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Independent Fiscal Institutions

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Practice Advice on Strategy and Structure

Independent Fiscal Institutions (Fiscal Councils) (OECD and IMF)

Summary Advice (OECD - Independent Fiscal Institutions): The OECD describes a number of good practices that are critical for the effectiveness of an independent fiscal institution.

Summary Advice (OECD - Fiscal Consolidation): Fiscal councils have the potential to underpin fiscal consolidation through their effect on fiscal performance and by taking a wider view on fiscal consolidation needs than a rule-based system is likely to do on its own

Summary Advice (IMF): Fiscal councils can, in principle, play a useful role in disciplining fiscal policy and strengthening government finances, but their benefits should not be oversold, especially for developing countries in which the fiscal policy reform agenda is long and institutional capacity is limited. Moreover, along with many other good fiscal policy practices and innovations, the decision to create a fiscal council, and its role should a council be set up, has to be appropriate to country circumstances.

Main Points (OECD - Independent Fiscal Institutions): Although relatively novel worldwide, independent fiscal institutions have illustrated an important oversight role over fiscal policy-making in democratic societies, especially as they seek to restore public debt sustainability in the wake of the recent global financial crisis. Several countries have established independent fiscal institutions that are entrusted with real-time surveillance of public finances. These watchdogs differ markedly from other independent institutions that may have monitoring responsibilities too. In particular, they are not to be mistaken for public audit institutions that operate, with a long tradition, in more than 150 countries around the world. Audit institutions are responsible for conducting a detailed ex post inspection of the physical, financial and legal integrity of every public sector entity. By contrast, the principal function of an independent fiscal institution (known under various names such as fiscal council, parliamentary budget office, or office for budget responsibility) is analysis and assessment of the budget bill or of any other legislative proposal in the fiscal area, including its consistency with fiscal rules (if any) prior to enactment. More specifically, an independent fiscal institution performs real-time costing and forecasting to ascertain the macro-fiscal consequences of the budget bill over a short and medium term to a long-term horizon. They exist to maintain discipline and transparency in public finances during the policy-making process, which in turn helps bolster the credibility of government.

Independent fiscal institutions are relatively few and of recent vintage. Yet, at least on a tentative basis, the experience accumulated so far can be useful toward formulating an internationally accepted set of good practices. These institutions must be judged within their country-specific context. Subject to this caveat, the OECD identifies the following good practices as being critical for the effectiveness of an independent fiscal institution.

Institution must be home-grown and home-owned in every respect. It must address local needs (in particular, lack of transparency and discipline in public finances); also, it must conform to the country’s legal framework and political culture. It should not be adapted from abroad, or established under pressure from an international or regional authority pursuant to an external commitment. In the event, the local authorities and citizenry are likely to regard the institution as an externally imposed alien body. Credibility cannot be imported from abroad; it must be based on broad political consensus at home.

The institution must be independent, non-partisan, technically competent, and accountable to the legislature. These characteristics are primarily determined by the professional standing of the leadership of the institution and the manner of its appointment (preferably elected by the legislature). Whereas in a parliamentary system the institution must be independent from both the executive and the legislature, in a presidential system independence may be sufficient with respect to the executive branch alone. The governing body must be appropriately remunerated and free from any conflict of interest, and, to strengthen its independence, its tenure should preferably cover more than an electoral cycle and not be renewable. The institution should exercise its independence to the fullest extent possible, as provided by law, and with an adequate level of resources. It should not be inhibited in openly expressing its differences with the government though unnecessary conflict must be avoided at all times. Whether organisationally embedded in the legislature or not, the institution should stand ready to serve all legislators, but especially the members of the budget or treasury committee, in a non-partisan manner.

The institution can only conduct meaningful surveillance of fiscal policy-making, and fulfill its remit with the support of a skilled technical staff and with unlimited access to timely information from the government. The need for competent support staff and a strong mandate to secure access to information is higher if there is a greater degree of opacity in public accounts and official budgetary projections. Staff should be hired through open competition and should not have any links to other public or private institutions. There should not be any impediment in access to government information, though with appropriate safeguards (that is, security clearance for staff) for protection of state secrets in the areas of national defence and security.

