‘Second-generation’ fiscal rules: From stupid to too smart

Xavier Debrun, Luc Eyraud, Andrew Hodge, Victor Lledo, Catherine Pattillo 22 May 2018

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The ongoing debate on fiscal governance in the euro area – and by implication on the implied degree of fiscal discipline – reminds us that four decades after Kydland and Prescott (1977), the debate on ‘rules versus discretion’ still rages on. The basic problem is that policymakers’ ability to respond at any time to unforeseen circumstances (discretion) comes at the risk of accommodating short term demands that undermine desirable long-term goals, including price stability and fiscal responsibility. For monetary policy, the solution proved swift and effective – delegating policy levers to independent experts with a mandate to keep inflation low and predictable. Today, independent and accountable central bankers are the norm. We summarise our recent research on fiscal rules and how they can be used to mitigate discretionary excesses (Eyraud et al. 2018).

As usual, fiscal policy is more complicated (Leeper 2010), and fixing the commitment problem is no exception. For a start, the term ‘fiscal delegation’ is an oxymoron. Decisions to extract tax money and use it for the ‘common good’ belong to taxpayers’ elected representatives, not to appointed experts (e.g. Alesina and Tabellini 2007). Thus, if the consequences of unconstrained fiscal discretion are deemed bad enough, constraining the latter through delegation to technocrats is not the way to safeguard against unwanted behaviour. This is where fiscal rules – defined as binding numerical constraints on aggregate indicators of fiscal performance (Kopits and Symansky 1998) – come into play. In the same way as speed limits aim to prevent reckless driving, caps on government deficits, debts, or expenditures are meant to deter fiscal profligacy.

Why fiscal rules?

The rationale for fiscal rules is that unconstrained discretion leads to neglect of public sector solvency. Discretion cannot preclude behaviours, such as seeking electoral advantage through futile expenses or tax breaks, that can result in dangerously high public debts. So fiscal rules are essentially about obligating the government to ‘control itself’ financially and prevent policy mistakes that could jeopardise solvency. Acceptance of constrained discretion as a desirable regime lies at the roots of modern democracies and the well-understood need for a government to “control itself” through “auxiliary precautions” (Madison 1788).1 So, unlike many have argued, there is nothing intrinsically shocking about imposing formal restraint on fiscal behaviour.

Historically confined to sub‑national governments, fiscal rules now constrain central budgets in about 90 countries. Their proliferation reflects the realisation that rising public debt ratios since the 1970s cannot go on indefinitely without raising concerns about the government’s capacity to face its obligations in full. The recent sovereign debt crisis in the euro area was a powerful reminder that no one can take solvency for granted.

Fiscal rules can help a government establish a reputable track record of financially responsible policies in three possible ways: by tying politicians’ hands, by signalling an intrinsic commitment to fiscal responsibility, or by crystallising political consensus on a specific standard of fiscal responsibility across political parties. Successful rules thus reassure voters and investors, allowing policymakers to access borrowing at better conditions whenever that is required to buffer the economy against shocks or to finance policies promoting long-term growth. 

Stupid at first, then too smart

While first principles are clear, the devil hides in the details of design and implementation. A good rule should combine three desirable properties – simplicity to facilitate communication and anchor expectations about the financial sustainability of future fiscal policies, flexibility to accommodate temporary changes in fiscal policy when desirable, and enforceability to inflict tangible costs to financially reckless governments.

Yet, blending these three properties has been frustrating. The evolution of Europe’s Stability and Growth Pact (SGP) illustrates these experimentations. The original arrangement based on a deficit cap of 3% of GDP and a debt ceiling of 60% of GDP gradually morphed into a maze of potentially conflicting and overlapping benchmarks affecting the level and first-difference of most macro relevant fiscal indicators, including public debt, nominal budget balance, structural budget balance, and expenditure. That complexity resulted not only from new provisions to make the limits more contingent on the state of the economy, but also from countermeasures aimed at making the rules more binding (automatic correction mechanisms, rules at the national level, etc.). 

In a nutshell, simplicity was sacrificed to maximise flexibility while enhancing enforceability, which ultimately undermined the rules’ capacity to guide fiscal policy. Formal compliance with fiscal rules remained underwhelming, with rules being complied with half of the time, on average. Have stupid rules become too smart for their own good? 

Rules can work

Of course, non-compliance with a rule does not preclude systematic effects on fiscal behaviour (i.e. effectiveness). However, identifying a causal effect of rules on fiscal outcomes is difficult because unobservable factors, such as deep societal preferences, might simultaneously explain policy patterns and the decision to adopt a rule. Unsurprisingly, the empirical literature on the effectiveness of fiscal rules is by and large inconclusive, particularly when taking this simultaneity problem seriously. 

Drawing on new evidence from a broad sample of IMF members over the last three decades, case studies and econometric analyses show that fiscal rules can mitigate the penchant for excessive deficits if they are well designed. Desirable features include a broad coverage of the public sector, a clear link to fiscal sustainability objectives, and provisions allowing flexibility to avoid procyclical fiscal policy or adequate responses to specific emergencies. Supporting institutions, like independent fiscal councils, also play a role. In contrast, rules that are poorly designed and not tailored to country circumstances can be counterproductive. Overall, the mix of case studies and econometric evidence we have assembled converge to suggest that fiscal rules can tame the bias towards excessive deficits even when they are not complied with.

