008; European Commission, 2006). Further results suggest that rules embedded in the law or in a constitution appear to have a larger impact on fiscal outcomes. Tapsoba (2012) supports the introduction of fiscal rules as a remedy for fiscal indiscipline.

A well-designed medium-term expenditure rule could overcome procyclical bias on the expenditure side. Deroose, Moulin, and Weirts (2006) argue that expenditure rules are important in complying with national medium-term expenditure plans. Expenditure rules were very common in cases of large fiscal adjustment and were usually combined with budget balance rules (IMF, 2009). However, expenditure rules could be effective only if the cost of noncompliance were sufficiently large (Wierts, 2008). Two findings that emerge from Holm-Hadulla, Hauptmeier, and Rother (2010) are that (1) government is subject to procyclical bias and (2) expenditure rules reduce government responses to surprises in cyclical conditions.

However, the findings on the impact of expenditure rules differ across expenditure items, with impact being muted for nondiscretionary items. Relative to debt and balance budget rules, the impact of expenditure rules could be insignificant, reflecting limited coverage to central government (Larch and Turrini, 2008). Reviewing the experience of Australia and New Zealand, Campos and Pradhan (1999) demonstrate that certain mechanisms that enhance transparency and accountability could lead to a sufficiently high cost for noncompliance and produce better expenditure outcomes.

Good budgetary institutions are essential. One strand of the literature takes a broader perspective, examining the impact on fiscal outcomes of budget institutions. Usually, the impact is reflected in higher primary balances and lower debt levels, suggesting that good budgetary institutions matter (Marneffe and others, 2011; Dabla-Norris and others, 2010; Stein, Talvi, and Grisanti, 1999; Eichengreen, 1992; Gollowitzer, 2011; von Hagen, 1992, 2006; von Hagen and Harden, 1995; Debrun and others, 2008; Poterba and von Hagen, 1999). Typically under this approach, an index is constructed to measure the quality and adequacy of budget institutions, including fiscal rules. The impact may depend on whether the political environment is appropriate for rule-based policymaking (von Hagen, 2006). With strong budgetary institutions, there is better scope for conducting countercyclical policies (Dabla-Norris and others, 2010).

The experiences of U.S. states overwhelmingly demonstrate that fiscal rules enforce some budget discipline in terms of lower deficits (Eichengreen, 1992; Poterba, 1994; Bohn and Inman, 1996; Auerbach, 2008; Alt and Lowry, 1994; Bayoumi and Eichengreen, 1995). But as argued by Bohn and Inman (1996), rules should be appropriately designed and enforced. In particular, in times of fiscal crisis, Poterba (1994) finds, states with tighter constitutional or statutory fiscal rules experienced more rapid adjustment when revenues fell short of expectations or expenditure exceeded projections. In addition to the impact of budget balance rules in achieving higher fiscal surpluses, Eichengreen (1992) finds that they also significantly affect both bond yields and borrowing. However, there is some evidence that the impact of fiscal rules is not significant, as they have also led to a debt substitution effect—off-budget entities and municipal governments incurring larger debts than otherwise (von Hagen, 1991; Kiewiet and Szakaly, 1996).

Findings are mixed regarding the impact of fiscal rules on governments’ ability to engage in countercyclical fiscal policy. While the main motivation in the literature was to analyze the impact of fiscal rules, a related issue is whether the reduced discretion could affect the responsiveness of fiscal policy to output volatility. On the one hand, Fatas and Mihov (2005), Bayoumi and Eichengreen (1995), and Levinson (1998) all find that strict budgetary restrictions lower the responsiveness of fiscal policy to output shocks. In contrast, Alesina and Bayoumi (1996) and Brzozowski and Siwinska-Gorzelak (2010) find limited cost in terms of increased output volatility. As argued by Brzozowski and Siwinska-Gorzelak, the impact of fiscal rules on the extent of fiscal policy volatility may depend on the type of rule and the fiscal measure being constrained.

