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EU Fiscal Rules and Challenges to EU Fiscal Policies

This seminar discusses the EU fiscal rules, fiscal outcomes from 1992-2001, criticisms of EU rules, and challenges to EU fiscal policies. It explores the need for fiscal rules in the EU and compares them to federal countries' rules. The seminar also examines the ideal fiscal rule and the fiscal outcomes up to 2000 and 2002. The conflicting views on the stability pact and the criticisms of fiscal rules are also addressed.

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EU Fiscal Rules and Challenges to EU Fiscal Policies

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  1. 27-30 January 2003Santiago de ChileXV Seminario Regional de Política FiscalDaniele Franco The Debate on EMU Fiscal Rules

  2. OUTLINE a) EU fiscal rules b) Fiscal outcomes in 1992-2001 c) Criticisms of EU rulesd) Challenges to EU fiscal policies

  3. 1992: European Union countries decide to create amonetary union(Treaty of Maastricht) 1999: exchange rates of eleven countries irreversibly locked (Greece joins in 2001) 2002: euro coins and banknotes replace national currencies New development: many sovereign countries share a common currency andretain fiscal responsibility  extensive implications for fiscal policy

  4. The need for EU fiscal rules Budgetary discipline widely recognised as essential condition for EMU success Fiscal rules considered necessary to: prevent moral hazard avoid externalities of deficits and debts avoid pressures on European Central Bank for ex-ante & ex-post bail-outRules necessary also for contingent reasons: obtain radical changes in policies rapidly ensure credibility of EMU  select EMU Member States

  5. The development of EU rules Gradual development of rules: 1992: Treaty of Maastricht set deficit (3%) and debt (60%) conditions for access to EMU, but left open issues 1997: Stability and Growth Pact (SGP) defined rules to accompany EMU on a permanent basis 1999: specification of operational aspects (e.g., target year for reaching balanced budget)

  6. Main aspects of EU rules 1) deficit should not exceed 3% of GDP unless  exceptional events  excess is temporary  excess is limited 2) close-to-balance or surplus target over the cycle 3) multilateral surveillance (stability programs, notifications) 4) excessive deficit procedure (from recommendations tosanctions) 5) common statistical framework

  7. EU rules vs federal countries rules EU approach is stricter  rules defined with reference to numerical parameters  ex-ante and also ex-post compliance required  non-compliance triggers predefined pecuniary sanctions  flexibility margins defined ex-ante for exceptional factors  no special provision for investment spending Multinational dimension requires formal & predefined solutions

  8. Why these rules? 1) Multinational context limited available solutions: cannot have implicit rules applying to many sovereign countries2) Solutions influenced by contingent factors:(i) problematic fiscal developments:  high deficits and rising debts rising tax burden  pro-cyclical policies need to obtain radical changes in policies need to rapidly ensure credibility of EMU (ii) need to select EMU members rules for selection applied in steady state

  9. EU rules vs Kopits-Symansky criteria • Ideal fiscal ruleEU fiscal rules • Well-defined ++ • Transparent ++ • Simple +++ • Flexible ++ • Adequate relative to final goal ++ • Enforceable + • Consistent ++ • Underpinned by structural reforms +

  10. EU rules vs Inman criteria • Criteria Strong rule EU rules • Timing for reviewEx post Ex post • Override by • majority rule Not allowed Not allowed • Enforcement • Enforcer Independent Partisan • Access Open Closed • Penalties Large Large • Amendment • Process Difficult Difficult

  11. Fiscal outcomes up to 2000  EU rules successful up to 1998 (deficit declines: 6.4%  1.7%)  1999-2000: EU governments introduced tax cuts, without spending cuts (deficit about stable: 0.8%  0.7%)  EU and US: similar deficit levels in early 1990s, but US improve budget balance faster and longer  Fiscal consolidation: expenditure-based in EU, spending-and-tax-based in US 1993-2000 GP/GDP T/GDP USA -3.4% + 2.4% EU -4.7% +0.7%

  12. Fiscal outcomes 2000-2002  EU reaction to downturn milder than US: Budget balance: 2000 2002 EU: -0.7%  -1.7% US: +1.5%  -2.6% GP/GDP T/GDP USA +1.7% -1.8% EU +1.5% -0.5%  Four EU countries close or above 3% deficit limit. - either avoid discretionary anti-cyclical policies / adopt pro-cyclical policies - or neglect rules  loss of credibility  New discussion on EU rules

  13. Conflicting views "The stability pact is a vote of no confidence by the European authorities in the strength of the democratic institutions in the member countries. It is quite surprising that EU-countries have allowed this to happen, and that they have agreed to be subjected to control by European institutions that even the IMF does not impose on banana republics.” Paul de Grauwe, Financial Times, 25 July 2002"Of course, the stability pact restricts the room for manoeuvre enjoyed by national fiscal policymakers. But this is the price that must be paid for a common currency. Historically, stability between currencies has been possible only when countries have been prepared to relinquish some national sovereignty.” H. Siebert, Financial Times, 6 Aug. 2002

