A. Introduction

17. This chapter makes the case for refinements to Iceland’s fiscal framework. In this regard, it explores certain features of fiscal policy in Iceland, and illuminates various aspects of fiscal frameworks in other European countries that are possibly worthy of emulation. The chapter proceeds as follows: Section B provides a detailed summary of the key issues affecting fiscal policy in Iceland. It argues that political economy factors lead to procyclical fiscal trends, and this is exacerbated by macroeconomic volatility. Following this, Section C begins with a brief account of the current fiscal framework in Iceland, springboarding to a discussion of the experience of countries similar to Iceland in terms of underlying political institutions, especially Belgium and the Netherlands. Some recommendations for reform in the context of Iceland are then offered. Section D concludes.

B. Fiscal Policy in Iceland: Political Economy, Procyclicality, and Volatility

18. Political economy factors are frequently cited to explain procyclical fiscal policy. By the common pool model, politicians who represent different groups and vested interests have no incentive to constrain their spending demands given that the costs are shared by the population as a whole. The literature shows that a plethora of inter-related factors—large and disparate coalitions, a high number of spending ministers, proportional electoral systems, electoral uncertainty, and short government duration—can all act to feed deficit or expenditure biases and procyclical fiscal policy (Alesina and Perotti, 1995, Annett, 2002). The bias toward procyclicality can be especially pronounced during good times (Jaeger, 2001, Balassone and Francese, 2004), as revenue windfalls are seen as common property that, absent coordination, feed through to higher spending or tax cuts. Some have also argued that output volatility matters, in the sense that higher booms unleash greater political distortions and more procyclical behavior (Talvi and Vegh, 2000; Lane, 2003).

19. Fiscal policy in Iceland has been marked by a secular increase in government expenditure. Since 1980, total expenditure as a percent of GDP has risen by around 10 percentage points, approaching 45 percent, close to the EU average (Figure 1). The driving force behind the rise in expenditure was a secular increase in the government wage bill (Figure 2). Spending was first ratcheted up in the late 1980s, prompting a deterioration in the fiscal balance. But expenditure started increasing again in the late 1990s, although this time, revenue rose apace, and the fiscal balance did not deteriorate accordingly. From an international perspective, Iceland’s expenditure experience goes against the grain, especially when compared with those European countries sharing similar political structures, including penchant for multi-party coalition governments (Belgium, Finland, Ireland, and the Netherlands). These countries witnessed a large decline in expenditure over the 1990s, focused on government wages and transfers, and consolidation exceeded the EU average.

International Comparisons of Fiscal Policy I

Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A002

1/ Belgium, Finland, Ireland, and the Netherlands.Source: OECD

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International Comparisons of Fiscal Policy I

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1/ Belgium, Finland, Ireland, and the Netherlands.Source: OECD

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International Comparisons of Fiscal Policy I

Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A002

1/ Belgium, Finland, Ireland, and the Netherlands.Source: OECD

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International Comparisons of Fiscal Policy II

Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A002

1/ Belgium, Finland, Ireland, and the Netherlands.Source: OECD

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International Comparisons of Fiscal Policy II

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1/ Belgium, Finland, Ireland, and the Netherlands.Source: OECD

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International Comparisons of Fiscal Policy II

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1/ Belgium, Finland, Ireland, and the Netherlands.Source: OECD

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20. Part of Iceland’s recent spurt in revenue may reflect predominantly cyclical factors. The cyclical response of revenue to real activity can be exacerbated during boom-bust cycles, turning revenue elasticities sharply procyclical. In such an environment, underlying balances can appear healthier than is actually the case during booms, increasing the risk that revenue windfalls are spent in a procyclical fashion. Some point the finger at asset price booms; indeed, one estimate is that the cyclical responsiveness of the fiscal balance more than doubles during EU asset price-driven cycles, leading to an over-estimation of the underlying balance with standard cyclical-adjustment methodologies (Jaeger and Schuknecht, 2004). There also seems to be a clear relationship between revenue elasticities and the extent of real appreciation across European countries over the past decade, reflecting tax-rich consumption booms in these countries (see also European Commission, 2006). In Iceland, cyclically-adjusted revenue seems to track movements in the private consumption-potential output ratio over time (Figure 3). Iceland also stands apart as the country with the highest average elasticity, and the largest real appreciation among this sample.

21. On the expenditure side, there is some evidence of procyclical policy inspired by the common pool problem. Empirical evidence suggests the following results:

• Based on cross-country evidence, there is a positive association between the procyclicality of wage government consumption and macroeconomic volatility (Figure 4). Countries with the highest degree of procyclicality (Iceland, Greece, and Portugal) are those very countries with the most volatile output. Iceland stands apart, both in terms of its volatility and in the fact that its expenditure is considerably more procyclical than the international norm (this is especially true of wage government consumption).

