Budget Institutions and Fiscal Performance

1. Budget Institutions and Fiscal Performance Ernesto Stein Research Department Inter-American Development Bank

2. Why the interest in budgetary institutions? • Growth of deficits in the U.S. • Changes in legislative procedures (1974) • Supply side economics (Reagan) • Gramm-Rudman-Hollings (1985) • Great variety of fiscal experiences among relatively homogeneous countries (or states) • Difficulty of explaining those differences on the basis of purely economic variables motivates several authors to explore the role of political and institutional variables

3. Budget institutions and fiscal performance • Several studies exploit the differences in the balance budget rules across U.S. states to measure the impact of budget institutions on fiscal performance • Von Hagen (1992) and von Hagen and Harden (1995) study the role of budget institutions in explaining fiscal performance in the countries of the European Union • Alesina, Hausmann, Hommes and Stein (1998) study the same thing for 20 countries in Latin America. • Jones, Sanguinetti y Tommasi (1998) do the same for the case of Argentine provinces

4. Budget institutions and fiscal performance • In general, this literature finds that budget institutions contribute to explain an important part of the differences in fiscal performance across countries (or states)

5. Budget Institutions • Definition: We define budget institutions as the set of rules, procedures and practices according to which budgets are drafted, approved and implemented.

6. Why are BI important? • If fiscal decisions were made by the social planner we studied in textbooks, one would observe optimal fiscal behavior • In such a context, any rules that constrain the decisions of the social planner have to be sub-optimal • Of course, the social planner does not exist. The process of fiscal decision-making is a collective one, in which a variety of actors, each with its own preferences and motivations, is involved. • This generates a number of potential problems, which good budget institutions may contribute to solve.

7. Problems to be solved • The common pool problem (Weingast, Shepsle and Johnsen 1981) • Other potential externalities across government units (Canzoneri and Diba 1990) • The electoral cycle (Nordhaus 1975, Tufte 1978, Rogoff 1990) • Strategic use of debt (Alesina and Tabellini 1990)

8. Problems to be solved • Principal/agent problems (private benefits of those who participate in the budget process) • Problems associated with the short time horizon of politicians (Cuckierman and Meltzer 1989) • Problems of dynamic inconsistency in fiscal policy

9. The common pool problem • Two important characteristics of public programs: • While their benefits tend to be concentrated, they tend to be financed from a common pool of resources • The budget is the result of a collective decision-making process, involving a variety of agents: • Legislators • Spending ministers • The finance minister

10. The common pool problem • Legislators: they respond to the interests of their respective jurisdictions; tend to favor programs that benefit their districts, but are financed by the nation as a whole • Spending ministers: Favor programs that fall within their control. Their power within the government is associated with the size of the budget they manage. • Finance minister: Is responsible for macro stability, and therefore usually has incentives to promote fiscal discipline

11. The common pool problem • Since most of the agents involved in the budget process represent geographical or sectoral interests, the combination of these two characteristics of government public budgets can, under certain institutional arrangements, result in an overutilization of the common pool of resources, and in excessive spending and deficit

12. The common pool problem • Weingast, Shepsle y Johnsen 1981, find that the common pool problem generates excessive spending under the practices of universalism and reciprocity common in the US legislature. • Velasco (1998) introduces dynamic elements into the model, and obtains also excessive debt and deficit

13. The tale of the chicken and the lobster

14. Why do BI matter?? • Budget institutions matter because they affect the rules of the game under which the different actors involved in the budget process interact, either by placing constraints to the whole process, or by distributing the power, information and responsibilities among the different agents, and thus affecting fiscal outcomes.

15. Budgetary rules • Following Alesina and Perotti (1995), we identify three different types of budgetary rules: • numerical rules • procedural rules • rules that affect the transparency of the budget

16. Numerical rules: examples • Balanced budget rules, such as those of the U.S. states • Maastricht criteria (which impose limits on deficit and debt) • Gramm-Rudmann-Hollings (in the US), which imposes a gradual reduction of deficits, until their elimination

17. Numerical rules may differ... • Regarding the indicator of performance they refer to • regarding the legal rank of the norm that establishes them • regarding their coverage • regarding the stage of the budget process in which they apply • regarding their “flexibility” • They may be non-contingent or contingent, with clearly specified escape clauses • may be defined on the basis of an indicator of structural deficits • as a general rule, the greater the flexibility, the greater the complexity, the easier it becomes to elude them

18. Numerical rules: pros and cons • Pros: • If they are enforced, they may solve the majority of the problems identified above • they limit the strategic used of debt • they limit the transfer from future to present generations • they limit the electoral cycle • they limit the common pool problem, etc. • Cons: • They may generate incentives for “creative accounting” • They limit the possibility of engaging in tax-smoothing (a la Barro) (at least in the case of balanced budget rules) • They tend to be too inflexible (in particular in the case of highly volatile regions such as Latin America)

