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Practice Advice on Public Financial Management

Fiscal Rules (OECD and IMF)

Summary Advice (OECD - Fiscal-Consolidation Strategies for Canadian Governments): The OECD advises that fiscal rules must be carefully designed to be effective and provides a list of recommended design features.

Summary Advice (OECD - Fiscal Consolidation): Fiscal rules can set targets for budget balances, spending and less commonly taxation, as well as ceilings on debt.

Summary Advice (IMF - Public Financial Management and Its Emerging Architecture): The IMF states that fiscal rules should aim to correct distorted incentives and contain pressures to overspend, to ensure fiscal responsibility and debt sustainability. Fiscal rules need a set of institutional arrangements to convert the intent of the rules into the reality of budget policy and execution; they should not be implemented in isolation.

Summary Advice (IMF - IMF Fiscal Monitor): Policymakers may seek to achieve compliance with expenditure rules (also known as fiscal rules) by compressing high-quality discretionary items, such as public investment (Blanchard and Giavazzi, 2004). Although this may be an argument for excluding public investment from the rule’s coverage, there are potential drawbacks to doing so because it weakens the link with debt sustainability and opens the door to reclassification of spending items.

Main Points (OECD - Fiscal-Consolidation Strategies for Canadian Governments)A fiscal rule can be defined in general terms as a constraint on fiscal policy expressed in terms of an indicator of overall fiscal performance. The specifics of the rule or rules chosen to guide budgeting are important determinants of its efficacy. Inappropriate fiscal rules can be destabilising, such as balanced-budget rules that may force governments to cut spending when revenue falls during a downturn (as occurred recently in many US states). Fiscal rules may also lead to behaviour aimed at respecting the letter but not the spirit of the rule.

The characteristics of the fiscal rule determine its credibility with the capital markets and the electorate and its efficacy in reaching the government’s fiscal targets. Following Kopits and Symansky (1998), a good fiscal rule would:

  • Have a track record of satisfactory compliance - For instance, while it did not involve fiscal rules per se, the approach taken in the mid-1990s by the federal government worked well for several years in that it achieved the objective of eliminating the federal deficit and reducing the level of debt. These objectives may have been achieved at the expense of creating other problems with the fiscal framework, such as too much caution in forecasting (O’Neill, 2005), but the success achieved with respect to the main objectives argues for using a similar approach in the coming years.
  • Be supported by well-specified policy measures - For instance, a fiscal rule that limits the growth rate of expenditure should be accompanied by specific explanations of how the reduction in spending growth is to be achieved, including, if necessary, structural reform (e.g. reforms to social entitlement programmes). In the case of provinces, health-sector reforms are especially important to limit expenditure growth, given this sector’s relative size in provincial budgets.
  • Be well defined and transparent. The indicator to be constrained, the institutional coverage, the specific escape clauses and the accounting and forecasting concepts used should all be clearly spelled out to improve transparency and avoid ambiguities and ineffective enforcement.
  • Target the objective. The rule specified should correspond directly to the objective sought. For instance, sustainability of the public debt-to-GDP ratio would require a rule expressed as a maximum and non-increasing debt ratio, perhaps in conjunction with other rules on expenditure growth, etc, that support this objective.
  • Be consistent with other rules and objectives of the government. For instance, price stability being an objective of the central bank, a fiscal rule should support price stability by avoiding pro-cyclical fiscal policy.
  • Be simple. The simplicity of a fiscal rule enhances its appeal and understanding, to politicians and members of the public alike, making it more likely to be followed.
  • Be flexible. A fiscal rule should be flexible enough to accommodate exogenous shocks beyond the control of the authorities, but there can be tradeoffs between flexibility and other objectives. Fiscal rules defined over the medium term, or in terms of cyclically adjusted balances, can allow flexibility over a strict year-to-year budget balance rule, but at the cost of diminished simplicity, transparency and possibly credibility. A highly flexible rule can even border on discretion.
  • Be enforceable. The consequences for non-compliance, whether in the form of financial, judicial or reputational sanctions, should be clearly spelled out. The likelihood of enforcement, both by the capital markets and from self-imposed mechanisms, is increased if an independent authority is responsible for monitoring compliance.  

The OECD outlined the different types of fiscal rules and what influences them in an earlier paper (OECD (2009)).

