Transcript The Design of Fiscal Policy Rules: Principles and Cross

The Design Of
/1,2
Fiscal Rules
Davide Lombardo
International Monetary Fund
Turkish Banks’ Association Seminar
February 26, 2009
1/ The views expressed in this presentation are the author’s, and not necessarily the IMF’s.
2/ Based on the December 1-2 2008 workshop organized by the Treasury, SPO, and MOF together with the Fiscal
Affairs Department of the IMF. In particular it borrows on the presentations by Debreu and Debreu and Kumar
(available on the website of the Turkish Treasury—see press release dated 18 Dec 2008).
Outline

First principles: (Definition, Rationale, Function)

Taxonomy

Design trade-offs

Basic properties of selected rules

Monitoring and enforcement

Fiscal rules around the world:


EU sample
Broader sample

Lessons from stylized facts

Conclusions
Definition

Mechanism placing durable constraints on fiscal
discretion through numerical limits on budgetary
aggregates (expenditure, revenue, budget
balance and/or public debt).

Any fiscal policy rule is made of 3 parts:



Numerical target/ceiling on one or more specific fiscal
indicators
Explicit cost for non-complying policymakers
A monitoring/enforcement procedure.
What is not a fiscal policy rule?

The annual budget is not a rule, as it only
applies for one year.

An IMF-supported program, as it is not expected
to be a permanent feature of fiscal policy.

The new UK “rule”: “To set policies to improve
the cyclically-adjusted current budget each year,
once the economy emerges from the downturn,
so it reaches balance and debt is falling as a
proportion of GDP once the global shocks have
worked their way through the economy in full.”
Rationale: why constraining discretion?

Unconstrained fiscal policy may be perceived as
systematically deviating from desirable policies. In practice:
pro-cyclical and/or unsustainable policies.

Reasons why unconstrained policies can be biased:
 Time-inconsistency
 Fiscal federalism/monetary union
 Political economy: Myopia, re-election concerns, fiscal
illusion, distributive conflicts, and coordination failures.

Other disciplining mechanisms?
 Markets: yes, but unreliable (comes too late and to
strongly)
 Delegation to non-partisan technical agencies: poses
considerable issues in terms of democratic accountability.
Functions of fiscal rules

Rules are commitment devices: they make
deviations from socially desirable targets too
costly for policymakers.

Rules are signaling tools: they can help
policymakers signal their genuine commitment
to sustainable and stabilizing policies.

Rules can also serve to anchor expectations,
thus reducing uncertainties and risk premia.
Principles of a taxonomy

Many parameters enter the design of an actual
fiscal policy rule:





fiscal target(s)
nature of costs in case of deviation
monitoring/enforcement
escape clauses, etc.
A good rule must imply good policies in most (if
not all) circumstances
 the policy response induced by the rule to a
variety of shocks is therefore key.
Key feature of the rules: response to shocks
 Limits
to discretion make sense, but they
should NOT:



Prevent adequate responses (e.g., let
automatic stabilizers play in bad times)
Force inadequate responses (e.g., force a
fiscal contraction in response to a temporary
spike in interest rate, or depreciation of the
exchange rate)
Let the bias unchecked in specific
circumstances (e.g., allow for procyclical
expansions).
The design of fiscal rules

There is no one-size-fits-all fiscal policy rule.
Much depends on:



Constellation of shocks prevalent in the economy
Nature and magnitude of policy bias under discretion.
A good rule is (Kopits and Symansky, 1998):




…simple
…transparent
…coherent with the final goal
…but mindful of other goals of public policy:
• Not discouraging structural reforms
• Allowing for fiscal stabilization (time-frame, cyclical
adjustment)
• Avoiding low-quality adjustments (undue tax hikes, cuts in
quality/priority spending).
Two key trade-offs

Credibility-flexibility: allowing for greater
responsiveness to shocks could undermine
credibility of attaining the final goal.

Flexibility-simplicity: combinations of rules can
relax somewhat the credibility-flexibility trade-off,
at the cost of simplicity and transparency.
 The devil is in the details
Other design issues

Coverage of the government sector

Policy coordination in federal/decentralized
systems

Legal foundations

Need for adequate budgetary procedures
(preparation, execution, and ex-post auditing of
budgets)

Need to limit scope for creative accounting
Pros and cons of selected rules

Simple rules:





Debt rules
Budget balance rules
Expenditure rules
Revenue rules
Combined rules: e.g., debt objectives coupled
with binding deficit ceilings, debt/budget balance
objectives coupled with binding medium-term
expenditure ceilings
Deficit Rules
Balanced budget and overall deficit limits
 Pros:
 pin down asymptotic properties of debt
 directly address the deficit bias
 can be simple and transparent (unless cyclical
considerations, escape clauses, etc).

