Abstract
This paper estimates the extent of spare capacity in the U.K. economy using a range of methodologies pointing to an output gap and the behavior of inflation during large output gaps. The usefulness of fiscal rules in supporting fiscal consolidation is generally positive, and a more permanent rules-based fiscal framework is required. The banking system has recovered fast; however, the sustainability of the sector’s recovery is still uncertain, and risks remain. An update on reforms to the financial sector’s regulatory and supervisory framework is also provided.
IV. What Fiscal Rule Would Work Best for the UK? 1
The government’s current fiscal mandate provides an appropriate guide for the medium-term fiscal consolidation process. However, a more permanent rules-based fiscal framework may eventually be required to guide policy over the longer term, as the government has indicated. Although there is no rush to adopt more permanent fiscal rules, work could begin now to have time to chose and design rules carefully. In this context, this chapter illustrates how alternative fiscal rules would work in the UK, taking into account country-specific factors. It finds that a structural balance rule (or an augmented growth-based balance (AGB) rule) with a sufficiently high cyclical coefficient could have promoted more countercyclical policy during the pre-crisis expansion—resulting in lower debt and deficit levels—while allowing significant stimulus during the crisis. Such rules would also provide broad budget coverage and promote debt sustainability under a wide range of simulated shocks.
A. Introduction
1. The recent crisis led the UK to suspend its two national fiscal rules-golden and sustainable investment rules—at the end of 2008.2 However, the credibility of the national rules as effective constraints for policy action was weakened well before the crisis. The rules failed to prevent a worsening of the fiscal balance in the years leading up to the crisis, leaving insufficient buffers as the economy entered the downturn. While in place, the golden rule was often criticized because it provided insufficient monitoring, transparency, and accountability of fiscal policy. The debt rule, in turn, did not provide any guidance when debt was below its ceiling, albeit rising fast. Essentially, both rules did not provide enough practical guidance for the conduct of fiscal policy.
2. The Fiscal Responsibility Act that replaced the rules attempted to enshrine policy targets into law, but fell short of cementing credibility. The Act—announced alongside the 2009 Pre-Budget Report and approved by Parliament in February 2010—made it a legal requirement for the government to: halve public sector net borrowing over four years from its 2009/10 level; reduce borrowing as a share of GDP in each year; and ensure that public sector net debt fell as a share of GDP from 2015/16. One issue with the Act’s credibility is that it did not allow for any potential deterioration of the fiscal position arising from further negative shocks to the economy. Conversely, under a scenario where the recovery is faster than expected, the targets set in the Act would be too modest.
3. The crisis thus left the UK’s fiscal framework in need of reform and public finances in a weak state. The deterioration of the fiscal position during the recession was unprecedented. The deficit reached 11 percent of GDP in 2009/10, some 8½ percentage points of GDP higher than before the crisis, and the resulting increase in debt between 2007 and 2010 is estimated at over 30 percentage points of GDP.
4. Significant steps toward reforming the UK’s fiscal framework were announced in the context of the June 2010 budget. The government kept the objective of putting the net debt-to-GDP ratio on a downward path by 2015/16, but made the deficit objective more ambitious and cyclically sensitive by establishing a “fiscal mandate” to balance the cyclically adjusted current budget by 2015/16.3 The government also established a new independent Office for Budget Responsibility (OBR), whose envisaged tasks include to provide the macroeconomic and fiscal forecasts for the budget and to assess fiscal sustainability and compliance with the fiscal mandate (and with any future rules or targets(. The newly established OBR should support the consolidation, as international experience with independent fiscal councils has generally been favorable. Specifically, they have been associated with greater transparency and accountability of fiscal policy.4 Nonetheless, despite the establishment of both a fiscal mandate to provide a clear guidepost for the consolidation process and an independent OBR, the longer-term fiscal framework remains uncertain.
5. The government has indicated that it may eventually establish a more permanent fiscal framework to succeed the current mandate once the latter has been achieved. One issue with the current mandate is that it only requires that the cyclically adjusted current budget be balanced at the end of a rolling five-year horizon. In theory, a government less committed to fiscal discipline could potentially use this rolling horizon—combined with continually backloaded fiscal plans—to perpetually avoid fiscal adjustment. Similarly, the exclusion of capital expenditure from the target potentially opens an avenue for fiscal laxity and could create incentives to aggressively label expenditure as capital rather than current where ambiguities exist. Given the current government’s clear commitment to fiscal consolidation, these issues are not concerns at the moment, and the fiscal mandate is an appropriate guide for the consolidation process. However, in light of these considerations, it may be useful to begin work on considering a more permanent rule-based framework that could become effective for the post-2015/16 period. In this regard, the June budget noted that “a tighter constraint” on public finances could be set “once the public finances are closer to balance.”
6. The establishment of a more permanent rules-based fiscal framework could yield a number of benefits. The rising use of some form of fiscal rule over the last two decades reflects the view that well-designed and properly implemented fiscal rules could support credibility and discipline and help limit distorted incentives in policymaking.5 After an appropriate transition period from the recent crisis, more permanent rules in the UK could secure the gains of the consolidation process, support fiscal discipline, and anchor long-term expectations about fiscal sustainability. Although bringing a new fiscal rule into force too early would not be desirable,6 there would be value in eventually adopting legislation that establishes new fiscal rules for the longer term, including a timetable for those rules to become effective. Germany provides an example in this regard.7 In the transition period, the fiscal mandate set in the June budget will serve to guide policy and is appropriate to put the UK debt-to—GDP ratio on a declining path. The fiscal mandate also provides sufficient time to carefully study and build broad consensus for a more permanent framework before adopting it.
7. Against this background, the objective of this chapter is to illustrate how alternative fiscal rules would work in the UK, taking into account country-specific factors. To this end, the chapter simulates the hypothetical path of key fiscal variables predicted by various fiscal rules had they been in place in the UK since 1997. This exercise will help assess, for instance, which fiscal rule would have been most effective in containing the growth of the structural deficit in the run-up to the crisis. The rule-based simulated outcomes are then compared to the actual fiscal outturns over the same period, when the golden and the investment sustainability rules were in place. The chapter also presents a forward-looking exercise that illustrates how these fiscal rules behave in response to various stochastic shocks that fit the historical UK data. Fan charts quantifying the risks to the fiscal position and debt sustainability as a result of potential shocks are estimated for each rule and year of the forecasting horizon.
8. The findings of the chapter could help guide the choice and design of a fiscal rule that could be implemented by 2015–16. The results of the chapter suggest that:
The rules under consideration—structural balance, expenditure, and augmented growth-based—would have outperformed the previous national rules by preventing a deterioration of the fiscal position prior to the crisis and yielding lower debt ratios.
