“Lisbon II and the new Pact: prioritising structural reform over fiscal prudence?”

1. Workshop on“Policy learning and experimentation in EU economic governance : Laboratory federalism in practice?”European Institute (LSE)London, 31 March 2006 “Lisbon II and the new Pact: prioritising structural reform over fiscal prudence?” Fabienne Ilzkovitz and Lucio Pench Directorate General Economic and Financial AffairsEuropean Commission

2. Contents • Trade-off between structural reforms and budgetary discipline? • The renewed Lisbon strategy : prioritisation structural reforms over fiscal prudence? • The EU budgetary framework and the new Pact • The first year of implementation of the new Pact • The way forward

3. Trade-off between structural reforms and budgetary discipline? Two questions : • Do reforms necessarily entail significant budgetary costs? Reforms  Budget • Does budgetary consolidation slow down structural reforms? Budget  Reforms

4. Reforms  Budget Direct budgetary implications of reforms: • Reforms reinforcing fiscal discipline •  efficiency of public expenditures instead of  public expenditures • Better control of public subsidies • Reforms neutral regarding fiscal discipline •  in administrative burden • Improve links between universities and business • Reforms in conflict with fiscal discipline • Uncompensated tax cuts •  in public R&D, in education  Depends on the package of reforms

5. Reforms  Budget Indirect budgetary implications : • Temporary deterioration in economic activity (reallocation of resources across sectors and restructuring of firms) • Reforms are difficult to implement because of identifiable short-term adjustment costs and long-term and more uncertain benefits  Compensatory packages consisting of targeted expenditures or tax cuts • Expansionary fiscal policy (but time inconsistency problem) • May increase the political support for reforms

6. Budget  Reforms Does budgetary consolidation slow down structural reforms? • Expansionary fiscal policy may raise the “political capital” available to governments for carrying out reforms BUT • A sound budgetary position could facilitate the implementation of reforms • A credible commitment towards budgetary discipline could also reduce resistance against reforms

7. Trade-off between structural reforms and budgetary discipline? Empirical evidence: • Debrun X., IMF (2005): “Fostering structural reforms in industrial countries” • Trade-off between fiscal consolidation and labour and tax reforms • It can be difficult to undertake fiscal adjustment and structural reforms simultaneously • Structural reforms associated positively with favourable fiscal position • OECD (2006): “Political economy of structural reform” • A healthy fiscal position tends to be associated with higher overall reform activity • Fiscal consolidation negatively associated with LMR

8. Trade-off between structural reforms and budgetary discipline? Empirical evidence: • Heinemann, ZEW (2005): “How Distant is Lisbon from Maastricht?” • No general short-term trade-off between Maastricht and Lisbon • Possible short-term conflicts for tax and LMR • Deroose and Turrini, EC (2005): “Short-term impact of structural reforms” • No evidence that reforms are less frequent when budgetary consolidation takes place • Slight deterioration of budget balances (about 0.2 to 0.3 pp of GDP) • Trade-off cannot be easily dismissed but it depends on the specific reform considered (more likely for LMR)

9. Trade-off between structural reforms and budgetary discipline? Empirical evidence not conclusive: Reforms  Budget • No general trade-off between fiscal discipline and structural reforms • Only for LMR, such a trade-off might exist Budget  Reforms • Some support for a negative association between structural reforms (LMR and tax reforms) and budgetary consolidation • Some support for a positive association between structural reforms and a healthy fiscal position  Results depend on the type and design of reforms

10. The renewed Lisbon strategy : prioritisation structural reforms over fiscal prudence? Conclusions of the mid-term review of the Lisbon strategy : Too many priorities and problem of governance • Refocus the strategy on growth and jobs • Improvement of the governance • Streamlining • Increased ownership (NRPs)

11. Increase national ownership • National reform programmes presented in Autumn 2005: a major novelty of the re-launched Lisbon strategy • Transfer policy-making initiatives to the MS • Identifying main challenges and specific measures to be taken over the 3 next years (possibility to amend every year) • Subject to a broad political debate at the national level (Parliament, social partners, …)

