Sweden: Selected Issues

International Monetary Fund

doi:10.5089/9781451948707.002.A001

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Sweden

Selected Issues

Author: International Monetary Fund

Publication Date:: 15 Sep 2005

eISBN:: 9781451948707

Language:: English

Keywords:: ISCR; CR; central government; expenditure ceiling; government; local government; budget balance; government commitment; decentralized government structure; contingency margin; Output gap; Budget planning and preparation

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This Selected Issues paper for Sweden reports that the gradual introduction of a detailed fiscal framework accompanied the successful consolidation effort over the last decade in Sweden. The framework includes a surplus target of 2 percent of GDP for the general government, multiyear expenditure ceilings for central government, and a balanced budget requirement for local governments. Reliance on the expertise of an independent agency for the implementation of the fiscal framework could further enhance transparency and strengthen enforcement.

Abstract

I. The Swedish Fiscal Framework: Towards Gradual Erosion?¹

A. Introduction and Overview

1. The gradual introduction of a detailed fiscal framework accompanied the successful consolidation effort over the last decade in Sweden. The framework includes a surplus target of two percent of GDP for the general government, multi-year expenditure ceilings for central government, and a balanced budget requirement for local governments. Several independent agencies and institutions regularly report and comment upon budgetary assumptions, plans and outcomes, although none is formally entrusted with the task of assessing their consistency with the overall fiscal framework.

2. The framework has so far adequately supported the government commitment to sound fiscal policy. While the framework has clearly played a part in Swedish fiscal consolidation, as elsewhere, the role of political commitment is central. The main drive behind successful consolidations is always political will backed by strong public opinion support. However, a well designed fiscal framework can provide a reference against which progress along the adjustment path can be assessed, so as to keep the process on track and to avoid the loss of momentum which may occur once the crisis which initially motivated the correction is left behind.

3. Signs of pressure are emerging. The definition of the surplus target for general government lends itself to different interpretations. The ensuing ambiguity allowed subsequent downwards revisions of annual budgetary targets, thus pushing the attainment of the two percent surplus beyond the medium-term policy horizon. Margins under the expenditure ceilings for central government have gradually narrowed, while compliance has relied on recourse to various ad hoc measures such as tax expenditures and the postponement of outlays. Central government finances have progressively deteriorated and have been in deficit since 2002. The balanced budget rule for local governments has allowed procyclical fiscal policy in good times, followed later by increased local tax rates and central government transfers. The former offset some of the tax cuts by the central government, while the latter added to pressures on expenditure ceilings.

4. The paper discusses whether these pressures are minor disturbances in an otherwise unproblematic setting or symptoms of potentially serious problems. The paper takes the view that although the framework is generally well-designed and the compliance record is decidedly superior in the EU context, Swedish fiscal rules face the risk of gradual erosion.

5. The paper also examines possible amendments to the current fiscal framework to preserve its contribution to sound policymaking. While bringing together in a systematic framework the results of previous work (Schimmelpfennig, 2002; Annett, 2003; Danninger, 2004), the paper attempts to provide further insights on crucial elements in the design of the Swedish fiscal framework. Specifically the paper argues that:

Resolving the ambiguity concerning the 2 percent surplus target for the general government is a priority. Based on its current definition, legitimate interpretations of the 2 percent target range from an annual value in cyclically adjusted terms to an average value in nominal terms over a period of unspecified length. This makes it difficult to assess compliance based on actual budgetary outcomes (as it is not clear which nominal balance would be consistent with the framework in any given year) and can compromise the effectiveness of the whole system of fiscal rules. Choosing unambiguously one interpretation is the precondition for the adoption of a transparent and consistent methodology to translate the 2 percent surplus target into annual nominal targets.
The interpretation of the surplus target as an annual cyclically adjusted value would provide a better check against procyclical policies in good times than averages over the cycle (or any other period of time). To guard against procyclicality, restrictions to the use of the margins under the expenditure ceilings could also be introduced. A procyclical bias in good times reduces the margins for countercyclical policy in bad times. In the event, compliance with the target may require a procyclical correction during a downturn. The lack of economic rationale for such a prescription would harm the credibility of the fiscal framework and would likely lead to either pragmatic neglect or explicit repudiation.
Formal guidelines could be issued to ensure that central government expenditure ceilings are set at a level consistent with the 2 percent surplus target. In this respect, the introduction of an explicit intermediate target in terms of central government budget balance could prove a useful device to foster transparency. The somewhat elusive definition of the general government target has so far proved an obstacle to the implementation of such guidelines. The level of ceilings has become somewhat arbitrary. Moreover, in the absence of an anchor in terms of the budget balance, it has been possible to ensure compliance with expenditure ceilings through tax expenditures.
Reliance on the expertise of an independent agency for the implementation of the fiscal framework could further enhance transparency and strengthen enforcement. The framework aims at reconciling soundness and flexibility of fiscal policy. Therefore its consistent implementation ultimately relies on variables such as the output gap and the cyclically adjusted balance. The complexity of the task of assessing and measuring these concepts adversely affects transparency and enforcement. In this respect, once a more precise definition of the surplus target is agreed upon by policy-makers, consideration could be given to relying on an independent agency for the task of translating the prescriptions of the framework into annual nominal budget targets as well as for the ex post assessment of budgetary outcomes.
Encouraging the introduction of multiyear expenditure ceilings and basing the balance budget requirement on potential (as opposed to actual) revenue may help control procyclical biases and encourage fiscal prudence also at the local government level. It should be noted, however, that budgetary pressures arising in the local government sector may have deeper roots in the definition of mandates and in the incentives provided by the system of grants to local governments.