The core remit of the institution should consist of assessments of fiscal stance and debt sustainability- including monitoring compliance with fiscal rules or targets, if any- through real time evaluation of the budgetary effects of all legislative proposals. This involves preparation of pre-budget baseline (no policy change) macro-fiscal forecasts, to be followed by forecasts upon submission of the budget bill, as well as costing of the effects of major legislative proposals. Periodically, this should be supplemented with computation of numerical long-term scenarios, based on prudent macroeconomic and demographic assumptions. Quantitative estimates and forecasts should be made publicly available (in time for the legislative debate and well ahead of enactment) along with a full account of the underlying data and methodology. Surveillance by the institution should not overlap or duplicate the monitoring task of the national audit office; in fact, the tasks of the two institutions are complementary. The remit of the institution should preclude any policy-making or normative responsibility, and care should be taken in conducting any advisory role in a strictly non-partisan manner.  

A newly created independent fiscal institution must identify itself and start operating according to its terms of reference as soon as possible. This is the first and most important step toward establishing a reputation and gaining public support because “cement dries quickly/” It cannot be taken for granted that the role and attributes of the new institution will be readily understood, its non-partisanship trusted, or its beneficial effects recognized without proof. Speed in implementation is all the more important since, in order to gain respectability and protection from threats to its existence, the institution’s non-partisanship must be tested over at least two electoral cycles, possibly covering governments of different political orientation.

The institution must develop effective communications very early, especially with the media. Given that the institution can only have influence over fiscal policy-making through dissuasion (rather than through coercion by means of legal sanctions or other punitive measures), it must avail itself of media outlets which in turn can help foster an informed constituency (and financial markets) that will exercise timely pressure on the government to behave transparently and responsibly and thus build credibility. Ultimately, in a free society, the media are the closest allies and promoters of the institution.

Main Points (OECD - Fiscal Consolidation):

A fiscal council could contribute to improved fiscal performance in a number of ways (Hagemann, 2010). For example, by providing an independent view on fiscal policy, whether related to policy formulation, evaluation or monitoring, they can inform voters and other stakeholders more accurately when fiscal policy is off-track and raise the political costs of fiscal laxity. However, the creation of fiscal councils, as with fiscal rules, may simply be an expression of a political commitment to consolidation and unless they achieve credibility they may not affect performance, once popular support for consolidation wanes.

Fiscal councils can complement fiscal rules. In some cases, a fiscal council that has sufficient credibility could monitor the implementation of more complex fiscal rules, such as those targeting cyclically-adjusted or underlying balances, which would allow less simplistic fiscal rules to be implemented. Furthermore, an additional attraction with respect to fiscal rules would be for the fiscal council to assist politicians in deciding when a breach of rule was justified by economic conditions and possibly when governments should begin consolidating.

A fiscal monitoring body could complement fiscal rules by having a mandate to comment explicitly on the long-term sustainability of public finances. In some cases, fiscal councils have such mandates, for example by providing long-term analyses (even though many governments already systematically perform these calculations). To be fully effective, the fiscal council may need to comment on whether current policies are consistent with meeting long-term objectives, if medium-term objectives are not explicitly linked to the long-term sustainability of the public finances.

Fiscal councils can perform tasks that may mitigate specific political economy problems. When a deficit bias arises from over-optimistic forecasting an independent fiscal council given this task can counter the source of deficit bias. Indeed, there appears to be a relationship between comparatively poor budget outcomes and systematic over-optimism: errors in budget balance forecasts are larger for countries running worse budget positions (Frankel, 2011). However, while independent forecasting can help correct over-optimistic forecasting, deficit biases arising from other pathologies may be better addressed by other approaches such as cautious budget assumptions.

Main Points (IMF): 

Fiscal councils are typically executive or legislative agencies, and as such they should be distinguished from fiscal authorities, which have been proposed by some as the fiscal counterpart to independent central banks. The idea is that giving a fiscal authority the power to set fiscal targets or adjust taxes and spending within specified limits should depoliticize fiscal policy decisions and thereby improve fiscal outcomes. However, the analogy with independent central banks is flawed. Fiscal policy decision making is more complicated than formulating monetary policy, in particular because tax, expenditure, and borrowing decisions can have complex and often contentious distributional consequences.

This is where the idea of setting up fiscal councils comes in, because increasing independent scrutiny of fiscal policy design and oversight of fiscal policy implementation is a good fiscal transparency practice that can help to keep governments honest. This scrutiny, in turn, can bolster rules-based commitments to fiscal discipline. Some crosscountry evidence suggests that fiscal councils create positive perceptions about a government’s ability to secure and safeguard fiscal discipline, especially if provisions are in place to formalize their influence and guarantee their independence (Debrun and Kumar, 2008). However, even fiscal councils cannot guarantee fiscal discipline.  Much of the discussion of fiscal councils addresses their potential contribution to fiscal discipline. It is also important to remember that governments lack incentives to allocate and manage resources in an efficient manner, with the result that they do not necessarily use public money effectively. Reforms that seek to bring more information on costs and performance to bear on resource allocation decisions frequently have a goal of providing the incentives necessary to foster spending efficiency.