Decentralising expenditure capacity to lower levels of government can have positive effects on efficiency, as local governments are more aware of local needs and tastes than central governments. But this can also undermine global macroeconomic stability, as sub-national governments do not always take into account the effect of their fiscal decisions on the rest of the country on the one hand, and might even have incentives to overspend on the other hand. Fiscal rules are therefore needed, in order to reduce this possible risk. Fiscal rules are defined as a set of institutional constraints on policymakers’ decision-making discretion. Such rules may be imposed on sub-national governments by a higher level of government, or sub-national governments may adopt them themselves, where constitutional arrangements grant them the autonomy to do so. The increase in sub-national governments spending responsibilities has been larger than the increases in their tax autonomy. Sub-national governments do not bear the whole costs of the public goods and services they are responsible for, thus creating incentives for overspending. If subnational governments are allowed to borrow on capital markets, they might face interest rates that do not fully reflect their credit risk (as lenders perceive that their borrowing is implicitly guaranteed by central government), thus leading to possible over-borrowing. If investors anticipate a bailout in case of default by a sub-national government, fiscal decisions of one sub-national government will impact on the borrowing costs of the other sub-national governments and of the central government, reflecting a higher overall risk of default. Sound sub-national governments fiscal policies are therefore crucial for the macroeconomic stability of the whole country. Four types of rules can be used to support fiscal sustainability and shortterm stability: balanced budget requirements, borrowing constraints, tax and expenditure limits (TEL) and process and implementation regulations.

  • Balanced budget requirements in OECD countries vary according to whether they are applied to the current budget and/or the capital account (balanced budget requirement applied only to the current budget, thus allowing borrowing to finance net investments is usually referred to as the “golden rule” of public finance); whether they are set annually or multi-annually; and whether they are imposed from above or self-imposed. Most commonly, balanced budget requirements are applied to current and capital budgets, are set annually, and are imposed from above.
  • Borrowing constraints are widely used in OECD countries, but with a substantial variation in terms of restrictiveness. They range from total prohibition (Denmark and Korea) to no restriction at all. In most cases, sub-national government borrowing requires prior approval by higher levels of government, and is often restricted to certain purposes (such as investment). Box 6 gives some examples of borrowing constraints in OECD countries.
  • Tax and expenditure limits. Overall limits on tax rates or reliefs are widely used in OECD countries, and usually take the form of an explicit limit on tax autonomy set by central government (see table 2). Expenditure increase limits are usually linked to income, inflation of population growth. But explicit, binding, expenditure limits are rather rare (they exist only in Germany, Korea, Portugal and Turkey). In some countries such as Japan, the Netherlands, Poland and Spain, expenditure limits are not imposed by central government, but self imposed.
  • Process rules that govern implementation will determine the degree of commitment of subnational governments to the set of rules described above (indeed, without a proper commitment mechanism, sub-national governments could either ignore, or change the rules binding their autonomy). Process rules include the obligation to produce financial accounts (transparency), monitoring and reporting, and eventual sanctions in case of non compliance. But process rules should also allow for flexibility of response, as breaking the fiscal rules might be the appropriate response to an unanticipated shock such as large revenue shocks, downturns in the local economy, the impact of natural or other disaster, etc. This is why many countries incorporate escape clauses that allow sub-national governments to breach the rule in case of certain predetermined events.

The need for fiscal rules is influenced by three factors: expenditure assignments, revenue assignments and financial market oversight.

  • Expenditure assignment. Fiscal rules are particularly important when sub-national governments are responsible for large and politically sensitive areas such as health, education or social welfare, as it may then be difficult for central governments to resist bailing out deficit-prone sub-national governments. However, fiscal rules limiting sub-national governments’ spending autonomy must not reintroduce central direction, which would then undermine the benefits from decentralising spending decisions.
  • Revenue assignment (the extent and sources of sub-national governments’ income) also affect the need for fiscal rules: the more sub-national governments depend on transfers, the more fiscal rules (such as borrowing constraints) are needed to compensate for the lack of matching between the benefits from spending, and the weight from financing these expenditures. For those subnational governments with higher tax autonomy, tax competition can be a positive factor in keeping deficits small without the need for fiscal rules.
  • Finally, financial market oversight might substitute for other monitoring mechanisms by imposing higher borrowing costs to profligate sub-national governments. However, this market discipline requires that central governments credibly commit not to bailout defaulting subnational governments. Besides, the adoption of fiscal rules limiting their deficit and debt levels may still be used by sub-national governments as signals of fiscal discipline in order to obtain lower interest rates.