All three rules ensure long-term debt sustainability in response to a constellation of adverse economic shocks. The probability that debt will fall below 60 percent of GDP by 2026/27 is about 50 percent under the three rules.
While the choice of fiscal rule should reflect the authorities’ preferences regarding the degree of countercyclicality, tolerance for debt, and simplicity, among other objectives, a structural balance rule may work well in the UK.
9. The chapter is organized as follows. The next section provides an overview of fiscal rules in the UK. Section C discusses simulation-based properties of different rules applied to the UK economy. Section D illustrates how different rules behave in response to macroeconomic shocks. The final section concludes.
B. The Golden and Sustainable Investment Rules: Theory and Practice
In practice
10. The government met its fiscal rules over the cycle that ran between 1997/98 and 2006/07, albeit by a small margin. In 1998 the government adopted two fiscal rules—a golden rule and a sustainable investment rule—designed to be met over an economic cycle in order to give fiscal policy enough flexibility to smooth fluctuations in the economy while containing debt. The golden rule stated that the government should only borrow to fund investment, not current spending. More specifically, it required the current budget to be in balance or surplus on average over the economic cycle. The sustainable investment rule required that public sector net debt should not exceed 40 percent of GDP. The Treasury judged that the cycle started in 1997 and ended in 2007. Over this period, the current budget, which excludes capital investment, averaged 0.1 percent of GDP, meeting the golden rule by a small margin. At the same time, public net debt averaged about 35 percent of GDP, thereby meeting the sustainable investment rule (Figure 1).
Meeting the Golden and Sustainable Investment Rules
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: Office for National Statistics; and IMF staff calculations.Meeting the Golden and Sustainable Investment Rules
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: Office for National Statistics; and IMF staff calculations.Meeting the Golden and Sustainable Investment Rules
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: Office for National Statistics; and IMF staff calculations.11. Nevertheless, the rules did not prevent a significant deterioration of the UK budgetary position in the run-up to the crisis, which eventually led to the breaching and abeyance of the rules. The overall fiscal balance averaged -2¾ percent of GDP between 2002/03 and 2006/07, compared to a surplus of about 1 percent of GDP in the preceding years. The bulk of this deterioration was structural and primarily reflected increases in spending on public services. The risk of breaching the golden rule increased sharply in the second half of the cycle. Indeed, the average balance on the current budget since the beginning of the cycle started to decline in 2002 and got very close to the breaching threshold by 2007. Koeva (2005) concluded that meeting the golden rule with a high degree of confidence would require on average a current surplus of 0.5-2.5 percent of GDP and that fiscal policy in 2004 did not conform to a reasonable probability of meeting the golden rule. The absence of any safety margin as the economy entered the crisis forced the government to abandon the rules in 2008.
In theory
12. The golden and sustainable investment rules can be assessed against key criteria for effective fiscal rules. To be effective, fiscal rules should: anchor public debt sustainability; allow countercyclical policy response; ensure transparency, clarity, and ease of monitoring; and provide credibility and guidance for fiscal policy. Furthermore, rules need to include effective enforcement and accountability mechanisms. Other considerations for using fiscal rules include the ability to support intergenerational fairness.
Sustainableinvestmentrule. Debt rules are, in theory, effective in terms of ensuring convergence to a debt target or at keeping debt below a given ceiling. Debt rules conform to intergenerational equity objectives as they avoid the creation of excessive burdens of debt repayments on future generations. However, they do not provide enough guidance when debt is below its ceiling. Furthermore, policy slippages are only reflected in debt ratios with a lag. Thus, remedial action may come too late to avoid adverse debt dynamics or market reaction. Debt could also increase abruptly as a result of one-off financing operations, such as the interventions in the financial sector during the 2008–09 global crisis. The resulting debt volatility could have undesirable implications, such as requiring unrealistically large fiscal adjustments to meet the rule. Finally, debt rules designed to be met every year provide little cyclical flexibility and are likely to require highly procyclical policy responses, since debt-to-GDP ratios typically rise sharply in recessions and fall during booms.
Golden rule. Golden rules target the overall balance net of capital spending. The rationale for such a specification is usually to promote and protect capital spending, which is often seen as more pro-growth than other types of spending, by excluding it from the rule. Such a rule can also be consistent with intergenerational equity, since public consumption that benefits the current generation is paid for by that generation. However, if such a rule promotes rapid capital spending growth (possibly including through incentives to label more types of spending as capital spending), this could undermine fiscal sustainability. As a result, golden rules are less linked to debt sustainability than overall balance or debt rules. Indeed, after the adoption of the golden rule in 1997, capital spending in the UK increased significantly as a share of GDP (Figure 2), contributing to the deterioration in the fiscal position. Moreover, there are alternative mechanisms for protecting capital spending while still covering under a broader rule. For example, a rule covering the overall or primary balance combined with a (relatively modest) floor on capital spending could protect capital spending from being cut excessively while still restricting its excessive expansion.
Over the cycle. Rules defined over the cycle provide high budgetary flexibility to output shocks, as they provide room for the operation of automatic stabilizers and for discretionary fiscal stimulus. However, greater flexibility may come at the expense of less credibility, as these rules could lead to excessively loose fiscal policy at times during the cycle. In addition, monitoring the performance of the rule requires precise dating of the cycle, which hinges on the methodology used and the stability of national accounts data. In practice, the dating of economic cycles involves a degree of judgment, which can be controversial. And since the length and level of peaks and troughs of any cycle are unknown until the cycle is complete, the performance of the rule is only fully tested ex-post.
Capital Spending
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Source: Office for National Statistics (ONS).Capital Spending
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Source: Office for National Statistics (ONS).Capital Spending
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Source: Office for National Statistics (ONS).13. Each fiscal rule entails a different weighting of objectives. Figure 3 illustrates the “tradeoffs” involved in a debt rule and in a golden rule over the cycle vis-à-vis four of the criteria for effective fiscal rules discussed above, namely the ability to anchor debt sustainability, allow for countercyclical policy response, provide clear operational guidance, and ensure transparency and ease of monitoring. The shaded area within the diamond represents the overall benefit accruing from the adoption of a particular rule.8 In the case of the golden rule over the cycle, the high degree of policy flexibility may come at the expense of transparency, ease of monitoring, and operational guidance. Conversely, a debt rule prioritizes the link to debt sustainability, but may exhibit weak countercyclical properties.