19. Numerical rules and inflexibility: 3 caveats • Volatility itself may be induced by the absence of fiscal discipline. Thus, if the rule is effective, the need to respond to the cycle may be decline • Even in the absence of numerical rules, Latin America has been characterized by having a procyclical fiscal policy. • It is possible to combine numerical rules with other mechanisms which allow a response to the cycle (such as stabilization funds)

20. What makes a rule more credible? • It must be simple, and easy to monitor • has to be defined on the basis of fiscal indicators which cannot be easily manipulated • must be defined on the basis of fiscal indicators which are to a reasonable extent under the control of the fiscal authorities • must be defined in such a way that the cost of complying with the rules should not be excessive under a reasonable set of likely circumstances

21. Procedural rules • They affect the rules of the game in the interaction among the different agents that participate in the budget process • May be more “hierarchical” or more “collegial” • Hierarchical rules concentrate the power on the finance minister vis a vis the spending ministers, and on the executive vis a vis the legislature • Collegial rules tend to allocate power more equally among all the actors involved

22. Examples of hierarchical and collegial rules • During the drafting of the budget: • Hierarchical: At the beginning of the drafting of the budget, spending ministers receive spending caps which they must observe. • Collegial: each spending minister drafts its own budget, and these are then negotiated within the cabinet. • During the approval of the budget: • Hierarchical : Congress can modify the composition of expenditures, but cannot increase total expenditure or deficits • Collegial: Congress may propose any changes, without restrictions

23. Examples of hierarchical and collegial rules • During the implementation of the budget: • Hierarchical : The government may cut expenditures unilaterally if revenues are lower than projected • Collegial: Congress has the initiative to propose increases in the budget, even after it has been approved

24. Procedural rules: pros and cons • Pros: • They may generate fiscal discipline by concentrating power on those who are responsible for macro stability. • May solve the common pool problem • They are more flexible than numerical rules, and allow a response to the cycle • Cons: • They do not solve the electoral cycle problem • They do not solve the problems associated to the short time horizon of politicians. • They do not solve the problem of the strategic use of debt • By allowing a greater degree of discretion, they may have a slower effect on the credibility of fiscal policy

25. Rules that affect the transparency of the budget • Off-budget items • strategic use of macroeconomic forecasts used for the drafting of the budget • Treatment of contingent liabilities • Creative accounting

26. Numerical rules, procedural rules and transparency: complements or substitutes? • Numerical rules and procedural rules: • alternative ways of introducing fiscal discipline • But they solve different problems • Numerical rules and transparency: • They are complements: without transparency, numerical rules will not be effective • However, the more restrictive the rule, the larger the incentives for creative accounting • Thus, if numerical rules are introduced, it is important to improve transparency at the same time

27. Fiscal rules at the subnational level

28. Several reasons why they may be more appropriate at the subnational level • Possibility to balance budgets during recessions with anti-cyclical transfers from the central government • Automatic stabilizers of the central government may provide stabilization services • Bailout problem (Eichengreen and von Hagen 1997) • Macro stability as a public good • Need to coordinate restrictions

29. Budget institutions and fiscal performance: International experience

30. Numerical rules • Gramm-Rudman-Hollings • Maastricht • The experience of the US states

31. Gramm-Rudman-Hollings • Gradual reduction of the deficit to achieve balance • Limited results • Increase in creative accounting • Part of the reduction was covered by asset sales • But GRH did have some effect on deficits

32. Maastricht: • Criteria for access to common currency • deficit/GDP<3% • debt/GDP<60% • Credibility of the rule is in this case imposed by a group of countries (with some flexibility), not by the individual countries alone. • Have been effective in helping achieve convergence, but part of the adjustment was achieved through creative accounting, as well as a reduction in the quality of expenditures (Easterly 1998)

33. The experience of the US states • 49 out of 50 states have balanced budget rules. The only exception is Vermont. • But they differ in several dimensions: • legal rank of the rule (statutory or constitutional) • Coverage of the rule • Stage of the budgetary process in which they apply: drafting, approval or implementation. • In 1987, ACIR put together an index that measures how restrictive the different balanced budget rules are

34. The experience of the US states • States with more restrictive rules (see Poterba, 1995)... • Tend to have lower deficits (Eichengreen 1992, Bohn and Inman 1995) and lower debt (von Hagen 1991) • tend to face lower interest rates, even after controlling for the size of deficits (Goldstein and Woglom 1992, Eichengreen 1992, Lowry and Alt 1995, Poterba and Reuben, 1998) • adjust more in response to past deficits (Alt and Lowry 1994) • react by adjusting more during the fiscal year in response to adverse shocks (Poterba 1994) • have a less counter-cyclical fiscal policy (Bayoumi and Eichengreen 1996), but... • This is not translated into increased output volatility (Alesina and Bayoumi 1997)

35. Procedural rules • Budget Enforcement Act (US) • The experience of the European Union • The experience of Latin America

36. The experience of the European Union • Studied by von Hagen (1992) and von Hagen and Harden (1995) • build index of BI based on • relative power of finance minister within the cabinet • structure of negotiations within the cabinet • relative power of executive vis a vis legislative • Degree of expenditure control by the finance minister • degree of transparency of the budget • They find that more hierarchical (centralized) institutions tend to reduce deficits and debt, without affecting the capacity of govt. to stabilize output.

