The Design Of Fiscal Rules /1,2

1. The Design Of Fiscal Rules /1,2 Davide Lombardo International Monetary Fund Turkish Banks’ Association Seminar February 26, 2009 1/ The views expressed in this presentation are the author’s, and not necessarily the IMF’s. 2/ Based on the December 1-2 2008 workshop organized by the Treasury, SPO, and MOF together with the Fiscal Affairs Department of the IMF. In particular it borrows on the presentations by Debreu and Debreu and Kumar (available on the website of the Turkish Treasury—see press release dated 18 Dec 2008).

2. Outline • First principles: (Definition, Rationale, Function) • Taxonomy • Design trade-offs • Basic properties of selected rules • Monitoring and enforcement • Fiscal rules around the world: • EU sample • Broader sample • Lessons from stylized facts • Conclusions

3. Definition • Mechanism placing durableconstraints on fiscal discretion through numerical limits on budgetary aggregates (expenditure, revenue, budget balance and/or public debt). • Any fiscal policy rule is made of 3 parts: • Numerical target/ceiling onone or more specific fiscal indicators • Explicit cost for non-complying policymakers • A monitoring/enforcement procedure.

4. What is not a fiscal policy rule? • The annual budget is not a rule, as it only applies for one year. • An IMF-supported program, as it is not expected to be a permanent feature of fiscal policy. • The new UK “rule”: “To set policies to improve the cyclically-adjusted current budget each year, once the economy emerges from the downturn, so it reaches balance and debt is falling as a proportion of GDP once the global shocks have worked their way through the economy in full.”

5. Rationale: why constraining discretion? • Unconstrained fiscal policy may be perceived as systematically deviating from desirable policies. In practice: pro-cyclical and/or unsustainable policies. • Reasons why unconstrained policies can be biased: • Time-inconsistency • Fiscal federalism/monetary union • Political economy: Myopia, re-election concerns, fiscal illusion, distributive conflicts, and coordination failures. • Other disciplining mechanisms? • Markets: yes, but unreliable (comes too late and to strongly) • Delegation to non-partisan technical agencies: poses considerable issues in terms of democratic accountability.

6. Functions of fiscal rules • Rules are commitment devices: they make deviations from socially desirable targets too costly for policymakers. • Rules are signaling tools: they can help policymakers signal their genuine commitment to sustainable and stabilizing policies. • Rules can alsoserve to anchor expectations, thus reducing uncertainties and risk premia.

7. Principles of a taxonomy • Many parameters enter the design of an actual fiscal policy rule: • fiscal target(s) • nature of costs in case of deviation • monitoring/enforcement • escape clauses, etc. • A good rule must imply good policies in most (if not all) circumstances  the policy response induced by the rule to a variety of shocks is therefore key.

8. Key feature of the rules: response to shocks • Limits to discretion make sense, but they should NOT: • Prevent adequate responses (e.g., let automatic stabilizers play in bad times) • Force inadequate responses (e.g., force a fiscal contraction in response to a temporary spike in interest rate, or depreciation of the exchange rate) • Let the bias unchecked in specific circumstances (e.g., allow for procyclical expansions).

9. The design of fiscal rules • There is no one-size-fits-all fiscal policy rule. Much depends on: • Constellation of shocks prevalent in the economy • Nature and magnitude of policy bias under discretion. • A good rule is (Kopits and Symansky, 1998): • …simple • …transparent • …coherent with the final goal • …but mindful of other goals of public policy: • Not discouraging structural reforms • Allowing for fiscal stabilization (time-frame, cyclical adjustment) • Avoiding low-quality adjustments (undue tax hikes, cuts in quality/priority spending).

10. Two key trade-offs • Credibility-flexibility: allowing for greater responsiveness to shocks could undermine credibility of attaining the final goal. • Flexibility-simplicity: combinations of rules can relax somewhat the credibility-flexibility trade-off, at the cost of simplicity and transparency.  The devil is in the details

11. Other design issues • Coverage of the government sector • Policy coordination in federal/decentralized systems • Legal foundations • Need for adequate budgetary procedures (preparation, execution, and ex-post auditing of budgets) • Need to limit scope for creative accounting

12. Pros and cons of selected rules • Simple rules: • Debt rules • Budget balance rules • Expenditure rules • Revenue rules • Combined rules: e.g., debt objectives coupled with binding deficit ceilings, debt/budget balance objectives coupled with binding medium-term expenditure ceilings

13. Deficit Rules Balanced budget and overall deficit limits • Pros: • pin down asymptotic properties of debt • directly address the deficit bias • can be simple and transparent (unless cyclical considerations, escape clauses, etc). • Cons: • procyclical (unless cyclically adjusted or “over the cycle”) • could force cut in investment… •  golden rule, but these open door to manipulations, and do not guarantee debt sustainability. • Overall vs. primary balance? Primary is more robust to volatility in interest payments.