New evidence suggests that the adoption of the 3% deficit limit by European countries since 1992 acted as a magnet for countries’ deficits. Comparing the distribution of deficits for countries subject to the rule to a counterfactual distribution constructed to address endogeneity concerns, we see that fewer countries record very high deficits and fewer countries have very high surpluses (Figure 1). All in all, about one fifth of the probability mass moves closer to the 3% limit. So, a highly visible rule appears to be able to attract fiscal positions towards its threshold. Therefore, the rule can be a useful compass for governments, even when they do not formally comply with it. The counterfactual would be that some governments would have even higher deficits without the rule. 

Figure 1 Distributions of fiscal deficits in European countries with or without the 3% deficit rule 

Source: Caselli et al. (2018).

Another key result is that the reputational costs of breaching rules seem to matter more than the threat of illusory financial sanctions. First, sanctions exacerbate the financial difficulties of already distressed governments, limiting the appropriateness of such sanctions and their credibility in bad times. Second, what financial markets say about enforcement procedures is also very telling. Indeed, markets would be expected to reward – with lower yields – the ability of rules to shape both current and future fiscal behaviour. In particular, the activation of formal enforcement procedures would be expected to trigger expectations of a credible return towards more sustainable fiscal positions, resulting in lower sovereign spreads. However, the evidence related to the existence of an Excessive Deficit Procedure in the context of the SGP points to the opposite effect. All else equal, yields are higher by 50 to 150 basis points for governments facing an EDP (Caselli et al. 2018). This points to the existence of material reputational costs to breaching a rule, as markets might well see a government willing to face an EDP as having a weaker underlying commitment to fiscal discipline. 

Way forward

As well-designed fiscal rules can enhance fiscal responsibility, policymakers could address eventual shortcomings following three principles.

  • First, get the overall design right

This requires a parsimonious set of mutually consistent rules anchored in sustainable public debt trajectories. A combination of consistent debt and expenditure ceilings should provide both the long-term anchor and the short-term operational guidance for the annual budget. The fear of opening the proverbial Pandora’s box should not prevent comprehensive reforms that preserve the consistency of the rules-based framework. Transparent procedures to review rules-based fiscal frameworks periodically, possibly under the auspices of an independent fiscal council, could be made explicit ex ante to avoid fears of political meddling with the framework.

  • Second, move away from sanctions

As incentives to comply with rules seem to stem more from reputational factors than non-credible threats of sanctions, independent fiscal councils have a role to play in monitoring compliance and explaining to voters and other stakeholders in the budget process the consequences of breaching fiscal rules. In the EU, certain tangible benefits from membership could also be conditioned on compliance with the SGP and national fiscal rules.

  • Finally, cater for simplicity

Inextricable complexity defeats the purpose of rules-based fiscal policy by preventing the formation of stable fiscal expectations. There are pragmatic ways to enhance flexibility without additional complexity. For instance, relying more on the binding expenditure ceilings inherent to the annual budget can allow for greater responsiveness to the business cycle without the technical difficulties associated with the estimation of structural budget balances.

Authors’ note: The views expressed in this column are the authors’ own and do not necessarily represent the views of the IMF, its Executive Board, or IMF Management.

References

Alesina, A, and G Tabellini (2007), "Bureaucrats or Politicians? Part I: A Single Policy Task", American Economic Review 97(1): 169-179.

Caselli, F , L Eyraud, A Hodge, F Diaz Kalan, Y Kim, V Lledó, S Mbaye, A Popescu, W H Reuter, J Reynaud, E Ture, and P Wingender (2018), “Second-Generation Fiscal Rules: Balancing Simplicity, Flexibility, and Enforceability—Background Papers”, IMF.

Eyraud, L, X Debrun, A Hodge, V Lledó, and C Pattillo (2018), “Second-Generation Fiscal Rules: Balancing Simplicity, Flexibility, and Enforceability”, IMF Staff Discussion Notes 18/04.

Kopits, G, and S Symansky (1998), “Fiscal Policy Rules”, IMF Occasional Paper 162, International Monetary Fund, Washington, DC.

Kydland, F, and E Prescott (1977), "Rules Rather Than Discretion: The Inconsistency of Optimal Plans", Journal of Political Economy 85(3): 473-491.

Leeper, E (2010), “Monetary Science, Fiscal Alchemy”, Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, 361-434.

Madison, J (1788), “The Structure of the Government Must Furnish the Proper Checks and Balances Between the Different Departments”, Federalist Papers, No 51, available here.

Endnotes

[1] The “auxiliary precautions” Madison had in mind were – the now obvious – pillars of modern democracies such as the separation of powers, not fiscal rules. Yet the logic is quite similar. Madison’s full quote reads: “If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. A dependence on the people is, no doubt, the primary control on the government; but experience has taught mankind the necessity of auxiliary precautions.”

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Topics:  EU institutions EU policies Taxation

Tags:  fiscal policy, rules vs. discretion, independent councils

Chief, Systemic Issues Division, Research Department, IMF

Deputy Division Chief, IMF

Economist, IMF

Senior Economist, IMF

Assistant Director, Fiscal Affairs Department and Chief, Fiscal Policy and Surveillance Division, IMF

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