Selected Euro-Area Countries: Rules-Based Fiscal Policy and Job-Rich Growth in France, Germany, Italy and Spain
Author: International Monetary Fund
Publication Date:
07 Nov 2001
eISBN:
9781451813005
Language:
English
Keywords:
ISCR; CR; government; spending; deficit; rule; expenditure rule; government activity; spending cut; government behavior; discretionary regime; Fiscal rules; Fiscal stance; Global
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Fiscal deficits and the public debt has grown throughout much of the postwar period in most industrialized countries under the pressure of rising public expenditure, a trend that has begun to reverse after 1992. A number of studies argue that fiscal consolidation in association with expenditure restraint, particularly reductions in primary current expenditure, has proved more durable historically. All in all, the fiscal consolidation essential to qualify for European Monetary Union is a major achievement but also a difficult process in the four countries (France, Germany, Italy, and Spain).

Abstract

Fiscal deficits and the public debt has grown throughout much of the postwar period in most industrialized countries under the pressure of rising public expenditure, a trend that has begun to reverse after 1992. A number of studies argue that fiscal consolidation in association with expenditure restraint, particularly reductions in primary current expenditure, has proved more durable historically. All in all, the fiscal consolidation essential to qualify for European Monetary Union is a major achievement but also a difficult process in the four countries (France, Germany, Italy, and Spain).

II. Rules-Based Fiscal Policy and the Fiscal Framework in France, Germany, Italy, and Spain

A. Introduction

7. In recent decades, France, Germany, Italy, and Spain, along with most industrial countries, witnessed a sharp rise in the size of government as well as a large accumulation of public debt. While the latter trend has recently begun to be reversed, 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 will increase spending on pensions and health care while reducing the labor force and therefore economic growth and the tax base.

8. In practice, reducing public spending and government debt is politically difficult, as 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 the public finances makes it easier for fiscal authorities to withstand pressures for higher spending and for delaying fiscal adjustment. Critics highlight that rules may constrain the ability of governments to run counter-cyclical fiscal policy and express skepticism on the effectiveness of rules, because of the scope for creative accounting.

9. This chapter 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, due to the high level of outstanding public debt (Italy in particular), the consequences that a rapidly-aging population entails 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 chapter addresses how additional rules could be devised to constrain the behavior of policymakers in these four countries. Such rules would necessarily operate within the broader constraints set by the Maastricht Treaty and the Stability and Growth Pact, which establish safeguards to ensure that monetary union is not jeopardized by fiscal profligacy in one member country. The key issues are the choice between deficit and expenditure rules, enforcement, and the relationship among different levels of government.

10. While other countries have experienced similar difficulties in controlling fiscal expansion and face similar challenges looking ahead, this chapter focuses on these four countries alone mainly for reasons of tractability. Examining the design of fiscal rules from both a theoretical and a practical perspective requires reviewing the specific institutional setting of each country as well as the recent experience with fiscal policymaking, a task that would quickly become unwieldy if carried out for a larger set of countries. In addition, the four countries share a number of common characteristics such as belonging to EMU and facing 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.

11. This chapter is structured as follows. The next section reviews fiscal policy, the fiscal framework, and the outlook in the four countries. Section C discusses the rationale for fiscal rules, the costs and benefits of alternative rules, enforcement and compliance issues, and the question of how to ensure fiscal discipline in federal systems. Section D provides a brief analysis of how the rules may alter the response of the economy to a fiscal shock. Section E summarizes our conclusions.

B. Fiscal Policy and the Fiscal Framework in France, Germany, Italy, and Spain

Fiscal consolidation in the last ten years

12. Fiscal deficits and the public debt grew throughout much of the postwar period in most industrialized countries under the pressure of rising public expenditure, a trend that began to reverse after 1992 (IMF, 2001). While the improvement in the government financial position was fairly universal (Japan being a notable exception), the largest turnaround was probably in a group of Anglo-Saxon countries (Figure 1), where relatively fast economic growth also facilitated the process of consolidation.3 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).4

Figure II.1.
Figure II.1.

Selected Countries: Government Revenue, Expenditure, and Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2001, 203; 10.5089/9781451813005.002.A002

Source: OECD Analytical and Economic Databases (UMTS Receipts are excluded from revenue and disbursements)
Figure II.2.
Figure II.2.

Selected Countries: Composition of Expenditures

(Percent of GDP)

Citation: IMF Staff Country Reports 2001, 203; 10.5089/9781451813005.002.A002

Source: OECD Analytical and Economic Databases (UMTS Receipts are excluded)

13. A number of studies argue that fiscal consolidation associated with expenditure restraint, particularly reductions in primary current expenditure, has proved more durable historically.5 Figure 2 indicates that, in the four countries covered in this study, the adjustment effort on transfers and subsidies has been relatively modest or non-existent. Furthermore, in contrast with the Anglo-Saxon countries, and with the possible exception of Spain, spending on goods and services remains near historical highs. Somewhat troubling also is that reduced capital outlays accompanied the recent 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 3). In the four countries that are the subject of this study the tendency has been to reduce direct taxes and social security contributions and rely more on indirect taxes.

Figure II.3.
Figure II.3.

Selected Countries: Composition of Revenue

(Percent of GDP)

Citation: IMF Staff Country Reports 2001, 203; 10.5089/9781451813005.002.A002

Source: OECD Analytical and Economic Databases (UMTS Receipts are excluded)

14. All in all, the fiscal consolidation necessary to qualify for EMU was a major achievement but also a difficult process in the four countries. 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. 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 over-performance.