Main Points (Fiscal Consolidation):

An important rationale for the adoption of fiscal rules is related to the reluctance of governments to commit to fiscal discipline and their ability to abandon announced plans before implementation. In this light, fiscal rules may help governments commit and allay the fears of financial markets. Indeed, rules have a role to play in communicating with the public and as such should be relatively simple in order to perform this role effectively. Tensions affecting fiscal policy include respecting the inter-temporal budget constraint and long term-sustainability, achieving short-term stabilisation, addressing distributional concerns and promoting allocative efficiency. More complex or state-dependent rules will be more difficult to enforce and communicate, while undermining accountability. There is unlikely to be an easy formula. As such, fiscal rules are difficult to design.

In practice, multiple rules are often used and past empirical analysis found that countries using a suite of rules have managed to sustain fiscal consolidation more successfully than others relying on a single rule (Guichard et al., 2007, IMF, 2009). New econometric work finds that countries that have either spending or budget balance rules or a combination of the two are more likely to stabilise debt (Molnar, 2012). Budget balance rules tend to increase the duration of consolidation episodes. The findings also suggest that more comprehensive fiscal rules – that is the larger part of government activity and the larger number of government levels they cover inter alia – are more likely to help stabilise debt. However, causality can also run the other way, as governments that are more committed to debt stabilisation are more likely to adopt fiscal rules or more comprehensive fiscal rules.

The effects of fiscal rules and combinations of them can be examined with macro-econometric scenarios using the NiGEM model (Barrel et al., 2012). Using scenarios to examine the effects of different types and combinations of fiscal rules stochastic simulations were used to show the effect of country-specific shocks to spending and debt on consolidation efforts. Assessing the impact of echanical fiscal rules on debt developments is one aspect of policy and a fuller analysis would need to consider whether this impact is optimal. Bearing in mind this caveat, fiscal rules that correct fordeviations from either debt or deficit targets constrain adverse debt dynamics from developing relative to the baseline. Differences in the impact of fiscal rules across countries reflect differences in the respective economies as captured in the country models and the different size of historical shocks to debt and deficits. Nonetheless, a rough hierarchy of the fiscal rules emerges in their ability to control debt dynamics. Fiscal rules based on deviations from deficit targets and often combinations of rules based on deficit targets and debt targets tend to have a greater impact than rules based solely on debt.

Notwithstanding the attraction of fiscal rules, they may create unwelcome side effects. For example, spending rules may affect allocative efficiency or attempts to restrain aggregate spending could lead to distortions in spending patterns as some programmes are less amenable to short-term discretionary control than others, such as reforms to unsustainable entitlement programmes. Instead, there may be an over-emphasis on measures that have a high short-term payoff, but at the cost of weaker longer-term performance. In addition, fiscal rules may encourage creative accounting. Creative accounting is less likely when the social cost of missing fiscal targets or the probability of being discovered is high (for example, when fiscal transparency is high) (Koen and van den Noord, 205).

Main Points (IMF - Public Financial Management and Its Emerging Architecture):

 A fiscal rule is a long-lasting constraint on fiscal policy using numerical limits on budgetary aggregates. Numerical limits on a particular budgetary aggregate set boundaries for fiscal policy that cannot be frequently changed and provide operational guidance. However, the demarcation lines of what constitutes a fiscal rule are not always clear. This entry uses the following principles:

  • In addition to covering rules with specific numerical targets fixed in legislation, those fiscal arrangements, in particular expenditure ceilings for which the targets can be revised, but only seldom (e.g., as part of the electoral cycle) are considered to be fiscal rules, as long as they are binding for a minimum of three years. Thus, medium-term budget frameworks (MTBFs) or expenditure ceilings that provide multiyear projections but can be changed annually are not considered to be rules.
  • Only those fiscal rules that set numerical targets on aggregates that capture a large share of public finances—deficit, debt, expenditure, or revenue—and at a minimum cover the central government level, are included. Thus, rules for subnational governments or fiscal subaggregates—for example, expenditure caps on particular spending items or those linked to the use of revenues from natural resources—are not included.
  • The focus is on de jure arrangements, not the extent to which rules have been adhered to in practice.

