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January 14, 2011

Structural Breaks in Fiscal Performance: Did Fiscal Responsibility Laws Have Anything to do With Them?

By Carlos Caceres (IMF), Ana Corbacho (IADB, ex-IMF), and Leandro Medina (IMF),

Fiscal Responsibility Laws (FRLs) are permanent institutional devices that aim to enhance the credibility, predictability, and transparency of fiscal policy. They generally combine procedural rules to strengthen fiscal transparency and budget management, with numerical fiscal rules such as ceilings on fiscal deficits and public debt to impose fiscal discipline. In contrast to standalone fiscal rules, FRLs seek to provide a comprehensive framework to govern fiscal policy in a single piece of legislation.

FRLs are a relatively new fiscal institution and their empirical effects on fiscal performance remain to be documented and analyzed systematically. New Zealand was at the forefront of these reforms, adopting an FRL in 1994. Since then, FRLs have been implemented in several countries in Latin America, Europe, and Asia. In some countries, FRLs seem to have signaled a regime change towards fiscal responsibility. In other countries, fiscal performance has not shown meaningful improvement, also due to implementation problems.

In a recent IMF Working Paper, we study whether there was a structural break in fiscal performance following the adoption of an FRL, measured as an improvement in the level or the volatility of fiscal balances after the adoption of the law. Our sample covers a wide ranging group of Latin American and advanced economies. The empirical model controls for the effect of business and commodity cycles to capture changes in fiscal performance beyond those explained by economic conditions.

Importantly, our empirical strategy recognizes that the timing of the potential effect of an FRL on fiscal performance may be uncertain. When should one expect an impact from an FRL? When it was passed by the legislature, when it was legally implemented, or some time before or after? Uncertainty in the timing of the effect renders traditional tests for structural breaks biased, and the direction of the bias is unknown. Following the recent econometrics literature, we apply two techniques that take into consideration that the timing of the break may be unknown a priori.

We find significant breaks in fiscal performance in several countries, but in most cases these preceded the adoption of the FRL. Overall, the evidence suggests that it is difficult to link improvements in fiscal performance to the adoption of an FRL. In fact, FRLs seem to have been introduced once the strengthening of fiscal discipline was already underway.  This likely reflects political commitment to fiscal prudence, which may have prompted and supported structural reforms, including the introduction of an FRL. FRLs may have helped anchor efforts to strengthen fiscal policy, but do not seem to have been the driver of such efforts.

FRLs could still have positive effects other than on fiscal balances. As mentioned, our analysis focused on the potential impact of FRLs on the level and volatility of fiscal balances. Although empirically this did not seem to be the case in general, FRLs could still have other positive effects on the conduct of fiscal policy. For example, FRLs could play an important role in enhancing transparency and providing guidance in the budget process. They could also lower sovereign risk premia and facilitate access to government financing. These remain interesting areas for further research.

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.

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