Empirical Analysis

Methodology

We estimate a fiscal policy reaction function for a panel of 40 microstates using annual data for 1970–2009. Similar to Debrun and Kumar (2007), and Debrun and others (2008), we characterize fiscal policy as a response of the cyclically adjusted primary balance (CAPB) to fiscal rules, controlling for other determinants of fiscal policy, including measures of institution and temporary events such as natural disasters. Given that we are interested in examining the impact of fiscal rules on fiscal performance, we introduce fiscal rules into the following commonly estimated model:

Pi,t=α0+ρdi,t1+γrulesi,t+xi,tβ+ηi+εi,t,t=1,,T,i=1,,N,(11.1)

where Pit is the ratio of the cyclically adjusted primary balance to potential GDP in country i and at time t; dit-1 is the government-debt-to-GDP ratio at the end of period t–1; rulesi,t is a dummy variable for fiscal rules, which takes the value 1 for the presence of fiscal rules in country i at time t, and 0 otherwise; and x’i; is a vector of other potential determinants of fiscal outcomes, including relevant measures of institution and exogenous events such as natural disasters. The ηi is the unobserved country effects, and εi,t is a time- and country-specific error term.

The Data

All fiscal data—CAPB, debt, and output gap—were obtained from the IMF’s World Economic Outlook. The measure of political risk is taken from the International Country Risk Guide compiled by the PRS Group. Data on natural disasters were obtained from EM-DAT.7

Cyclically adjusted primary balance

Since we are interested in discretionary policy behavior, we adopt the CAPB as the dependent variable on the ground that it excludes the impact of automatic stabilizers.

Fiscal rules

We assume that a positive value for the estimated γ coefficient in the model would signal a disciplinary effect of fiscal rules on fiscal policy.

Debt

As noted by Bohn (1998), a positive estimated response of primary balance to increases in government debt suggests that fiscal behavior satisfies the inter-temporal budget constraint and hence long-run solvency criterion. Thus, we expect the coefficient of government debt (ρ > 0) to be positive.

Output gap

As theory suggests, we expect a positive response of the CAPB to the output gap, indicating that fiscal policy is countercyclical.

Political risk

We use political risk, a composite index from the International Country Risk Guide, as a measure of institutional quality. The ICRG Risk Rating System assigns a numerical value to a predetermined range of risk components, according to a preset weighted scale, for each country covered by the system. Each scale is designed to award the highest value to the lowest risk and the lowest value to the highest risk. The components of political risk include law and order, bureaucratic quality, democratic accountability, government stability, and corruption. The composite political risk index is a 100-point scale—the highest overall rating being 100, indicating the lowest risk, and the lowest score being 0, indicating the highest risk. We expect countries with high-quality institutions and therefore low political risk to have a higher CAPB.

Natural disaster

This variable represents the number of natural disasters that occur yearly. The coefficient of natural disaster is expected to be negative.

Model estimation

To estimate the model, we use the fixed-effects and dynamic-panel approaches (system generalized method of moments or GMM). The explanatory variables in the model could either be simultaneously determined with the dependent variable or have a two-way causal relationship with it. There is also potential for the presence of unobserved country-specific effects, which if ignored may produce inconsistent estimates. The GMM approach proposed by Arellano and Bond (1991) and further developed by Blundell and Bond (1998) is appropriate, as it simultaneously addresses the issues of correlation and endogeneity among the variables.

The difference GMM approach of Arellano and Bond begins by specifying a panel model as a system of equations, one per period, and allows the instruments applicable to each equation to differ in subsequent periods (Baum, 2006). The instruments include suitable lags of the levels of the endogenous variables, which enter the equation in differenced form, as well as strictly exogenous regressors. It is assumed that there is no second-order serial correlation in the first differences of the error term to ensure consistency of the GMM estimator.

Blundell and Bond (1998) argue that lagged levels of variables are likely to be weak instruments for current differenced variables when the series are close to random walk. Under these conditions, the differenced GMM estimates are likely to be biased and inefficient. As an alternative, they proposed the more efficient system GMM estimator that combines a difference equation and a levels equation to form a system estimator. For the first differenced equation, the instruments are the lagged levels of the endogenous variables. For the levels equation, the endogenous variables are instrumented with appropriate lags of their own first differences, while the strictly exogenous regressors can directly enter the instrument matrix for use in the levels equation. The system GMM is consistent and more efficient than the difference estimator so long as there is no significant correlation between the differenced regressors and country fixed effects. In this study, we apply the one-step variant of the system GMM estimator.