6. The paper is organized as follows. Section B analyzes the Swedish fiscal performance between the mid-1970s and the early 1990s in order to highlight the rationale for the introduction of the current fiscal framework. Section C describes the framework and provides an assessment of the adequacy of its design with respect to the pursued policy goals. Section D examines the recent fiscal performance and the evidence of rising pressures on the framework. Section E discusses possible amendments to ease those pressures and keep public finances on a solid track.

B. Public Finances in Sweden Until The Mid-1990s

7. Public debt rose from about 30 percent of GDP to close to 75 percent from the mid-1970s to the early 1990s (Figure 1). During this period, the debt dynamics was clearly not on a sustainable path. Besides graphical inspection, this can also be seen by way of reference to the government’s intertemporal budget constraint. As is well known, solvency requires that the debt to GDP ratio rise at a rate lower than the difference between the nominal interest rate and the nominal growth rate of output.² However, in Sweden the debt to GDP ratio grew at an average rate of 5.2 percent over 1975-94, far exceeding the difference between interest and growth rates (averaging at 0.7 per cent over the period).³

8. The Swedish debt followed a similar trend to that of the European Union average, but fluctuated more than in most other EU countries and displayed a clear ratcheting pattern. This behavior reflects both a stronger sensitivity to cyclical conditions and some degree of asymmetry in the conduct of fiscal policy over the cycle. Fluctuations in debt indicate that fiscal balances moved countercyclically both in downturns and in upturns. However, the increase in the debt ratio during the downturn of the first half of the 1980s was not fully offset in the subsequent upturn. With the onset of a new recession in the 1990s, debt rose to even higher levels.

9. A more pronounced reaction of the fiscal balance to negative output gaps than to positive ones is confirmed by regression analysis, suggesting that discretionary fiscal policy may have been procyclical during the upturn. (Table 1, Figure 2) Estimation of a standard fiscal reaction function⁴—whereby the general government primary balance is a function of its lagged value, the lagged value of the debt ratio and the output gap—yields an estimate of 0.78 for the output (semi)elasticity of the budget over 1970-93 (the year in which the deficit peaked). This is close to available estimates of the size of automatic stabilizers (see, e.g. EC, 2001; IMF, 2004; van den Noord, 2000; and Bouthevillain and others, 2001).⁵ However, when coefficients for positive and negative output gaps are estimated separately, it appears that the elasticity to a negative output gap is higher than that suggested by automatic stabilizers, while the elasticity to positive output gap is lower.⁶ Based on this evidence, discretionary policy appears countercyclical in bad times—as it increases the effect of automatic stabilizers—and procyclical in good times (see also Lindh and Ohlson, 2000; IMF, 2001; SOU, 2002:16).

Table 1.

Asymmetry in Cyclical Sensitivity of the Primary Balance ^1/

Source: EU Commission, AMECO. Output gap is estimated by HP filter (λ=30).

^{^1/}Dependent variable: primary balance (percent of GDP). Sample period: 1970-93. OLS, t statistics in brackets. *, **, *** = significant at 10, 5, and 1 percent levels.

Table 1.

Asymmetry in Cyclical Sensitivity of the Primary Balance ^1/

	Levels		First Differences
Constant	-2.42	-1.90	-0.42	-0.40
Lagged primary balance	0.72 ^**	0.70 ^**	…	…
	(3.52)	(3.43)
Lagged debt/GRP	0.04	0.04
	(0.85)	(1.02)
Output gap	0.78 ^*		0.70 ^**
	(1.92)		(2.13)
Positive output gap		0.19		0.46
		(0.30)		(0.79)
Negative output gap		1.39 ^**		0.91 ^*
		(2.13)		(1.73)
Adjusted R2	0.67	0.67	0.14	0.11

Source: EU Commission, AMECO. Output gap is estimated by HP filter (λ=30).

^{^1/}Dependent variable: primary balance (percent of GDP). Sample period: 1970-93. OLS, t statistics in brackets. *, **, *** = significant at 10, 5, and 1 percent levels.

Table 1.

Asymmetry in Cyclical Sensitivity of the Primary Balance ^1/

	Levels		First Differences
Constant	-2.42	-1.90	-0.42	-0.40
Lagged primary balance	0.72 ^**	0.70 ^**	…	…
	(3.52)	(3.43)
Lagged debt/GRP	0.04	0.04
	(0.85)	(1.02)
Output gap	0.78 ^*		0.70 ^**
	(1.92)		(2.13)
Positive output gap		0.19		0.46
		(0.30)		(0.79)
Negative output gap		1.39 ^**		0.91 ^*
		(2.13)		(1.73)
Adjusted R2	0.67	0.67	0.14	0.11

Source: EU Commission, AMECO. Output gap is estimated by HP filter (λ=30).

^{^1/}Dependent variable: primary balance (percent of GDP). Sample period: 1970-93. OLS, t statistics in brackets. *, **, *** = significant at 10, 5, and 1 percent levels.

10. Rising deficits stemmed from a rapidly increasing expenditure to GDP ratio in the early eighties as well as the early nineties (Figure 3). Expenditure rose from 57 to 66 percent of GDP between 1977 and 1982; subsequently, although declining, it did not return to its original level and, from a low of 59 percent in 1990, grew further, to reach 70 percent in 1993 in conjunction with the deep economic crisis the country faced in those years. Revenue lagged behind: the ratio to GDP rose from 57 to 59 percent over 1977-82 and, after rising further to reach to an average reach to an average of 62 percent over 1986-90, it fell back to 59 percent in 1993. Superimposed on these trends, Sweden was also facing the prospect of further sharp increases in spending due to population ageing.