Weighting of Criteria for Fiscal Rules
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Source: IMF staff calculations. A maximum of 5 is assigned to each criteria.Weighting of Criteria for Fiscal Rules
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Source: IMF staff calculations. A maximum of 5 is assigned to each criteria.Weighting of Criteria for Fiscal Rules
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Source: IMF staff calculations. A maximum of 5 is assigned to each criteria.Country Examples of Fiscal Rules
Structural balance rule in Germany
In June 2009, the German parliament amended the constitution to include a new rule for both federal and state governments. The rule requires the federal government’s structural deficit not to exceed 0.35 percent of GDP. The rule becomes binding in 2016, with a transition period starting in 2011. The states will be bound by a balanced structural budget from 2020. Execution errors are cumulated in a notional account that has to be corrected once errors accumulate above 1 percent of GDP. However, the adjustment only needs to start after an economic recovery is in place to avoid a procyclical tightening. The provisions allow for an escape clause that can be invoked by parliamentary majority in the event of natural catastrophes and other emergencies outside government control.
Swiss debt-brake rule
This rule took effect in 2003 with the objective of stabilizing government debt, which had increased rapidly during the 1990s. The rule specifies a one-year ahead ex-ante ceiling on central government expenditure equal to predicted revenue, adjusted by a factor reflecting the cyclical position of the economy. Effectively, the rule aims at maintaining a structural budget balance every year. It is then possible to run deficits in a recession, but over the medium-term deficits and surpluses are expected to cancel out. Differences between budget targets and outcomes are recorded in a notional account. If the negative balance in the account exceeds 6 percent of expenditure, the authorities are required by law to take measures sufficient to reduce the balance below this level within three years. An escape clause exists, by which Parliament may allow deviations to the rule in exceptional circumstances. For details see Danninger (2002).
Augmented growth-based balance rule in Turkey
Turkey has recently considered adopting a fiscal rule that promotes countercyclical policy while circumventing the need to estimate the output gap. The draft law submitted to Parliament specifies a general government deficit target of 1 percent of GDP. In any given year, the actual deficit may deviate from the target to account for cyclical developments. In this case, the deficit may react to changes in the growth rate (relative to the long-run trend of 5 percent), rather than changes in the output gap. In addition, the rule allows gradual adjustment when the deficit is away from its medium-term target. As a result, the amount of required adjustment in any given year would almost always be feasible, making the rule more politically durable. For details see Fletcher and Benelli (2010).
Expenditure rule in Finland
A system of multi-annual expenditure ceilings was initiated in Finland in 2003 to rein in public expenditure and consolidate public debt. The ceilings are set in real terms for a four-year period at the start of a new government. Every March, ahead of the budget, the government converts real ceilings into nominal ceilings using an updated deflator of the central government price index. Local government, public enterprises, and about a quarter of the central government budget are excluded from the ceilings. The deficits are not explicitly anchored in debt and deficit limits. Compliance and monitoring is done primarily by the finance minister, and there are no formal sanctions for exceeding the ceilings. But commitment to the ceiling has been high. See Ljungman (2008) for a survey of expenditure ceilings.
C. Alternative Fiscal Rules Under the Observed Economic Cycle in the UK
14. This section analyzes fiscal outcomes under various fiscal rules had they been in place in the UK during the decade starting in 1997. We simulate the hypothetical path of key fiscal variables dictated by three alternative fiscal rules in response to the actual economic cycle of the UK since 1997. This enables the comparison of the behavior of the rules to one another and to actual fiscal policy in the UK when the golden and sustainable investment rules were in place.
15. The following three rules are analyzed. A formal representation of these rules and the choice of the parameter values are discussed in Box 2.
Structural balance rule. This rule allows for temporary deviations in the overall fiscal balance from its medium-term structural deficit target according to cyclical developments. In particular, the rule allows full operation of automatic stabilizers, calling for larger deficits (or lower surpluses) when the output gap is negative and requiring lower deficits (or higher surpluses) when the output gap is positive.9 The target is set at a level that is consistent with a pre-determined long-term fiscal sustainability target. Given the government’s objective in 1997 to bring net debt below 40 percent of GDP, the baseline simulations assume a structural balance target of -0.9 percent of GDP (see Box 3 for details). In the baseline simulations, the structural balance rule only allows for automatic stabilizers, but sensitivity analysis is performed to show how the variation of the deficit with the cycle could be increased to allow for discretionary countercyclical policy.
Augmented growth-based balance (AGB) rule. This rule sets a medium-term target for the overall balance. The balance is then permitted to be lower than the medium-term target in years when economic growth is below trend, while in years when actual growth is faster than trend growth, a higher balance is required, all other things equal. The rule also allows for gradual adjustment back to the medium-term target in the event past shocks cause the balance to deviate from its medium-term target level. In this way, the rule promotes countercyclical policy (broadly mimicking a structural balance rule), but without requiring explicit estimates of the level of the output gap.
Expenditure rule. This rule sets a ceiling for the annual growth rate of real expenditure. Revenue is not constrained by the rule and, for simulation purposes, is assumed to follow the path of actual revenue. In the simulations, the rate of real expenditure growth is linked to the long-term rate of real GDP growth. In practice, however, fiscal consolidation or debt sustainability needs may require tighter spending limits.
Analytical Definitions of Fiscal Rules
Structural balance rule
Under a structural balance rule, the overall budget balance in any given year is equal to the medium-term overall balance target adjusted for changes in the output gap. Formally,
where bt is the overall balance (as a percent of GDP) in the current year, b* is the medium-term overall balance target (as a percent of GDP), a is the semi-elasticity of the budget balance with respect to the output gap, and
Augmented growth-based balance (AGB) rule
This rule aims to broadly mimic a structural balance rule, but makes some adjustments to avoid relying on output gap estimates, which in some cases are uncertain and subject to revision. To do this, the rule first replaces the output gap with the difference between actual and long-term growth. To promote countercyclicality and avoid requiring an unrealistically large adjustment in any single year, the rule also includes a term that smoothes the adjustment from any deviation from the medium-term overall balance target in the previous year. In other words, this term delays the adjustment of the balance back to target. Formally,
where a, bt, and b* are defined as for the structural balance rule and c is the pace of adjustment when the overall balance in the previous year, bt-1 is away from the medium-term target b*. A smaller coefficient c implies a faster correction. In the baseline simulations, a = 0.45, b* = -0.9, g* = 2.3 percent (average growth from 1970-1997), and c= 0.65. Sensitivity analyses are performed using different values for the parameters a and c.
Another way to see this rule’s logic is to view it in first differences by subtracting bt-l from both sides:
This shows that the rule sets a minimum change in the overall balance each year. This change is a function of (i) how far the overall balance is from its medium-term target (this promotes convergence back to the target) and (ii) how strong growth is in the current year (this promotes countercyclical policy). The rule essentially establishes a minimum amount of structural adjustment each year, with more structural adjustment required when the overall balance is further below its medium-term target. To see this, note that if g* equals potential growth, then the percentage change in the output gap in the current year can be approximated by (gt -g*). If the coefficient a is set just to reflect automatic stabilizers, then the structural adjustment in any given year is the following:
which shows that the required amount of structural adjustment each year is a function of how far the overall balance is from its medium-term target. In this way, the rule promotes convergence back to the medium-term target while allowing countercyclical policy and avoiding output gap estimates.
