Keeping a Lid on Spending

Posted by Gosta Ljungman

One of the more intriguing aspects of public policy making is the difficulty of maintaining healthy government finances. Not only is the short sighted temptation to spend now and pay later sometimes too hard to resist, but even with the best of intentions do countries end up with high deficits and a growing debt. It is almost like there is a gravitational force pulling government budgets into red figures. Some institutionalized support appears to be, if not necessary, at least enormously valuable to stay on the straight and narrow path of fiscal sustainability.

Judging from the performance of a handful of countries that have established aggregate expenditure ceilings as a centrepiece of their fiscal framework, this type of arrangement seems to be particularly effective in combating the tendency for spending growing faster than revenue. In a recent IMF Working Paper: Expenditure Ceilings—A Survey, I look more closely at the choices that have to be made when designing an aggregate expenditure ceiling, namely: 1) the comprehensiveness; 2) inflation adjustments; 3) mechanisms to manage expenditure fluctuations; 4) time horizon; 5) numerical definition; and 6) legislative status. I also examine the construction of the expenditure ceiling in three countries: Finland, the Netherlands and Sweden, to see how each of these six aspects have been treated. From this study, some interesting—and for countries considering the introduction of an aggregate expenditure ceiling potentially valuable—patterns emerge.

The objective of avoiding an excessive aggregate expenditure growth obviously speaks in favour of making the coverage of the ceiling as wide as possible. This approach has also been taken by the Netherlands and Sweden, where virtually all central government expenditure is included, with one notable exception: interest payments on the government debt. In Finland, the ceiling is substantially more narrow, with—in addition to the expenditure for debt service—most social security and unemployment transfers being excluded from the ceiling. In all three countries is the majority of investment expenditure included under the ceiling, albeit with some special arrangements preventing capital expenditure from being squeezed out by current spending.

The effect of inflation on government expenditure could create problems under an expenditure ceilings regime—particularly if inflation is volatile and difficult to forecast. By setting the medium-term expenditure ceiling in real terms, Finland and the Netherlands attempt to insulate the ceiling from such inflation shocks. In Sweden, the simplicity and transparency of the ceiling have been considered more important than the potential distortions created by an unexpected change in inflation, and the ceiling is set in nominal terms.

Even with good expenditure forecasting, some unexpected fluctuations are unavoidable—particularly in a time-horizon of three or four years. In all three countries, a certain margin between the expenditure ceiling and projected expenditure is maintained as a buffer against an unfavourable development. The experience in all three cases has been that it is difficult to protect this margin from being used for discretionary expenditure increases, however. Despite some relatively minor possibilities to shift expenditure between fiscal years, change criteria for expenditure financed by user fees and more extensive use of tax expenditure, the most common way of dealing with a risk of exceeding the ceiling has been to make expenditure cuts. In no case have established expenditure ceilings been increased with a reference to an unfavourable expenditure development.

All of the three countries set their expenditure ceiling for the medium term, but differ in way in which this is done. Finland and the Netherlands set ceilings for the upcoming four years at the beginning of the government’s term. In Sweden, the expenditure ceiling is set on a rolling basis. Every year a new ceiling is added to the third outer year in the three year framework. Although both the time-frame and the choice between a fixed-term and a rolling ceiling have implications for the ability to calibrate the ceiling to macroeconomic and fiscal conditions, the country specific regime appears to have strong ties to the political environment.

Given that the expenditure ceiling is predominantly seen as an instrument for ensuring sustainability, it is somewhat surprising that neither one of the three countries have established a methodology for how the ceiling is calculated. The level of total expenditure is viewed as a highly political matter, and there seems to be a reluctance to give up any discretion over this decision.

The fact that in all of the three countries, the model with an expenditure ceiling was born out of a severe fiscal crisis largely explains the firm political commitment to the fiscal framework. Interestingly enough, this has not translated into a legislative basis for the ceiling, or any pre-defined sanctions should the ceiling be exceeded. Although the expenditure formally are voluntary in all three countries, they continue to be applied and respected.

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[Steven Burda]

People will still live and spend... and so will business...!

Thank you.
- Steven Burda, MBA
http://www.linkedin.com/in/burda
http://www.cio.com/article/print/470122