C. The Fiscal Framework

11. Sweden undertook a successful and impressive fiscal consolidation starting from the mid-1990s. The general government debt to GDP ratio went down from 74 percent in 1994 to 53 percent in 2000 (Figure 4). Over the same period, the ratio of general governmment expenditure to GDP was cut by about 15 percentage points, from about 70 to 55 percent.⁷ Most of the reduction came from the central government (local government spending declined from 23.5 to 22.2 percent of GDP). The revenue ratio remained stable at around 60 percent and the general government budget balance turned into a 5 percent of GDP surplus in 2000 from a double-digit deficit in 1993 (Figure 5). Over most recent years, the expenditure ratio hasn’t changed much, while the revenue ratio has been cut by about 4 percentage points, with the budget gradually drifting towards a balanced position. The gross debt ratio has not declined much further either, but net debt has fallen to zero.

12. Sweden also implemented a radical reform of its pension system. The reform, put into effect in 1999, introduced an automatic balancing mechanism to adjust for demographic changes, placing the system—a pay-as-you-go defined contribution one, with notional individual accounts—on a financially sustainable basis (see Thakur and others, 2003; and, for an insider’s view of the reform, Settergren, 2001).

13. However, financial pressure from population ageing is still expected to build health and long-term care programs. Expected spending increases in these programs, forecast at about 3 percentage points of GDP by 2050, are among the highest in Europe (EPC, 2001). Figure 6—from Danninger (2004)—depicts projected increases in the demand for the components of these public services provided by local governments.

14. The fiscal turnaround was accompanied by the introduction of a detailed fiscal framework, defining rules for all levels of government and resting on a transparent accounting system. Concerns about the sustainability of public finances as well as the need to correct “stabilization failures” in good times and a desire to allow for effective countercyclical policy provided the rationale for the gradual implementation of a rules-based fiscal framework after the crisis of the early 1990s (Heeringa and Lindh, 2001; SOU, 2002:16). In 1997, nominal expenditure ceilings for central government were introduced with a view to setting the budget process in a controllable medium-term framework. At the same time, it was decided that general government should aim for a budgetary surplus of 2 percent of GDP, in order to secure a reduction in net debt level and to address the budgetary impact of an ageing population. This provision became operational in 2000, after the pension reform. Beginning from that year, a balanced budget requirement was also applied to local governments.

15. while the definition of the general government surplus target as an average over the cycle has remained unchanged since its initial formulation (SOU, 1997), the interpretation of the target has changed over time. Initially the target was set with reference to the cyclically adjusted balance on a yearly basis (Swedish Ministry of Finance, 1998). Based on this definition, countercyclical movements of the budget balance would have been restricted to those arising from automatic stabilizers. Subsequently, the government specified that annual deviations from the medium term target could be tolerated depending on economic circumstances. Thus, in Swedish Ministry of Finance formulation (2000), the cyclically adjusted target for 2001 was set at 2.5 per cent of GDP, in a context where the economy was approaching a situation of full utilization of resources (Heeringa and Lindh, 2001). More recently, the 2 percent surplus target has been interpreted as referring to the average general government nominal balance as of the year 2000 (Swedish Ministry of Finance, 2004; Fischer, 2005).

16. Central government expenditure ceilings are determined annually for a period of three years based on a proposal by the government. The ceilings cover primary expenditure in the state budget (including transfers to local governments) and old age pension expenditure. Based, inter alia, on forecasts of government revenue prepared by the Ministry of Finance (taking into account current tax rules plus any planned change), the ceilings are set with a view to the need to fulfill the medium-term budgetary target for the general government (Heeringa and Lindh, 2001). However, there is no formal guideline to this effect (Fischer, 2005). Recently, ceilings have come to be set as a constant share of potential GDP. Overall expenditures allowed under the ceilings are allocated to 27 spending areas and to a contingency reserve. The latter is not specifically designed to allow room for countercyclical spending; it also provides a buffer against forecasting errors and unspecified reforms (SOU, 2002:16; Schimmelpfennig, 2002). The detailed spending ceilings are voted as a whole by the Parliament, which limits the room for amendments, as opposition parties find it difficult to unite on a comprehensive alternative (Molander, 2000).

17. Local governments must plan for revenue higher than current expenditure. Local governments can borrow to finance investment but revenues must cover the financing cost of the loans. In case the budget outturn is a deficit, compensating surpluses are required over the following years (though under some circumstances this may not be necessary). There is no sanction mechanism in the event of noncompliance.

18. The rule-based system is backed by high standards of transparency (IMF, 2000). Budget documents provide a comprehensive coverage of general government and they are available on a timely basis on the government website. The economic assumptions used are clearly stated in budget documents. A number of institutions regularly report and comment on budgetary assumptions, plans and outcomes (although none is formally entrusted with the task of assessing their consistency with the overall fiscal framework). The independence of the national statistics office is guaranteed by law.

D. Emerging Pressures

19. The fiscal framework has so far adequately supported the political will to preserve sound fiscal policies. While the main drive behind successful fiscal consolidations is always political commitment backed by the support of strong public opinion, a well designed fiscal framework can provide a reference against which progress along the adjustment path can be assessed, so as to keep the process on track and to avoid the loss of momentum which may occur once the crisis which initially motivated the correction is left behind.

20. The Swedish fiscal framework encompasses rules for all levels of government; it makes reference to several indicators and rests on a transparent accounting system. Targeting a relatively high surplus for the general government addresses concerns over the sustainability of public finances arising from experience with rapid debt accumulation as well as from pressures related to population ageing. The definition in terms of “over the cycle” intends to reconcile soundness with flexibility and to ensure margins for stabilization policy. Multi-year expenditure ceilings for central government are a means to maintain control of the budgetary process, allowing a reduction of the tax burden, while avoiding excess spending in good times. The balanced budget rule for local governments recognizes that in a decentralized framework, fiscal discipline can only obtain with the contribution of all levels of government. Finally, the open discussion of policy, both at the implementation and at the assessment stage, underpins public support and ownership of the framework and increases the reputation costs of noncompliance.

