Fiscal Rules - Beneficially Binding?

Gsta Ljungman

February 6, 2008

Posted by Gösta Ljungman

Widespread turbulence in public finances over the past decade has rekindled an interest in numerical fiscal rules as a way of addressing the well-known difficulty in ensuring that political assemblies take full consideration of the fiscal impact of their decisions. On top of a creeping increase in public expenditure and deficits in a number of countries, the future challenge posed by an ageing population is receiving more and more attention, and various options for ensuring sustainability are being discussed. Medium- and long-term fiscal policy objectives, and institutionalized restrictions on fiscal policy formulation, are possible ways of addressing these issues.

However, the experience with fiscal rules presents a mixed message. In some cases they have been highly successful in consolidating public finances and promoting a responsible fiscal policy, while in other cases the actual impact has been negligible. The emerging picture seems to be that numerical fiscal rules in themselves are not sufficient to promote fiscal discipline; they have to be supplemented by institutional reforms supporting the rules, and implemented in a political environment, which is conscious and concerned about the long-term health of public finances.

What is a fiscal rule?

A well established definition is that a fiscal rule is a “…permanent constraint on fiscal policy, typically defined in terms of an indicator of overall fiscal performance” (Kopits and Symansky 1998, Fiscal Policy Rules, IMF Occasional Paper 162, Washington DC).  The definition highlights two fundamental characteristics of a rules based approach to fiscal policy.

Firstly, a fiscal rule is a permanent constraint, which means that it stretches over the foreseeable future. Fiscal rules bind not only the current government and parliament, but a changed political composition in these institutions as well. Such an agreement and commitment across the political spectrum naturally requires a broad support for the fiscal rules.

Secondly, a rule is a concrete indicator of fiscal performance, in the sense that it is expressed in unequivocal and verifiable terms. Ideally, there should be little ambiguity about the construction of the rule, and it should be possible to assess compliance.

Why fiscal rules?

There is an abundant academic literature on why unconstrained discretion over revenue and spending can erode public finances. The bottom line is that there is generally a strong pressure on expanding government expenditure, and a reluctance to raise taxes to the extent necessary to fully finance public undertakings. These phenomena—repeatedly observed in governments across the globe—are often referred to as a fiscal illusion and a deficit bias. The explanations for such tendencies can be found in a short sightedness when assessing costs and benefits, the difficulty in evaluating adverse behavioral effects of tax and expenditure schemes, a common pool resource problem in the provision of public goods and services, and various other political economy aspects of public decision making.

The idea behind a fiscal rule is that the government and parliament voluntarily make an explicit commitment to a medium- to long-term target for fiscal sustainability. In the hackneyed analogy of Ulysses, politicians tie themselves to the mast of a fiscal rule to resist the sirens cry for irresponsible fiscal behaviour. By introducing a cost—in the wide sense of the word—for breaching the rule, there will be less temptation to expand public spending, cut taxes and not take responsibility for the deficit.

Fiscal rules will—if observed—bring fiscal sustainability issues into the annual process of preparing and executing the budget. The confidence of the general public in the government’s and parliament’s commitment to running responsible policies will promote economic activity and growth. Financial markets will accumulate trust in the fiscal stability and interest rates on the government debt will decline.

In an environment plagued by a history of fiscal indiscipline, however, the mere introduction of a fiscal rule is not likely to change the situation for the better overnight. The government and parliament—and where relevant, the president—have the ultimate authority over government finances, and a fiscal rule will only be observed as long as it is expedient to do so, in other words as long as the cost of breaking the rule is higher than the benefit of doing so. Building trust in the commitment to fiscal sustainability takes time. By showing resolve, and by observing fiscal rules for a successive number of years the benefits of a rules based fiscal framework can be reaped.

Some alternative rules

The post now turns to consider four broad alternate types of fiscal rules:

  1. Balance, Surplus or Deficit Rules
  2. Expenditure Rules
  3. Debt Rule
  4. Revenue Rules

Balance, surplus or deficit rules

The classical fiscal rule is a balanced budget rule. Many countries have, at one time or another, introduced an explicit or implicit requirement that the budget cannot show a deficit. Such a simplistic approach for fiscal policy is rarely adequate, however. Firstly, although it may be possible to prepare a budget that shows a balance between revenue and expenditure, it is seldom possible to ensure balance ex post without introducing substantial costs to the public. Secondly, a simple annual budget balance rule will be pro-cyclical. In an economic upturn—when the wheels of the economy are spinning quickly and revenue is flowing into the government coffers—it will be possible to increase expenditure, which will run the risk of overheating the economy. Conversely, in a recession the government would be forced to raise taxes and cut spending in order to maintain the annual budget balance. Simple balanced budget rules are, for these reasons, rare.

A more sophisticated version of he balanced budget rule is, what is commonly known as, the golden rule. This rule states that the government is only allowed to borrow to finance investments. The reasoning behind this rule—which is obviously more flexible than the balance rule—is that public investments generate returns over a longer period of time, and should not be constrained by the annual flow of revenue. The concept of a golden rule is, naturally, only applicable in a cash budget. In an accruals framework, this rule effectively becomes a balanced budget rule.

