Posted by Xavier Debrun
The April 2014 issue of the IMF’s Fiscal Monitor usefully reminded us of a simple truth: getting government spending right entails tough choices, always and everywhere. Since 2008, elevated risks of economic and financial collapse had forced policymakers to think mostly in terms of how much government money should be injected in the economy. Now that the crisis has morphed into an uneven recovery, more attention is being given to ensure that public finances are on a sustainable path, and that the allocation of resources through the budget is efficient and in line with a country’s spending priorities.
Getting the level and composition of public expenditure right is easier when fiscal institutions provide effective safeguards against inadequate policies. Sound public financial management (PFM) systems anchored in numerical fiscal rules have been found to reduce the risk that governments spend beyond their means or fund low-priority but politically convenient programs. By definition, a fiscal rule combines an explicit limit on a broad budget aggregate—such as public debt, the fiscal balance, or expenditure growth—with provisions making deviations from the limit costly for policymakers.
Rules aimed at capping public spending have received a lot of attention recently, and it is important to understand how they can affect expenditure reforms. The growing appetite for expenditure rules resides in a number of attractive features, including a direct link with budget formulation (setting the envelope), an explicit focus on the main source of excessive deficits (lack of expenditure restraint), and a compatibility with automatic stabilizers (which operate mostly on the revenue side). Expenditure ceilings are increasingly used to implement other rules constraining budget aggregates that are highly relevant from a sustainability perspective but less easily controlled by policymakers, such as the structural balance or public debt.
Although a well-designed expenditure rule is economically relevant and easily plugged into the rest of the budget system, its impact on expenditure reforms is a priori ambiguous. On the one hand, strong incentives to keep total spending in check can encourage stricter prioritization and greater efficiency in spending. On the other hand, the nature of a rule is to constrain discretion, and therefore the ability to make choices. As such, it creates incentives to avoid politically difficult decisions. Thus the decisions dictated by the rule are not necessarily better than unconstrained decisions. To take a simple example, if overspending results from a political preference to fund electorally rewarding but economically dubious projects and programs, a binding constraint on total spending might well result in the crowding out of valuable but electorally unappealing projects.
The evidence in the Fiscal Monitor generally suggests that expenditure rules do their job when it comes to durable spending containment, stronger counter-cyclicality, and better fiscal discipline, all this without being systematically associated with deleterious side effects.
First, there is a strong association between an expenditure rule and improved fiscal performance. This empirical result can be ascribed to the desirable features of the rule itself. In particular, greater enforceability could explain why compliance with expenditure rules is generally much higher than for budget balance rules, especially if the spending limit is defined in the budget law. In part, greater compliance also reflects better control since public expenditure is less subject to business cycle fluctuations. The resulting compatibility between expenditure rules and the operation of automatic stabilizers on the revenue side could in turn explain why fiscal policy tends to become more counter-cyclical after the adoption of these rules. In particular, better compliance in good times than in bad times suggests that expenditure rules are effective in encouraging the saving of revenue windfalls. Indeed, the tendency to spend cyclical windfalls has been one of the main culprits in the deviations from budget balance rules, including the European Union’s Stability and Growth Pact.
Evidence of adverse side effects is mixed and likely depends heavily on the overall quality of PFM systems. The economic literature suggests that in emerging markets, but not other countries, the introduction of expenditure rules is associated with a decrease in public investment. This finding indicates that well-designed budgetary frameworks and procedures, which are more prevalent in advanced economies, could mitigate any adverse effects on public investment.
Finally, the empirical analysis points to two positive side effects. The first is that countries operating under expenditure rules have less volatile expenditure, reducing the likelihood that fiscal policy itself is a source of destabilizing shocks to the economy. The second positive side effect is greater efficiency. Although data availability severely limits the size of the sample, there is tentative evidence that countries with expenditure rules also exhibit a higher index of public investment efficiency.
Overall, the empirical evidence tends to support the view that expenditure rules can foster better spending behavior provided that sound PFM systems are in place. This is good news when spending decisions are made so difficult by growing pressures on public resources. In advanced economies, the rising tide of aging-related outlays clashes with the need to gradually eliminate structural deficits and reduce public debts. In developing economies, rising demands for public goods and services, including education, health care, social safety nets and infrastructure are often constrained by slow progress in mobilizing government revenues.
Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.
