The Design Of Fiscal Rules /1,2

The Design Of The Design Of Fiscal Rules Fiscal Rules /1,2/1,2

Davide LombardoDavide LombardoInternational Monetary FundInternational Monetary Fund

Turkish Banks’ Association SeminarTurkish Banks’ Association SeminarFebruary 26, 2009February 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).

OutlineOutline First principles: (Definition, Rationale, Function)First principles: (Definition, Rationale, Function)

TaxonomyTaxonomy

Design trade-offsDesign trade-offs

Basic properties of selected rulesBasic properties of selected rules

Monitoring and enforcementMonitoring and enforcement

Fiscal rules around the world:Fiscal rules around the world: EU sampleEU sample Broader sampleBroader sample

Lessons from stylized factsLessons from stylized facts

ConclusionsConclusions

DefinitionDefinition

MechanismMechanism placing placing durabledurable constraintsconstraints on fiscal on fiscal discretion through numerical discretion through numerical limitslimits on budgetary on budgetary aggregates (expenditure, revenue, budget aggregates (expenditure, revenue, budget balance and/or public debt).balance and/or public debt).

Any fiscal policy rule is made of 3 parts:Any fiscal policy rule is made of 3 parts: Numerical target/ceiling Numerical target/ceiling onon one or more specific fiscal one or more specific fiscal

indicatorsindicators Explicit Explicit costcost for non-complying policymakers for non-complying policymakers A A monitoring/enforcement procedure.monitoring/enforcement procedure.

What is What is not not a fiscal policy rule?a fiscal policy rule? The The annual budgetannual budget is not a rule, as it only is not a rule, as it only

applies for one year.applies for one year.

An An IMF-supported program, IMF-supported program, as it is not expected as it is not expected to be a permanent feature of fiscal policy.to be a permanent feature of fiscal policy.

The new UK “rule”: 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.”

Rationale: Rationale: why constraining discretion?why constraining discretion? Unconstrained fiscal policy may be perceived as Unconstrained fiscal policy may be perceived as

systematically deviating from desirable policies.systematically deviating from desirable policies. In practice: In practice: pro-cyclicalpro-cyclical and/or and/or unsustainableunsustainable policies. policies.

Reasons why Reasons why unconstrained policies can be biased:unconstrained policies can be biased: Time-inconsistencyTime-inconsistency Fiscal Fiscal federalismfederalism/monetary union/monetary union Political economy:Political economy: Myopia, re-election concerns, fiscal Myopia, re-election concerns, fiscal

illusion, distributive conflicts, and coordination failures.illusion, distributive conflicts, and coordination failures.

Other disciplining mechanisms? Other disciplining mechanisms? Markets:Markets: yes, but unreliable (comes too late and to yes, but unreliable (comes too late and to

strongly)strongly) Delegation to non-partisan technical agencies:Delegation to non-partisan technical agencies: poses poses

considerable issues in terms of democratic accountability.considerable issues in terms of democratic accountability.

Functions Functions of fiscal rulesof fiscal rules

Rules are Rules are commitment devices:commitment devices: they make they make deviations from socially desirable targets too deviations from socially desirable targets too costly for policymakers.costly for policymakers.

Rules are Rules are signaling tools:signaling tools: they can help they can help policymakers signal their genuine commitment to policymakers signal their genuine commitment to sustainable and stabilizing policies. sustainable and stabilizing policies.

Rules can alsoRules can also serve to serve to anchor expectationsanchor expectations, , thus reducing uncertainties and risk premia.thus reducing uncertainties and risk premia.

Principles of aPrinciples of a taxonomy taxonomy Many parameters enter the design of an actual Many parameters enter the design of an actual

fiscal policy rule: fiscal policy rule: fiscal target(s) fiscal target(s) nature of costs in case of deviationnature of costs in case of deviation monitoring/enforcement monitoring/enforcement escape clauses, etc.escape clauses, etc.

A good rule must imply good policies in most (if A good rule must imply good policies in most (if not all) circumstances not all) circumstances

the policy response induced by the rule to the policy response induced by the rule to a a variety of shocks is therefore key.variety of shocks is therefore key.

Key feature of the rules: response to shocksKey feature of the rules: response to shocks

Limits to discretion make sense, but they Limits to discretion make sense, but they should NOT:should NOT: Prevent adequate responsesPrevent adequate responses (e.g., let (e.g., let

automatic stabilizers play in bad times)automatic stabilizers play in bad times) Force inadequate responsesForce inadequate responses (e.g., force a (e.g., force a

fiscal contraction in response to a temporary fiscal contraction in response to a temporary spike in interest rate, or depreciation of the spike in interest rate, or depreciation of the exchange rate)exchange rate)

Let the bias unchecked Let the bias unchecked in specific in specific circumstances (e.g., allow for procyclical circumstances (e.g., allow for procyclical expansions).expansions).

TheThe design design of fiscal rulesof fiscal rules There is There is no one-size-fits-all fiscal policy rule. no one-size-fits-all fiscal policy rule.

Much depends on:Much depends on: Constellation of shocks prevalent in the economyConstellation of shocks prevalent in the economy Nature and magnitude of policy bias under discretion.Nature and magnitude of policy bias under discretion.

A good rule is (Kopits and Symansky, 1998):A good rule is (Kopits and Symansky, 1998): ……simplesimple ……transparenttransparent ……coherent with the final goalcoherent with the final goal ……but mindful of other goals of public policy:but mindful of other goals of public policy:

• Not discouraging structural reformsNot discouraging structural reforms• Allowing for fiscal stabilization (time-frame, cyclical Allowing for fiscal stabilization (time-frame, cyclical

adjustment)adjustment)• Avoiding low-quality adjustments (undue tax hikes, cuts in Avoiding low-quality adjustments (undue tax hikes, cuts in

quality/priority spending).quality/priority spending).