A fiscal council could review and comment on many aspects of fiscal policy, including:

  • the government’s medium-term fiscal policy objectives, which would typically be specified as a debt or deficit path, including the debt sustainability analysis on which it is based;
  • unfunded and contingent liabilities, and other prospective developments and sources of fiscal risk, that determine the need for future fiscal space;
  • whether short-term fiscal targets are appropriate, given medium-term objectives;
  • the cyclical position of the economy, commodity price changes, and other economic developments that might warrant a fiscal policy response;
  • the size and impact of automatic stabilizers and the design and timing of discretionary tax and spending measures;
  • the impact and cost of proposed policies, with a view to providing a check on the natural tendency of those proposing policies to overstate their benefits and understate their costs; and
  • any other aspects of fiscal policy related to the fiscal council’s mandate or that are the subject of a request from government.

A fiscal council could be assigned either advisory or auditing functions, but a case can be made for having them do both. There are strong synergies between the two functions. Providing good advice is difficult without knowing that the information on which it is based is reliable, or without being able to tailor auditing activities to advisory activities. Thus, many fiscal councils have both advisory and auditing functions. A common auditing function of fiscal councils is reviewing government forecasts. Poor forecasts have been a persistent source of unplanned deficits and debt, and a high priority is often attached to improving the quality of government forecasts. However, some fiscal councils go further, and actually provide independent forecasts for use by the government. Macroeconomic and fiscal forecasts are often biased (they tend to be optimistic or pessimistic) or inefficient (they do not use all available information). A specific concern is the tendency to commit to too much spending based on optimistic revenue forecasts, which leads to additional borrowing when revenue collections underperform and spending is not adjusted.

Although formal influence and guaranteed independence have been mentioned as factors that determine the impact of a fiscal council, no comprehensive investigation has yet been made of what determines the success of a fiscal council in promoting fiscal discipline. However, relevant factors might include the following:

