A new budget rule for Germany in the light of uncertainty about medium-term economic perspectives

1. A new budget rule for Germanyin the light of uncertainty about medium-term economic perspectives Elke Baumann Federal Ministry of Finance, Germany 39th CMTEA September 25, 2008 Iaşi

2. Outline • Status quo and problems of the existing budget rule • Why a reform now? • Criteria for a new budget rule • Proposal of the Federal Ministry of Finance for a new budget rule • Special focus on changing economic conditions and medium-term economic perspectives

3. Regulations restricting budgetary policyStatus quo - Art. 115 German Constitution: Revenue obtained by borrowing shall not exceed the total of investment expenditures provided for in the budget (“Golden Rule”) Exceptions shall be permissible only to avert a disturbance of the macroeconomic equilibrium

4. Golden Rule - Art. 115 German ConstitutionProblems and limitations of the existing rule • Gross investment concept – depreciations and sales are not taken into account • No clear definition of the exception clause • Asymmetric reaction over the business cycle • Possible conflicts with objectives and rules of the European Stability and Growth Pact (SGP) • No enforcement during execution • In almost half of the years since 1975 net borrowing was higher than gross investment • Increase in the central government's indebtedness could not be prevented

5. Increase of public debt since 1970 Public debt (% of GDP)

6. Why a reform now?Favourable conditions for a reform • Short term: improvement of the fiscal stance and compliance with the existing budget rules (German Constitution and SGP). • Medium term: structural improvement of revenues (substitution of one-off measures by tax revenues). • Judgement of Federal Constitutional Court in July 2007 about budget in 2004 • Länder are looking for early-warning system for distressed budget cases (Federalism Commission II). • High acceptance by the public. • Grand coalition may have the majority to change the Constitution.

7. Why a reform now?Favourable conditions for a reform

8. A new budget rulecriteria and requirements • Compatibility with SGP • Stabilisation over the business cycle • Limit for (structural) net borrowing • Limit one-off measures • Enforcement (ex post correction) • Flexibility - future viability (exception clause)

9. A new budget rulecomposition of net borrowing The new three components of net borrowing structural component cyclical component net financial transactions + - • Allowing automatic stabilizers to work symmetrically over the business cycle by cyclical adjustment in net borrowing in case of divergences from potential output • calculated as the product of the budgetary sensitivity (0.51) and the output gap • negative output gap deficit • positive output gapsurplus • structural deficit of central government max. 0.35% of GDP • Reason: in principal balanced budget, but sufficient flexibility for e.g. one-off effects of reforms. • Size: SGP allows max. deviation of 0.5% (“close to balance”), federal level incl. social security funds gets 0.35% according to its share in overall debt. • correction for net financial transactions (mainly privatization gains) in order to be compatible with the Maastricht definition

10. Symmetric fiscal policy over the business cycleCyclical component with OG calculated by PF approach

11. Symmetric fiscal policy over the business cycleCyclical component depending on medium-term economic forecast • Lower GDP growth than in baseline scenario • Risk scenario I (1-time effect): -1 PP in 2009 • Risk scenario II (dynamics weaker over whole forecasting horizon): -1 PP in 2009 + 2010, -0.5 PP in 2011

12. A new budget rulecomposition of net borrowing The new three components of net borrowing structural component cyclical component net financial transactions + - • Allowing automatic stabilizers to work symmetrically over the business cycle by cyclical adjustment in net borrowing in case of divergences from potential output • Size: product of the budgetary sensitivity (0.51) and the output gapcentral govt: 50 % according to share of cyclical components • negative output gap deficit • positive output gapsurplus • structural deficit of central government max. 0.35% of GDP • Reason: in principal balanced budget, but sufficient flexibility for e.g. one-off effects of reforms. • Size: SGP allows max. deviation of 0.5% (“close to balance”), federal level incl. social security funds gets 0.35% according to its share in overall debt. • Correction for net financial transactions (mainly privatization gains) in order to be compatible with the Maastricht definition • Reason: national financial statistics are on a cash basis => net borrowing does not include revenues from net financial transactions

13. Limit for (structural) net borrowingStructural element • limitation of structural net borrowing, maximum structural deficit of 0.5 % of GDP • limit complies with medium term objective of the SGP (close to balance or in surplus) • need of distribution of structural net borrowing between the central government and the Länder. • Breakdown of 70:30, this means: • 0.35% of GDP for the central govt and social security funds • 0.15% of GDP for the Länder

14. Financial transactionsLimitation of one-off measures • Existing budget rule: limit of net borrowing as defined in national financial statistics does not include revenues from financial transactions (deficit ≠ net borrowing) • in the past net financial transactions have been strong • incentive for one-off operations in order to comply with golden rule • New budget rule: definition of net borrowing will still be based on national financial statistics, nevertheless full inclusion of financial transactions (i.e. privatisations, net changes in assets) in accordance with the methodology in the system ofnational accounts reduction of assets reduces limit of net borrowing by the same amount

15. Net borrowing limit according to the new budget rule (central govt)size of the different components in real time (at the time of establishment of budget)

16. Control fund enforcement and viability • Need for monitoring and setting incentives not only for the formulation but also for the execution of the budget – ex post control of compliance • Deviations from the allowed limits in the execution of the budget will be put on a special account • The account should only track structural deviations from the allowed net borrowing, cyclical deviations due to another economic development than expected ex ante should not be accounted • Accumulation over the years. If the (accumulated) debit side of the account exceeds a specified threshold – i.e. maximum debit of 1% of GDP –, consolidation measures have to be introduced • Credit not allowed to be used in order to finance net borrowing in following years

17. Control fund example calculation for central government

18. Control fund Ex post correction of cyclical component Strong revisions of output gap estimates

19. Net borrowing limit according to new budget rule (central govt)Simulation result:Comparison of ex ante and ex post

20. Net borrowing limit according to new budget rule (central govt)Simulation result:Comparison of ex post limit and realization

21. Exception clauseflexibility • Exception clause for emergency cases (i.e. natural disaster) • coupled with a high quorum of the parliament(60 % or even two-third)

22. Open questionsWhat remains to be clarified? Further procedure? • Federalism Commission II wants to have a solution, but still some remaining differences between political parties, esp.: • Structural component: elimination (CDU) vs. higher than 0.5 % (SPD) • Control fund: What threshold should be introduced and how quick should the debit above the threshold be reduced? • Specification of exceptions? • Decisions have to be made very soon as new elections are coming closer (Sept 2009) • Reform of Constitution is necessary • Communication to the public

23. The golden rule is there are no golden rules George Bernhard Shaw Thank you for your attention