21. However, the brief description in the previous section already suggests a number of problems potentially impairing the effectiveness of the framework:

The 2 percent surplus target for general government is proving to be an elusive concept. Subsequent shifts in the interpretation of the target are hampering assessment of compliance (Fischer, 2005). The currently prevailing interpretation, which refer to average values over a period of unspecified length, provides little check against a possible tendency to run procyclical policies in good times.
The expenditure ceilings for central government lack a formal anchor to a budget balance target (ESV, 2004). This makes their level somewhat arbitrary and allows the use of tax expenditures to comply with the ceilings, substantially undermining the role of ceilings in ensuring fiscal discipline (IMF, 2000).
There is no specific provision for cyclical margins under the expenditure ceilings. The full contingency margin can therefore be spent procyclically and leave little leeway in case of a downturn (Heeringa and Lindh, 2001; SOU, 2002:16; Schimmelpfennig, 2002; Annett, 2003).
The balanced budget requirement for local governments is not adjusted for the cycle. Coupled with the high cyclical sensitivity of local government revenue—which is strongly dependent on personal income taxes⁸—this may result in procyclical policy in good times⁹ and induce restrictive corrections or force a central government bailout in bad times¹⁰ (McGranahan, 1999; Balassone and Franco, 1999; Danninger, 2004; Spilimbergo, 2005).

22. Annual targets for the general government budget have been repeatedly revised downwards, pushing the attainment of the two percent surplus beyond the medium-term policy horizon (Figure 7). The general government recorded surpluses almost uninterruptedly since 1997. However, after 2001 the surplus has remained well below 2 ercent of GDP and no significant increase is planned over 2005-07, in spite of an improving output gap.¹¹ In recent years, when assessing compliance with the fiscal framework, reference has been made to the average surplus recorded since 2000. This may have blurred the perception of the slippage.¹² However, even when interpreted in in this way, the 2 pecent surplus target is now unlikely to be met before the end of the decade. On the current policies, the average structural surplus is projected to fall to 0.9 percent of GDP during 2005-07 from an average of 1.9 percent of about 3¼ percent of GDP would be required over 2008-10 to attain the target of 2 percent of GDP over the decade to 2010.¹³

23. Tax expenditure have been rising over recent years and margins under the expenditure ceilings for central government have gradually narrowed. Tax expenditures rose from less than 2 billion SEK in 2001 to a budgeted value of 16 billions in 2005 (Figure 10). To avoid pressure on expenditure ceilings, for instance, local authorities have been charged lower value added taxes in return for reduced expenditure transfers (IMF, 2000). In 2003 the employment subsidy to local governments was treated as a decrease in revenue rather than as an expenditure item (Annett, 2003). Subsequent budgets have progressively set narrower expenditure margins even though the output gap has been improving since 2003 (Figure 11). The margins are now too thin to provide any leeway in the event of unexpected shocks (around 0.1 percent of GDP for 2005-06; 0.3 percent, on a provisional basis, for 2007). While compliance with the expenditure ceilings has been formally achieved—also by postponing some outlays—tax expenditure and full use of expenditure margins contributed to a deterioration of central government finances, with the balance moving from a 2.6 percent of GDP surplus in 2000 to a planned 1.6 percent deficit in 2005 (Figure 12).

24. Consistent with the balanced budget requirement, local governments used high revenues in the late 1990s and the early 2000s to support an expansion of consumption. When local government revenue faded, the balanced budget requirement resulted in increases in both local income tax rates (by about 1 percentage point over 2003-04; Figure 13) and central government grants (from 5.0 per cent of GDP in 2000 to 5.4 percent in 2005). The former have offset some of the tax cuts at the central government level, while the latter have added to pressures on central government expenditure ceilings.

25. Sweden’s fiscal performance over the last decade nevertheless remains impressive in comparison with other advanced economies. The fiscal framework has certainly contributed to this success. It is only when gauged against its own ambitious targets that the fiscal framework shows signs of stress. Compliance with the rules is not perfect, but it undoubtedly exceeds the standards achieved elsewhere in Europe. However, while the weaknesses of the framework are not an immediate threat, they could become more problematic in the medium-long term.¹⁴

26. A drift away from the spirit of the fiscal framework under the current relatively favorable economic conditions may erode its credibility. The lack of margins for countercyclical policy in a downturn may put in question the economic rationale of the framework. Failure to maintain a countercyclical stance across the business cycle may force the authorities into a painful choice between having to forfeit stabilization policies and repudiating their medium term fiscal target, in the event of an unexpected downturn. The second option may turn out to be politically more palatable, as experience with the European Stability and Growth Pact suggests.

E. Policy Implications

Surplus Target and Expenditure Ceilings

27. Resolving the ambiguity concerning the interpretation of the 2 percent surplus target for the general government is a priority. The interpretation of the 2 percent surplus objective determines which annual targets in nominal terms are consistent with the fiscal framework. Ambiguities in the interpretation therefore impair the assessment of compliance. Clear and simple targets are the cornerstone of an effective fiscal framework. They are the precondition of accountability. They allow monitoring by the public and facilitate control by technical bodies formally entrusted with the task.

28. All interpretations utilized in the Swedish context are consistent with the rationale of the fiscal framework. However, there are differences in both the degree of discretion allowed and the implementation difficulties involved.