Fiscal policy and the business cycle

15. 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.6 In Western Europe, inflexible labor markets may also reinforce the need for countercyclical policies. One of the criticisms levied at fiscal rules is that, by limiting discretion, they take away an important instrument of macro-economic stabilization and may even cause fiscal policy to be pro-cyclical. In practice, however, this loss may not be so important if, under discretion, fiscal policy tends not to be used for stabilization.7 For instance, there may be a tendency for new spending programs to be introduced during cyclical upturns, when budgetary resources are more easily available, resulting in a pro-cyclical fiscal stance. In this case, fiscal rules that limit spending or the deficit may actually reduce pro-cyclicality. In addition, by making fiscal policy more stable and predictable, fiscal rules may reduce a source of shocks to aggregate demand.

16. To shed some light on these issues, this section briefly explores fiscal policy over the cycle in the four countries. Figure 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”).8 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.9 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.10 Accordingly, if during a recession the deficit is widening but the structural primary balance improves, then discretionary intervention operates to partly offset the automatic stabilizers and vice versa.

17. In the four countries fiscal policy was not consistently counter-cyclical (Figure 4). While deficits typically widened at the beginning of a downturn, thus presumably helping 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 II.1 summarizes some of the information in Figure 4. In all countries the fiscal impulse is negatively correlated with the output gap, suggesting overall pro-cyclicality, except in Spain, where the correlation is close to zero. The negative correlation is even stronger when the output gap is lagged, suggesting that pro-cyclicality is not explained by delays in learning about the structural position. An alternative measure of pro-cyclicality is the fraction of observations for which the output gap and the impulse have opposite sign. This fraction is above 50 percent in all four countries, confirming the pro-cyclical nature of fiscal policy.11 Interestingly, the four countries found it especially difficult to save the cyclical component of the improvement in the balance during expansions (Table II.1).12

Figure II.4.
Figure II.4.

Selected Countries: Fiscal Policy and the Cycle

Citation: IMF Staff Country Reports 2001, 203; 10.5089/9781451813005.002.A002

Note: The impulse is defined as the change in the structural primary balance.Source: OECD.
Table II.1.

Fiscal Policy and the Cycle Before Maastricht

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Source: OECD and 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.

18. But why was fiscal policy so seldom counter-cyclical? One possible answer is that policymakers were deliberately avoiding “fine tuning,” because output gaps are difficult to gauge and fiscal policy affects the economy with delay. In addition, monetary policy was available to smooth the cycle, especially in the early years in which substantial capital controls were still in place. These considerations, however, can at best explain a neutral fiscal impulse, not a pro-cyclical one. Fiscal tightening in the late phase of a downturn may be caused by the fact that, after rising sharply early on, the deficit becomes unsustainable (economically or politically), thus forcing a discretionary contraction (Artis and Buti, 2000). This would suggest that to conduct counter-cyclical fiscal policy there needs to be a comfortable budgetary margin during normal times. To explain why fiscal policy turns expansionary during upturns, it may be conjectured that policymakers tend to be overly optimistic or just myopic, and fail to recognize the temporary nature of the fiscal improvements during cyclical upswings. In addition, political economy arguments suggest that it may be difficult to stand up to pressures from spending ministries or organized interest groups to share the growth dividend during good times, when budgetary resources are available (Tornell and Lane, 1999).

The fiscal framework

19. In joining the European Monetary Union, the four countries under consideration committed to a prudent fiscal policy. Specifically, under the Maastricht Treaty the countries must keep the general government deficit within 3 percent of GDP except for exceptional and temporary reasons, and the gross general government debt must be below 60 percent of GDP; for countries joining EMU with debt above that threshold, substantial progress should be made in reducing the debt. Countries that violate the Maastricht Treaty ceilings may be subject to pecuniary sanctions. Subsequent Council regulations and resolutions have further strengthened the framework of the Treaty, by committing member countries to maintaining 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 computing “minimum benchmarks” for each member country based on past history.13

20. 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, or SPs). 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, countries can set fiscal policy according to their own national frameworks.

21. In Germany the federal government, as well as many of the regional governments, has a constitutional obligation to adhere to the “golden rule,” namely that borrowing should finance only capital expenditures. However, the rule has imposed little budgetary discipline because it is applied ex ante rather than ex post. In addition, the definition of investment applied at the federal level is very broad (including financial as well as non-financial assets and excluding privatization and depreciation), it excludes special funds, and it can be violated if the government determines that the economy is not operating at the “national equilibrium.”14 More recently, in the SPs the German government has undertaken to keep nominal spending growth at or below 2 percent per year at the level of the general government. No rules to deal with spending overruns are specified, however.

22. In its SPs, France sets out multiyear rates of increase of real expenditure for the three components of general government, the 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. In fact, on current plans real expenditure growth during 2000-02 and 2001-03, respectively, will exceed that envisioned in the earlier SPs covering the corresponding periods. For 1999–2003, real expenditure is projected to exceed the initial target by a cumulative 2.2 percent, and no plans for clawing back the overruns exist.

23. In Italy and Spain no multiyear rule beyond the SGP framework exists at present. In Spain, however, a new law currently submitted to Parliament will, if approved, shift fiscal policymaking to a much more strongly rules-based model. Under the draft law, all levels of government would have to formulate, approve, and execute a budget in balance or in surplus. If, due to exceptional circumstances, they fail to present a balanced budget, they would have to explain the reasons, identify the revenue or expenditure items responsible, and formulate a fiscal adjustment program for the medium term including corrective actions. In addition, the cabinet would set fiscal targets for each level of government and impose limits on central government expenditures for a three-year period. A contingent liability fund equal to 2 percent of the maximum central government expenditures would provide some flexibility. The accounting standard would be ESA-95. All public entities including public enterprises would have to formulate their budget in a multiyear framework. The Ministry of Finance would be in charge of monitoring whether the law is respected by all levels of government. Finally, the law establishes that, in case 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 contribution to the breach.

