Fiscal Rules and Public Debt Sustainability

1. Fiscal Rules and Public Debt Sustainability Christophe Schalck Bank of France IBFI International Seminar March 27th, 2007

2. Fiscal Policy Rule:permanent constraint on fiscal policy expressed of a summary indicator of fiscal performance. Plan • What is at stake in fiscal rules • Fiscal rule components • Various fiscal rules in developed countries • Effectiveness of fiscal rules

3. What is at stake in fiscal rules1.1. Public finance sustainability

4. Sustainability risks: • Snowball effect:leads to self sustainability growth of debt generated by successive deficits and interest expense. • No flexible:excessive debt makes economic policy less flexible in the short run. • Fiscal distortions:fiscal measures can modify individual behaviour and economic equilibrium. • Intergenerational equity:beneficiary agents are different from financing agents.

5. New indicators of sustainability: European indicators taking into account future contingent liabilities tied to age-related spending. • S1: differences between the average tax ratio required to generate debt ratio equal to 60% in 2050; • S2: average primary balance required to equalize the present discounted value of all future primary balances to the current gross public debt.

6. 1.2. Credibility of macroeconomic policies • Establish credibility of fiscal policy: • Reduce deficit bias of governments (Buchanan & Wagner, 1977); • Fiscal policy can be time inconsistent (Kydland & Prescott, 1977); • Managing of policy-mix: avoid conflicts of interest between monetary and fiscal policies. • Role of financial markets: an excessive debt implies • high risk premium; • Changes in the credit ratings.

7. 2. Fiscal rules components 2.1. Criteria for an ideal fiscal rule Kopits and Symansky (1998) have identify the desirable features of an ideal rule: • Well-defined; Simple; Transparency; Flexible; Adequate; Enforceable; Consistent; Efficient;

8. 2.2. Designing effective fiscal rules • Statute:Constitution, Law, Treaty • Target: • Fiscal balance (actual or primary). • Cyclically-adjusted balance: allows automatic stabilizers to play their role. But target is unobservable and subject to margins of interpretation.

9. Fiscal balance excluding public investments: so called golden rule. Takes into account that public investments are productive spending, hence investments increase potential growth. • Implementation: Total or partial coverage a risk of expenditures transfers. • Level of government: • The autonomous approach: subnational governments are large and desire to maintain favourable credit rating. • The coordinated approach: top-down approach to ensure a degree of fiscal discipline. • Sanctions:juridical, financial or loss of reputation.

11. 3. Existing fiscal rulesThe United States

12. EU countries

13. The United Kingdom

14. Spain

15. 4. Effectiveness of fiscal rules4.1. Public finances performances

16. Results can come from economic environment. Thus a second approach consists in studying the cyclically-adjusted primary balance (capb).

17. Fiscal adjustments should be based on a reduction of public expenditures and not on an increase of revenues (Alesina and Perotti, 1997)

18. Financial sustainability demands structural reforms: • Labour market reforms were pushed through to create added flexibility and improve training opportunities. • Set up reserve funds and pension system reforms improving the viability of the publicly-funded pillar. • For a fiscal rule to be successful, there must be a national consensus.

19. 4.2.Macroeconomic stability performances • The economic literature show that level of cyclical responsiveness has been reduced by fiscal rules. • To identify the behaviour of governments facing business cycle and debt accumulation. • Positive a’s denote counter-cyclical policy; • Positive b’s denote sustainable policy. • Results can differ according to the fiscal balance which is selected.

20. Dynamic approach

21. Thank you for your attention