Averages over the cycle provide flexibility, but the availability of discretion says nothing about its use. Reliance on a target defined as an average over the cycle implicitly assumes that flexibility will be consistently used for stabilization purposes. This assumption is not supported by evidence on the cyclical asymmetry of fiscal policy.¹⁵ If fiscal policy tends to be countercyclical in bad times and procyclical in good times, the definition of an average target will have to be supported by further guidelines to avoid procyclicality.¹⁶ Moreover, compliance with average targets requires that policy in the early years of the cycle be guided not only by an assessment of current cyclical conditions but also by forecasts concerning the length and width of the cycle (Box 1). Interpreting the 2 percent surplus target as an annual cyclically adjusted value (possibly making it explicitly contingent upon economic circumstances) would strike a better balance between flexibility and discipline.

Box 1.

Cyclical Asymmetry in Fiscal Policy and Targets “Over the Cycle”.

By overlooking the tendency of policy towards asymmetric procyclicality, fiscal frameworks based on targets defined as averages over the cycle may carry the seeds of their own demise. Reference to average budgetary outcomes allows conducting relatively lose policies today and to postpone adjustments towards the end of the reference period (or to postpone the end of the reference period itself, if this is not tightly specified). The likely end game is that the fiscal framework will come under strain as soon as it requires a procyclical adjustment in bad times. The unchecked deficit bias in good times will ultimately undermine the credibility of the framework because its prescriptions will be seen as lacking economic rationale; it will be either de facto disregarded or repudiated outright.

Recent developments in the European Union provide the most prominent example of this type of problems. The difficulties of several member states in keeping their deficits within the limit set by the Maastricht Treaty arose after 2001 in an adverse macroeconomic environment. However, their origins are rooted in insufficiently ambitious policies followed over 1999-2000, when conditions were favorable (Figure 1). Nevertheless, the Stability and Growth Pact (SGP) has notoriously been labeled as “stupid”, it has been put on hold and its reform has been the subject of a hot debate (Buti, Eijffinger and Franco, 2003, and Annett, Decressin and Deppler, 2005, provide succinct accounts).

In this case, the different status of the 3 percent of GDP ceiling set for the annual nominal deficit and of the medium term objective of close to balance or in surplus may have been an augmenting factor. While the former is defined in the Treaty and sanctions are foreseen in case of non compliance, the latter is defined in the SGP and is not backed by similar incentives. This asymmetry has allowed attention to focus on the nominal deficit ceiling at the both the policy and the monitoring levels, thus reducing pressure against the adoption of procyclical policies in good times. Significantly, most of the reforms proposed by policy makers aim at relaxing the nominal deficit ceiling in bad times, while little attention is paid to how to induce countercyclical behavior in good times. This tendency is also reflected in the reform proposals recently agreed upon, as described in European Council (2005).

However pressure is also building up in the UK, where the objective to achieve a current balance surplus over the cycle is not accompanied by nominal deficit ceilings. The cumulative current balance in this cycle is still in small surplus, so the target is likely to be met or missed by an insignificant amount (Figure 2). However, on current policies the next cycle is likely to start with a less favorable current balance position than the large initial surplus recorded at the beginning of the present cycle and there is a risk that the target may not be met in the next round (IMF, 2005).

29. The main problem with the expenditure ceilings as they are currently set is that they can be circumvented through tax expenditure.¹⁷ Formal guidelines could be issued to ensure that the ceilings are set at levels consistent with the 2 percent surplus target for general government. The elusive definition of the 2 percent target has so far proved an obstacle to the implementation of such guidelines. In this context, the introduction of a budget target for central government—to accompany the one set for general government—would be a facilitating element (ESV, 2004).¹⁸ This option would also increase the transparency of the overall framework by spotlighting the implications for central government finances of the target set at the general government level.

31. A second issue relates to the absence of a specific provision for cyclical margins under the expenditure ceilings. That the full contingency margin could be spent procyclically and leave little leeway in case of a downturn was noted early in the debate on the Swedish fiscal framework (e.g., Heeringa and Lindh, 2001). This has been relatively unproblematic so far because the Swedish economy has not undergone a serious downturn since the introduction of the expenditure rule. However, while SOU (2002:16) suggested a cyclical margin of 1 percent of GDP, overall margins are currently at 0.1 percent of GDP. One possibility is that quotas of margins under the ceilings be earmarked for different purposes. Margins under the ceiling, however, tend to work asymmetrically (Schimmelpfennig, 2002). They would be used fully during a downturn but compensating underspending would not be guaranteed in the upswing. To avoid this potential overspending bias, the ceilings, and the underlying margins, could be set at central values consistent with potential growth, allowing overruns/savings depending on output deviations from trend (Danninger, 2002). The technicalities of these and similar solutions are discussed in Schimmelpfennig (2002).

32. The possibility to delegate to an independent agency the estimation of the nominal balance consistent with the 2 percent surplus target could be considered. While resolving ambiguities will increase transparency, this is only a necessary condition for the effectiveness of the fiscal framework. Transparency may enhance the reputation costs of non-compliance, but this may prove a weak incentive if, for instance, fiscal issues do not have a dominant weight in voters’ choice at elections. Moreover, if the potential for deviations from the fiscal framework is rooted in time-inconsistency of policy, voters may well approve the governments’ choice to deviate. In this respect, the literature on fiscal rules and frameworks has long stressed the importance of enforcement mechanisms.¹⁹ More recently, with the debate on “independent fiscal councils” (IFCs), the emphasis has shifted to the possibility to delegate, at least partially, the implementation of policy. The notion of IFCs covers a wide range of arrangements, from soft versions—where IFCs simply provide monitoring of compliance—to hard ones—where IFCs are entrusted with the power to implement policy changes using selected fiscal instruments.²⁰ While beneficial in terms of transparency, the arrangement proposed here can be seen as a step in the direction of introducing a “soft” IFC.²¹ The independent agency, by estimating the annual nominal balance consistent with the provisions of the framework, would actually be setting the envelope within which policymakers would then take decisions concerning the allocation and distribution of resources.²² Given appropriate legal status,²³ the agency’s recommendations could provide a shield against time-inconsistency problems and/or weaknesses of reputation-based incentives provided by transparency.

