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November 22, 2010

Should Advanced Countries Adopt a Fiscal Responsibility Law?

Posted by Ian Lienert

Fiscal Responsibility Laws (FRLs) have become fashionable, especially in middle-income countries. In contrast, only a few advanced countries have adopted an FRL. Is this because the existing legal framework for the budget system is already adequate? Or are advanced countries reluctant to bind themselves to the goals of an FRL? Or do they believe that a law to regulate fiscal transparency, accountability and macro-fiscal stabilization is not needed?

After first defining what is meant by “fiscal responsibility”, a new IMF working paper examines the experience of FRLs in a wide number of countries. It is shown that laws that embody quantitative fiscal rules have generally not been successful in reaching fiscal consolidation goals. Although FRLs are most useful for promoting greater transparency of fiscal information, especially intended medium-term fiscal strategies, without government and parliamentary consensus to fiscal discipline, the macro-fiscal stability aims of a FRL may not be attained.

When I was growing up in New Zealand in the 1950s on “Budget Night” the entire adult population would tune in to the radio to hear the annual budget speech of the Minister of Finance. “The price of petrol will go up by 3 cents as from midnight tonight”, he would proclaim. Midnight tonight! Yes, the government unilaterally raised excise taxes on petroleum products. There was no public discussion and Parliament was by-passed. Only later did the government initiate changes in laws that validated the Budget Night’s revenue and expenditure measures.  Such was the inheritance from Britain, where the annual budget was a secret document until the day that its contents were spilled out to the public by the Chancellor of the Exchequer from the House of Commons. In such a system, there was an absence of fiscal transparency. And the government was accountable to no one but itself.

Forty years later, in the 1990s, the New Zealand government was a pioneer in the drafting of a Fiscal Responsibility Law that served as a model for a few advanced countries (notably Australia and the U.K.) and several non-OECD countries. The New Zealand government had realized that it was in its interests to provide the public with full fiscal information, including an intended path for future fiscal aggregates. Previously, in the 1970s and 1980s, public debt had been soaring. One reason why the FRL was adopted in 1994 was to ensure further progress was made to reduce debt to a prudent level. This was to be achieved by running fiscal surpluses. The 1994 FRL required full reporting of the government’s planned medium-term fiscal strategy. The law helped to consolidate the move away from detailed annual budgets to medium-term fiscal strategies and objectives. Annual fiscal targets, specified over a medium-term period, were not set in the FRL but determined each year. The FRL prescribed that any deviations from the principles of responsible fiscal management, including the previously announced medium-term fiscal strategy, had to be justified by way of reporting publicly the fiscal results. Timely annual accounts prepared on an accrual basis, were judged to be necessary for accurate monitoring of fiscal developments.

The idea of medium-term fiscal strategies was not new. In the 1960s, Germany had adopted a slew of new laws (included Constitutional changes) that, inter alia, required the formulation and political agreement on a medium-term fiscal (“financial”) plan. Two laws in particular are worth mentioning: the 1967 law to promote economic stability and growth, and the 1969 law on budget principles (which is the basis for similar laws for the Federation and each of the 16 Lander). However, they do not explicitly require a description of how the annual budget strategy contributes to the attainment the fiscal objectives over the medium term. Thus, neither of these two laws could, by itself, be considered to be a FRL.

The examples of New Zealand and Germany (not to mention other European countries such as Spain and Portugal, which have adopted Fiscal Stability Laws) illustrate the criteria that define the essential and optional provisions of an FRL. In this working paper, four core components of a fiscal responsibility law are proposed:

  • Specification of the medium-term path of fiscal aggregates.
  • Description of the medium-term and annual budget strategy for attaining the chosen fiscal objectives.
  • Regular publication of reports (at least twice a year) on the attainment of fiscal objectives or targets.
  • Audited annual financial statements that assure the integrity of fiscal information.

In practice, FRLs tend to include more than these four features. However, a limited-scope, budget-related law that includes several “optional” features, but not all four obligatory provisions, is considered to be an “FRL-type” law. But on the basis of the above definition, only four OECD member countries currently have in place an FRL and, amongst the advanced countries, only Australia has had an FRL in place for more than 10 years.

In contrast, in some regions of the world, notably Latin America, many FRLs have been adopted by legislatures. Athough many of these FRLs embed quantitative fiscal rules, the experience has been so far generally disappointing: several Latin American countries (and also India, Pakistan, and Sri Lanka) were unable to respect the FRLs’ quantitative targets, resulting in either a modification of the FRL or abrogation of the law.

Brazil is an exception: its FRL has been quite successful in attaining its objectives. There are several reasons for this, including the following: successive governments and congresses have been committed to the FRL’s objectives; there are no quantitative targets for debt or deficits in the FRL; instead, a separate Budget Guidelines  Law, with quantified macro-fiscal targets, is adopted every year to guide the evolution of medium-term  budget aggregates; and, finally, there are strong sanctions for noncompliance. Unlike in some countries/regions, sanctions are effectively applied, including at subnational levels of government (e.g., mayors have lost positions when the FRL has been breached). The implementation of sanctions is strongly supported by independent Courts and a separate Fiscal Crimes Law.

After an examination of country experiences with FRLs, the working paper discusses why most advanced countries have not adopted a FRL. There is no single reason for this, mainly because institutional arrangements for budgeting, including the balance of budgetary power between the executive and the legislature, vary from country to country. The various reasons why many advanced countries have not adopted a FRL include:

  • The existing legal framework for the budget system is deemed to be adequate.
  • Country authorities do not perceive that it is necessary to adopt a law for attaining the objectives of an FRL. In EU countries, supranational fiscal rules and reporting requirements minimize the need for any individual EU member State to adopt an FRL. In countries with coalition governments, limited-duration coalition agreements may specify an agreed desirable path for fiscal aggregates and the policies needed to attain annual and medium-term fiscal targets.
  • Political authorities may have little desire, or find it too difficult to reach consensus, for becoming more transparent and accountable in budgetary matters, especially the need to commit to a binding medium-term fiscal strategy. This is especially the case in countries with strong legislatures, which reject executive dominance in formulating the fiscal policies needed to attain a sustainable medium-term path for fiscal aggregates.
  • In some countries, an independent fiscal institution, rather than a limited-scope law (a FRL), provides an alternative mechanism for holding the government to account and promoting greater fiscal transparency.
  • There has been limited success for including quantitative fiscal rules in FRL-type laws.

These aspects are discussed more fully in IMF Working Paper 10/254, just published. The working paper’s six annexes and various boxes describe features of FRLs in a number of countries.

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