  14. Criticisms 1: There is no need for fiscal rules Rules lead to sub-optimal solutions. Better rely on discretionary decisions Either rely on wise governmentsor on effective financial marketsHigh deficit high interest rates  pressure on government  consolidationbut: (i) sufficient information?(ii) timely reaction of markets? (iii) timely reaction of governments? a risky solution with 12 ( 25) sovereign countries

  15. Criticism 2: rules are necessary but there are better rules Core issue: What rules would we want if we could start again from scratch? Are there rules clearly more intelligent than the SGP? Critical aspects of EU fiscal rules: reduce budgetary flexibility work asymmetrically disregard aggregate fiscal stance discourage public investment focus on short term commitments and disregard structural reforms too demanding for countries in sound positions

  16. Fiscal stabilisation  EU rules designed to combine a sound fiscal position (3% deficit limit) and budgetary flexibility in recessions (structural balanced budget)Deficit fluctuates over cycle (automaticstabilisers can operate - contrary to past EU experience) But: (i) problems in the initial transition to balancedstructural budget (ii) asymmetric structure of incentives: sanctions for deficits  3% but no incentive to avoid loosening in upswings Need policy-makers with medium or long-term views

  17. Fiscal co-ordination  No explicit co-ordination procedure. Implicit rule-based co-ordination: let stabilisers work over the cycle In some circumstances aggregation of national fiscal policies may not result in optimal area fiscal stance - free-riding in stabilisation in bad times? -pro-cyclical policies in good times?  However, supranational co-ordination would be problematic: - different cycles & policy views - forecasting & timing problems - enforceability of decisions Does the EU need a federal budget?

  18. Public investment Balanced budget  tax-finance for public investment Risk: reduction of capital accumulation Transition period problematic: pay for new investment and pay back debt Exclude public investments from deficit rule (golden rule or dual budget)? but: • what is capital spending? • bias in favour of physical capital • contrasting evidence on effects of public investments on growth • multilateral surveillance more complex (e.g., evaluation of depreciation) • bigger role of private sector in infrastructure development

  19. Long-term fiscal sustainability  no reference to long-term indicators in EU rules. Outcomes are assessed on a yearly basis  this can discourage some tax and pension reforms (PAYG  funding) involving a temporary deficit  but the use of sustainability indicators (e.g., projections, generational accounting) would be problematic (e.g., comparability)  moreover, balanced budget forces reforms and determines fast debt reduction

  20. Alternatives to the SGP? 1) fiscal co-ordination at EU level1a) one EU fiscal policy 1b) co-ordination of national policies 1c) a market for deficit permits 2) fiscal institutions and procedures2a) national budgetary procedures 2b) institutional reform (Fiscal Policy Committee)3) different numerical rules3a) golden rule 3b) expenditure rule3c) permanent balance rule3d) debt sustainability pact

  21. EU rules: a preliminary conclusion - 1  EU without rules: new experiment. Will have to rely on financial market discipline. Leap in the dark?  Greater EU integration would allow more flexibility, but unlikely in medium- term EU rules related to traditional solutions: balanced budget with exception for cyclical and exceptional events (but not for investment)  EU rules present some problems, but no alternative solutions clearly superior  Rules-based co-ordination necessarily somewhat inflexible (implicit mistrust of other countries’ behaviour)

  22. EU rules: a preliminary conclusion - 2 • EU enlargement: if current EU members do not respect rules, can EU ask new members to do so? Radical changes of rules are very difficult (need unanimity). Risk: revisions can reduce credibility  Can EU rules survive the current slowdown? If not, can monetary union survive (with up to 25 countries)? If rules survive, there is room for improvement: country differentiation, pro- cyclical bias in good times, transparency Rules can be effective and not harmful only if governments endorse their spirit and are prepared to make efforts

  23. Are fiscal rules the problem? the debate on EU rules may divert attention away from more relevant issues: EU economic performance is unsatisfactory in terms of growth, activity and employment rates EU USAGDP growth rate 1985-1990 3.2 3.4 1991-2000 2.1 3.3Unemployment rate 1991 8.1 6.8 2000 8.1 4.0 Labour market participation rate 2000 69 78

  24. Fiscal challenges  EU large public sectors and high tax burdens induce distortions & inflexibility economic integration increase tax competition and revenue losses reduces  greater burden on less mobile bases  inequity, distortions the ageing process increases spending: 2000 2050 EU12 18.0% 24.5%USA 11.2% 16.7%  need for structural reforms a tight budget constraint may increase the pressure to introduce expenditure reforms and accelerate debt reduction

  25. Fiscal co-ordination - 1 1a) Move to single EU fiscal policyone money  one fiscal policy Solve flexibility and fiscal stance problems but: are we ready for a federal country? 1b) Co-ordinate aggregate fiscal stanceHave an aggregate stability programme: 3% limit applies to area deficit (or can even scrap limit). Political allocation of deficit permitsSolve flexibility and fiscal stance problems but:  national sovereignty problem  different cycles & policy views conflicts in allocation of deficits  forecasting & timing problems  enforceability of decisions (regions, etc)

  26. Fiscal co-ordination - 2 1c) A market for deficit permits Set total volume of deficit permits & let countries trade(A. Casella - drawing from markets for pollution rights)Solve flexibility & aggregation problems but: • initial allotment of rights?• small number of traders• different countries  different externalities• who can predict cycle and set amount of rights?