12. The renewed Lisbon strategy : prioritisation structural reforms over fiscal prudence? Issue of trade-off not really addressed in the Commission WP “Next steps in implementing the revised Lisbon strategy”: “Macroeconomic priorities identified in the NRPs are discussed in more details in the SCP…” “The NRP would cover … where relevant, a description of budgetary resources available…to implement the referred measures together with a link to the SCP”

13. The renewed Lisbon strategy : prioritisation structural reforms over fiscal prudence? Integrated guidelines Guideline 1: Fiscal prudence In line with the SGP, MS should respect their medium-term budgetary objectives. As long as this objective has not yet been achieved, they should take all the necessary corrective measures… Guideline 2: Quality and efficiency of public finance …MS should, without prejudice to the G on economic stability and sustainability, re-direct the composition of public expenditure towards growth-enhancing categories in line with the Lisbon strategy… BUT Guideline 7 : Increase and improve investment in R&D … through more effective and efficient public expenditure on R&D….and developing and making better use of incentives to leverage private R&D Guideline 23 : Expand and improve investment in human capital

14. What can be learnt from the NRPs? • Few concrete measures • Budgetary implications of these measures largely missing • Question to be investigated : Do MS in EDP have a different strategy of reforms than other MS? Work in progress

15. What can be learnt from the NRPs (challenges)?

16. What can be learnt from the NRPs (challenges)?

17. What can be learnt from the NRPs (Challenges)? For all the MS : • Budgetary discipline is generally formulated in terms of public finance sustainability and less so in terms of budgetary short-term stability • All the MS seem reluctant to make choices between different priorities : no perceived trade-off? For the MS in EDP : • MS in EDP seem to attach a greater importance to the business environment and competition and to the sustainability and efficiency of public finance • Only 2 MS in EDP identify short term budgetary stability as a challenge

18. What can be learnt from the NRPs?Product market reforms

19. What can be learnt from the NRPs: measures (1) Product market reforms : Improving business climate Countries in EDP tend to focus more than other MS on : • Reduction of administrative burden and other costs to set-up a new business • Measures to assist SMEs • Framework conditions for competition  In most cases, these measures have no significant budgetary implications

20. What can be learnt from the NRPs?R&D policies

21. What can be learnt from the NRPs? Measures (2) R&D and innovation • All MS target a significant increase in overall domestic R&D spending by 2010 • The most common measure is an increase in the public spending on R&D (25 MS) • Tax credits for private R&D expenditures are also used (13 MS) • MS in EDP do not seem to focus less on measures to stimulate R&D having potentially a negative impact on budgetary stability • However, improvement in quality of public finances can counterbalance this negative impact (to be investigated)

22. What can be learnt from the NRPs? Measures (3) Labour market reforms : • Reforms of the benefit systems • Reforms of the tax systems • Modernising public employment services • Active Labour Market policies • Budgetary impact of these reforms is more uncertain • MS in EDP seem to focus more on ALMP and modernising public employment services (to be investigated further)

23. Measures in the NRPs: recognition of the trade-off? • MS in EDP tend to have a relatively larger business environment/competition agenda and a relatively smaller labour market agenda • MS in EDP MS do not seem to focus less on measures to stimulate R&D having potentially a negative impact on budgetary stability • But 1/2 MS under EDP envisage to improve the quality of public finances  At this stage, difficult to conclude whether the trade-off was really addressed More information to be obtained in autumn when the MS will provide more details on measures taken to address their challenges

24. Structural reform and the EU budgetary framework

25. The EU budgetary framework Set of legally-based fiscal rules aiming at contrasting deficit bias and ensuring sustainability of government finances. • ‘Corrective arm’ (EDP): 3% of GDP deficit threshold; graduated enforcement mechanism; possibility of sanctions. • ‘Preventive arm’ (SCPs): medium-term budgetary objectives and programmes; multilateral surveillance mechanism; possibility of warning. Strategic complementarity of the two arms.