The structure of the general government and relationships among different levels of government

24. In all four countries important areas of government activity are carried out by social security funds (Table II.2).15 Social security funds, while large, tend to be closely integrated with the 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 two branches of the general government has become increasingly blurred.

Table II.2.

Structure of the General Government in 1999

(In percent of GDP)

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Sources: National authorities; IMF, Government Financial Statistics Database; and staff calculations.

Includes transfers to other levels of government.

In Germany and Spain state government and municipalities on an unconsolidated basis.

Includes transfers from other levels of government.

25. Turning to subnational governments, in Germany, excluding intergovernmental transfers, expenditure by the federal government is smaller that of the subnational governments (the regions, Länder, and communes, Gemeinden). In principle, sub-national governments have a large degree of autonomy, as the Constitution stipulates that public services are to be provided in a decentralized manner. 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. In June 2001 this body expressed the continuing (although voluntary) commitment by all levels of government to abide by the 2 percent spending rule to meet the budget balance goals outlined in the SP. The fiscal projections of the Finanzplanungsrat and the SP were made public, including the expenditure and deficit targets of all levels of government separately on an administrative basis, as well as the conversion to a national accounts basis. The ceilings for nominal expenditure growth vary depending upon the year and the level of government and range between -1 percent per year (eastern Länder in 2002) and 2 percent per year (western Länder in 2003). These targets, which resulted from intense bargaining, are not legally binding rules.

26. In France local authorities remain relatively small, with expenditures and revenues accounting for about 10 percent of GDP. They operate under a “golden rule,” mandating that current receipts must equal current expenditures. Receipts come from various local taxes, mainly under the control of Parliament, and from transfers from the central budget of the order of 30 percent of local governments’ budgetary receipts.

27. In Italy, there are three levels of local government: regions, provinces and municipalities. There are 15 “ordinary statute” and 5 “special statute” regions, the latter having a higher degree of autonomy. As sources of 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 the revenue from national taxes produced in the region. An ongoing process of fiscal decentralization has recently increased the share of taxes earmarked for local authorities, resulting in tax revenues reaching 44 percent of total local authorities’ receipts in 2000 (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 2000.16 In particular, local authorities have faced problems in controlling health care expenditure, and recent attempts to impose discipline through an internal stability pact have not been very successful (see Chapter IV of the Supplementary Information paper). To address these problems, the government has adopted in August-September 2001 a set of measures to strengthen regional expenditure control, particularly in the health area.

28. In Spain, regional governments in the “Specific Regime” have extensive fiscal autonomy, while those in the “Common Regime” have more limited fiscal autonomy. Every five years, the Council for Fiscal and Financial Policy (Consejo de Politica Fiscaly Financiera), chaired by the Ministry of Finance and consisting of representatives of the regions, establishes the financial arrangements between the “Common Regime” regions and the central government. Regional governments have direct access to financial markets subject to several restrictions. As the law does not envisage any sanction, these restrictions have been violated on a number of occasions (Viñuela, 2001).

The current fiscal position and the medium-term outlook

29. Thanks to recent fiscal consolidation, general government deficits were below 1.5 percent of GDP in all four countries in 2000 (Table II.3), although the economic slowdown and tax cuts in some countries are likely to result in deteriorating deficits in 2001. The structural balance is even more favorable than the actual balance in France, Italy, and Germany, and slightly less favorable in Spain. Debt levels remain quite high, however, and in Italy very high. Concerning the outlook, the four countries are engaged in a medium-term strategy of further fiscal consolidation accompanied by some relief in the tax burden. The latter is still high relative to other OECD countries except in Spain (Table II.4). The taxation of labor remains particularly heavy because of large social security contributions (Table II.5). In Spain the need to upgrade infrastructure is expected to put upward pressure on government expenditures in the medium term.

Table II.3.

General Government Balance and Gross Debt in 2000

(In percent of GDP)

article image
Sources: National authorities and staff calculations.

Excluding UMTS revenues.

Table II.4.

Effective Tax Rates and Tax Burden (1999)

article image
Sources: European Commission, Public Finances in EMU-2000 and OECD.
Table II.5.

Income Tax plus Employer’s and Employees’ Social Security Contributions for a Married Worker With Two Children

(In percent of average wage)

article image
Source: OECD.

30. The latest updates of the SP provide information concerning fiscal policy plans beyond 2001 for each country (Table II.6). Under favorable economic growth assumptions, the authorities plan to reach a small budget surplus in 2004 in France, Italy, and Spain, and budgetary balance in Germany. Less optimistic assumptions, now more plausible in the light of the recent deterioration in the global economic outlook, would result in a small deficit in France, Italy and Germany, and in a budget close to balance in Spain.

Table II.6.

Main Features of the 2000-04 Stability and Growth Program

(In percent of GDP unless otherwise specified)

article image
Source: National authorities.

31. In a longer-term perspective, population aging is expected to increase considerably the financial burden of pensions and health care in the four countries, although the timing of the phenomenon varies because of different demographic situations (Table II.7). While further pension and health-care reform and policies to foster higher employment and growth can ease the forthcoming pressure on the budget, the need to safeguard the standard of living of pensioners and the increasing preference for a shorter work life suggest that reforms may not fully eliminate the problem. Thus, in all countries the net asset position of the public sector needs to improve to make room for the additional spending without compromising sustainability.

Table II.7.

Pension Expenditure Projections

article image
Source: Economic Policy Committee-Ecofin.1Assumed 5 percentage points lower in 2050.

Assumed 0.5 percentage points lower in 2005-50.

Assumed 1 percentage point lower.

