Fiscal Responsibility Laws – More Popular Than Ever Thanks to the Crisis
Posted by Holger van Eden
Fiscal Responsibility Laws (FRL) are presently being developed or considered in countries as diverse as Mongolia, Jamaica, Romania, Ghana, and The Maldives. In Germany, while the country already functions within the Maastricht framework – which has been put in a more accommodating stance in the present crisis – a return to a more restrictive fiscal policy path has recently been enshrined into the Constitution. Many larger emerging market and developing economies –Brazil, India, Argentina, Nigeria – have introduced some form of fiscal responsibility legislation in the past years. Some of these laws focus on a concrete set of numerical fiscal policy rules, i.e. a maximum deficit, debt or expenditure growth rule, others are more focused on enhancing fiscal transparency and accountability.
The repeated fiscal problems that these countries have faced, are no doubt a major contributor to these legislative initiatives. The present financial crisis seems also to have stimulated the interest in FRLs considerably. Perhaps because countries with fiscal responsibility laws seem to have fared better, and kept their deficits better in check than the countries without such laws. At present the deficits in the Eurozone are about half the size of those in the Anglo-Saxon world. Further research on this hypothesis is needed, and in the past evidence has been inconclusive, but quite a few countries seem to have already made the decision that FRLs are helpful in supporting fiscal discipline.
The argument against fiscal responsibility laws has always been that a fiscal framework doesn’t substitute for “enlightened”, or first-best fiscal policy. Fiscal frameworks are always somewhat crude and 2nd best because: (a) they are developed to withstand numerous types of shocks to the economy, and (b) they need to be simple and straightforward to be politically effective. Most FRLs would not guide fiscal policy as well as a “first best” policy makers. Nominal deficit rules, for example, ignore the desired counter-cyclicality of fiscal policy. For these reasons, economists have often disliked FRLs. In real life, however, fiscal frameworks usually do not have to compete against the best fiscal policy or “enlightened” policy makers. The reality of fiscal policy is that there is a strong political and institutional bias for unduly loose fiscal policy. Thus fiscal responsibility laws have to compete, against 3rd or fourth best competitors, and compared to these, fiscal responsibility laws can be quite successful.
Emerging practice reveals a number of rules-of thumb for developing FRLs.
1. Don’t over do it. In many countries ministries of finance need to be convinced not to make the fiscal framework too restrictive. If the political reality is not ready for very tough fiscal rules, do not introduce a framework which will be broken at the first cyclical downturn. It’s better to have a relatively weak framework that functions, than no framework at all. Strengthen the framework gradually by constraining the key parameters of the FRL at regular intervals, for example at the start of a new government’s term in office. In this way, for example, the maximum debt level can be constrained as the framework demonstrates success, and a country can gradually get used to the confines of a disciplined fiscal policy.
2. Make the framework flexible but comprehensive. Fiscal policy which does not explicitly encompass all government spending and incurred liabilities will not have much benefit, as spending ministries will find ways to evade it by setting up alternative spending vehicles such as extrabudgetary funds, providing guarantees to public enterprises and financial institutions, and so on. However, there is good reason to have escape clauses for natural and economic disasters. The framework should withstand “normal” cyclical and price fluctuations, but not major natural disasters or once in generation economic crises. A process for returning to the framework should be defined, however.
3. Don’t neglect transparency, process and accountability. While in many countries the discussion on FRLs focuses on the fiscal rules, for developing countries presentation of a fiscal policy document ahead of the budget document can be useful in itself, as is the reporting and political accountability over last year’s fiscal policy aims. In many countries fiscal policy is alas the outcome of budgetary policy, and not the other way around. Turning around the consideration of fiscal and budgetary policy, fiscal policy first and then budgetary policy, is a big step, even for some developed countries. In a number of FRLs the fiscal policy document is given special status by approval by government and parliament. Some countries have (Sweden) or are considering enacting medium-term fiscal policies, i.e., giving them the status of law, and requiring that the budget be restrained by the fiscal aggregates in such a law.
4. Ensure a credible penalty regime. As FRLs mature, the political capital invested in them increases, and the political costs of breaking the framework become higher. FRLs are relatively weak at their birth, and often it is argued that the “naming and shaming” of the government which transgresses the FRL is not enough. For this reason, FRLs include a wide variety of penalty clauses. Yet penalty regimes are difficult to enforce as they are like promising self-inflicted wounds, i.e. it is not very credible that they will be imposed. Firing the government or disbanding parliament are measures that probably attempt to impose more than is realistic. A mandatory wage freeze in the civil service might be a more realistic penalty, with considerable political costs. There are other examples of what might work however, often very context specific. In Suriname, the Finance Minister would be put in jail if the FRL is broken. This mechanism is actually much appreciated by the Finance Minister, as his colleagues have not had the temerity to go down this route. In other countries, the poor Finance Minister might have been behind bars in no time.
5. Introduce safety margins within the fiscal rules framework or make fiscal rules somewhat flexible. The fiscal framework in an FRL usually sets limits on important fiscal aggregates. Just targeting these limits will result in breaking the FRL as economic shocks can easily push actual deficits or debt levels over their target level. To avoid such embarrassing transgressions of the FRL, there has to be a safety margin between target fiscal aggregates over the medium term and the fiscal aggregate limit. Such a policy framework can also accommodate other considerations such as enabling fiscal policy to be counter-cyclical or ensure more strict sustainability or inter-generational considerations. In the EU the within framework fiscal policy is explicitly defined. Alternatively, for some countries it can be useful to incorporate some of the economic variability in the fiscal limits themselves. By imposing a structural balance target, for example, the surplus or deficit limit incorporates the cyclical fluctuations of the economy, and thus has less chance of being broken.
 See for example Fiscal Responsibility Laws by Ana Corbacho and Gerd Schwartz in Promoting Fiscal Discipline, edited by Manmohan S. Kumar and Teresa Ter-Minassian, 2005.