  • Political support. The chances of a fiscal council being successful are better if politicians inside and outside government are open to providing full information on fiscal plans and performance to outsiders, and if they are willing to listen to, resist influencing, and act upon independent views based on that information. They also have to be prepared to give the fiscal council permanent legal status as an independent entity, commit to its multiyear funding, and allow its staff to work without interference or fear of reprisal (e.g., seconded civil servants or academics who may want future government funding for their research). If politicians are not prepared to subordinate their own self-interests to the cause of fiscal discipline, fiscal councils will be ineffective and possibly short lived. This was the fate of the Hungarian fiscal council. As a consequence of critical comments made in 2010 on the new government’s fiscal program, the council’s 2011 budget was cut to near zero and its dedicated staff eliminated. It was replaced by a much smaller and more compliant alternative.
  • An appropriate fiscal framework. Commitment to fiscal discipline requires more than setting up a fiscal council; if that is all that happens, it will probably have little impact on turning around a weak fiscal position or safeguarding a strong one. Governments that truly want to strengthen government finances will address weaknesses in the entire fiscal framework by improving fiscal transparency, possibly putting in place fiscal rules, and reforming the budget process. These steps would ideally include moving toward a medium-term budget framework, but not before basic budget procedures are brought up to the necessary level, and addressing other systemic obstacles to sound fiscal policy formulation and implementation.
  • A well-defined mandate. Even though a fiscal council could have an auditing function or advisory function alone, it will be most effective when it performs both advisory and auditing functions, with the reviewing of forecasts and cost estimates part of the latter. Whether a fiscal council provides macroeconomic or fiscal forecasts and costs new policies for official use depends on the quality of government forecasts and costing, and on the resources and priorities of the fiscal council. Resources will invariably be limited, which may constrain the ability of a fiscal council to undertake some tasks. Once the role of a fiscal council is determined, it should be given a formal mandate specifying the scope and limits of its responsibilities.
  • Clear legal backing. Legislation should set up the fiscal council; describe its role and responsibilities; and specify the relationship between the legislature, the executive, and the fiscal council. The role of the fiscal council should also be included in formal descriptions of the budget process (e.g., in the budget law), with the timing of its input reflected in the budget timetable.
  • The right location. In the United States, with its presidential system and separation of powers, the CBO is a legislative office, formally independent from the executive and, in practice, independent from the legislature by virtue of the nonpartisan nature of it judgment. The CBO counterparts in Mexico and the Republic of Korea are in the same position. In a parliamentary system, the fiscal council is usually an independent executive office, as in Belgium, Denmark, the Netherlands, and Sweden. In a few cases in which specialist committees perform some fiscal council functions, these committees are in effect part of government, as in Germany. In general, there is no right or wrong location, especially if the fiscal council is truly independent. The case may be stronger for a legislative or parliamentary office if the legislature or parliament is an effective counterbalance to a spendthrift executive. By the same token, the case for an executive office is stronger if the legislature is a source of deficit bias because it interferes with what might otherwise be the sound policies of the government. An executive office may also be appropriate if the legislature is adequately supported by budget, public accounts, and other specialized committees.
  • Technically qualified staff. Some fiscal councils are quite small while others are large; size will ultimately reflect the mandate.14 The mandate will also determine whether staffing is temporary or part-time—in which case a committee of experts might suffice—or whether a fiscal council has permanent staff with a skill mix appropriate to its tasks. One issue that arises in staffing a fiscal council is finding technically competent staff, especially in countries where the necessary skills are in limited supply. For example, it clearly makes little sense for a fiscal council to hire talented forecasters from the ministry of finance to review the forecasts made by the less talented forecasters who remain behind. It makes more sense to hire them to make independent forecasts that the government will use (and then redeploy the less talented forecasters). That said, a fiscal council is not a substitute for an effective government, and especially for a strong ministry of finance. It may be beneficial to transfer some ministry of finance functions to an independent body and to subject other functions to oversight by that body, but the ministry of finance still has to perform its core functions well. If it does, a fiscal council will help it perform them even better.
  • Clear reporting requirements. To be effective, a fiscal council must work in the open, with its reports made public. Government should also be required to respond to the fiscal council’s reports, indicating where it has followed the advice of the fiscal council, used its forecasts, agreed with its analysis, and so forth, and where this is not the case. When disagreeing, government should explain why it is ignoring all or part of what the fiscal council says.15 Such requirements play an important part in ensuring that the fiscal council is truly independent and that its work assists governments seeking to make better fiscal policy decisions, both by constraining their ability to make poor choices and helping them resist the poor choices of others. They also make governments more accountable by ensuring that information is available that can result in bad fiscal policy decisions having a financial or political cost.
  • Accountability. Finally, whether the fiscal council is doing work of good quality could be an issue. Although the usefulness of the fiscal council’s work will be reflected in the way the government responds to its views and ultimately in fiscal outcomes, perhaps an appropriate model is national audit offices, which are guided in their work by an international body, the International Organization of Supreme Audit Institutions, the aim of which is to promote the adoption of good audit practices. A similar entity could be put in place for fiscal councils. However, with the limited, albeit growing, number of fiscal councils in place to date, perhaps membership in a more informal knowledge-sharing group would provide necessary assurances.

Discussions of fiscal councils have not directly addressed certain questions, but these questions are relevant if fiscal councils are to be part of concerted policy responses to the large fiscal imbalances that are the legacy of the global financial and economic crisis.