Conclusions

32. The four countries under consideration have made substantial progress towards 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 the fiscal balance is in the neighborhood of the “close to balance or in surplus” guideline of the SGP, this has been achieved to some extent through tax increases which are now being undone in the context of multiyear tax reduction plans. The strong growth performance of the last two years also contributed substantially to the recent improvement in the fiscal accounts. The combination of tax relief and a growth slowdown may push the goal of fiscal balance further into the future. Thus, additional fiscal consolidation is likely to be necessary in order to remain within the guidelines of the SGP.

33. With the exception of Spain, the burden of taxation (especially on labor) will remain high relative to other OECD countries even after the programmed tax cuts, while in the medium term, population aging and health care costs are expected to impose a substantial burden on the public sector. Given these challenges, there is a danger that the same processes that led to large spending and large deficits before 1992 will 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.

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

C. Fiscal Rules: Issues and Experiences

35. Rules constrain policymakers’ autonomy in policy decisions. But what is the justification for limiting discretion in fiscal policy? This question has been addressed by the political economy literature. While recognizing that history, tradition, and preferences—in addition to economic factors—may cause the optimal size of government and public debt to vary across countries, this literature has shown how the political and institutional environment can lead to distortions in the conduct of fiscal policy, resulting in outcomes which may be undesirable from society’s point of view (for more details see Chapter I of the Supplementary Information paper).

36. A number of factors can push policymakers toward running structural budget deficits (Alesina and Perotti, 1995). Politicians facing the possibility of losing power may discount the future more heavily than private agents, or may be induced to manipulate policy levers to facilitate their re-election. Conflicts among coalition partners may generate a stalemate in the policy decision process, thus delaying pressing fiscal reforms.

37. Certain features of the political process can also lead to excessive government spending. For instance, the literature on the so-called “common pool problem” highlights the distortions that can result from certain forms of collective decision-making, in which policy reflects the aggregation of individual decisions. A classic example is elected officials, spending ministers, or parties in a coalition government asking for spending on projects that benefit their constituencies but failing to fully internalize the consequences of the higher taxes needed to finance such decisions. The result is excessively high spending (Weingast, Shepsle and Johansen, 1981).

38. Fiscal rules have been proposed as a possible device to overcome the distortions described above. For instance, a deficit bias can be addressed through a legally binding balanced-budget rule. Alternatively, setting an aggregate spending ceiling (an expenditure rule) forces individual spending bids to explicitly take into account aggregate resource constraints, thus reducing the common pool problem.17 The rest of the section explores in more detail the design of fiscal rules.

Deficit and expenditure rules and targets

39. Countries committed to a multi-period fiscal framework have typically chosen to anchor fiscal policy on a numerical rule relating to the budget balance, public expenditure, or the public debt (see Chapter II of the Supplementary Information paper).18 The rule needs to support, but need not be identical with, the ultimate objective of the policymaker. For instance, an expenditure rule can be designed to safeguard a medium-term target for the budget balance by being consistent with the projected path of revenues.

40. Perhaps the simplest and most intuitive rule is a balanced budget or, more generally, a rule on the maximum level of the budget deficit. The rule recently proposed in Spain and the 3 percent deficit threshold of the Maastricht Treaty are examples of rules on the budget balance. Such a rule has the important advantages of being easy to explain to the public and market participants, and to be relatively simple to monitor.19 One obvious drawback is that it does not address biases towards excessive expenditures, as higher expenditures can be financed through higher taxes. A second shortcoming is that fiscal policy would become pro-cyclical: as revenues declined and expenditures rose in a recession, a discretionary tightening would be needed to keep the balance in check. In addition, the “activist” fiscal policy needed to abide by this rule might imply a tax policy that varies over the cycle (if the adjustment takes place on the revenue side), a policy that would conflict with principles of optimal taxation. If expenditures have to adjust, on the other hand, efficient medium-term expenditure management may become difficult, or capital expenditures may be excessively squeezed.20

41. Some of the difficulties of a budget balance rule can be remedied by targeting the structural balance.21 This rule requires taking a stand on the position of the economy in the cycle and the effects of the cycle on fiscal revenues and expenditures. Different methodologies can be used, and if the government can change the methodology or the parameters from year to year, then the scope for manipulation may be large. To be credible, the rule itself should specify the methodology and parameters of the cyclical adjustment; alternatively, an independent agency could be put in charge of estimating the cyclically-adjusted deficit. In either case, the rule may be difficult to explain to the public and, possibly, if the rule is enshrined in a law, to a court. This would make the rule difficult to monitor and enforce. In addition, the methodology may turn out to be inadequate, especially if there are structural changes in the economy, and failure to revise it would lead to wrong policy decisions.

42. Instead of focusing only or primarily on a country-specific goal for the balance, some countries have set binding upper bounds on expenditure growth as a key operational focus for policy. The Netherlands, Finland, and Sweden are examples (see Chapter II of the Supplementary Information paper). This type of framework directly addresses distortions leading to excessive spending and does not automatically lead to a pro-cyclical fiscal stance, because stabilizers on the revenues side are free to operate.22 This type of rule can also curb the tendency to increase public spending during upturns. In addition, an expenditure rule can be easily explained to the general public and market participants, provided that the control aggregate is clear.

43. One drawback of an expenditure rule is that it does not necessarily correct a tendency towards excessive deficits, for instance through large tax cuts or the systematic over-prediction of revenues. However, empirical studies suggest that fiscal consolidation based on expenditure reduction tends to be long-lasting (Alesina and Perotti, 1997). In addition, the deficit risk can be overcome by anchoring the framework over the medium term, for example by supplementing the binding expenditure rule with an explicit medium-term “target” for the budget balance, as in Sweden. While a target represents a weaker form of commitment than a binding rule, it may nonetheless ensure enough discipline. Because the target would have to be met only over the cycle, fiscal policy would not need to be pro-cyclical. A slight variant to this approach would be to adopt an explicit target for the stock of debt relative to GDP, arguably a more relevant yardstick for the sustainability of public finances since changes in the stock of public debt often differ from the budget balance. Another approach is that taken by Switzerland, where revenue forecast errors are cumulated into what is referred to as a “notional” debt stock that must be reduced to zero over time (Chapter II of the Supplementary Information paper).