Types of Fiscal Rules:

  • Debt rules set an explicit limit or target for public debt as a percentage of GDP. A debt rule, by definition, will most effectively ensure convergence to a debt target and is relatively easy to communicate. However, it takes time for debt levels to be affected by budgetary measures; therefore, debt rules do not provide clear short-term guidance for policymakers. Debt could also be affected by developments outside the control of government, such as changes in interest rates and the exchange rate, as well as “below-the-line” financing operations (such as financial sector support measures or the calling of guarantees), which could cause unreal-istically large fiscal adjustments. Moreover, fiscal policy may become procyclical when the economy is hit by shocks and the debt target, defined as a percentage of GDP, is binding. Conversely, when debt is well below its ceiling such a rule would provide no binding guidance.
  • Budget balance rules constrain the variable that primarily influences the debt ratio, and these rules are largely under the control of policymakers. Such rules provide clear operational guidance and can help ensure debt sustainability. Budget balance rules can apply to the overall balance, structural balance, cyclically adjusted balance, and balance “over the cycle.” An overall budget balance rule does not have economic stabilization features, but the other three explicitly account for economic shocks. However, estimating the adjustment, typically through the output gap, makes the rule more difficult to communicate and monitor. A balance “over the cycle” rule has the added disadvantage that remedial measures could be put off to the end of the cycle. Although interest payments are the only expenditure item not directly under the control of policymakers—even though spending rigidities may also complicate achieving short-term targets—excluding them from the rule weakens the link to debt sustainability. Similarly, a “golden rule,” which targets the overall balance net of capital expenditure, is less linked to debt. “Pay-as-you-go” rules stipulate that any additional deficit-raising expenditure or revenue measures must be offset in a deficit-neutral way. Because pay-as-you-go rules do not set numerical limits on large budgetary aggregates, they are typically considered procedural rules and thus not included as numerical fiscal rules in this chapter.
  • Expenditure rules set limits on total, primary, or current spending. Such limits are typically established in absolute terms, apply to growth rates, or occasionally, are established as a percentage of GDP. The time horizon most often ranges between three and five years. These rules are not linked directly to the debt sustainability objective given that they do not constrain the revenue side. However, they can provide an operational tool for triggering the fiscal consolidation required for consistency with sustainability when they are accompanied by debt or budget balance rules. Furthermore, they can constrain spending during temporary absorption booms, when windfall revenue receipts are temporarily high and headline deficit limits easy to comply with. Moreover, expenditure rules do not restrict the economic stabilization function of fiscal policy in times of adverse shocks because they do not require adjustments to cyclical or discretionary reductions in tax revenues. Even greater countercyclicality can be achieved by excluding cycle-sensitive expenditure items, such as unemployment support, but at the expense of creating a larger gap with the sustainability target. Also, expenditure rules are not consistent with discretionary fiscal stimulus. However, expenditure ceilings directly define the amount of public resources used by government, and are in general relatively easy to communicate and monitor.
  • Revenue rules set ceilings or floors on revenues and are aimed at boosting revenue collection or preventing an excessive tax burden (or both). Most of these rules are not directly linked to control of public debt because they do not constrain spending. Furthermore, setting ceilings or floors on revenues can be challenging because revenues can have a large cyclical component, fluctuating widely with the business cycle. Exceptions are those rules that restrict the use of windfall revenue for additional spending. Revenue rules alone could result in procyclical fiscal policy because floors and ceilings do not generally account for the operation of automatic stabilizers in a downturn or an upturn. However, like expenditure rules, they can directly target the size of government.

Given the trade-offs, many countries combine two or more fiscal rules. Not all types of fiscal rules are equally apt to support the objectives of sustainability, economic stabilization, and possibly the size of government, even when the design features of a rule are fine-tuned. Using a combination of fiscal rules can help address the gaps. For example, a debt rule combined with an expenditure rule would provide a link to debt sustainability while assisting policymakers with short- to medium-term operational decisions, allowing for some countercyclicality, and explicitly targeting the size of government. This objective could similarly be achieved through a combination of a debt rule and a structural budget balance rule.

What Types and Combinations of Rules:

The most frequently used rules constrain debt and the budget balance, often in combination. In part, the national rules mirror the supranational rules for members of monetary unions and the EU, except in the ECCU, which has only a budget balance rule. Across national fiscal rules, expenditure rules are also prevalent, but mostly in advanced economies. The expenditure rules are often combined with budget balance or debt rules to provide a greater anchor for debt sustainability. Revenue rules play a much more limited role, probably because they are less well suited to ensuring the sustainability of public finances.

