Eduardo Ley

In the past decade, several countries—often reacting against the deterioration of their public finances—have adopted rules constraining the extent of discretionary fiscal policy to correct for the deficit bias. This article summarizes recent IMF research on the potential benefits of rules-based fiscal policy frameworks to enhance policy credibility and fiscal sustainability.

George Kopits and Steven Symansky (1998) define a fiscal policy rule as a permanent constraint on fiscal policy, expressed as a summary indicator of fiscal performance, such as the government budget deficit, borrowing, debt, or a major component thereof. They argue that the strongest case for fiscal rules is based on political economy arguments that the rules correct the bias of short-sighted governments to accumulate public debt at the expense of future generations and that avoiding time-inconsistency issues results in significant credibility gains. These benefits must be weighed against the loss of discretion. Kopits and Symansky also identify a list of characteristics for ideal fiscal rules—the now classic Kopits-Symansky (K-S) criteria—which dictates that an ideal fiscal rule should be well-defined, transparent, simple, flexible, adequate relative to the final goal, enforceable, consistent, and supported by sound policies, including structural reforms if needed.

Kell (2001) evaluates the two fiscal rules introduced in the United Kingdom in 1997—a golden rule and a debt rule—against the K-S criteria. Although Kell concludes that U.K. fiscal rules broadly measure up strongly against the K-S ideal characteristics, he also identifies room for improvement—by simply clarifying the benchmarks and objectives—in the policy framework. Moreover, Kell argues that the discrepancy between the two rules and medium-term fiscal plans could undermine the credibility of the fiscal policy framework.

Drawing on international experience, Kopits (2001) reexamines the merits for and against fiscal rules. He identifies three broad lessons. First, governments with a strong reputation for fiscal prudence do not need to be constrained by rules. Second, in countries that lack such a reputation, fiscal rules can indeed provide a useful policy framework that is conducive to stability and growth. Third, to enhance their usefulness, fiscal rules need to meet the K-S criteria at the both national and subnational levels.

Dabán and others (2003) study the design of rules-based fiscal frameworks in the four largest economies in the euro area—France, Germany, Italy, and Spain. They argue that, to avoid procyclicality, the four countries would benefit from incorporating spending rules on deficit and debt targets. Their paper advocates binding spending rules consistent with medium-term debt targets while allowing cyclical revenue fluctuations to affect the budget balance. Daban and others review implementation issues and suggest that fiscal rules be embedded in medium-term macroeconomic frameworks, applied to the general government, and use comprehensive expenditure targets. On real versus nominal rules, their paper points out that nominal rules may be preferable in countries where cyclical stabilization is a priority, while real rules may be more appropriate when there are automatic indexation clauses for significant expenditures (e.g., entitlements).

Tanner (forthcoming) uses numerical simulations to compare three fiscal regimes: a pure tax-smoothing regime, a balanced-budget rule regime, and a regime in which the government runs primary deficits and accumulates debt in the present. On introducing two sources of uncertainty—output uncertainty and random “sudden stops” to foreign capital flows-—Tanner finds that the tax-smoothing regime is preferable to the balanced-budget rule because tax rates have about the same average but are less variable. Also, although over an infinite horizon the economy clearly gains by moving from a deficit regime to a balanced-budget rule, over shorter horizons the issue is not as clear-cut. Under the deficit regime, policymakers can give current constituents their “tax-break,” but only at the expense of higher tax rate variability: in the event of a credit cutoff, the country must undertake a sharp fiscal adjustment. The simulations conducted by Tanner suggest that the cross-regime trade-offs between higher average tax rates and less dramatic fiscal adjustments may be substantial. He finds that, even in the short run, taxpayers might accept higher taxes in return for a steadier fiscal policy. Basci, Fatih, and Yulek (2004) also use numerical simulations to compare the performance of a variable-surplus rule with a simple fixed-surplus rule. They find that the variable-surplus rule—defined as an increasing function of the debt ratio—performs better than the simple fixed-surplus rule, by reducing debt sustainability concerns and the necessary medium-term primary surplus (Ley, 2004).