Expenditure rule
An expenditure rule dictates the growth rate of budgetary expenditure in real terms. In the simulations, the rate of growth is fixed at a predetermined level, equal to the average of real GDP growth between 1970 and 1997 (2.3 percent). Sensitivity analyses are performed using rolling averages of the rate of real output recorded in previous periods.
Setting a Structural Balance Target
Given an initial debt ratio, d0, and a target debt ratio,
where γ is the long-run growth rate of nominal GDP.
The overall balance that will bring the debt ratio to a level d* over the long term (N → ∞) is given by b* below. Thus, if the overall balance target is set at a constant level b*, the actual debt ratio will asymptotically converge to d* from any initial level (Escolano, 2010).
Balance target in the simulations using historical data (section C)
In section C, the structural balance target is set at -0.9 percent of GDP. This is the balance that would bring the debt ratio down to 40 percent of GDP over 10 years, given initial conditions in 1997. In 1997, the debt ratio was about 50 percent of GDP, trend growth was about 2.3 percent (average growth during 1970-1996), and the inflation target was 2 percent.
Medium-term balance target in the stochastic simulations (section D)
The sharp increase in debt as a result of the recession and the expected increase in age-related costs call for a more stringent balance target in the period ahead. A fiscal rule starting after 2015/16 could embed a structural balance target of -0.5 percent of GDP. As the charts below show, this is consistent with reaching a target debt ratio of 40 percent of GDP in 25 years, given an initial debt level of about 85 percent of GDP in 2015/16, an inflation target of 2 percent, and a long-term real growth rate of 2 percent.
Structural Balance Target
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Source: IMF staff calculations.Structural Balance Target
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Source: IMF staff calculations.Structural Balance Target
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Source: IMF staff calculations.
16. During the pre-crisis period (1997–2007), the three alternative rules would have delivered better fiscal outcomes than the actual policy stance under the golden and sustainable investment rules (Figure 4).10 In particular, the alternative rules would have been more effective in:
Preventing a deterioration of fiscal finances in the run-up to the crisis. Fiscal policy was quite expansionary and procyclical during 2002–07, with the deficit averaging 2.5 percent of GDP. In contrast, the average deficit implied by the rules during 2002–07 would have been in the range of 0.2-0.9 percent of GDP.
Reducing debt. After a period of consolidation, the debt-to-GDP ratio started to increase in 2002. In contrast, the debt ratio would have kept falling under the three alternative rules. In particular, the debt ratio would have been between 5 and 9 percentage points lower by the end of 2007 than that implied by the actual policy stance (Table 1).
Alternative Fiscal Rules Applied to the UK 1/
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; and IMF staff calculations.1/ The simulations assume a structural debt target of -0.9 percent of GDP; trend real GDP growth of 2.3 percent; semi-elasticity of the overall balance to the output gap of 0.45; adjustment coefficient in the augmented growth-based rule of 0.65; and real discretionary expenditure growth equal to long-term real GDP growth.Alternative Fiscal Rules Applied to the UK 1/
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; and IMF staff calculations.1/ The simulations assume a structural debt target of -0.9 percent of GDP; trend real GDP growth of 2.3 percent; semi-elasticity of the overall balance to the output gap of 0.45; adjustment coefficient in the augmented growth-based rule of 0.65; and real discretionary expenditure growth equal to long-term real GDP growth.Alternative Fiscal Rules Applied to the UK 1/
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; and IMF staff calculations.1/ The simulations assume a structural debt target of -0.9 percent of GDP; trend real GDP growth of 2.3 percent; semi-elasticity of the overall balance to the output gap of 0.45; adjustment coefficient in the augmented growth-based rule of 0.65; and real discretionary expenditure growth equal to long-term real GDP growth.Change in Fiscal Policy Stance 1/
(Percentage points of GDP)
“Prior to crisis” refers to the period between Q1-2002 and Q1-2008. “During crisis” refers to the period between Q1-2008 and Q4-2009. Changes in the fiscal balance exclude the effects of financial sector interventions for both actual policy and the rules. Actual changes in valuations were used in all debt simulations.
Change in Fiscal Policy Stance 1/
(Percentage points of GDP)
| Prior to crisis | During crisis | |||
| Fiscal balance | Debt | Fiscal balance | Debt | |
| Actual policy stance | -2.4 | 6 | -7.8 | 20 |
| Structural balance rule | 0.5 | -5 | -3.3 | 13 |
| Augmented growth-based (AGB) rule | -0.3 | -6 | -3.9 | 14 |
| Expenditure rule | 1.7 | -9 | -5.9 | 11 |
“Prior to crisis” refers to the period between Q1-2002 and Q1-2008. “During crisis” refers to the period between Q1-2008 and Q4-2009. Changes in the fiscal balance exclude the effects of financial sector interventions for both actual policy and the rules. Actual changes in valuations were used in all debt simulations.
Change in Fiscal Policy Stance 1/
(Percentage points of GDP)
| Prior to crisis | During crisis | |||
| Fiscal balance | Debt | Fiscal balance | Debt | |
| Actual policy stance | -2.4 | 6 | -7.8 | 20 |
| Structural balance rule | 0.5 | -5 | -3.3 | 13 |
| Augmented growth-based (AGB) rule | -0.3 | -6 | -3.9 | 14 |
| Expenditure rule | 1.7 | -9 | -5.9 | 11 |
“Prior to crisis” refers to the period between Q1-2002 and Q1-2008. “During crisis” refers to the period between Q1-2008 and Q4-2009. Changes in the fiscal balance exclude the effects of financial sector interventions for both actual policy and the rules. Actual changes in valuations were used in all debt simulations.
17. Simulation results suggest that the observed policy stance after 2002 was more expansionary than warranted by cyclical considerations, with expenditure growing significantly above output. The rules’ better performance stems from:
Structural balance rule: During 2002–07, the average output gap was close to zero. Therefore, the simulated path under the structural balance rule does not deviate much from the structural target of -0.9 percent of GDP. The observed policy stance, which yielded an average balance of -2.5 percent of GDP, was not the result of uncertainty about the size of the output gap or lack of accuracy in estimating the gap.11 Indeed, if the rule is simulated using ex-ante (instead of ex-post) estimates of the output gap, the results are very similar (Figure 5). This suggests that fiscal policy was too expansionary to be consistent with a medium-term debt target of 40 percent of GDP.