Some regional differences in the types of fiscal rules persist. In particular, national debt rules predominate in low-income countries, possibly reflecting institutional weaknesses that would complicate the implementation of expenditure rules. Budget balance rules that account for the economic cycle are still more prevalent in advanced than in emerging market economies. Pinpointing the output gap is challenging for the former group, but even more so for economies that are still undergoing structural changes. Thus, emerging market economies with budget balance rules that account for the cycle tend to use thresholds of actual economic activity rather than an output gap concept.

Other Design Features of Fiscal Rules

  • Legislative Framework - The legislative basis differs by type of rule and country. The bulk of national expenditure, balance, and debt rules are embedded in statutory norms. The fewer existing revenue rules are implemented through a mix of political commitments, coalition agreements, and statutory norms. Overall, a majority of budget balance and debt rules are supranational rules established by international treaties. Legislative support for national fiscal rules in advanced economies differs from that in emerging market economies and low-income countries. Expenditure rules are more commonly established through statutory norms in emerging market economies and low-income countries than in advanced economies. More limited medium-term planning capacity in the former group of countries has led to relatively simple forms of legislated expenditure rules (e.g., expenditure growth cannot exceed trend GDP growth). In advanced economies, however, expenditure rules tend to be more closely integrated into the MTBFs, which are sometimes part of coalition agreements. In advanced economies, more diverse legislative support of fiscal rules is observed. Only a few countries have enshrined fiscal rules in their constitutions, most of which were adopted after 2000. The desirable legislative framework depends on country-specific circumstances. Rules enshrined in higher-level legislation are more difficult to reverse and therefore tend to be longer lasting because they are more difficult to modify even with a change of government. Although higher-level legislation thus tends to confer more stability to the framework, it may not necessarily enhance the effectiveness of the fiscal rules if enforcement mechanisms and accountability procedures are weak. For some countries with weak institutions, the simplicity of adoption and rapid implementation may also be key factors in deciding which legislative framework to use.
  • Institutional and Economic Coverage - Although the majority of supranational budget balance and debt rules cover general government aggregates, less than half of the national rules do so. In monetary unions the importance of constraining general government arises from the potential moral hazard problems that could lead small countries to engage in fiscal neglect. Moreover, the higher legislative status of supranational rules makes it more likely for them to extend to the general government. Coverage of national expenditure rules and budget balance rules often does not extend beyond the central government, likely in response to autonomy and coordination issues with subnationals. For national revenue and debt rules, coverage of the general government is about as frequent as coverage of the central government alone. About 20 percent of countries with fiscal rules in place by end-March 2012 exclude certain revenue or expenditure items from the target variable. Among these countries, the item most frequently excluded from targeted fiscal aggregates is capital expenditure. A rule that allows net lending only for investment purposes is termed a “golden rule”. A few countries also exclude interest payments and cyclically sensitive expenditure from target variables. Fiscal sustainability considerations argue for more comprehensive coverage, but other objectives and controllability arguments are put forward to exclude certain items. Broad coverage aims to manage total revenue and expenditure, and makes the target more transparent and easier to monitor. Nevertheless, excluding capital expenditure, for example, is sometimes seen as desirable because it is generally expected to contribute positively to long-term growth. However, this exclusion weakens the link with gross debt; not all capital expenditure is necessarily productive and other items such as health care and education expenditure may raise potential growth even more. Excluding interest payments and cyclically sensitive expenditure from target variables is also often discussed because they are not under government control in the short run and require short-term adjustments in other expenditure categories, with capital spending often the easiest to cut.
