Practice Advice on Public Financial Management
Summary Advice: The OECD recommends that fiscal consolidation be treated as a political process aimed at achieving a sustainable fiscal balance.
Deficit bias is real and will not be corrected by the markets alone…
The discussion in this chapter leads to a number of conclusions about the political economy challenges involved in fiscal consolidation, at least prior to the financial crisis:
Politically-induced deficit bias is marked and related to particular characteristics of governance institutions. This may be a partial explanation of differences in budgetary situations in OECD economies. In particular, deficit bias is related to government fragmentation and government stability (electoral uncertainty) which contribute, if left uncorrected, to a political business cycle.
The private sector is partially aware of the deficit bias and responds by saving more in anticipation of future budget corrections; however, it appears that deficits only impinge on saving behaviour when they pass a certain threshold. There is evidence of self-interested indifference to debt accumulation on the part of many agents.
Financial markets do sometimes exercise discipline on governments – particularly when deficits become unsustainable – but their influence on government borrowing has often been too benign.
Fiscal crises have often been needed to prompt consolidation episodes; however, fiscal crises are not the best times to embark on longer run budgetary reforms, because they exacerbate distributional conflicts.
…and requires a policy response involving informational transparency and effective institutions
The analysis of more, and less, successful consolidations points to some lessons about the kind of policy mix best suited to supporting sustained fiscal adjustment:
- Ensuring that consolidations are lasting requires some assistance from monetary policy, via the beneficial impact on potential growth; however, monetary policy independence needs to be preserved to ensure the longer run credibility of the consolidation process.
- Consolidation based on expenditure cuts is more likely to endure than adjustment based on tax increases, and is also likely to impose lower costs in terms of output. Relying primarily on tax increases to consolidate appears to be detrimental to longer run consolidation gains.
- The empirical studies show that failed consolidations usually result from a breakdown of spending discipline. This points to the need for structural cuts in expenditure that address the underlying causes of over-spending, rather than simply relying on ad hoc measures such as postponement of public investment or temporary freezes on certain expenditure items.
- Fiscal relaxation can help structural reform in the short run, which may impede short-run fiscal consolidation; however, the longer run effects of structural reform on growth and employment assists fiscal adjustment in the longer term.
It is likely to be far easier to sustain such an approach where fiscal rules and institutions are supportive of consolidation. Fiscal rules may help overcome some of the problems of fiscal bias, but they can also be used as “smokescreen” devices and can be circumvented, via creative accounting. The quality of fiscal rules and their institutional settings thus matters enormously:
- Fiscal transparency is crucial: greater transparency facilitates effective monitoring and enforcement of fiscal rules. It also makes it easier for policy makers to explain the need for consolidation to the electorate.
- The most effective combination of rules appears to include both multi-year nominal expenditure ceilings and an explicit, cyclically adjusted budget-balance target.
- Rules may need to be supported by new fiscal institutions. There has been an expansion of independent fiscal institutions in recent years, designed to compensate for built-in deficit bias. These may be particularly helpful in controlling the tendency for spending to rise in response to unexpected revenue buoyancy.
International institutions have a role to play in fostering fiscal consolidation and reform
It is useful to distinguish between consolidation and the reform of fiscal institutions such as budgetary processes, fiscal rules and the activities of fiscal oversight bodies. The role of international and supra-national institutions in consolidation is often linked to some form of “strong” conditionality – International Monetary Fund (IMF) programmes or the European Union’s application of the Maastricht Treaty’s criteria for participation in Economic and Monetary Union (EMU). The experiences of many OECD members confirm the impact that such conditionality can have on policy, but fiscal slippage has often followed once the conditions have ceased to constrain policy makers. If the hard-won gains of a consolidation effort are to be sustained over the long term, a reform of fiscal institutions may be needed. Yet such institutional change cannot be imposed with the same kind of hard conditionality as an IMF programme or the EMU entry criteria. For institutional reforms to work, governments must take ownership of them. Consequently, the role of international institutions in respect of such reforms relies much more on “soft” methods of co-ordination – on education, the exchange of experiences among policy makers and, to some extent, peer pressure to adopt “best practice” in various fields. Many of the activities of the European Commission fall within this domain, as does the work of the OECD, with its “best practices for budgetary transparency” and other work on budgeting processes, as well as the growing focus on fiscal institutions in the context of country reviews in the OECD Economic and Development Review Committee.
Source: OECD (2010) "Making Reforms Happen: Lessons From OECD Countries" OECD at http://www.oecd.org/site/sgemrh/46159078.pdf (accessed 25 March 2013).
Page Created By: Matthew Seddon on 25 March 2013. The content presented on this page is drawn directly from the source(s) cited above, and consists of direct quotations or close paraphrases. This material does not necessarily reflect the official view of the publishing organization.