  • Is it necessary to combine fiscal councils and fiscal rules? Fiscal councils, simply by virtue of monitoring and reporting on fiscal performance, have the potential to make well-functioning rules more effective in containing the inappropriate use of discretion and thereby improve fiscal outcomes. By the same token, fiscal rules, by providing a benchmark against which fiscal performance can be assessed, should enable a fiscal council to make more definitive judgments. It is too early to say whether fiscal councils and rules work well together, in part because the evidence to date is unclear on the effect of rules on fiscal performance given that causality is difficult to assess. Moreover, if government will always try to circumvent rules, ultimately financial markets and the electoral system must be relied on to discipline government. The issue then is how fiscal councils can contribute to fiscal discipline other than by making rules more effective. This depends on the answer to the following question:
  • Can fiscal councils help to make financial markets and the electorate more effective constraints on fiscal policy? Market discipline does not work well because it is not sufficiently forward looking. It works eventually, as it did in Greece, but light needs to be shed on why financial markets have in the past responded slowly and abruptly to an accumulated record of bad policies and outcomes rather than reacting more quickly and in a more measured way as policies and outcomes deteriorate. One reason may be that the costs of monitoring fiscal developments on a continuous and timely basis in a large number of countries are too high, even for organizations that have surveillance mandates like the Organisation for Economic Co-operation and Development, the IMF, and the European Commission. Thus, fiscal councils can contribute to making market discipline more effective by providing regular updates on fiscal performance. These updates could make transparency more effective in providing relevant fiscal policy information because, instead of monitoring fiscal developments, financial markets would monitor the fiscal policy reports of the monitors, which are the fiscal councils. By the same token, the availability of better information will allow voters to educate themselves about fiscal policy matters, and politicians will understand that voters are well placed to use the ballot box to penalize bad and reward good fiscal performance. In this way, fiscal councils can help to reinforce democratic accountability. If financial markets and the electorate become more effective because timely, independent analyses of fiscal policy are the norm, then rules are probably best thought of not as an independent source of fiscal discipline, but rather as a clear statement of fiscal policy intent against which fiscal performance can be judged. In other words, the role of rules (with an assist from fiscal councils) is to help transparency, financial markets, and voters do their jobs.
  • Should fiscal councils play a stabilization role? Although fiscal councils could make judgments as to whether the stance of fiscal policy is appropriate given the cyclical position of the economy, they are not directly involved in stabilization as envisaged under some fiscal authority proposals. This leaves unaddressed the well-known problems with discretionary stabilization, particularly its procyclicality in good times. However, making the short-term management of rainy-day or stabilization funds part of the fiscal council’s mandate is something to consider. For example, the fiscal council could advise on using such funds to launch quick, reversible changes to a key tax rate or spending program in response to stabilization needs. Such an approach could blend independent input and democratic accountability in a way that provides a practical means of helping discretionary stabilization work in a more timely, temporary, and targeted manner. However, although final decisions on stabilization measures must inevitably rest with government, routinely involving a fiscal council in even limited tax and spending decisions may make it appear to be too much like a fiscal authority.
  • What impact can a fiscal council have on expenditure efficiency? When focusing on fiscal discipline, it is easy to lose sight of expenditure efficiency, yet improving efficiency is a key objective of most governments. Although fiscal councils do not have expenditure efficiency as part of their mandates, their actions can be efficiency enhancing because fiscal discipline and spending efficiency are closely related. Governments that are not preoccupied with having to address fiscal imbalances and their wider macroeconomic consequences can pay more attention to the microeconomic aspects of fiscal policy, including the efficiency of spend-ing. Moreover, fiscal stability provides an appropriate background for making sound decisions about spending with medium-term implications, especially in the context of a medium-term budget framework. One reason that spending efficiency has proved to be such an elusive objective is that fiscal discipline has itself proved to be elusive. Therefore, even though the role of spending watchdog should be left to others, most notably national audit offices and relevant parliamentary committees, fiscal councils can make contributions to both fiscal discipline and expenditure efficiency.
  • Could other institutions play the fiscal council’s role? Clearly, other institutions often perform some fiscal council functions. National audit offices, research institutes, international organizations, and even central banks do so, often quite well. However, specialization provides benefits, as is often the case in connection with national audit offices, for which fiscal council functions have been a sideline, but which are frequently not well suited in their analytical perspective or staffing to perform these functions. National audit offices are probably better left to concentrate on their traditional financial and performance audit functions. Moreover, political legitimacy and impact will be greater if fiscal council functions are the responsibility of one exclusively focused organization, and if that organization is inside government so that it can play a formal role in fiscal policy formulation and implementation, especially in the budget process. This issue, however, has to be placed in a country-specific context. Advanced and emerging market economies with well-functioning fiscal institutions and good technical capacity can afford the luxury of considering which modern public financial management practices are appropriate for them and how best to implement those practices. But many developing countries do not have this luxury. Although they can certainly benefit from independent scrutiny of fiscal policy, this may not be their highest priority, and they might not have access to high-quality local input even if they were interested in it. Under these circumstances, involving outsiders should be considered when and where it can make a more significant difference than other reforms. The precise response to the need for an outside view should also be tailored to country requirements and opportunities, and could fall well short of setting up a fiscal council.

Source: OECD (2011). Independent Fiscal Institutions: Developing Good Practices at http://www.oecd-ilibrary.org/governance/independent-fiscal-institutions-developing-good-practices_budget-11-5kg3pdgcpn42 (accessed 14 October, 2012). IMF (2013) "Public Financial Management and Its Emerging Architecture" edited by Cangiano, M., Curristine, T., and Lazare, M. in Chapter 6: "The Role Of Fiscal Councils In Promoting Fiscal Responsibility" authored by Hemming R., and Joyce P. (accessed April 21, 2014).

Page Created By: Matthew Seddon on 11 November 2012. Updated by Ian Clark on 2 January 2013. Updated by Matthew Seddon on 24 April 2014. 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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