• Estimating a basic fiscal reaction function for Iceland shows that while total expenditure and current expenditure display countercyclical responses, the effect of wage government consumption is procyclical, implying that an improvement in the output gap leads to an increase in ratio of the government wage bill to GDP). Cyclically-adjusted current expenditure also displays a procyclical effect.

• Interacting the output gap with some measure of political fragmentation¹⁰ suggests that the translation of positive output shocks to higher government spending is greater in the presence of more pronounced divisions within government. Specifically, the coefficients on the interactive terms for four key variables—current expenditure, cyclically-adjusted current expenditure, wage government consumption, and government transfers—display positive and significant signs, signaling a larger procyclical effect in the presence of higher government fragmentation. The same result emerges using consumption booms rather than output gaps.

22. In sum, the unusual macroeconomic volatility in Iceland calls for a particularly robust fiscal framework. As its fiscal balances are subject to larger swings, Iceland needs an anchor to curb excess volatility. In the European context, it was precisely the more volatile countries that latched onto the Stability and Growth Pact, the EU’s rules-based fiscal framework (Annett, 2006). The prevalence of boom-bust cycles creates uncertainty about the output gap and elasticities, justifying rules pertaining to expenditure growth and a suitably conservative target for the fiscal balance over the cycle (Jaeger and Schuknecht, 2004). And, as noted, macroeconomic volatility is associated with procyclical tendencies. And finally, of specific relevance in Iceland, fiscal policy needs to assume a far greater countercyclical bent to relieve the pressure on monetary policy. The next section explores some options for improving Iceland’s fiscal framework to cope with these pressures.

Iceland: Cyclicality and Revenue Elasticities

Citation: IMF Staff Country Reports 2007, 296; 10.5089/9781451819366.002.A002

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Iceland: Cyclicality and Revenue Elasticities

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Iceland: Cyclicality and Revenue Elasticities

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Procyclicality and Volatility

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Procyclicality and Volatility

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Procyclicality and Volatility

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C. Institutional Fiscal Reform and Lessons for Iceland

23. Iceland began reforming its budgetary institutions in 1992. It did so by adopting “frame budgeting”, a top-down approach whereby ministry-level expenditure ceilings are set at a relatively early stage in the process, forcing the ministries to prioritize different expenditure items and projects. At the outset, the minister of finance prepares the macroeconomic framework and brings proposals to the cabinet-level Committee on Public Finances—comprising the prime minister, the minister of finance, two other ministers, and the chairman and vice-chairman of the coalition parties—which decides on the aggregate expenditure envelope. Following negotiations, the cabinet then approves the individual frames. The budget is passed later in the year after a further review of the macroeconomic framework. It then goes to parliament, where amendments are permitted.

24. To bolster this framework, the government adopted fiscal rules pertaining to the growth of real expenditure from 2004. The real annual increase in public consumption is limited to 2 percent, while the growth in transfer payments is restricted to 2½ percent a year. Real targets are translated into nominal terms using ministry of finance forecasts of CPI inflation. The targets are defined on average over a number of years, however, meaning that temporary deviations are allowed. Also, there are no mechanisms in place for ensuring targets are met.

25. This framework has not acted as a sufficient bulwark against overspending. The expenditure ceilings have not been respected, either at the central or local government level. The legislature is prone to altering budget targets during the parliamentary phase of the budget, and deviations between the budget and outturns reflect the entrenched use of supplementaries (Suppanz, 2003; OECD, 2006). Ministries and agencies frequently overspend their budgets with few consequences, despite existing regulations. The medium-term framework is also weak, as targets are largely illustrative.

26. Before contemplating how Iceland can reform its institutions, it is useful to reflect upon developments elsewhere in Europe. Over the past few decades, European countries have adopted a wide variety of institutional reforms geared toward suppressing the political economy biases suffusing fiscal policy. Two broad approaches include delegation, whereby power is ceded to a strong minister of finance (suited to single-party governments), and commitment, whereby the different parties negotiate a “fiscal contract” involving strict budget targets (suited to coalitions)¹¹. Reforms proceeded apace over the 1990s, with most EU countries adopting or strengthening one of these core fiscal governance technologies. Commitment countries—including Belgium, Finland, Ireland, and the Netherlands—were more inclined to use fiscal rules and rely on independent committees and councils to aid in fiscal policy coordination. Institutional reforms tended to have a salutary effect on fiscal discipline, and stringent targets proved key to fiscal discipline in commitment countries. Independent forecasts can also help as can independent arbiters of fiscal policy.

27. Iceland is clearly a commitment country, and should look to other commitment countries for emulation. In terms of the breadth of their institutional reforms, Belgium and the Netherlands represent the most appropriate role models for Iceland. Both countries have strengthened their commitment technologies through complementary combinations of institutional reforms, fiscal rules, and recourse to independent agencies. They are two of the three EU countries to use independent forecasts and are the only two countries to have adopted formal rules dealing with positive revenue windfalls. In Belgium, an independent entity (the High Council of Finance) set fiscal targets for each level of government, for the short, medium, and long term, which the coalition government agreed to adopt. The Netherlands introduced expenditure ceilings, and let the independent Central Planning Bureau provide forecasts for the parties to use before elections, during coalition formation, and to underpin the annual budget process.