Local Government Finances

33. Multi-year expenditure ceilings could be introduced for the local governments and/or the balanced budget requirement could be based on potential rather than actual revenue. This would reduce the procyclical bias resulting from the interaction between the high cyclical sensitivity of local government revenue and the balanced budget rule. SOU (2002:16), in a similar vein, suggests that “To strengthen the automatic stabilisers, local government income should be stabilised over the business cycle. The primary model that should be considered is to calculate the local government tax base on the basis of an average of taxable income over several years. Alternatively, central government grants can be formulated so that they automatically compensate for the effects of the business cycle on the local government tax base” (p. 20).

34. However, budgetary pressure arising in the local government sector may have deeper roots. As the mandate of local governments is open-ended and the determination of central government transfers allows some discretion, incentives for fiscal discipline are low. Local governments provide a large share of social services (notably health services) to which equal access must be granted across the nation. However, there is no fixed rule or mechanism to link changes in grants to changes in demand or other economic developments.²⁴ Central government grants are partly distributed according to tax capacity and structural costs. Nevertheless, the central government has full authority to decide over the level of transfers and budgetary risks have been specifically associated with the presence of this discretionary element within the transfer system (Johansson, 2003).²⁵

Box 2.

Decentralization: Equalization Schemes and Budgetary Discipline

A decentralized government structure offers potential allocation and cost efficiency advantages. As responsibility for the management of services is entrusted to a level of government which is closer to the area in which the services are provided, supply can be better adjusted to the needs and preferences of the citizens (Buchanan, 1965; Cornes and Sandler, 1995). Moreover, monitoring of the conduct of elected representatives can be more effective and yardstick competition across jurisdiction can provide further efficiency-enhancing incentives (Tiebout, 1956; Salmon, 1987). Tight conditions must be met in order to actually exploit these advantages. The effectiveness of monitoring and the extent of yardstick competition depend on high standards of transparency. Dominance of local interest groups can prevent the full deployment of allocation advantages.

Since decentralization typically involves more locally determined expenditure than revenues, the need to cover the resulting gap by central government transfers can reduce the incentives to fiscal responsibility (Buchanan, 1967; Oates, 1972). A rigorous interpretation of the classical theory of the assignment of government functions would leave very little scope for own revenues at the local level (Musgrave, 1959; Ter-Minassian, 1997). A gap between expenditure and revenue at the local level may also result from the pursuit of a homogeneous minimum level of services across jurisdictions with an uneven distribution of tax bases.

Central governments’ financial support to local administrations is often cited as one of the factors underlying excessive growth in public expenditure (e.g., Stein, 1998; Garcia-Milà, Goodspeed and McGuire, 1999; De Mello, 2000; Drummond and Mansoor, 2002; Rodden, 2002 and 2004; and Bordignon, 2004). The mandated level of service is usually difficult to specify clearly. Therefore, the cost implication of uniform service provision across the country are difficult to assess and the responsibility for any budget overrun becomes blurred, with the blame falling with equal plausibility on unfunded mandates and on inefficient management. In these circumstances, the probability that the central government is called to bailout the local government is high. The bargaining position of the local vis-a-vis the central government is stronger if local governments carry out a large share of social expenditure and a failure to accommodate the level of transfers entails the risk of significant disruptions in the provision of services. Allowing borrowing authority is not a solution, indeed an open bailout then becomes a possibility.

The reaction to these problems has usually been the introduction of some form of fiscal rules for local governments (Eichengreen and von Hagen, 1995; Ter-Minassian and Craig, 1997; Balassone and Franco, 1999; Banca d’Italia, 2001; Daban and others, 2003; Kopits, 2004). However, unless the roots of the problems are adequately dealt with, issues arise concerning the credibility and the enforcement of rules. If responsibilities are blurred and local governments have a high bargaining power the presence of formal rules can make little difference to actual behavior (Banca d’Italia, 2001; Rodden, 2004).

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Prepared by Fabrizio Balassone, Fiscal Affairs Department. I wish to thank Robert Boije, Leo Bonato, Urban Hansson-Brusewitz, Yngve Lindh, James Morsink, Subhash Thakur, Thomas Nordstrom, Evridiki Tsounta and the participants in a seminar held at the Swedish Ministry of Finance for helpful comments and insightful discussions.

Under this condition, the discounted value of the debt ratio tends to zero $\lim_{T \to \infty} {[(1 + r) / (1 + g)]}^{- T} d_{T} = 0$ which ensures that the discounted value of future primary balances tends to equal the initial level of the debt ratio $\lim_{T \to \infty} Σ_{t = 1, T} {p_{t} {[(1 + r) / (1 + g)]}^{- t}} = d_{0}$ (see, e.g. Blanchard and others, 1990).

The rate of growth of the debt to GDP ratio exceeded the difference between interest and growth rate also between 1975 and 1990 (when the debt to GDP ratio was at a through).

See, e.g., Bohn (1998), Ballabriga and Martinez-Mongay (2002), and Gali and Perotti (2003).

The semi-elasticity of the Swedish budget may have diminished somewhat over the last decade.

See Balassone and Francese (2004) and Balassone and Kumar (2005) for an application of a similar analytical framework to panels of industrial and emerging market countries.

The sustained growth following the crisis of the early 1990s amplifies the reduction of both debt and expenditures, measured as a share of GDP.