44. All in all, the advantages of an expenditure rule may overcome its drawbacks in countries—such as the four countries under study—where the tax burden is high and the medium-term level of the deficit is already bounded by the SGP. To further guard against systematic revenue underperformance or excessive tax cuts, such a rule may be combined with a medium-term stock anchor, such as a target for the public debt-to-GDP ratio. This target should be chosen to achieve the medium-term goals of reducing the tax burden, contributing to address population aging, and ensuring an adequate margin for counter-cyclical fiscal policy. This chapter does not address the question of which targets would be appropriate for each of the four countries studied, but focuses instead on the broad design features of the fiscal framework.

Issues in designing multiyear expenditure rules

The macroeconomic assumptions and the time horizon

45. Multiyear fiscal plans need to be based on a macroeconomic scenario that projects the evolution of the various expenditure categories and illustrates how they relate to overall economic trends. In this context, a crucial choice is whether to adopt a realistic or cautious scenario, an issue that also arises in drafting the yearly budget. The advantage of using a cautious scenario is that it is likely to deliver “favorable” surprises ex post, as cyclically-sensitive spending components are likely to turn out lower than projected. Accordingly, each year there will likely be some room within the expenditure ceiling to finance new programs or deal with overruns in non-cyclical expenditure categories. This may facilitate negotiations within the cabinet and help deal with unexpected spending pressures without violating the framework.23

46. Using a realistic macroeconomic scenario presents distinct advantages. A cautious scenario obfuscates the true fiscal goals of the government, while one of the purposes of multiyear fiscal rules is precisely to make those goals explicit and build consensus around them. It may also encourage a second-guessing by ministries of the likely scope for additional spending, resulting in unrealistic initial budgets. Furthermore, with an overly cautious scenario the authorities may use the additional room to engage in procyclical policy when the outturn is favorable. With a realistic macroeconomic scenario, a limited margin for new discretionary spending can be introduced in the form of a contingency reserve.24

47. Concerning the time-horizon, a longer horizon means less discretion but also less flexibility. The length of the legislature (as used in the Netherlands) may be a natural time frame for rules that are self-imposed by a governing coalition, as it acknowledges that such rules would not bind future governments. A four-year rolling horizon, as in the SPs, would also be a sensible choice, provided that each update only introduces a ceiling for the additional year rather than modifying those for previous years. Using multiyear frameworks to constantly push adjustment into the future would, of course, be counterproductive.

Real versus nominal rules

48. The multiyear framework could specify either the evolution of nominal spending or real spending. With a real rule, each year the spending ceiling for that year is transformed into a nominal ceiling using the latest inflation forecast.25 26 In contrast, with a nominal rule changes in the inflation outlook do not lead to revisions in spending ceilings. Accordingly, a nominal target implies lower real government expenditures in periods of unexpectedly high inflation. If higher inflation results from excessive domestic demand, reducing real government expenditure would help cyclical stabilization. Similarly, in the case of a permanent adverse supply shock, lower real government expenditure would help absorb the shock and stabilize the expenditure-GDP ratio. By contrast, if the supply shock were temporary, a more appropriate response would be to increase government spending, but the nominal ceiling would force a reduction instead. Thus, a nominal rule may be more appealing in countries where cyclical stabilization is an important concern, temporary supply shocks are unlikely, and automatic stabilizers on the revenue side are small.

49. The presence of automatic indexation rules on some spending categories may make a real rule more attractive. For instance, in a number of countries pensions and other entitlements are indexed to expected inflation; thus, a real spending rule would make it easier to set (and respect) the ceiling on entitlement spending.

The choice of the aggregate

50. In choosing which expenditure aggregate to target, it is desirable to use a comprehensive measure. A broad aggregate is what is most relevant from a macroeconomic perspective; in addition, a narrow definition of expenditure makes it easy to circumvent the ceiling by introducing new expenditures as items not covered. An aggregate with a clear counterpart in national account statistics would also increase transparency and facilitate monitoring, key elements of a fiscal rule.

51. Using a comprehensive aggregate, however, has its drawbacks. For instance, if there is a history of containing spending growth by excessively compressing capital expenditures, as in the United Kingdom, it may be desirable to exclude these expenditures. In this case the framework must also clearly spell out the criteria to separate investment from current expenditures, to limit the scope for arbitrary expenditure re-classifications designed to get around the rule. Interest payments could also be excluded on the grounds that they are not under the direct control of the government; this would not provide opportunities for creative accounting, given that this type of expenditure is easily identifiable.27 However, to the extent that the main goal of the spending rule is to make sure that small deficits and lower taxes are mutually compatible, capital and interest expenditure should remain in the control aggregate.

52. Another issue is whether cyclically-sensitive expenditure items (mainly, unemployment compensation) should be included. While comprehensiveness and ease of monitoring recommend inclusion, it may be undesirable to cut discretionary spending during a downturn to make room for higher unemployment outlays. On the other hand, if changes in unemployment have a strong permanent component, as was the case in the four countries of interest in the last 30 years, then it is necessary to adjust other expenditures permanently rather than let the deficit increase, and excluding this item from the framework would not help achieve this outcome. Table II.8 shows that, while unemployment spending is a small component of total spending in the four countries, when a recession hits the increase in this spending item can be non-trivial. In addition, unemployment spending was fairly closely correlated with the cycle in Germany, France, and Italy during 1980-2000, though this was not the case in Spain, where unemployment had a strong structural component. All in all, in spite of the possibility of structural changes in unemployment, it may be preferable to exclude this item from the spending ceiling to increase the ability of the framework to deal with cyclical fluctuations.