  • Escape Clauses - Escape clauses can provide the rules with the flexibility to deal with rare events. The parallel with escape clauses within fiscal responsibility laws is evident. They should include (1) a very limited range of factors that allow the clauses to be triggered in legislation, (2) clear guidelines on the interpretation and determination of events (including voting rules), and (3) a specific path back to the rule and treatment of accumulated deviations. Formal escape clause provisions are primarily found in more recently introduced rules, and trigger events differ. In all cases, the escape clauses allow for temporary deviations from the rules in the event of a recession or a significant growth slowdown. Other triggers include natural disasters , and banking system bailout. Escape clauses have not always been well specified. Although it is difficult for rules to be both comprehensive and specific about potential trigger events, escape clauses in the past have occasionally left too much scope for interpretation. For example, until the constitutional change in 2009, the German rule allowed for deviations for “a disturbance of the macroeconomic equilibrium,” which was frequently used to justify exceeding the deficit ceiling. In India, the escape clause allowed the government to deviate from the targets in exceptional circumstances “as the central government may specify.” The Swiss and the Spanish fiscal rules also include rather broad “exceptional circumstances” provisions, although they do need to be justified by certain events (such as natural disaster, severe recession, and the like). In Switzerland, the escape clause can be invoked only by a supermajority in parliament, and in both countries, it must be accompanied by a medium-term correction plan. Escape clauses are embedded to some extent in the EU and WAEMU supranational fiscal rules. The escape clause introduced in the EU with the 2005 reform of the SGP provides that an excessive deficit procedure may not be opened if the deficit is close to its ceiling and the breach is temporary (both conditions have to be fulfilled simultaneously). It also allows for an extension of deadlines for the correction of the excessive deficit in case of adverse economic developments. In WAEMU, the escape clause is triggered by a large and temporary negative shock to real GDP and revenues, but the clause does not specify a transition path back to the rule.
  •  Automatic Corrective Mechanisms - Automatic corrections of ex post deviations from the rule can raise enforceability, but to date they have been built into very few rules. As with other elements of rules, specifying the mechanism clearly and anchoring it in legislation can help adherence, but ultimately political will matters most. Some examples are summarized below:
    • The Swiss and German structural budget balance rules contain automatic correction mechanisms known as “debt brakes”. In both countries, deviations from the structural budget balance rule (positive or negative) are stored in a notional account. When the accumulated deviation exceeds a threshold, improvements in the structural balance are required within a defined time frame to reverse the deviation. The main differences between the two countries are the thresholds (1.0 percent of GDP in Germany per ordinary law and 1.5 percent per constitution; and 6 percent of expenditure in Switzerland) and the type of deviation that needs to be corrected. In Germany, only those deviations that did not result from errors in real GDP growth projections enter the notional account, whereas in Switzerland all misses are tallied. The latter course is more transparent but provides less flexibility to accommodate errors outside the control of government. In Switzerland, the excess amount must be eliminated within the next three annual budgets. In Germany, overruns only need to be reduced during an economic recovery to avoid procyclical tightening and can be corrected via expenditure and revenue measures.
    • Poland’s and the Slovak Republic’s debt rules, which set a 60 percent debt-to-GDP ceiling, include thresholds that trigger actions to prevent the rule from being missed. In the Slovak Republic, when the debt-to-GDP ratio reaches 50 percent, the minister of finance is obliged to explain the increase to parliament and suggest measures to reverse its growth. At 53 percent of GDP, the cabinet is required to pass a package of measures to trim the debt and freeze wages. At 55 percent, expenditures are to be cut automatically by 3 percent and the next year’s budgetary expenditures would be frozen, except for cofinancing of EU funds. At 57 percent of GDP, the cabinet mustsubmit a balanced budget. Ideally, the later trigger points would not be needed if effective action is taken earlier.
    • So-called sequesters are another form of automatic correction. In the United States, as a result of the failure of the Joint Select Committee on Debt Reduction to reach agreement on deficit-reduction proposals, automatic spending cuts (sequesters) are scheduled to take effect in March 2013 if Congress does not take legislative action. In this case, the sequestration is intended to be a one-time adjustment to the expenditure path rather than a recurrent mechanism embedded in a fiscal rules framework. Sequesters also tend to have the disadvantage of creating a bias against capital spending, which is the easiest item to cut quickly, as experienced in the United States in the 1990s.
    • Under the Fiscal Compact, EU countries’ national structural budget balance rules will need to include an automatic correction mechanism. In light of the role that such mechanisms can play in avoiding a ratcheting up of debt from target misses, the 25 EU members that signed the treaty have committed to creating appropriate mechanisms, in line with guidelines to be issued by the European Commission.