Cons:
 procyclical (unless cyclically adjusted or “over the cycle”)
 could force cut in investment…
•  golden rule, but these open door to manipulations,
and do not guarantee debt sustainability.

Overall vs. primary balance?
Primary is more robust to volatility in interest payments.
Debt Rules
Upper limit (or desirable time path) for gross or net public debt

Pros:
 Directly tackle debt sustainability
 Can be transparent and simple
 Can accommodate large shocks if debt is well below the
ceiling

Cons:
 Lack controllability
 Can force procyclical and undesirable responses to
interest rate and exchange rate shocks if debt is close to
the limit

Borrowing constraints generally applied at regional and local
levels
Expenditure Rules
Set expenditure ceilings (nominal or in terms of
GDP) or limits on growth (nominal or real).
Pros:
 tackle one of main source of deficit bias
 translate directly into budget preparation
 minimizes pro-cyclicality risks
 fosters medium-term planning
Cons:
 May leave room for discretionary tax cuts 
sustainability?
 complex to design (nominal vs. real,
exclusions,…)
Best used in combination with deficit or debt rules.
[Revenue Rules]

Rules imposing limits on revenues with a view to:



Pros:


Contain size of the public sector / tax burden
Allocate ex-ante revenue windfalls (e.g., due to surprisingly
high growth)
Can reduce procyclicality in good times
Cons:


Limited impact on deficit bias if not coupled with other rules
Can be procyclical in case the rule targets a given revenue-toGDP ratio (due to the progresssivity of the tax system)
Combination of rules

Drawbacks with individual rules have led most
countries to adopt combination of rules

Most common combinations:
 Debt and overall deficit ceiling and overall
balance target (e.g., Maastricht)
 Overall balance and expenditure ceilings
(Sweden, Finland, Netherlands, etc).
Monitoring
 Ex-ante

Is the government proposed fiscal policy
consistent with the rule and its objectives?
 Ex-post

auditing:
assessment:
Was the rule implemented?
• Analysis of underlying policies
• Certification role: track attempts to resort to
creative accounting
• Assessment of ex-post adjustments to the target
(CABs,…), activation of escape clauses, etc.
A key pre-requisite
Budgetary transparency:




Fiscal data need to be accessible, timely, and
reliable
Comprehensive periodic reporting requirements
Clarity about the budget preparation and
execution procedures
Clarity about roles and responsibilities of
different levels of government
Fiscal councils
 Independent



institutions with
country-specific mandates
adequate and highly qualified staff
guaranteed multi-year budget.
 Can
contribute to greater transparency
and accountability of fiscal policy.
 Can help monitoring and enforcing a rule.
The case of Chile

Fiscal institutional setup designed to buttress fiscal
sustainability and dampen cyclical fluctuations.

Rule: maintain a structural surplus of 1 percent of GDP
for the central government. Fiscal expenditures follow
the dynamics of structural revenue.

Two independent expert panels provide key projections:
1.
2.

the inputs (growth of the labor force, real investment, and total
labor productivity) for estimating trend GDP
ten-year forecasts of the price of copper.
Independent panels enhance policy credibility, while
allowing some policy flexibility.
The case of the Netherlands

The Central Planning Bureau plays a key role in
the budgetary process:





Provides projections and forecasts
Estimates desired structural budget balance
Vets the programs of all political parties (which are
thus subject to reputational sanctions)
Undertakes analysis of specific budgetary projects.
High credibility borne out of tradition
Fiscal Rules: International Experience
 Stylized
facts for EU (EC database: annual
data over 1990-2005), and the rest of the
world (IMF-FAD database on the design
and implementation of fiscal rules)
 Worldwide:
81 countries identified as
having fiscal policy rules, with complete
information for 77 of them
Growing appetite for fiscal rules (EU)
0.90
Maastricht
SGP
EMU
0.80
0.70
Raw index
0.60
0.50
0.40
0.30
0.20
EU-15
Euro-11
0.10
NMS
Big-4
0.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Emerging Market and LICs are
catching up with industrial countries
Number of fiscal rules by category of countries: 1990-2008
80
70
Industrial
EU-27
Emerging
60
LIC's
50
40
30
20
10
0
1990
1995
2000
2008
Budget-balance and debt rules dominate, but
expenditure rules are increasingly popular
Number of countries with at least one fiscal policy rule (by type of rule)
80
70
Budget balance
Debt
Expenditure
60
Revenue
50
40
30
20
10
0
1990
1995
2000
2008
Expenditure and revenue rules are thus relative
newcomers
Median duration of existing fiscal rules (in years)
10
9
8
7
6
5
4
3
2
1
0
Budget balance
Debt
Expenditure
Revenue
Same trends in EU sample
60
50
Revenue Rules
Expenditure rules
Debt Rules
Budget balance rules
40
30
20
10
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Budget balance rules appear stronger and have wider coverage
Selected features of rules-based fiscal frameworks by type of rule
(common features only)
1.00
Budget balance
Debt
0.90
Revenue
0.80
Expenditure
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Independent
enforcement (relative
frequency)
Independent
monitoring (relative
frequency)
Coverage (median Statutory basis (median
relative to maximum
relative to maximum
possible score)
possible score)
This is reflected in synthetic measures
of strength and coverage
Indices of strength (max= 6) and of coverage (max=4) by type of rule
3
4.0
Strength
Coverage
3.5
2.5
3.0
2
2.5
1.5
2.0
1.5
1
1.0
0.5
0.5
0
0.0
Budget balance
Revenue
Debt
Expenditure
Strength and coverage relatively similar across countries
Indices of strength (max= 6) and of coverage (max=4) by country category
3.0
Strength
4.0
Coverage
3.5
2.5
3.0
2.0
2.5
1.5
2.0
1.5
1.0
1.0
0.5
0.5
0.0
0.0
Industrial
Resource rich
LICs
Emerging markets
Features by country groups
Selected features of rules-based fiscal frameworks
(relative frequencies by country groups)
1.00
0.90
Industrial
Emerging
LIC's
Resource-rich
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
Independent
M TEF
Independent FRL (all rules) Provision(s)
enforcement
(relative to
forecasts (all
for fiscal
procedure (all BBR and DR)
rules)
stabilization
rules)
(relative to
BBR)
Exclusion of Independent
high-quality monitoring (all
spending
rules)
(relative to
BBR and ER)
Fiscal rules lower interest rates (EU-25)
Table 2. Determinants of Long-Term Interest Rates in the EU-25 (1990–2005): Selected Sub-Samples
Arellano-Bond
Estimator:
EU-15
Long-term interest rate (lagged)
Non-EU15
Enlargement (dummy)
0.55
(8.77)
0.26
(4.23)
-0.08
(-2.44)
0.01
(0.73)
0.13
(3.04)
0.22
(2.10)
…
Election year (dummy)
…
…
Stability and Growth Pact (dummy)
…
…
Government stability
…
…
Ideological range of governing coalition
…
…
-0.16
(-1.58)
0.10
(0.10)
213
15
0.93
1.00
47
10
0.16
1.00
Short-term interest rate
Cyclically-adjusted primary balance
Public debt (lagged)
Real GDP growth
Inflation
Fiscal Rule Index
Number of observations
Number of countries
Test for 2nd order autocorrelation (p-value) 2/
Sargan test (p-value) 3/
***
0.35 ***
(4.26)
***
0.58 ***
(16.99)
**
-0.01
(-0.03)
0.00
(0.22)
***
-0.01
(-0.06)
**
-0.07 *
(-1.77)
…
Euro
Non-euro
Fixed effects 1/
High debt
-0.11
0.53 ***
(-1.44)
(5.67)
0.50 ***
0.23 ***
(10.52)
(3.07)
0.00
-0.03
(-0.26)
(-0.39)
-0.01
0.00