There may, however, be good reasons not to focus on the balance, which is the foundation of the two rules discussed above, in the short to medium term. A temporary deficit may be justified to stimulate an economy in recession. When balance targets are used, they are often formulated in terms of a structural deficit or surplus, or alternatively the average of the deficit or surplus over a number of years—for example the business cycle. Such targets introduce some ambiguity in the verification, and highlights the necessity of finding the right balance between the firmness and the flexibility.

An expenditure rule

The fiscal balance is the sum of two very large numbers, and is typically hard to project and control on an annual basis. An important explanation for this is that, although legislation regulates which economic activities that should be taxed, and at what rate, the government does not control the level economic activity. Revenue is, in the short term, largely outside the control of the government. A number of governments have therefore turned their attention to spending, and have introduced maximum limits on expenditure. The idea is here to establish a binding ceiling on government expenditure, based on a projection of available resources (given the desired deficit or surplus), before the process of negotiating the various expenditure proposals is initiated. An expenditure ceiling attempts to separate the determination of overall spending, from the prioritization of individual government programs. An expenditure ceiling can avoid a temporary boost of revenue to be used to expand expenditure, and can, therefore, function counter-cyclically in an economic upturn.

Although it could be debated whether or not an expenditure ceiling is a fiscal rule in the pure sense, it has proven to be an effective instrument in promoting fiscal discipline in a number of countries. In order to generate the desired development of government finances, the expenditure ceilings has to take into account the expected revenue projection. For this reason, expenditure ceilings are sometimes referred to as an operational instrument to implement a deficit or surplus rule. Terminological discussions aside, there are a number of aspects that have to be considered when institutionalizing an expenditure ceiling.

An important aspect of a spending rule is the time horizon for which the limit is placed. Although an annual ceiling is conceivable, a multi-annual ceilings seems to be paramount in ensuring that it has an impact on fiscal outcomes. Conflicting time-horizons—or time inconsistency—is one of the fundamental problems addressed by a ceiling on expenditure. The first issue is the number of years included in the ceiling. Between three and four seem to be the most common approach. A second issue is whether the ceilings are set for a fixed multi-annual period—such as the mandate period of the government—or if they are rolling, with a new outer year added every year.

A second issue is the comprehensiveness of the ceiling, i.e. which expenditure items that are constrained. There are strong indications that fiscal discipline increases with the ceiling’s comprehensiveness, but that this rectitude may come at a price. Hard ceilings can, if not set up and managed properly, limit the automatic stabilizers on the expenditure side in an economic downturn, and therefore restrict the government’s ability to run counter-cyclical policies. Consequently, some countries have excluded cyclical expenditure from their ceilings. For analogous reasons, interest payments on the government debt under the ceiling is often excluded.

A third issue is how the expenditure ceiling takes into account inflation, and whether the ceiling is formulated in real or nominal terms. Real ceilings insulates the room under the ceiling from unexpected changes in inflation. The draw-back is that the transparency of the ceiling may decrease with the translation of the ceiling from real to nominal terms.

A debt rule

A third possibility for a fiscal rule is a target or an upper limit on debt. Variations of such a rule are found in some countries. A first issue concerns the targeted debt. Provided that it is used to amortize debt, sale of government property affects gross debt. A lower debt is therefore not always a reflection of a prudent fiscal policy. This problem can be circumvented by formulating a rule for net debt, but introduces an added problem of valuating government assets. A second issue is the choice between central government debt, general government debt and general government consolidated debt as the targeted variable. The development over time of these three debt measures will not necessarily move in parallel.

Although the debt is a relevant indicator for fiscal policy over a longer period of time, there are some objections for using this as an operational fiscal rule. The value of the debt stock—particularly the foreign debt—is partly beyond the immediate control of the government. Short term variations of the debt is, consequently, not necessarily a good indication of current fiscal policy. Over a longer period of time it is meaningful to analyze and take into consideration the development of government debt. The difficulty in making regular and unambiguous verifications, however, imply that a focus on the flow variables that result in the debt, rather than the accumulated deficits, is operationally more appropriate.

Revenue rules

If a government has major political goals related to the revenue side of the budget, it could formulate a revenue rule, for instance a revenue or tax ratio to GDP or a nominal tax floor. Revenue rules can be used to restrict the tax burden or—with an explicit or implicit target for deficit or surplus—the size of the government sector. Such revenue rules are difficult to operationalize. For individual years, fluctuating revenue may well be justified, and verification of the compliance with a revenue floor may be difficult. Revenue rules can also be used to avoid the risk of pro-cyclical policies by making a commitment to how higher-than-expected revenues are used.

The formal status of the rule—does it matter?

As discussed above, the ultimate authority over fiscal matters rests with parliament—typically significantly influenced by the government and, in applicable cases, the president. Fiscal rules will only survive if they have the support of these institutions. Any fiscal rule, irrespective of how it is expressed in legislation, can be abolished if it is not perceived to support the fundamental objectives of political assemblies. This does not, however, mean that the formal status of fiscal rules is without importance, but that the legislative basis is in no way a substitute for broad support from the decision making bodies that are expected to respect the rule.

Irrespective of what the foundation of the fiscal rule is, it should be possible to verify compliance. Public access to the information necessary to monitor actual development against the rule is essential, but may not be sufficient. The complexities of analyzing the relevant parameters may require expertise with a certain degree of independence from the government. Financial markets and international financial institutions can also play a role in monitoring compliance.