The tax base also includes transfers not directly related to the cycle (e.g., pensions, early retirement benefits etc.). This somewhat reduces its cyclical sensitivity.

Cross country comparison suggests that procyclical spending of revenue gains in good times is the rule, rather than the exception (see, e.g., Balassone and Kumar, 2005, and references therein).

The possibility to compensate for a deficit over subsequent budgets somewhat reduces the problem (SOU, 2002). Moreover, legislation provides for unspecified exceptions to the rule and there are no sanctions for non compliance. However, this makes the rule a weak one. The end-result may be unchecked expenditure increase.

Between 2002 and 2006, while annual values of the cyclically adjusted balance (outturn and projections) remain significantly below the 2 percent surplus target (with the exception of 2004), the average of these values as of 2000 is close to 2 per cent of GDP, thanks to the large surpluses recorded in 2000-01(Figure 9).

While the cyclically adjusted fiscal balance reacted in a timely manner to the widening of the output gap over 2001-03, there are no plans for a symmetric response to the foreseen narrowing of the gap over 2003-06 (Figure 8). This suggests that the current framework is having problems in correcting the procyclical bias underscored in Section II.

The assessment would be similar if compliance with the target were to be gauged in nominal terms.

Similar concerns are also expressed in Riksbank (2004).

See section II (and references therein) and Footnote 10 above.

APPENDIX I Data Sources and Definitions

This appendix analyzes the data sources used in the empirical analysis.

Time Period: 1980-2001

List of Countries: Australia, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, the U.K. and the U.S.

Participation Rate by gender: Data were obtained from OECD’s Labor Force Statistics database available at

http://www.oecd.org/topicstatsportal/0,2647,en 2825 495670 1 1 1 1 1,00.html

Data were interpolated for years for which data were not available.

Total and by Gender Hours worked per working age population: Data for annual hours worked per employee, working age population (aged 15-64) and numbers employed by average weekly hours bands by gender and for the total population were obtained from the OECD Labor Force Statistics database cited above. Total hours worked per working age person were then computed as:

(Total employment x average actual annual hours worked per person in employment)/ population aged 15-64.

Computation of average annual hours worked by gender necessitate the use of some simplifying assumptions, which would become more apparent using an example. In particular, OECD provides data for the number employed (by gender) per average weekly hours bands. For example, in Sweden in 2001, the following men hourly band distribution were reported:

Assuming that each agent worked the average hours in his band (e.g., 77,000 men worked 10 hours, 83,200 men worked 25 hours per week and so on) we are able to obtain a proxy for the number of hours worked every week by men.

The same procedure is repeated for women and the total weekly hours worked are obtained by adding the two constructed series. The total average weekly hours worked are then fitted to the total annual hours worked to obtain the average numbers of weeks worked. This number can then be multiplied with the constructed average weekly hours worked by gender to obtain the annual hours worked by gender.

Tax Wedge: Data on primary earner’s tax wedge were obtained from OECD’s Taxing Wages Statistics- Historical Tax Rates. Primary breadwinners tax wedge is defined as the tax wedge of a household with two children, with a sole breadwinner earning 100 percent of the average production wage (APW). Data were interpolated when missing. The secondary breadwinner’s tax wedge was obtained from Jaumotte (2003). The reader is referred to Jaumotte (2003) for an explanation of how the series was constructed.

In the econometric analysis, we only consider the tax wedge for secondary earners using gross income rather than labor costs (i.e., we ignore social security contributions) due to the lack of available data for the pre-1996 period. We believe that this limitation does not affect our results. Even when ignoring employer’s social security contributions, the Swedish tax wedge on secondary earners is not one of the highest in the OECD.

Benefit Wedge: The benefit wedge series was constructed using the OECD Social Expenditure Database (2004) and OECD Labor Force Statistics. The benefit wedge which refers to a household with two children and an elderly, was constructed using the following formula:

B e n e f i t W e d g e = \frac{P u b l i c B e n e f i t s i n k i n d f o r o l d a g e a n d f a m i l y}{\frac{0.5 \times P o p u l a t i o n b e l o w 15 y e a r s + P o p u l a t i o n a b o v e 65 y e a r s}{H o u s e h o l d G r o s s {I n c o m e}_{B} - H o u s e h o l d G r o s s {I n c o m e}_{A}}}

where A denotes a household with two children and a single earner married couple earning 100 percent of APW, and B denotes a similar household with two breadwinners earning 100 and 67 percent of APW.

Female and Male Wage Rate: The wage rate is measured by the average hourly wages in manufacturing (in PPP) as obtained from Gauthier, A.H. (2003), “Comparative Family Benefits Database,” Version 2 (University of Calgary), available at:

http://www.soci.ucalgary.ca/fypp/family policy databases.htm

Data were interpolated for missing years.

Wage Gap: The wage gap used for the women is defined as the ratio of male to female wage rate. The wage gap used for men is defined symmetrically.

output Gap: The output gap is measured as the percentage difference between actual GDP in constant prices and estimated potential GDP available from the OECD Main Economic Indicators.

Parental Leave: Data on parental leave duration (in weeks) were obtained from Gauthier, A.H. and A. Bortnik (2001), “Comparative Maternity, Parental, and Childcare Database,” Version 2 (University of Calgary), available at: http://www.soci.ucalgary.ca/fypp/family policy databases.htm

Data were interpolated for missing years.

Women Parliamentary Seats: Seats occupied by women as a percentage of total seats in parliament. Sources: E. Huber, C. Ragin and J.D. Stephens, D. Brady and J. Beckfield, 2004, “Comparative Welfare States Data Set,” Northwestern University, University of North Carolina, Duke University and Indiana University and IPU (Inter-Parliamentary Union) at http://www.ipu.org.