37. The experience of Latin America • Studied by Alesina Hausmann Hommes and Stein (1996) and by Stein Talvi and Grisanti (1998) • AHHS build an index of budgetary institutions, based on a questionnaire that was responded by budget directors in 20 Latin American countries, for the period 1990-1993 • Includes the stages of drafting, approval, and implementation of the budget

38. Questionnaire 1 Are there any constitutional or legal constraints on fiscal deficits? 2 Is there a requirement that the budget be consistent with fiscal targets previously specified in a macro program? 3 What kind of borrowing constraints are there on the government? 4 Is the authority of the Finance Minister greater than that of spending ministers on budgetary issues? 5 What kind of restrictions does Congress have to amend the budget proposed by the government?

39. Questionnaire 6 What happens if Congress rejects the budget, or does not approve it within the constitutionally set time frame? 7 Can the budget be modified after approval? On whose initiative? 8 Can the government legally empowered to cut spending after the budget has been approved? Under what circumstances? 9 Does the government typically assume debt originally contracted by other public agencies? Under what circumstances? 10 Can subnational governments and public enterprises borrow autonomously?

40. Effect of budget institutions • We find that more hierarchical and restrictive budget institutions lead to smaller primary deficits • A difference of 20 points in the index (which ranges from 0 to 100) is associated with a difference of three percentage points of GDP in the primary deficit • This result is very robust to changes in the way the index is built, in changes in the methodology of estimation, as well as to the inclusion of other variables that control for the effects of: • external shocks • the economic cycle • age structure of the population • initial level of debt • wars and natural disasters

41. Effect of budget institutions • Stein Talvi and Grisanti recalculate the index for the period 1990-95 • They obtain the following ranking of countries, according to the index of budget institutions:

42. Budget institutions in Latin America, 1990-95 Index of budget institutions COL 0.76 JAM 0.75 CHL 0.73 MEX 0.72 PAN 0.66 URY 0.62 TTO 0.58 BHS 0.57 GTM 0.57 ARG 0.57 CRI 0.56 ECU 0.56 PRY 0.55 VEN 0.55 PER 0.54 HND 0.52 BRA 0.50 SLV 0.50 BOL 0.47 DOM 0.45 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

43. More hierarchical institutions lead to smaller deficits Fiscal deficits:1990-95 (% of GDP) 0.04 JAM PRY 0.02 CHL TTO BRA MEX 0 COL PAN GTM CRI DOM ECU URY SLV -0.02 BHS PER ARG -0.04 BOL HND VEN -0.06 -0.08 0.4 0.45 0.5 0.55 0.6 0.65 0.7 0.75 0.8 Index of budget institutions

44. ... And lower debt Public debt: 1990-95 (as a share of revenues) 6.0 PER 5.0 HND 4.0 BOL PAN DOM ECU CRI 3.0 JAM SLV VEN GTM ARG 2.0 BRA TTO PRY URY MEX COL CHL 1.0 BHS 0.0 0.4 0.45 0.5 0.55 0.6 0.65 0.7 0.75 0.8 Index of budget institutions

45. Budget institutions:Some recent reforms

46. New Zealand: Fiscal Responsibility Act (1994) • Does not include numerical rules. It is based on procedural rules, and places a lot of emphasis on disclosure and transparency • Requires the government to follow a set of principles of responsible fiscal management • The government may depart from the principles, but must explain publicly why it does so, and indicate how and when it will conform with the principles again

47. New Zealand: Principles of responsible fiscal management • Reduce debt to prudent levels, so as to provide a buffer against future adverse events, by achieving operating surpluses every year until prudent levels of debt have been achieved • This suggests that debt reduction cannot be achieved by selling assets • Maintaining debt at prudent levels by ensuring that, on average, over a reasonable period of time, total operating expenses do not exceed total operating revenues • This allows for departures from budget balance during recessions

48. New Zealand: Principles of responsible fiscal management • Achieving levels of net worth that provide a buffer against future adverse events • Recognizes that financial strength depends on overall balance sheet, not just debt • Managing fiscal risk prudently • Recognizes the need to treat contingent liabilities in a prudent way • Pursuing policies that are consistent with a reasonable degree of predictability about the level and stability of tax rates

49. New Zealand: Principles of responsible fiscal management • Who defines what is a “prudent” level of debt, or a “reasonable” period of time over which the budget should be balanced? • The government of the time • However, the government must justify its interpretation of what is prudent and reasonable in parliament, as well as to the general public

50. In addition: • A lot of emphasis on “disclosure” • The government must present a Budget Policy Statement well before the beginning of the budget year, which should include: • their strategic priorities for the next budget • their short-term fiscal intentions • their long-term fiscal objectives • Three year horizon • Regularly present updates of impact of fiscal decisions.