Table II.8.

Characteristics of Unemployment Spending

(In percent of GDP)

article image
Source: IMF, WEO database.

53. Should the expenditure rule cover only discretionary expenditures or also entitlements? In the four countries under consideration, entitlements are large and growing both because of demographic and economic trends and because there are pressures to create new entitlements and expand existing ones. In addition, it would be relatively easy to disguise new types of expenditures as entitlements. Including entitlements creates problems for enforcement, as automatic cuts in case of overshoots are not feasible, an issue addressed in the next section. All in all, including entitlements is necessary to make the spending rule effective in the four countries.

Compliance and enforcement

54. When a country chooses to adopt a binding fiscal rule, the inevitable question is how the rule will be implemented and enforced. Deviations from the rule can occur ex ante, if the yearly budget proposed to Parliament does not conform with the multiyear rule, or ex post, if departures from the rule occur at the budget implementation stage. An effective rule should ensure compliance both ex ante and ex post.28 29

55. The means of enforcing a fiscal rule ex ante depend on its statutory nature -whether it is a constitutional amendment, organic law, regular law, or simply a political commitment. In the last case, violations are legally possible but presumably result in a loss of credibility that may damage the government. A rule sanctioned by ordinary law can be violated if Parliament approves a new law. Also in this case, therefore, a clear political commitment to the framework is necessary to ensure that violations result in a loss of reputation. Constitutional amendments or organic laws are usually more difficult to modify, and thus represent the strongest form of commitment. Because the commitment is so strong, however, budget rules written into constitutions may need to be vague to allow for flexibility to deal with unforeseen circumstances, resulting in less effectiveness. In the case of a spending rule, in which the numerical value of the rule is set every few years, a constitutional amendment is probably not a practical solution, and the rule would have to be entrusted to a political agreement, possibly strengthened by an ordinary law.

56. Concerning ex post compliance, the rules should specify how ex post deviations will be clawed back in the following years.30 This would provide an important anchor to the framework. To minimize deviations, it may be necessary to strengthen budget implementation provisions before introducing the rule.31 All countries have procedures to ensure that the budget implemented is close to what is approved by Parliament, but these procedures can be more or less restrictive depending on how easy it is to transfer expenditures across different chapters, on whether spending has to be approved by a centralized authority (such as the Ministry of Finance), on the powers of the Minister of Finance to block outlays in case of overruns, on the ease with which the budget law can be amended, and other aspects. In most countries with modern public expenditure management systems, ministers are held accountable at various times in the budget process. Safeguards may include hearings and questioning by the legislature as well as internal and external audits.32

57. Even though rules may not be broken in a legal sense, they may be broken de facto if they are not written clearly. According to Kopits and Symansky (1998), rules should define clearly what is the aggregate to be controlled and what are the escape clauses. Examples of rules that could benefit from greater specificity are a “golden rule” that leaves substantial room for interpretation of investment (as in Germany), or a “cyclically-adjusted” budget balance rule which does not define how to perform the cyclical adjustment.33 The rule should also be transparent, specifying accounting and reporting standards to limit “creative accounting.”34 Simplicity also enhances the ability of the legislature and the public to detect deviations, making the reputational mechanism more effective. Rules that are too rigid or require measures that are too costly to implement in certain circumstances are likely to be difficult to enforce, as the temptation to circumvent them would be too strong. For instance, the second version of the Gramm-Rudman-Hollings law in the U.S. proved unworkable since it would have entailed drastic cuts in discretionary programs (Chapter II of the Supplementary Information paper). From this perspective, rules that leave some flexibility to accommodate cyclical changes in the fiscal position may be easier to enforce. Additional flexibility can be introduced through contingency funds to be tapped in case of unpredictable events or emergencies, as in the case of the Spanish draft Fiscal Responsibility Law, or by allowing for (some) expenditures to be shifted across budget years (as in the U.K. DEL framework, see Chapter II of the Supplementary Information paper).

58. A particularly thorny issue, but a relevant one for the four countries of interest, is how to deal with overruns in entitlements. With discretionary spending, last-minute cuts to bring spending back within budgetary authorizations are always possible, but for entitlements this is neither realistic nor desirable. In this case, a limited contingency fund could cover overruns resulting from overly optimistic cost projections. Once the resources in the fund are exhausted, then discretionary spending would have to be cut or the overrun would have to be clawed back in the following year. On the other hand, the expansion of existing entitlement programs or the introduction of new ones during the budget year should be explicitly forbidden, unless they have been explicitly budgeted for under the spending ceilings.

Implementing a fiscal rules in a decentralized system

59. The existence of subnational governments with power to decide on important shares of public expenditures and public revenues and accumulate debt may enhance the effectiveness of public spending, but it may also complicate the achievement of national fiscal objectives.35 The previous section of this chapter examined spending rule for the general government. Implementing such a rule in a decentralized system is not straightforward, and the various possible approaches have their advantages and disadvantages.

60. Among the countries covered by this study, the issue of subnational governments is particularly relevant in Germany, Italy, and Spain. In France, the institutional arrangements result in sufficient control on local finances to implement a general government spending rule. In general, enacting fiscal rules in decentralized systems requires a negotiated agreement between the center and subnational governments which, to be effective, would have to be sanctioned by an explicit political commitment or enshrined in law.36 Such an agreement must also be supported by strong reporting requirements to allow monitoring, namely an effective information system that makes reliable and timely fiscal aggregates available at the subnational level. What should be the content of a pact with subnational authorities?