Augmented growth-based rule: During the pre-crisis period, actual real GDP grew faster than the trend growth rate used to calibrate the rule (based on average growth during 1970–97). This causes the rule to call for lower deficits than the medium-term target. As a result, the average balance implied by the rule is -0.3 percent of GDP, compared to the target of -0.9 percent of GDP and the observed average balance of -2.5 percent of GDP.
Expenditure rule: The rule sets a ceiling for the real growth of expenditure equal to trend output growth. With actual expenditure growing twice as fast and real GDP growing above trend, simulated expenditure-to-GDP ratios under the rule are much smaller than actually occurred (Figure 6). This, together with the strong growth of revenue observed during this period, results in a much lower average balance (-0.2 percent of GDP) under the expenditure rule. However, it is unclear that revenue would have performed so strongly if an expenditure rule had actually been in place, since in this case temptations for fiscal easing might have been channeled into tax cuts, which are unconstrained by an expenditure rule.
Structural Balance Rule and Output Gaps
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; HM Treasury; and IMF staff calculations.Structural Balance Rule and Output Gaps
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; HM Treasury; and IMF staff calculations.Structural Balance Rule and Output Gaps
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; HM Treasury; and IMF staff calculations.
Expenditure and Revenue under Expenditure Rule
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; HM Treasury; and IMF staff calculations.Expenditure and Revenue under Expenditure Rule
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; HM Treasury; and IMF staff calculations.Expenditure and Revenue under Expenditure Rule
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; HM Treasury; and IMF staff calculations.18. The rules would have allowed less of an increase in the deficit during the recession than actually occurred (Table 1).12 The smaller increase in the deficit implied by the structural balance rule suggests that much of the observed deterioration since 2007 is structural in nature. Under an AGB rule, the increase in the deficit would have been slightly larger than under a structural balance rule, but still much smaller than actually occurred.13 While the simulated expenditure rule would have accommodated the sharp loss of revenue from the financial and property sectors, it also would have allowed less fiscal easing than actually occurred. This is because part of the actual deterioration was due to rapid real spending growth, reflecting spending plans that were set in nominal terms in the 2007 spending review and maintained during 2008–09, despite much weaker-than-expected inflation. In practice, it is possible that such higher-than-expected deficits due to lower-than-budgeted inflation would have also occurred to some degree under all of the rules, since all of the rules eventually rely on nominal spending limits in the budget to achieve the targeted stance. However, a significant part of the increase in the deficit during the recession was due to discretionary stimulus, and this would not generally have been allowed under the structural balance and AGB rules if, as is the case so far in the simulations, the rules are parameterized to allow only automatic stabilizers (a=0.45).
19. To allow for more active countercyclical policy, the cyclical coefficient (a) in the structural balance and AGB rules could be increased. Table 2 and Figure 7 show how the simulated fiscal balance under the rules would change as the cyclical coefficient is progressively increased from 0.45 (which only allows automatic stabilizers) to 1.0. Higher cyclical coefficients allow more discretionary fiscal stimulus during recessions while requiring more discretionary fiscal tightening during booms. With higher cyclical coefficients, the structural balance and AGB rules would have allowed a similar amount of fiscal stimulus during the recession as actually occurred. However, while the change in the deficit would have been similar to the actual outcome, the level of the deficit at end-2009 would still have been lower under these rules, as they would have required smaller deficits in the run-up to the crisis than actually occurred. Promoting such a build-up of countercyclical buffers during the boom is a key way in which the rules would have outperformed actual policy.
Change in Fiscal Balance During the Crisis 1/
(Percentage points of GDP)
“During crisis” refers to the period between Q1-2008 and Q4-2009. Changes exclude the effects of financial sector interventions for both actual policy and the rules.
Change in Fiscal Balance During the Crisis 1/
(Percentage points of GDP)
| Actual policy stance | -7.8 | |
| Structural balance rule | ||
| a=0.45 | -3.3 | |
| a=0.60 | -4.4 | |
| a=0.75 | -5.5 | |
| a=1.00 | -7.3 | |
| Augmented growth-based rule | ||
| a=0.45 | -3.9 | |
| a=0.60 | -5.2 | |
| a=0.75 | -6.5 | |
| a=1.00 | -8.7 | |
| Expenditure rule | -5.9 | |
“During crisis” refers to the period between Q1-2008 and Q4-2009. Changes exclude the effects of financial sector interventions for both actual policy and the rules.
Change in Fiscal Balance During the Crisis 1/
(Percentage points of GDP)
| Actual policy stance | -7.8 | |
| Structural balance rule | ||
| a=0.45 | -3.3 | |
| a=0.60 | -4.4 | |
| a=0.75 | -5.5 | |
| a=1.00 | -7.3 | |
| Augmented growth-based rule | ||
| a=0.45 | -3.9 | |
| a=0.60 | -5.2 | |
| a=0.75 | -6.5 | |
| a=1.00 | -8.7 | |
| Expenditure rule | -5.9 | |
“During crisis” refers to the period between Q1-2008 and Q4-2009. Changes exclude the effects of financial sector interventions for both actual policy and the rules.
20. Figure 7 illustrates how the fiscal balance under the rules changes when subject to different assumptions on other key parameters:
Varying the AGB rule’s adjustment coefficient (c) over reasonable values would not have significantly affected the outcomes over the last decade. However, slower speeds of adjustment (higher values for c) back to the medium-term deficit target would make the rule somewhat more countercyclical.
Under the expenditure rule, changes to the expenditure growth rate ceiling can affect the fiscal balance path significantly. If the expenditure growth rate is set equal to the 12-quarter moving average of growth (instead of trend growth), then expenditure growth more closely follows short-run growth trends, making the rule more procyclical. However, even under this formulation, an expenditure rule would still have built a higher fiscal balance before the crisis than occurred under actual policy.