When is compliance with a fiscal rule just an illusion? To address the issue of whether fiscal rules lead to genuine fiscal adjustments or simply encourage the use of “creative accounting,” Milesi-Ferretti (2003) develops a model in which fiscal rules are imposed on “measured” fiscal variables, which can differ from “true” variables. In addition to the standard trade-off between deficit bias and margin for cyclical stabilization, he emphasizes a second trade-off between costly window dressing and real fiscal adjustment, relating it to the degree of transparency of the budget. In other words, rules that are imposed when the budget is not transparent yield more creative accounting and less fiscal adjustment, Milesi-Ferretti and Moriyama (2004) examine the degree to which reduction in government debt in EU countries has been more cosmetic—that is, accompanied by a decumulation of government assets—than structural. They find a strong correlation between changes in government liabilities and government assets in the run-up to the Maastricht Treaty.

However, fiscal rules may impose severe constraints on governments willing to undertake structural reforms with associated up-front costs. Beetsma and Debrun (2004) analyze the trade-off between short-term stabilization and long-term growth, and—in the context of the euro areas Stability and Growth Pact—they find that sometimes fiscal rules may need to be relaxed for countries that are actively pursuing much-needed structural reforms.

The essays in Kopits (2004) explore various aspects of rules-based fiscal policy in emerging markets. In the foreword to the edited collection, IMF Deputy Managing Director Agustin Carstens warns that “a major unifying theme is the sober and balanced assessment which helps counter the unrealistic view (popular in some quarters) that policy rules automatically insure fiscal sustainability and macroeconomic stability.” The first part of the book reviews the macroeconomic setting and rationale for rules-based policies m emerging markets, taking into account relevant political economy aspects. Drazen (2004) examines how properly designed fiscal rules can he a useful means for building reputation and can serve as a disciplining device, as long as they are accompanied by various procedural rules—including those that prevent creative accounting practices. Hausmann (2004) observes that emerging market economies would benefit from fiscal rules that aim not only at eliminating deficits and reducing debt ratios but also, more importantly, at containing the risk in the composition of the debt. Perry (2004) argues that Latin American economies—subject to high macroeconomic volatility, which is often aggravated by the procyclical stance adopted under various fiscal adjustment programs—ought to follow a rule that incorporates a countercyclical stance through a structural balance target or a stabilization fund. The openness of emerging market countries to high capital mobility, according to Kopits (2004), underscores the case for predictable time-consistent macroeconomic policies and, in particular, for well-designed fiscal policy rules. Nonetheless, fiscal rules by themselves do not guarantee sound fiscal management. Schick (2004) emphasizes the critical role of political will in the success of any fiscal policy rule, when supported by appropriate procedural rules. He notes that the recent literature on fiscal institutions and budgetary process neglects political will and fails to distinguish between formal rules and informal practices. Schick identifies innovations in budget procedures that are conducive to strengthening political will and enforcement of rules. Several other papers in the second and third sections of Rules-Based Fiscal Policy in Emerging Markets: Background, Analysis, and Prospects are devoted to design issues at the national and subnational levels of government.

Kopits (2004) draws several lessons for policymakers from the contributed essays: (1) in emerging market countries, just as in advanced economies, fiscal rules need the support of the electorate; (2) as a corollary, although in principle it is preferable to enshrine fiscal rules in the constitution or in a high-level law, informal rules might be equally effective as long as they are backed by broad public consensus; (3) macroeconomic policy rules can be viable only if underpinned by strong procedural rules, including good practices in transparency and accountability; (4) markets have far lower tolerance for relatively high public-debt-to-GDP ratios in emerging market countries than in advanced economies; (5) in emerging market countries, fiscal rules must be designed to take into account significant macroeconomic volatility; (6) as an alternative, particularly for economies with nonrenewable resources, a commodity stabilization fund that complements limits on the budget deficit and expenditure can cushion pressures stemming from wide fluctuations in the terms of trade; (7) fiscal decentralization requires considerable care in the design and enforcement of rules; and (8) for fiscal policy rules to be credible, initiating key long-term structural reforms early on is indispensable.