61. One option is to negotiate limits on spending by each level of government, effectively parceling out the general government ceiling. This type of agreement could include a limit on central government expenditure (net of transfers to subnational governments) and another on the expenditure of subnational governments as a whole. Expenditure ceilings could differ for the various levels of government and even within each level of government, depending on spending responsibilities and possibly reflecting different preferences across regions. This framework would allow automatic stabilizers to work at the level of subnational budgets provided that subnationals can borrow to finance deficits during downturns, or that financing from the center (transfers plus shared taxes) is adjusted to compensate for cyclical revenue shortfalls. The agreement could usefully specify rules for dealing with both ex ante and ex post deviations from the ceilings in order to assure compliance.

62. The drawbacks of this approach are that it may be difficult to reach an agreement on how to apportion the aggregate spending ceiling because there may be a large number of entities involved. Furthermore, monitoring may be quite complex because subnational governments tend to report with longer lags than the central government and public expenditure management systems are often less well developed at the subnational level.

63. An alternative option is to negotiate a budget balance requirement for subnational entities. This type of agreement would probably be simpler to negotiate and monitor than spending limits. If subnationals have little control on the revenue side—as is the case in Germany, Italy, and Spain—a deficit rule might effectively control spending growth over the medium term. However, depending on the formula used to allocate transfers, it could also result in a pro-cyclical fiscal policy at the subnational level. In addition, in years in which revenues overperform relative to expectations, subnational government would be able to expand spending, possibly beyond what would be consistent with the general government expenditure rule. To remedy these drawbacks, transfers from the central government (including shared taxes) could be designed to minimize cyclical influences on the revenue side, but this may be complicated and require an overhaul of the whole system of subnational finance.37

64. All in all, in countries where subnational governments have substantial fiscal autonomy, designing and implementing fiscal rules is more complex than in centralized systems. The main trade off is between a rule that is simple and easy to monitor (a balanced budget rule for subnational governments) and one that avoids pro-cyclicality (a spending rule). The choice has to be made on a country-by-country basis.

D. Fiscal Rules and the Effects of Fiscal Policy on Economic Activity

65. In this section, the impact of fiscal policy on economic activity under discretion and under rules is investigated. More specifically, we ask whether fiscal rules imply a change in the behavioral reactions of economic agents to fiscal policy. To what degree can this happen? Private-sector responses will be different if the same fiscal policy action today entails potentially different expectations about the path of fiscal policy in the future. In the discussion, which is conducted at a theoretical level because of data limitations, the focus will be “non-Keynesian” effects of fiscal policy, which depend crucially on expectations about future fiscal policy actions.38 Three assumptions help highlight the potential differences between a rule-based and a discretionary fiscal regime:

  • Fiscal rules are binding and credible. The rationale for this assumption is straightforward: if rules are not binding and/or not credible, the difference between a rules-based and a discretionary regime will vanish.

  • Under discretion governments have biases in the direction of higher spending and/or higher deficits. This assumption ensures that there is a rationale for fiscal rules. In addition, the presence of “biases” under a discretionary regime is one way to ensure that future government behavior, and hence private sector expectations about it, will be different under discretion and under rules.

  • The government’s intertemporal budget constraint is always binding. This third assumption simply ensures that the public internalizes the fact that the government has eventually to repay its debts. Under discretion and in the presence of a deficit bias this will occur later rather than sooner, but it will eventually occur.

66. Two types of fiscal rules will be considered: a rule on the cyclically adjusted budget balance; and an expenditure rule.39 We shall focus first on temporary tax and spending “shocks” and subsequently on announced permanent changes in policy. The analysis is mainly concerned with the impact of fiscal policy on aggregate demand in a small open economy.40 41 Fiscal rules may have additional effects related to their impact on uncertainty. For example, binding limits on fiscal imbalances will reduce, ceteris paribus, the likelihood of higher future taxes, with positive effects on capital accumulation.42 Investment may also be positively affected by the reduction in the volatility of fiscal policy that rules may entail.

67. The results of the analysis, presented in more detail in Chapter IV of the Supplementary Information paper, can be summarized as follows. Announcements of permanent changes in fiscal policy may be more credible if they are supported by rules; this would make private agents more likely to respond to a spending cut or a tax cut by raising their private consumption, as they anticipate a reduction in their future tax burden. By contrast, under discretion private agents may think that reductions in spending will only be temporary (given the assumed spending bias of the government), and therefore would raise their private consumption less in response to both tax and spending cuts. Accordingly, a permanent spending cut may be less contractionary and a permanent tax cuts may be more expansionary under rules than under discretion.

68. For the case of temporary fiscal shocks, the key issues are whether the shock is going to be offset by changes in taxes or in expenditure, and whether this offset is going to take place “sooner” or “later.” In general, under rules deviations of fiscal policy from its announced path may be expected to be reversed sooner rather than later, which would imply weaker effects of tax reductions on aggregate demand. The private sector response to a spending increase may instead differ between the case of a spending rule (making it likely that the offset is going to occur through lower future spending) or a deficit rule (the offset could occur with an increase in future taxes, much like in the case of discretion). Aggregate demand would then rise by more under a spending rule, because agents anticipate that the increase in public absorption is temporary.

69. To summarize, once fiscal rules are in place, are understood by the public, and have become credible, the impact of fiscal policy changes on aggregate demand may differ relative to a framework of discretion, because rules may change the public’s perception of how future fiscal policy will evolve. For example, with a spending rule a discretionary tax cut is likely to be more expansionary than under discretion if permanent but less so if temporary. A permanent spending cut, on the other hand, may be less contractionary, while a temporary spending increase is likely to be more expansionary. Of course, while the theory suggests that these might be the effects, whether they are large enough for policymakers to take them into account in practice is an empirical matter.