Sensitivity Analysis: Overall Balance
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; and IMF staff calculations.1/Assumes a structural balance target of -0.9 percent of GDP.2/Assumes long-term real GDP growth of 2.3 percent or a 12-quarters moving average.3/Assumes a medium-term overall balance target of -0.9 percent of GDP; trend real GDP growth of 2.3 percent; and adjustment coefficient(c) of 0.65.4/Assumes a medium-term overall balance target of -0.9 percent of GDP; trend real GDP growth of 2.3 percent; and a cyclical coefficient (a)of 0.75.Sensitivity Analysis: Overall Balance
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; and IMF staff calculations.1/Assumes a structural balance target of -0.9 percent of GDP.2/Assumes long-term real GDP growth of 2.3 percent or a 12-quarters moving average.3/Assumes a medium-term overall balance target of -0.9 percent of GDP; trend real GDP growth of 2.3 percent; and adjustment coefficient(c) of 0.65.4/Assumes a medium-term overall balance target of -0.9 percent of GDP; trend real GDP growth of 2.3 percent; and a cyclical coefficient (a)of 0.75.Sensitivity Analysis: Overall Balance
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: ONS; and IMF staff calculations.1/Assumes a structural balance target of -0.9 percent of GDP.2/Assumes long-term real GDP growth of 2.3 percent or a 12-quarters moving average.3/Assumes a medium-term overall balance target of -0.9 percent of GDP; trend real GDP growth of 2.3 percent; and adjustment coefficient(c) of 0.65.4/Assumes a medium-term overall balance target of -0.9 percent of GDP; trend real GDP growth of 2.3 percent; and a cyclical coefficient (a)of 0.75.21. The relative performance of the rules varies along several dimensions that are important in the choice of fiscal rules:
Countercyclicality and flexibility in response to shocks. In both the structural balance and AGB rules, the desired degree of average countercyclicality can generally be obtained through the choice of cyclical and adjustment coefficients. Depending on a country’s preference, the rule can be set to allow only automatic stabilizers or, if desired, to allow some discretionary stimulus during recessions with offsetting tightening during booms. Under the structural balance rule, the response to the cycle will be directly proportional to the output gap. Under an AGB rule, the relationship to the output gap will be slightly less exact, as the AGB rule intentionally avoids reliance on output gap estimates.14 Nonetheless, the AGB rule will generally mimic the cyclical pattern of a similarly calibrated structural balance rule, as demonstrated in Figure 4. The countercyclicality of an expenditure rule will depend largely on whether discretionary revenue policy, which is unconstrained under an expenditure rule, is employed in a countercyclical fashion or not. An expenditure rule will generally preclude discretionary countercyclical stimulus on the spending side.
Simplicity and ease of monitoring. The need to estimate and forecast the output gap represents the main challenge for implementing the structural balance rule, especially in periods of high uncertainty. Errors in estimating the output gap could lead to undesirable changes in the fiscal policy stance. Nonetheless, these errors had only limited consequences when applying the rule to the UK in the past (Figure 5). An annual structural balance rule, unlike one over the cycle, does not require precise dating of economic cycles and its performance is easier to monitor. An AGB rule is even easier to implement since it does not rely on output gap estimates. An expenditure rule is probably the easiest to implement and monitor, as it only requires the policymaker to set expenditure growth ceilings.
Comprehensive coverage and avoidance of loopholes. The simplicity of expenditure rules comes, however, at a significant cost—they do not constrain the revenue side of the budget. This may create temptations to spend through tax expenditures and may undermine the incentive to strengthen revenue collection and tax laws. Consequently, the risk that fiscal sustainability will be undermined by revenue reductions is much higher under expenditure rules. Similarly, the risk that large increases in capital spending will increase the deficit is much greater under a rule that only limits the current balance, as occurred after the adoption of the golden rule in the UK (Figure 2). In contrast, a key benefit of structural balance and AGB rules is that they constrain all elements of discretionary policy, thereby reducing loopholes.
Response to deviations from the rule. A fourth consideration is how the rules respond to deviations from the rule due to policy or forecasting errors. Under the structural balance rule, a deviation in the overall balance would have to be corrected immediately in the following year to get the structural balance back to the targeted level. This feature should keep the structural balance rule tightly on course. In contrast, the AGB rule allows gradual correction of past deviations. The upside of the AGB’s treatment is that it reduces reliance on large adjustments in any single year. The downside is that this opens the rule to gaming (e.g., a new government may intentionally miss the rule in its first year in order to increase the deficit ceiling in subsequent years). To avoid this, the convergence term in the rule could be modified, replacing last year’s actual deficit with last year’s targeted deficit under the rule (note that, in the simulations, there is no distinction between the targeted and actual deficit, since it is assumed that the rule is met every year). Under a basic expenditure rule, deviations from the rule in past years would not require lower spending growth in future years. However, as with the AGB rule, various feedback mechanisms to require at least partial “make-up” of policy errors could be envisioned.
D. Performance of Alternative Fiscal Rules in Response to Stochastic Shocks
22. To gain further insight about fiscal rule options in the UK, this section illustrates how different fiscal rules perform in response to macroeconomic shocks. First, the joint distribution of economic shocks (to output, the real interest rate, and the real exchange rate) is calibrated to fit the statistical properties of the UK historical data, using a VAR framework. A large number of scenarios that capture the structure of disturbances as well as the dynamic response of the economy are generated (see Box 4 for details). Second, fiscal policy is allowed to adjust to these shocks according to the fiscal rules analyzed in section C. Finally, through repeated simulations of random shocks, fan charts are derived representing the frequency distribution of budgetary aggregates for each fiscal rule and year of projection.15 This allows a probabilistic assessment of the fiscal policy stance and debt sustainability under realistic shock configurations. Since the implementation of any fiscal rule may not be feasible in the short term, WEO projections are used for the 2010–15 period, and the risk analysis of deficit and debt dynamics starts in 2016.
23. Fan charts summarizing risks (upside and downside) to the fiscal position and to debt dynamics when subject to shocks are estimated for the three fiscal rules:
Structural balance rule. Deviations of actual output from its potential level prompted endogenously by the different shocks lead to deviations of the overall balance from the medium-term target, which is set at -0.5 percent of GDP. This more stringent target, relative to the one used for the 1997-2007 period, is warranted given worse initial conditions and the projected increase in age-related liabilities (see Box 3 for details on how the target is estimated);
Augmented growth-based rule. Shocks prompting deviations of GDP growth from its long-term trend (assumed to be 2 percent, slightly lower relative to 1997-2007) trigger changes in the overall balance relative to the target; and
Expenditurerule. Real expenditure grows at a fixed rate, assumed to be 2 percent—in line with long-term output growth.
24. A number of results flow from the fan charts (Figure 8):
The proposed rules ensure debt sustainability in response to a wide range of shocks. The debt ratio follows a declining path over the simulation horizon under the vast majority of shock configurations. The response of all rules is strong enough to prevent debt ratios from growing above current levels (close to 90 percent of GDP).
The probability that debt will fall below 60 percent of GDP by 2026 is about 50 percent under all rules. This takes into account all constellations of potential shocks, whose structure is based on past data, up to and including 2009.
By construction, the three rules are calibrated to yield essentially the same baseline path. Modest differences in the variation around this path reflect modest differences in the average countercyclicality of the rules as calibrated, with narrower bands coming at the cost of less countercyclicality. However, the coefficients for the structural balance and AGB rules can be adjusted to achieve the desired degree of average countercyclicality.