"Next-Generation" Fiscal Rules

Next-generation fiscal rules explicitly combine sustainability objectives with more flexibility to accommodate economic shocks. Many of the new rules set budget targets in cyclically adjusted terms or account for the cycle in other ways. Some also correct automatically for past deviations with a view to avoiding the “ratcheting up” effects of debt. Others combine new expenditure rules with new or existing debt rules, thereby providing operational guidance as well as a link to debt sustainability—if the rules were to operate separately, one of these criteria would be missing.  At the same time, the design features of fiscal rules have become more comprehensive, and supporting arrangements have been strengthened—for example, by enshrining rules in legislation (away from political agreements), by adopting explicit escape clauses, and by providing for a path back to compliance if deviations occur.

But the greater complexity of the rules frameworks also creates new challenges. The increased number of rules, their interaction, and their sophistication can complicate implementation and make compliance more difficult to explain and monitor. To address the first challenge, several countries are reforming their budgetary procedures and MTBFs. Fiscal councils can also play an important role. In a number of countries, governance reforms have set up, or adopted plans for, independent fiscal councils. Such bodies can raise voters’ awareness of the consequences of certain policy paths, helping them reward desirable options and sanction poorer ones. Although the mere existence of fiscal councils and their ability to increase public awareness may not be sufficient to achieve good outcomes, combined with fiscal rules, councils can potentially raise, for governments, the reputational risk associated with noncompliance and serve as an additional enforcement tool.

Main Points (IMF - IMF Fiscal Monitor):

Expenditure rules include both specific numerical targets fixed in legislation and expenditure ceilings that are binding for a minimum of three years. The rules typically take the form of a cap on nominal or real spending growth in the medium term and are present in 26 countries (equally split between advanced and emerging market economies and between member states of the European Union and others). Establishing causation between expenditure rules and policy outcomes is challenging. For instance, it could be that expenditure rules are primarily adopted by countries with intrinsically strong commitments to fiscal discipline, good public expenditure management practices, or good institutions. In addition, the relatively small sample suggests that results could be affected by outliers. Therefore, the results reported here need to be interpreted with caution.

Overall, expenditure rules seem to have a better record of compliance than do budget balance and debt rules. The results are consistent with the fact that expenditure rules are easy to monitor and are most directly connected to instruments within the control of policymakers. In emerging market economies, however, compliance with debt rules is the highest. This result could be attributed to the favorable impact of financial repression on debt dynamics (Escolano, Shabunina, and Woo, 2011) and the nonbinding nature of debt rules in some of these countries. Compliance is generally better in “good economic times,” defined as a year of above-potential GDP growth, suggesting that expenditure rules may help alleviate spending pressures that arise during times of strong revenue performance. Two caveats are in order. First, the short lifetime of expenditure rules (on average 10 years) could mean that their resilience to difficult macroeconomic environments or tail events may not have been fully tested yet. Second, in many instances of “bad times,” countries relax the constraints imposed by their expenditure rules (for example, in Japan after the 2011 earthquake). Countries that use expenditure rules as a complement to other rules exhibit higher primary balances, on average. In addition, event studies, which normalize the implementation date of each country’s expenditure rule to year t, show that fiscal policy was countercyclical following the introduction of an expenditure rule. In emerging markets, this countercyclicality sharply contrasts with the years preceding the introduction of a rule, when fiscal policy was procyclical, on average.

Source: OECD (2012) “Fiscal-Consolidation Strategies for Canadian Governments?” at http://www.oecd-ilibrary.org/economics/fiscal-consolidation-strategies-for-canadian-governments_5km36j7nc2g4-en (accessed 4 January, 2013) and OECD (2009) "Mind the Gaps: Managing Mutual Dependence in Relations among Levels of Government" OECD Working Papers on Public Governance, No. 14, Charbit, C. and M. Michalun at http://www.oecd-ilibrary.org/docserver/download/5ks9zsgrqjg2.pdf?expires=1375028051&id=id&accname=guest&checksum=512D1725FD00ED77E8B9F4FB04FC5704 (accessed 28 July 2013) and  OECD, "Fiscal Consolidation: How Much, How Fast and by What Means?" OECD Economic Policy Papers No. 01, at http://www.oecd-ilibrary.org/economics/fiscal-consolidation_5k9bj10bz60t-en (accessed 28 April 2014). IMF (2013) "Public Financial Management and Its Emerging Architecture" edited by Cangiano, M., Curristine, T., and Lazare, M. in Chapter 3: "Numerical Fiscal Rules: International Trends" authored by Budina, N., Kinda, T., Schaechter, A., and Sateriale, C. (accessed April 21, 2014) and IMF (2014). IMF, “Public Expenditure Reform: Making Difficult Choices” IMF Fiscal Monitor, at http://www.imf.org/external/pubs/ft/fm/2014/01/pdf/fm1401.pdf (accessed 25 April 2014).

Page Created By: Matthew Seddon and Ben Eisen on 28 July 2013, updated on November 16, 2015. 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.


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