  27. Fiscal institutions and procedures - 1 2a) Reform national budget proceduresIntroduce institutions and proceduresconducive to responsible fiscal policy  attack deficit bias at rootse.g. rules about presentation, adoption and execution of budgets. “Hierarchical” procedures more conducive to fiscal discipline than “collegial” procedures.But: • full agreement on solutions?• national sovereignty problem • reforms difficult to monitor• what if (apparently) correct solutions do not deliver results?• need time for testing

  28. Fiscal institutions and procedures - 2 2b) Introduce Fiscal Policy CommitteeAssign to FPC (accountable to Parliament) management of stabilisation policies on the basis of predefined mandate and judgementFPC responsible for setting the budget balance within debt sustainability constraint defined over a number of yearsFPC expected to deliver both long-term sustainability and short-term stabilisationProblems:(i) difficult to separate stabilisation from allocation & distribution(ii) government interference (appointments)(iii) need time for testing

  29. Numerical fiscal rules - 1 Given multinational context and need for rapid results permanent numerical constraints on domestic fiscal policy in terms of indicator of overall fiscal performance • simpler to evaluate compliance • easier to grasp by public opinion and policy-makers • solution based on long debate on budgetary rulesWhat rule? golden rule, expenditure rule, debt rule

  30. Numerical fiscal rules - 2 3a) Exclude public investments from budget balance (golden rule) Solution adopted in some countries and decentralised governments Dual budget (current & capital): old issue (Musgrave, 1939) long debated (Sweden) Main pro: • spreading cost of durables over time (analogy to private sector finance) But: • what is capital spending? (opportunistic behaviour) • bias in favour of physical capital • unlimited borrowing  low attention for projects

  31. Numerical fiscal rules - 3 Moreover, •dual budget discussed but little used • contrasting evidence on effects of public investments on growth • bigger role of private sector in infrastructure development • multilateral surveillance more complex (e.g., evaluation of depreciation) • in developed countries small net investment (Germany 1980-1999 = 0.6%)

  32. Numerical fiscal rules - 4 3b) Expenditure rule Introduce comprehensive expenditure target (all primary items; central & local) Solution adopted in some countries Benefits: spending can be controlled by government; monitoring easier; medium term framework But problematic in multinational context: • cannot have uniform EU rule, must rely on countries’ programmes • cannot commit future governments • deficit & debt may increase because of tax cuts

  33. Numerical fiscal rules - 5 3c) Permanent Balance Rule Buiter & Grafe (2002): PBR would ensure sustainability while considering country differences Permanent budget in balance or in surplus = difference of future values of tax revenue and spending (strong form of tax smoothing: tax rates constant with G depending on cycle, interest tates, structural factors) Implementation problems: estimates of permanent value of tax and spending  take into account future preferences

  34. Numerical fiscal rules - 6 3d) Debt Sustainability Pact Pisani-Ferry (2002): countries (i) with debts 50% and (ii) publishing comprehensive fiscal accounts can opt out of EDP and embrace a DSP Countries indicate five-year target for debt ratio & have greater flexibility in short term • Avoid excessive tightening on sound countries. But can we fully overlook the deficit level? • Better fiscal accounting would provide more discipline by the financial markets. Estimate of future liabilities problematic: uncertainty related to macroeconomic, demographic and behavioural scenarios

  35. Old-age dependency ratios 2000-2050 (baseline scenario)

  36. DIFFERENT MEDIUM TERM TARGETS  Fix medium term targets also on the basis of debt level and future budgetary trends If debt and contingent liabilities are low: allow deficit up to minimal benchmarks  This would allow funding of net investment without distortions and monitoring problems  Need transparent fiscal accounting and accurate long-term projections

  37. IMPROVE TRANSPARENCY  Transparency can increase credibility of rules and allow greater flexibility in implementation  Current framework problematic: (i) one- off measures, (ii) delays in data provision, (iii) limited data on off-budget liabilities (i) Publicise one-offs, lower danger threshold for early warnings, net one-off in computing structural balances (ii) Make greater use of cash data and debt (more timely and less subject to estimates). More independent statistical authorities (iii) Have regular and transparent estimates of off-budget liabilities, net asset positions & long term budgetary trends

  38. MISBEHAVIOUR IN GOOD TIMES  Try to have some sanctions for slippages in good times and facilitate countries to behave prudently (i) Use early warning procedures in goods times when deficit diverge from structural target (ii) Allow the use of rainy-day funds: surplus in good times can increase room for manoeuvre in bad times Rainy-day funds require a change in ESA accounting: transfer should affect deficit (now they would be considered financial transactions)

  39. IMPLEMENTATION OF RULES  Now enforcement is partisan: national authorities apply the rules to themselves. This may also reduce the incentive to behave well in good times  Solution: give more responsibilities to the Commission - Commission responsible for technical assessment of compliance to the rules (excessive deficit) - Council decides what measures to require to countries in excessive deficit - Council decides sanctions on the basis of Commission recommendation

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