The sustainable debt path under the expenditure rule relies on the assumption that revenue is “well behaved”; the risk with the expenditure rule is that this will not be the case in practice. The expenditure rule simulations assume no discretionary changes in revenue policy. However, such changes are unconstrained by an expenditure rule, and the temptation to loosen revenue policies under an expenditure rule may be significant. As noted above, this failure to constrain the revenue side of the budget is a key shortcoming of expenditure rules.
Stochastic Simulations 1/
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: IMF staff calculations.1/ The simulations assume a structural balance target of -0.5 percent of GDP, long-term real GDP growth of 2 percent, a cyclical coefficient (a) of 0.75 for the structural balance and 0.9 for the augmented growth-based rule, an adjustment coefficient (c) of 0.65 for the augmented growth-based rule, and a semi-elasticity of the revenue-to-GDP ratio with respect to the output gap of 0.35 for the expenditure rule.Stochastic Simulations 1/
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: IMF staff calculations.1/ The simulations assume a structural balance target of -0.5 percent of GDP, long-term real GDP growth of 2 percent, a cyclical coefficient (a) of 0.75 for the structural balance and 0.9 for the augmented growth-based rule, an adjustment coefficient (c) of 0.65 for the augmented growth-based rule, and a semi-elasticity of the revenue-to-GDP ratio with respect to the output gap of 0.35 for the expenditure rule.Stochastic Simulations 1/
(Percent of GDP)
Citation: IMF Staff Country Reports 2010, 337; 10.5089/9781455208449.002.A004
Sources: IMF staff calculations.1/ The simulations assume a structural balance target of -0.5 percent of GDP, long-term real GDP growth of 2 percent, a cyclical coefficient (a) of 0.75 for the structural balance and 0.9 for the augmented growth-based rule, an adjustment coefficient (c) of 0.65 for the augmented growth-based rule, and a semi-elasticity of the revenue-to-GDP ratio with respect to the output gap of 0.35 for the expenditure rule.Stochastic Simulations of Macroeconomic Shocks
The joint distribution of shocks is calibrated to fit the statistical properties of historical data using an unrestricted VAR model. This approach is an extension to that of Celasun, et al (2006). The VAR model describes the comovements of the output gap, interest rates, and exchange rates and provides estimates of the conditional variances and covariances of the shocks. The model is estimated using quarterly data from 1980 to 2009. Formally,
where Yt= (rt, gt, zt) is a vector of endogenous variables, r is the domestic real interest rate, g is the output gap, z is the log of the real effective exchange rate, γk are matrices of coefficients, and ξ~N(0, Ω) is a vector of well-behaved error terms. The model is estimated using two lags. The variance-co variance matrix of residuals Ω characterizes the joint statistical properties of the contemporaneous shocks affecting fiscal aggregates. The VAR generates forecasts of Y consistent with the estimated structure of the shocks. As shocks occur each period, the VAR produces joint dynamic responses of all elements in Y. The model is not sensitive to the ordering of variables in the VAR.
For each simulated constellation of shocks, projections for growth, the output gap, the real interest, and the real exchange rate are generated. Similarly, projections for fiscal aggregates (overall balance, revenue, expenditure, and debt paths) dictated under each fiscal rule are constructed for each year of the forecasting horizon. Through repeated simulations (100,000 simulations) of random shocks, frequency distributions of the balance ratio and the debt ratio can be obtained for each fiscal rule and year of projection (after 2015). These are then used to draw fan charts of the fiscal aggregates, depicting confidence bands for varying degrees of uncertainty around the median projection (discussed in section D).
E. Conclusions and Policy Discussion
25. After an appropriate transition period from the recent crisis, a well-designed fiscal rule could secure the gains of the consolidation process in the UK, support fiscal discipline, and anchor long-term expectations about fiscal sustainability. A well-designed rule could also help moderate the business cycle by promoting countercyclical fiscal policy and could reduce the cost of borrowing by bolstering confidence in fiscal sustainability. Implementing a fiscal rule before 2015/16 might not be desirable, as a fiscal mandate to guide the consolidation process already exists, or feasible, as the required adjustment could be excessive.16 Nonetheless, there would be value in eventually preannouncing a rule-based framework to cement the policy credibility of the medium-term consolidation effort, as Germany and other countries are doing. The newly created OBR can play a central role in supporting and strengthening the operation and monitoring of the fiscal rule.
26. The chapter finds that three alternative fiscal rules would have outperformed the national rules in place during the period 1997–2008. The proposed rules are: (i) a structural balance rule; (ii) an AGB rule that aims to broadly mimic a structural balance rule, but without relying on output gap estimates; and (iii) an expenditure rule. The three rules would have prevented a deterioration of the fiscal balances in the years leading to the crisis and would have yielded lower debt ratios. In addition, these three rules would have provided more guidance in conducting fiscal policy, by explicitly providing a numerical objective for the relevant budgetary aggregates every year. The results suggest that the fiscal policy stance under the golden rule after 2002 was more expansionary than warranted by cyclical considerations and that the observed fast growth of expenditure was not consistent with a debt objective of 40 percent of GDP. Furthermore, the over-the-cycle feature of the golden rule added complexity, as the cycle needed to be defined and estimated, thereby reducing transparency and ease of monitoring.
27. Stochastic simulations show that the three alternative rules deliver long-term debt sustainability under a broad constellation of adverse economic shocks. Fan charts summarizing risks to the fiscal position and to debt dynamics show that the probability that debt will fall below 60 percent of GDP by 2026 (from about 85 percent in 2015/16) is about 50 percent under the three rules and all shock configurations.
28. A structural balance rule with a deficit target of about 0.5 percent of GDP could work well in the UK after 2015/16. With gross government debt expected to reach 85 percent of GDP by 20015/16 and rising age-related costs, a tight fiscal target is warranted. A structural deficit target of 0.5 percent of GDP would be consistent with a long-term debt ratio of 40 percent of GDP. The authorities’ choice of the medium-term objective should aim to deliver an appropriately modest long-run debt-to-GDP ratio. With a sufficiently high cyclical coefficient (e.g., 0.6-0.9), a structural balance rule could also allow for substantial countercyclical policy while still ensuring fiscal sustainability. The recent crisis has revealed challenges in measuring potential output. However, given the characteristics of the UK economy and the Treasury’s relatively good track record, estimating the output gap should not represent a major drawback in implementing the rule. The creation of an independent OBR should further strengthen economic assessments, minimizing estimation biases.17 Nonetheless, if estimation of the output gap is viewed as problematic, an AGB rule could be an alternative, as this rule broadly mimics a structural balance rule, but without relying on explicit estimates of the output gap. In either case, the credibility of the rule can be supported by inputs from the OBR. Ultimately, however, the choice of fiscal rule should reflect the authorities’ preferences regarding tolerance for debt, the degree of countercyclicality in response to shocks, and simplicity, among other objectives.