26. The reform of the SGP Introduction of restrained state-contingency in fiscal rules: • Corrective arm (EDP): (limited) extension of ‘exceptions’ and ‘relevant factors’; (limited) modulation of enforcement (effort vs. outcome). • Preventive arm (SCPs): (limited) cross-country differentiation of MTOs; (limited) modulation of adjustment to cyclical conditions and quality of policies (structural vs. nominal; good/bad times; allowance for reforms). Quality of monitoring and enforcement critical.

27. The new Pact and structural reform: EDP • Structural reforms (‘Lisbon agenda’) to be included in ‘relevant factors’ for deciding on existence of excessive deficit and in subsequent steps of EDP (except abrogation) – limit: deficit to be ‘close’(to 3% of GDP)and‘temporary’. • Pension reforms introducing funded second pillar to be considered in all steps of EDP - specifically, 'net cost of reform to the publicly managed pillar' to be deducted from deficit on 'linear degressive scale' - limit: deficit to be ‘close’and‘declining’.

28. The new SGP and structural reform: SCPs • ‘Major structural reforms' (e.g. ‘major health, pension and labour market reforms’) with ‘verifiable [positive] impact on long-term sustainability of public finances' to allow deviation from MTO or adjustment path toward it . • Special attention to be given to pension reforms introducing funded second pillar, with deviation reflecting 'net cost of reform to the publicly managed pillar' . Limit: deviation ‘temporary’ and ‘safety margin’ kept

29. The new SGP and structural reform: the 2005-06 experience Integration between ‘Lisbon’ and the SGP: • Re-launch of Lisbon strategy not elaborating on division of labour between ‘Lisbon’ programmes (NRPs) and ‘SGP’ programmes (SCPs). • Assessment of consistency between NRPs and SCPs possible in terms : – public finance strategy – ‘concreteness’ of actions – ‘budgetary implications’

30. The new SGP and structural reform: the 2005-06 experience Assessment of consistency between NRPs and SCPs made problematic by: • Timing of the Lisbon and SCPs exercises. • Lack of institutional detail and quantitative information in Lisbon programmes. • Different focus of the two exercises: overall reform (Lisbon); public finances (SCPs)

31. The new SGP and structural reform: the 2005-06 experience Broad consistency in assessments of fiscal strategy

32. The new SGP and structural reform: the 2005-06 experience Assessment of ‘concreteness’ of action sometimes different fort NRPs and SCPs

33. The new SGP and structural reform: the 2005-06 experience Budgetary implications of reform strategy sometimes assessed differently across NRPs and SCPs

34. The new SGP and structural reform: the 2005-06 experience Deviation clause of new SGP on ‘major structural reforms’ effectively NOT invokedby MS: • Strictness of the limits of permissible deviation (‘temporary’ and ‘safety margin’) • Unwillingness/inability to provide ‘detailed quantitative cost-benefit analysis of short-term costs and long-term benefits from the budgetary point of view’ • Clause on pension reforms introducing funded second pillarpossibly easier to invoke (LT)

35. Tentative conclusions • Structural reform is NOT being prioritised over fiscal discipline: – SGP clearly prioritising fiscal discipline. – Lisbonstrategy implicitly considering trade-off not problematic. • Consistency between SGP and Lisbon NOT elaborated and hampered by information deficiencies of Lisbon programmes • EU consensus deeply averse to taking risks with stability for the sake of growth

36. Ways forward Improve the consistency between Lisbon and the SGP: • Specify ‘division of labour’ between NRPs and SCPs: – NRPs could detail the overall reform strategy including on ‘quality’ of public finances – SCPs could provide itemised budgetary information on ex ante costs of the reform strategy • Fill information gap in Lisbon programmes to allow for tentative quantitative assessment of impact of structural reform.