Empirical Results

Table 11.4 presents results for four models. The first three models were estimated using the fixed-effects approach, while the fourth model uses the system GMM approach. Model 1 includes lagged debt, output gap, and fiscal rules. The results show that the three variables have the expected positive sign, but only the fiscal rule is significant. In Model 2, we add natural disaster to the variables in Model 1, and find that natural disaster is negatively correlated with fiscal policy, but again only the fiscal rule is significant. Model 3 includes political risk to the variables in Model 2, and reveals that lagged debt, fiscal rules, and political risks are important determinants of fiscal outcomes.

Table 11.4

Impact of Fiscal Rules on Fiscal Performance

(Dependent variable: cyclically adjusted primary balance

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Source: Author’s calculations.Note: SGMM = system generalized method of moments. Robust standard errors in parenthesis. ***, **, * denote significance at the 1, 5, and 10 percent levels, respectively.

Estimates using the system GMM approach reveal results similar to the estimates in Model 3 using a fixed-effects approach—lagged debt, fiscal rules, and political risk are significant determinants of fiscal policy outcomes in microstates. We also find that fiscal policy responds to its lagged value. In particular, the presence of fiscal rules improves the cyclically adjusted primary balance by 4.5 percentage points, and the result is robust to alternative model specification. The findings suggest that fiscal rules are relevant in microstates, since they would enhance fiscal consolidation and lower high debt levels. The results are consistent with earlier findings in the literature.

Summary and Conclusion

The chapter empirically analyzes the impact of fiscal rules on fiscal performance in microstates with a focus on the Caribbean, where fiscal consolidation has been a major challenge. We estimate a fiscal policy reaction function for a panel of 40 microstates, using annual data for 1970–2009. We find ample evidence of the existence of fiscal rules in microstates. In total, 17 countries, equivalent to 40 percent of the sample, have at least a fiscal rule. The rules are relatively new, about two decades old, mostly take the form of budget balance and debt rules, and aim to address fiscal and debt sustainability concerns. Empirical result shows that the presence of fiscal rules in microstates significantly influences fiscal performance. The findings suggest that by enhancing fiscal discipline and credibility, fiscal rules could bolster fiscal consolidation efforts and lower the high debt levels in micro-states generally, including the Caribbean countries.

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1

In addition, there are primary balances and golden rules, which do not guarantee debt sustainability (see Schaechter and others, 2012). The latter targets the overall balance net of capital expenditure, and thus permits deficits only to the extent of financing productive investment. An over-the-cycle rule requires the achievement of a nominal budget balance on average over the business cycle.

2

The credibility issue is mostly relevant for countries that have alternating periods of poor fiscal performance and fiscal adjustment.

3

Ljungman (2008) illustrates design issues using the experience of Finland, the Netherlands, and Sweden with expenditure ceilings.

4

With the exception of Jamaica, added to widen the coverage of the Caribbean countries.

5

They cover four economic and monetary unions: Equatorial Guinea and Gabon in the Central African Economic and Monetary Community (CEMAC); Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines in the Eastern Caribbean Currency Union (ECCU); Luxembourg and Malta in the European Union (EU); Botswana and Namibia in the Southern African Customs Union (SACU); and Guinea Bissau in the West African Economic and Monetary Union (WAEMU).

6

Included in the Maastricht criteria is a limit of 3 percent of GDP for fiscal deficit. If the limit is exceeded, an excessive deficit procedure (EDP) is opened for correction purposes. The reformed Stability and Growth Pact requires that an EDP may be opened subject to two conditions: the deficit exceeds 3 percent of GDP only temporarily and exceptionally and only if the deficit remains close to the 3 percent threshold. See Budina and others (2012) and Schaechter and others (2012) for recent EU governance reforms.

7

The OFDA/CRED International Disaster Database may be found at www.emdat.be.

Tackling Fiscal and Debt Challenges