14. Debt Rules Upper limit (or desirable time path) for gross or net public debt • Pros: • Directly tackle debt sustainability • Can be transparent and simple • Can accommodate large shocks if debt is well below the ceiling • Cons: • Lack controllability • Can force procyclical and undesirable responses to interest rate and exchange rate shocks if debt is close to the limit • Borrowing constraints generally applied at regional and local levels

15. Expenditure Rules Set expenditure ceilings (nominal or in terms of GDP) or limits on growth (nominal or real). • Pros: • tackle one of main source of deficit bias • translate directly into budget preparation • minimizes pro-cyclicality risks • fosters medium-term planning • Cons: • May leave room for discretionary tax cuts  sustainability? • complex to design (nominal vs. real, exclusions,…) • Best used in combination with deficit or debt rules.

16. [Revenue Rules] • Rules imposing limits on revenues with a view to: • Contain size of the public sector / tax burden • Allocate ex-ante revenue windfalls (e.g., due to surprisingly high growth) • Pros: • Can reduce procyclicality in good times • Cons: • Limited impact on deficit bias if not coupled with other rules • Can be procyclical in case the rule targets a given revenue-to-GDP ratio (due to the progresssivity of the tax system)

17. Combination of rules • Drawbacks with individual rules have led most countries to adopt combination of rules • Most common combinations: • Debt and overall deficit ceiling and overall balance target (e.g., Maastricht) • Overall balance and expenditure ceilings (Sweden, Finland, Netherlands, etc).

18. Monitoring • Ex-ante auditing: • Is the government proposed fiscal policy consistent with the rule and its objectives? • Ex-post assessment: • Was the rule implemented? • Analysis of underlying policies • Certification role: track attempts to resort to creative accounting • Assessment of ex-post adjustments to the target (CABs,…), activation of escape clauses, etc.

19. A key pre-requisite Budgetary transparency: • Fiscal data need to be accessible, timely, and reliable • Comprehensive periodic reporting requirements • Clarity about the budget preparation and execution procedures • Clarity about roles and responsibilities of different levels of government

20. Fiscal councils • Independent institutions with • country-specific mandates • adequate and highly qualified staff • guaranteed multi-year budget. • Can contribute to greater transparency and accountability of fiscal policy. • Can help monitoring and enforcing a rule.

21. The case of Chile • Fiscal institutional setup designed to buttress fiscal sustainability and dampen cyclical fluctuations. • Rule: maintain a structural surplus of 1 percent of GDP for the central government. Fiscal expenditures follow the dynamics of structural revenue. • Two independent expert panels provide key projections: • the inputs (growth of the labor force, real investment, and total labor productivity) for estimating trend GDP • ten-year forecasts of the price of copper. • Independent panels enhance policy credibility, while allowing some policy flexibility.

22. The case of the Netherlands • The Central Planning Bureau plays a key role in the budgetary process: • Provides projections and forecasts • Estimates desired structural budget balance • Vets the programs of all political parties (which are thus subject to reputational sanctions) • Undertakes analysis of specific budgetary projects. • High credibility borne out of tradition

23. Fiscal Rules: International Experience • Stylized facts for EU (EC database: annual data over 1990-2005), and the rest of the world (IMF-FAD database on the design and implementation of fiscal rules) • Worldwide: 81 countries identified as having fiscal policy rules, with complete information for 77 of them

24. Growing appetite for fiscal rules (EU)

25. Emerging Market and LICs are catching up with industrial countries

26. Budget-balance and debt rules dominate, but expenditure rules are increasingly popular

27. Expenditure and revenue rules are thus relative newcomers

28. Same trends in EU sample

29. Budget balance rules appear stronger and have wider coverage

30. This is reflected in synthetic measures of strength and coverage

31. Strength and coverage relatively similar across countries

32. Features by country groups

33. Fiscal rules lower interest rates (EU-25) Debrun and Joshi (2008)

34. Fiscal rules lower interest rates (EU-25) All key dimensions matter Effective rules deliver lower interest rates. Debrun and Joshi (2008)

35. Lessons • Historical preference for deficit and debt rule • But recently emergence of expenditure rules (in combination with BBRs and DRs) • What explains the trends for more rules and more expenditure rules? • Increasing realization that purely discretionary fiscal policies are inconsistent with sustainability (growing public debt) • Mounting pressures from long-term issues: aging, global warming, etc. • Regional monetary unions.

36. Conclusions • Well-designed fiscal rules can help improve fiscal performance on average… • …thus lowering risk-premia and interest rates on long-term government bonds. • But: political commitment is key • As are adequate public financial management, monitoring and enforcing systems.