E. Conclusions

70. This chapter has reviewed fiscal policy and the fiscal framework in the four largest countries of the euro area, France, Germany, Italy, and Spain. As in many other advanced economies, in these countries the size of government and the public debt grew rapidly since the 1970s. Furthermore, fiscal policy was often conducted in a pro-cyclical 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 pressures on expenditures in the medium run remain, with debt still large (especially in Italy), tax burdens heavy (less so in Spain), infrastructure needs (particularly in Spain) and population aging ahead (relatively soon in France). These challenges motivate the re-examination of the fiscal framework in the four countries conducted in this chapter.

71. This chapter 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 pro-cyclical character of fiscal policy. A framework 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 one based on a budget balance rule, as is 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 framework can be relatively easy to explain to the public, in contrast with one based on a cyclically-adjusted budget balance.

72. 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.

73. 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 level 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 rule or a deficit rule on subnational governments, monitoring responsibilities, and sanctions for noncompliance.

74. Finally, when countries conduct fiscal policy in a well-established and credible rules-based framework, the economic impact of discretionary fiscal policy measures may change compared to 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 chapter 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, both theoretically and empirically, by the political economy literature, which has analyzed how conflicts of interest are shaped by the political system and budget institutions (see Chapter I of the Supplementary Information paper).

2

These frameworks exhibit considerable variety regarding the choice of target, degree of flexibility, and other characteristics. While most countries adopting rules in recent years have experienced substantial fiscal consolidation, this has happened against a background of favorable economic conditions. Whether these rules can survive a downturn remains a largely untested proposition. Chapter II of the Supplementary Information paper reviews selected country experiences.

3

This group includes Australia, Canada, New Zealand, the United Kingdom, and the United States.

4

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.

5

Alesina and Perotti (1997), IMF (1996), Alesina and Ardagna (1998), Perotti, Strauch, and von Hagen (1998), and von Hagen, Hughes-Hallett and Strauch (2001).

6

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

7

Moreover, rules can be designed to allow for some cyclical stabilization (see Section C below).

8

According to this definition, a positive impulse corresponds to an improvement in the structural balance, and hence to a discretionary fiscal contraction.

9

If the years after 1992 were included, fiscal policy would appear even less countercyclical.

10

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 any discretionary policy measure. In addition, calculations of structurally-adjusted balances are difficult, and different methodologies can give rise to very different results (Hagemann, 1999, Giorno et al., 1995). A third problem is that such calculations typically compute tax revenues using long-run elasticities. If short-run elasticities tend to be pro-cyclical (with tax revenues growing faster than GDP during expansions and vice versa)—as suggested for instance by Quinet and Mills (2001)—then the calculated structural balance will be too smooth, and the discretionary component will appear more counter-cyclical than it is in actuality.

11

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.

12

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

13

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 a deficit of 1.6 percent of GDP for France and Italy, of 1.4 percent for Spain, and of 1.1 percent for Germany.

14

Wendorff (2001) shows that, using a standard definition of investment, the rule was violated ex post in nineteen out of the past 20 years at the level of the general government.

15

Of course, the numbers in Table II.2 do not indicate who controls the revenue or expenditure policy decisions.

16

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

17

Besides rules, the literature has 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).

18

By a rule is meant a numerical objective that is costly to violate as it is based on a legal obligation or a “reputational investment.” Typically, the framework would specify a mechanism to rein in departures from the rule in a particular year. In contrast, a target is an objective that can be missed without triggering any sanction, automatic claw back, or loss of reputation.

19

Even with a rule on the budget balance, ensuring compliance ex post, i.e. 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.

20

The latter drawback (but not the others) can be avoided by replacing the balance rule with a “golden rule.” The golden rule, however, introduces difficulties of its own, because it is often hard to distinguish between current and capital expenditures.

21

Switzerland is moving in this direction. According to the proposed Swiss rule, in each budget expenditures are set equal to “structural revenues,” defined as projected revenues multiplied by the ratio of trend to projected output (Chapter II of the Supplementary Information paper). This is close to targeting a zero structural balance.

22

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. In this case, for the stabilizers to operate correctly, revenue projections must be based on a realistic rather than cautious scenario.

23

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

24

In Sweden, the rate of growth of total spending is set above that implied by the aggregation of the components, thereby creating a margin for adjusting spending in mid-course. In practice, the margin has always been used for discretionary expenditures.

25

In this respect, a general price index is better than sector-specific deflators, as the latter are probably 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 would not address this problem either.

26

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 mid-year to reflect updated inflation projections.

27

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

28

Bohn and Inman (1996) shows that, in U.S. states rules requiring that the budget be balanced are associated with lower deficits only if the requirement has to hold also ex post.

29

Whereas the SGP framework 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’ SPs and discussed by fellow members of the Union.

30

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 Chapter II of the Supplementary Information paper).

31

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

32

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

33

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.

34

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

35

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.

36

This agreement could be called an Internal Stability Pact, although this terminology can be confusing if one understands by it a scheme to implement the SGP. A brief survey of ISPs in euro area countries is in Chapter III of the Supplementary Information paper.

37

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

38

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.

39

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

40

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).

41

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

42

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

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Selected Euro-Area Countries: Rules-Based Fiscal Policy and Job-Rich Growth in France, Germany, Italy and Spain
Author: International Monetary Fund
Volume/Issue:
Volume 2001: Issue 203
Publisher:
International Monetary Fund
ISBN:
9781451813005
ISSN:
1934-7685
Pages:
121
DOI:
https://doi.org/10.5089/9781451813005.002

Selected Countries: Government Revenue, Expenditure, and Debt

(Percent of GDP)

Selected Countries: Composition of Expenditures

(Percent of GDP)

Selected Countries: Composition of Revenue

(Percent of GDP)

Selected Countries: Fiscal Policy and the Cycle