29. Consideration could be given to the following implementation issues:
Debt brake. A structural balance or AGB rule can embed an automatic correction mechanism or debt brake for deviations due to discretionary policy or forecast errors. Any ex-post deviation of the deficit from the target would be logged into a notional account. Once the cumulative amount in this account exceeds a pre-determined level, a correction mechanism is triggered. The Swiss and German rules include such a mechanism.
Escape clause. To provide adequate flexibility to deal with extraordinary shocks, such as natural disasters or a large financial sector recapitalization, an escape clause could be considered to exclude from the rule spending that is directly related to the emergency. To ensure that the integrity of the rule is not undermined, there should be clear guidelines so that the escape clause is not abused and it is invoked only in truly exceptional circumstances. For example, approval by a supermajority of parliament could be required to invoke such an escape clause.
Enforcement. To be effective, the rule needs to include effective enforcement and accountability mechanisms. The cost for violating the rule could range from formal sanctions to the adverse reputational impact of reneging on a public commitment. Formal enforcement could include the obligation to take corrective action. Requiring public disclosure of compliance with the rule and explanations for deviations would also bolster the reputational mechanism.
30. However well designed the rules, there is no substitute for the government’s commitment to fiscal sustainability. It is the overall quality of the fiscal policy framework and the policymaking process, not just the presence of a rule, which determine fiscal credibility. In this context, the new government’s commitment to fiscal discipline and fiscal mandate, the newly created independent fiscal agency, and the eventual establishment of a more permanent rules-based framework can reinforce each other to ensure fiscal sustainability in the UK.
References
Celasun, O., X. Debrun, and J.D. Ostry, 2006, “Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A ‘Fan-Chart’ Approach,” IMF Working Paper, WP/06/67.
Danninger, S., 2002, “A New Rule: ‘The Swiss Debt Brake’,” IMF Working Paper, WP/02/18.
Debrun, X. and M.S. Kumar, 2007, “The Discipline-Enhancing Role of Fiscal Institutions: Theory and Empirical Evidence,” IMF Working Paper, WP/07/171.
Debrun, X., D. Hauner and M.S. Kumar, 2009, “Independent Fiscal Agencies,” Journal of Economic Surveys, Vol. 23, No. 1, pp. 44–81.
Escolano, J., 2010, “A Practical Guide to Public Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates,” IMF Technical Notes and Manuals.
Fletcher, K. and R. Benelli, 2010, “Simple Countercyclical Fiscal Rules that Avoid Output Gap Estimates,” IMF Working Paper, (forthcoming).
Girouard, N. and C. Andre, 2005, “Measuring Cyclically-adjusted Budget Balances for OECD Countries,” OECD Economics Department Working Papers, No. 434.
HM Treasury, 2008, “The Government’s Fiscal Framework,” November 2008.
Koeva, P., 2005, “The Implementation of the Golden Rule Over the Cycle,” IMF Country Report No. 05/81.
Kumar, M.S., S.A. Abbas, C. Caceres, M. Robinson, and R. Sierhej, 2010, “Poland—Strengthening the Fiscal Framework,” IMF Staff Report.
Kumar, M.S., E. Baldacci, A. Schaechter, C. Caceres, D. Kim, X. Debrun, J. Escolano, J. Jonas, P. Karam, I. Yakadina, and R. Zymek, 2009, “Fiscal Rules – Anchoring Expectations for Sustainable Public Finances.” http://www.imf.org/external/np/pp/eng/2009/121609.pdf (Washington: International Monetary Fund.)
Ljungman, G., 2008, “Expenditure Ceilings—A Survey,” IMF Working Paper, WP/08/282.
Prepared by Carlos Caceres (FAD) and Marta Ruiz-Arranz (EUR). Based on data as of June 2010.
The golden rule stated that the government should only borrow to fund investment. The sustainable investment rule stated that public sector net debt should not be higher than 40 percent of GDP. Both rules were designed to be met over the course of an economic cycle (HM Treasury, 2008).
Announced plans have been drawn up to meet this objective one year early, thus providing some margin.
In 2009, there were 80 countries with national and/or supranational fiscal rules, compared to only seven countries in 1990 (Kumar et al, 2009). See Box 1 for country examples of fiscal rules.
The required speed of adjustment may be excessive. Furthermore, the current uncertain economic environment may complicate the establishment of an appropriate target and the implementation of policies to attain it. The relevance of these considerations would depend on the specifics of the new rules.
In mid-2009, the government announced a fiscal rule, which would require the federal government to maintain a structural deficit not exceeding 0.35 percent of GDP. This rule will take effect in 2016 with a transition period from 2011.
See Kumar et al (2010) for further examples of assessing criteria for fiscal rules.
From the simulation exercise point of view, there is no difference between a structural balance rule and the Swiss debt brake described in Box 1. Both rules aim at maintaining a structural balance target, allowing for cyclical factors. Both rules can embed an automatic correction mechanism (debt brake) for deviations due to discretionary policy or forecast errors, as is the case in the Swiss rule and in the new German rule. Since the simulations assume no deviations from the rule, this correction mechanism is not triggered.
Note that in analyzing the response of the rules, these simulations take the actual output path as exogenously given.
The average ex-post gap in 2002-2007 was -0.1 percent, compared to an ex-ante estimate of -0.4 percent.
Note that these simulations do not include the effect that different fiscal balance levels could have on output.
The larger increase in the deficit under the AGB rule relative to the structural balance rule is mainly because, for a given revenue-to-GDP ratio, a structural balance rule effectively allows real spending to grow at the rate of estimated potential real GDP growth, which fell during the recession down to an average of about 1 percent over 2008-09. In contrast, the AGB rule effectively allows real spending to grow at the trend growth rate (2.3 percent), which is fixed in the rule and does not change during the recession.
Relative to a structural balance rule with the same average degree of cyclicality (as calibrated by the coefficients), the AGB rule will tend to produce more “front-loaded” fiscal policy: the fiscal stance will be more expansionary in the early stages of recessions and more contractionary in the early stages of recovery. However, Fletcher and Benelli (2010) show that the differences with a structural balance rule are typically modest—in general, the AGB rule broadly mimics the cyclical path of a structural balance rule.
For presentational purposes, only the overall balance and debt-ratio simulations are shown here.
The relevance of this consideration would depend in part on the specifics of the rule chosen. For example, the AGB rule allows for gradual adjustment from any starting point, which reduces or eliminates the need for a transition period.
If discretion in estimating the output gap is viewed as problematic, fiscal rule legislation could even specify the method by which the output gap should be calculated for purposes of determining the deficit ceiling prescribed by the structural balance rule.