28. As it stands, Iceland has a quasi-commitment systems that has evolved alongside the introduction of frame budgeting. There is a firm attempt to internalize spending pressures through a top-down approach to budgeting combined with greater oversight by the Committee on Public Finances, incorporating representatives of the coalition parties. Over the past few years, there has also been a tendency to move away from regular meetings between the minister of finance and spending ministers. But there are still some key weaknesses that could be addressed by the adoption of Belgian or Dutch-style reforms.

29. To help Iceland overcome tendencies toward expenditure drift and procyclical spending pressures, the following possibilities may be useful:

• Strengthen the expenditure rules. Ideally, the expenditure rule would be couched in terms of explicit multi-year expenditure ceilings that are binding on ministries, unlike the current illustrative rules that are seldom met. In practical terms, the government could set rolling 3–4 year nominal expenditure ceilings for each frame, adding up to an overall target. The ceilings should be binding on ministries, and the current practices of using supplementaries and altering the frames at the legislative stage should be eschewed. Each new budget would add the ceiling for one additional year and the scope for revising already-agreed targets would be limited. Realistic contingency funds could be included in the budget for emergencies, including unanticipated cyclical factors and forecast uncertainties. There could also be a contingent rule, ensuring that positive shocks to revenue did not lead to overspending.

• Switch to nominal, rather than real, ceilings. Nominal ceilings ensure that changes in inflation do not lead to revisions in targets. For a start, nominal ceilings have the advantage of transparency, which aids enforceability. Nominal rules are most beneficial when cyclical stabilization is a goal since the higher inflation leads directly to lower real expenditure in a countercyclical manner. This is especially important in Iceland, given the side effects of high interest rates and the concomitant need to relieve pressure on monetary policy. Ideally, for countercyclical purposes, the nominal ceilings could be set based on the central bank’s target for CPI inflation.

• Use a stakeholder committee to suggest targets for the different levels of government. Such a committee could involve officials from the ministry of finance, the local governments, and the central bank. It would serve as a coordinating device across different levels of government, while also offering recommendations on the overall stance of fiscal policy, especially over the medium term.

• Lay out detailed expenditure targets predicated on a path for the overall fiscal balance over the life of the government. If a coordinating fiscal policy committee as suggested above exists, its targets could be adopted, or at least form the basis of discussions, and these targets could be incorporated into coalition agreements. Presently, coalition agreements contain only vague references to fiscal policy. Greater political ownership would also shield against expenditure pressures at the parliamentary level, following the introduction of the government’s budget. Such an approach would also segue naturally into the medium-term framework underpinned by expenditure ceilings.

• Adopt independent macroeconomic forecasts, preferably from a domestic, well-respected, entity. If this is not an option in the short term, the government could follow the Canadian example of using an array of cautious assumptions from the private sector. And once the budget is set based on these assumptions, there should be few further modifications.

30. Such a fiscal framework would engender the necessary degree of countercyclical momentum in fiscal policy. Expenditure rules are especially suited to Iceland, given that they allow free play of automatic stabilizers on the revenue side and guard against expenditure drift and the translation of high revenues to expenditure growth. Concomitantly, nominal targets can complement this tendency by delivering countercyclical action on the expenditure side, letting real expenditure fluctuates with inflation. The automatic nature of such a rules-based framework bypasses some of the timing and implementation issues associated with discretionary countercyclical fiscal policy, and resorting to supplementaries weakens the credibility of framework. But the current practice of manipulating the timing of government investment for countercyclical purposes could be retained, by excluding capital expenditure from the coverage of the expenditure rule.

D. Conclusion

31. Iceland’s experience with volatility and procyclicality suggests the need for an improvement in its fiscal framework. Expenditure, especially the government wage bill, has risen precipitously, and often in a procyclical manner related to the fragmentation of political decision-making in Iceland. Iceland’s high degree of macroeconomic volatility reinforces these tendencies. Large boom-bust cycles can lead to procyclical revenue elasticities, making underlying fiscal policy appear healthier than is actually the case, further contributing to latent spending pressures. At the same time, there is a clear need for fiscal policy to shoulder more of the cyclical stabilization burden. Based on the experiences of countries like Belgium and the Netherlands, Iceland could consider reforms such as (i) establishing binding nominal expenditure rules; (ii) using a representative fiscal policy committee to negotiate medium-term fiscal targets across different levels of government; (iii) embedding medium-term fiscal targets in coalition agreements; and (iv) using independent fiscal forecasts. These policies have proved a recipe for success elsewhere, and Iceland can benefit from these experiences.