Abstract

In recent decades, France, Germany, Italy, and Spain—along with most industrial countries—witnessed a sharp rise in the size of government and a large accumulation of public debt. While the latter trend began to reverse under the constraints imposed by the Maastricht Treaty and the Stability and Growth Pact, public expenditure and debt remain high by international standards. These are well-recognized sources of concern to policymakers, especially as the rapid aging of the population increases spending on pensions and health care while reducing the labor force and therefore economic growth and the tax base.

In recent decades, France, Germany, Italy, and Spain—along with most industrial countries—witnessed a sharp rise in the size of government and a large accumulation of public debt. While the latter trend began to reverse under the constraints imposed by the Maastricht Treaty and the Stability and Growth Pact, public expenditure and debt remain high by international standards. These are well-recognized sources of concern to policymakers, especially as the rapid aging of the population increases spending on pensions and health care while reducing the labor force and therefore economic growth and the tax base.

In practice, reducing public spending and government debt is politically difficult because the process inevitably leaves some groups worse off.1 To overcome these difficulties, an increasing number of countries have adopted formal fiscal rules, such as balanced-budget rules or multiyear frameworks that limit discretionary fiscal policy.2 The proponents of rules argue that the commitment to a medium-term plan for public finances makes it easier for fiscal authorities to withstand pressures for higher spending and delayed fiscal adjustment. Critics highlight that rules may constrain the ability of governments to run countercyclical fiscal policy and express skepticism on the effectiveness of rules, because of the scope left for creative accounting.

This paper studies the design of fiscal rules and frameworks, with particular reference to France, Germany, Italy, and Spain. In different ways, these countries face substantial public finance challenges over the next decade: high levels of outstanding public debt (Italy in particular), the consequences of a rapidly aging population for future social spending, and the need to ensure adequate scope for reduction of the still-high tax burden while maintaining an adequate level of public sector capital spending.

This study argues that the four countries should place more emphasis on spending rules within the boundaries set by the Stability and Growth Pact. At present, fiscal frameworks are geared to achieving medium-term balances around zero. En route, annual deficits are meant to follow declining paths, as articulated in each country’s Stability Program. This paper suggests that countries should maintain medium-term targets for the budget balance—or alternatively, the stock of public debt—geared to long-term policy objectives. But it points out that rigid adherence to annual deficit targets can impart a procyclical bias to fiscal policy through contractionary measures to buttress revenues in a downswing and a temptation to spend windfall tax receipts in an upswing.

A binding spending rule consistent with the medium-term deficit or debt target and with tax policy objectives would allow cyclical revenue fluctuations to be reflected in annual outcomes for the budget balance. But it would not sacrifice—and perhaps it would even enhance—policy credibility. Nonetheless, a number of issues arise in designing effective spending rules. Should rules be imposed on “real” or nominal spending? How comprehensive should the definition of spending be? What safeguards can be put in place to ensure that the rules are credible? How can they be made to work in a decentralized system, where regions and states enjoy considerable autonomy? This study reviews the implementation issues and provides some practical answers to these and other questions.

While other countries have experienced similar difficulties in controlling fiscal expansion and face similar future challenges, this paper focuses on four countries only—France, Germany, Italy, and Spain—mainly for reasons of tractability. Examining the design of fiscal rules from both a theoretical and a practical perspective requires a review of the specific institutional setting of each country as well as recent experience with fiscal policymaking, an unwieldy task if carried out for a large set of countries. In addition, these four countries share a number of common characteristics: they are the largest economies in the euro area, they face potentially serious long-term fiscal imbalances because of population aging, and they have not been at the forefront of recent experimentation with multiyear fiscal frameworks.

The paper is structured as follows. Section II reviews how fiscal policy was conducted in the four countries in recent years, the challenges ahead, and the institutional context in which fiscal policy is formulated and implemented. Section III discusses the rationale for fiscal rules, the costs and benefits of alternative rules, enforcement and compliance issues, and how to ensure fiscal discipline in federal systems. Section IV briefly analyzes how the rules may alter the response of the economy to a fiscal shock. Section V summarizes the conclusions.

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