(-0.85)
(0.27)
0.04 **
0.11 **
(2.14)
(2.38)
0.11 **
0.22 *
(2.12)
(1.92)
…
0.03
(0.07)
0.08 **
0.38
(2.17)
(1.40)
…
…
0.47
(9.98)
0.26
(11.32)
-0.07
(-1.77)
0.01
(0.46)
0.26
(4.29)
0.45
(4.22)
…
-0.03 **
(-1.89)
-0.02
(-1.53)
-0.09 *
(-1.63)
-0.17 *
(-1.85)
0.13 *
(1.90)
-0.16
(-0.93)
-0.21 ***
(-3.75)
…
72
12
0.10
1.00
155
25
0.38
1.00
107
15
0.25
1.00
Low debt
***
0.31 ***
(6.35)
***
0.50 ***
(13.49)
*
-0.04
(-0.82)
0.00
(0.08)
***
0.04
(0.91)
***
-0.04
(-1.07)
…
…
…
…
…
-0.17
(-1.37)
0.03
(0.24)
…
Delegation
0.39
(4.52)
0.40
(4.29)
-0.07
(-1.34)
0.02
(2.04)
0.06
(1.93)
0.01
(0.17)
…
***
***
**
**
0.26
(1.48)
…
-0.31 **
(-2.48)
-0.18 ***
(-3.69)
-0.14
(-1.42)
-0.10
(-1.06)
153
22
0.21
1.00
72
9
0.55
1.00
No
delegation
0.39
(4.58)
0.23
(2.56)
-0.05
(-0.88)
0.01
(0.61)
0.09
(1.39)
0.33
(2.70)
-0.61
(-1.40)
0.28
(1.00)
-0.29
(-1.30)
-0.16
(-1.61)
0.11
(2.71)
-0.41
(-2.03)
***
***
***
***
**
Stable gov.
Unstable
gov.
0.56 ***
0.13
(6.41)
(1.53)
0.12
0.43 ***
(0.92)
(6.93)
0.03
-0.04
(0.56)
(-0.72)
0.00
0.01
(-0.29)
(0.88)
0.07
0.11 *
(1.63)
(1.80)
0.26 *
0.09
(1.88)
(1.18)
…
…
0.47 *
(1.76)
0.13
(0.56)
0.14
(0.59)
0.10
(1.52)
-0.06
(-0.50)
0.02
(0.11)
-0.96 **
(-2.13)
-0.08
(-1.19)
0.15
(1.65)
-0.43
(-1.59)
148
24
…
…
104
21
…
…
148
19
0.45
1.00
Note: The t-statistics are reported in parentheses (with superscripts *, **, and *** denoting statistical significance at the 10, 5 and 1 percent levels respectively). They are robust
to cross-sectional heteroskedasticity. All models include a constant and country effects (not reported). The latter are jointly significant at conventional confidence levels in all
equations. The enlargement dummy is equal to 1 for new member states, after they joined the EU. The SGP dummy is equal to 1 for euro area member states after 1998.
1/ Arellano-Bond estimation could not be obtained for one of the subsamples (lagged dependent variable highly insignificant and evidence of second-order autocorrelation).
The comparison is thus based on fixed-effects estimates.
2/ Arellano-Bond test of the null hypothesis of no autocorrelation of residuals.
3/ Test of the null hypothesis that identifying restrictions are valid.
Debrun and Joshi (2008)
Fiscal rules lower interest rates (EU-25)
Table 3. Impact of the Fiscal Rules on Long-Term Interest Rates: Specific Features
of the Rule (EU-25, 1990–2005, Non-Excessive Public Debt)
Specific dimensions of fiscal rules as captured by sub-indices:
Statutory basis
-0.47 **
(-2.07)
Independent body monitoring the rule's implementation
-0.48 **
(-2.07)
Independent body contributing to rule's enforcement
-0.52 **
(-2.01)
Strength of enforcement procedure
-0.40 **
(-2.03)
Media impact of the rule
-0.47 **
(-2.23)
Memorandum items:
Overall fiscal rule index
-0.45 **
(-2.09)
Expenditure rule index
0.05
(0.29)
Notes: The t-statistics are reported in parentheses (with superscripts *, **, and ***
denoting statistical significance at the 10, 5 and 1 percent levels respectively).
Given that subindices are only available for the overall fiscal rule index and the
expenditure rule index, the results, obtained with model (6) in Table 1, use the
overall index but control for the effect of expenditure rules.
Debrun and Joshi (2008)
All key dimensions
matter  Effective
rules deliver lower
interest rates.
Lessons

Historical preference for deficit and debt rule

But recently emergence of expenditure rules (in
combination with BBRs and DRs)

What explains the trends for more rules and
more expenditure rules?



Increasing realization that purely discretionary fiscal
policies are inconsistent with sustainability (growing
public debt)
Mounting pressures from long-term issues: aging,
global warming, etc.
Regional monetary unions.
Conclusions

Well-designed fiscal rules can help improve
fiscal performance on average…

…thus lowering risk-premia and interest rates on
long-term government bonds.

But: political commitment is key

As are adequate public financial management,
monitoring and enforcing systems.