Wage Compression: Wage compression was proxied by the ratio of the 10 percentile to the median of gross earnings for all employed. Data were obtained from the OECD Labor Force Statistics database cited above.

Employment protection: Data on employment protection were obtained from G. Allard (2003), “Jobs and Labour Market Institutions in the Postwar OECD,” Ph.D. dissertation, University of California, Davis (provided by Gayle Allard).

Unionization: Data on trade union density were obtained from the OECD’s Labor Force Statistics database cited above.

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Prepared by Evridiki Tsounta and Leo Bonato. The authors are grateful to Subhash Thakur for his suggestions and encouragement. Comments by Krister Andersson, Fabrizio Balassone, Marcello Estevao, Dimitri Tzanninis, and seminar participants at the Institute for Labor Market Policy Evaluation in Uppsala and the LO Trade Union Federation in Stockholm are also appreciated. Special thanks to Florence Jaumotte, Gayle Allard, David Neumark, William Wascher, and Gerwin Bell for generously providing their databases and to Haiyan Shi for excellent research assistance.

Jaumotte (2003) and Genre et al. (2005), who concentrate on female labor participation are obvious exceptions.

Lundgren et al. (2005) find that 90 percent of the incidence of taxes in Sweden eventually falls on labor. In that respect, changes in the tax burden would likely lead to a substantial distortion of the labor/leisure/home production decision.

The benefit system is assumed to have a minor impact on the primary earner’s labor supply decisions, since most of the benefits (such as subsidies for child and elderly care) specifically target the secondary breadwinner.

Due to the lack of available historical data on annual labor costs we ignore employer’s social security contributions when estimating the tax wedge on secondary breadwinners in the econometric exercise. This simplification does not influence our results. The reader is referred to the appendix for additional information.

Examples include Connelly (1989) and Blau and Robins (1988, 1989).

Programs such as the Head Start and the Family Support Act of 1988 in the U.S. are based on the idea that intervention is needed to enable disadvantaged children aged 3-5 (Gustafsson and Stafford, 1994).

This system is open at no cost to all children from the age of three until the age of school entry (age six). The nursery is open for the majority of the working day: 8:30 a.m. to 4:30 p.m. daily except Wednesday. Parents can purchase daycare for times when the nursery is not in session on a fee-paying basis (Kamerman, 1991).

The extension of the provision of subsidized childcare for infants, conditional on both parents working, is currently under political scrutiny in Germany, as an attempt to alleviate the unemployment problem and encourage higher female participation. The German federal

The fees are between 9 and 11 percent of cost in pre-school and family day-care homes, in Sweden.

OECD (2004a, pp. 40-3) provides a comprehensive analysis.

The other Nordic countries followed shortly afterwards; Norway in 1977, Finland in 1978 and Denmark in 1984.

Freeman and Schettkat (2005) reject the importance of wage compression across OECD countries in explaining the shift of traditional household production services to the market in the US. They claim that the shift was exogenously driven rather than related to wage compression.

For some countries, such as Sweden, these benefits are taxable, so throughout the analysis, this variable captures the after-tax subsidy rate.

Assuming that v(0,2) = 0. Since modeling the household’s capital accumulation problem is beyond the scope of this paper, we also drop the time subscript for brevity.

The analyses of the budget constraint, the household good production function and the market clearing conditions closely follow the previous framework. For brevity we choose not to include them in the current writing.

As a technicality we need to assume that there is a large number of ex ante identical households.

For a description of the data used, see the appendix.

Variations of participation and hours worked are a stylized characteristic of the business cycle, which can be explained by income effects—movements in household real incomes as emphasized by the “added worker” hypothesis (see, for example, Stephens, 2001)—or by substitution effects—movements in the opportunity cost of leisure as underscored by the “discouraged worker” hypothesis (see, for example, Lindbeck and Snower, 1994).

Panel unit root tests (Levin et al.(2002); Im et al. (2003)) allow to reject nonstationarity in both measures of the dependent variable.

Genre et al. (2005) are also unable to identify the labor supply equation.

In many other respects, the public insurance system does not provide similarly good incentives. For example, Bonato and Lusinyan (2004a, b) show how the generous sickness insurance system is affected by moral hazard problems.

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Sweden: Selected Issues

Author: International Monetary Fund

Volume/Issue:: Volume 2005: Issue 344

Publisher:: International Monetary Fund

ISBN:: 9781451948707

ISSN:: 1934-7685

Pages:: 59

DOI:: https://doi.org/10.5089/9781451948707.002

Keywords
I. The Swedish Fiscal Framework: Towards Gradual Erosion?1
References
- APPENDIX I Data Sources and Definitions
  - References

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Debt to GDP ratios in Sweden and the EU: 1970-1994

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Budgetary Response to 1 Percent Changes in Output Gap

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Expenditure and Revenue: Sweden, 1970-1994

(As a percentage of GDP)

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Debt to GDP

Hourly Bands Per Week	Males Employed
1-19	77,000
20-29	83,200
30-34	73,400
35-39	269,400
40 and over	1,696,200

Hourly Bands Per Week	Males Employed
1-19	77,000
20-29	83,200
30-34	73,400
35-39	269,400
40 and over	1,696,200

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Abstract

I. The Swedish Fiscal Framework: Towards Gradual Erosion?1

A. Introduction and Overview

B. Public Finances in Sweden Until The Mid-1990s

C. The Fiscal Framework

D. Emerging Pressures

E. Policy Implications

Surplus Target and Expenditure Ceilings

Local Government Finances

References

APPENDIX I Data Sources and Definitions

References

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I. The Swedish Fiscal Framework: Towards Gradual Erosion?¹