Two keyTwo key trade-offs trade-offs

Credibility-flexibility: Credibility-flexibility: allowing for greater allowing for greater responsiveness to shocks could undermine responsiveness to shocks could undermine credibility of attaining the final goal.credibility of attaining the final goal.

Flexibility-simplicity:Flexibility-simplicity: combinations of rules can combinations of rules can relax somewhat the credibility-flexibility trade-off, relax somewhat the credibility-flexibility trade-off, at the cost of simplicity and transparency. at the cost of simplicity and transparency.

The devil is in the detailsThe devil is in the details

OtherOther design design issuesissues Coverage of the government sectorCoverage of the government sector

Policy coordination in federal/decentralized Policy coordination in federal/decentralized systemssystems

Legal foundationsLegal foundations

Need for adequate budgetary procedures Need for adequate budgetary procedures (preparation, execution, and ex-post auditing of (preparation, execution, and ex-post auditing of budgets)budgets)

Need to limit scope for creative accountingNeed to limit scope for creative accounting

Pros and cons Pros and cons of selected rulesof selected rules

Simple rulesSimple rules:: Debt rulesDebt rules Budget balance rulesBudget balance rules Expenditure rulesExpenditure rules Revenue rulesRevenue rules

Combined rules:Combined rules: e.g., debt objectives coupled e.g., debt objectives coupled with binding deficit ceilings, debt/budget balance with binding deficit ceilings, debt/budget balance objectives coupled with binding medium-term objectives coupled with binding medium-term expenditure ceilingsexpenditure ceilings

Balanced budget and overall deficit limitsBalanced budget and overall deficit limits Pros:Pros:

pin down asymptotic properties of debtpin down asymptotic properties of debt directly address the deficit biasdirectly address the deficit bias can be simple and transparent (unless cyclical can be simple and transparent (unless cyclical

considerations, escape clauses, etc).considerations, escape clauses, etc).

ConsCons:: procyclical (unless cyclically adjusted or “over the cycle”)procyclical (unless cyclically adjusted or “over the cycle”) could force cut in investment… could force cut in investment…

golden rule, but these open door to manipulations, golden rule, but these open door to manipulations, and do not guarantee debt sustainability.and do not guarantee debt sustainability.

Overall vs. primary balance? Overall vs. primary balance? Primary is more robust to volatility in interest payments.Primary is more robust to volatility in interest payments.

Deficit Rules Deficit Rules

Upper limit (or desirable time path) for gross or net public debtUpper limit (or desirable time path) for gross or net public debt

Pros:Pros: Directly tackle debt sustainabilityDirectly tackle debt sustainability Can be transparent and simpleCan be transparent and simple Can accommodate large shocks if debt is well below the Can accommodate large shocks if debt is well below the

ceilingceiling

Cons:Cons: Lack controllabilityLack controllability Can force procyclical and undesirable responses to Can force procyclical and undesirable responses to

interest rate and exchange rate shocks if debt is close to interest rate and exchange rate shocks if debt is close to the limitthe limit

Borrowing constraints generally applied at regional and local Borrowing constraints generally applied at regional and local levelslevels

Debt Rules Debt Rules

Expenditure RulesExpenditure RulesSet expenditure ceilings (nominal or in terms of Set expenditure ceilings (nominal or in terms of GDP) or limits on growth (nominal or real).GDP) or limits on growth (nominal or real).Pros:Pros:

tackle one of main source of deficit biastackle one of main source of deficit bias translate directly into budget preparationtranslate directly into budget preparation minimizes pro-cyclicality risksminimizes pro-cyclicality risks fosters medium-term planningfosters medium-term planning

Cons:Cons: May leave room for discretionary tax cuts May leave room for discretionary tax cuts

sustainability?sustainability? complex to design (nominal vs. real, complex to design (nominal vs. real,

exclusions,…)exclusions,…)Best used in combination with deficit or debt rules.Best used in combination with deficit or debt rules.

[Revenue Rules][Revenue Rules] Rules imposing limits on revenues with a view to:Rules imposing limits on revenues with a view to:

Contain size of the public sector / tax burdenContain size of the public sector / tax burden Allocate ex-ante revenue windfalls (e.g., due to surprisingly Allocate ex-ante revenue windfalls (e.g., due to surprisingly

high growth)high growth)

Pros:Pros: Can reduce procyclicality in good timesCan reduce procyclicality in good times

Cons:Cons: Limited impact on deficit bias if not coupled with other rulesLimited impact on deficit bias if not coupled with other rules Can be procyclical in case the rule targets a given revenue-to-Can be procyclical in case the rule targets a given revenue-to-

GDP ratio (due to the progresssivity of the tax system)GDP ratio (due to the progresssivity of the tax system)

Combination of rulesCombination of rules

Drawbacks with individual rules have led most Drawbacks with individual rules have led most countries to adopt combination of rulescountries to adopt combination of rules

Most common combinations:Most common combinations: Debt and overall deficit ceiling and overall Debt and overall deficit ceiling and overall

balance target (e.g., Maastricht)balance target (e.g., Maastricht) Overall balance and expenditure ceilings Overall balance and expenditure ceilings

(Sweden, Finland, Netherlands, etc).(Sweden, Finland, Netherlands, etc).

MonitoringMonitoring

Ex-ante auditing:Ex-ante auditing: Is the government proposed fiscal policy Is the government proposed fiscal policy

consistent with the rule and its objectives?consistent with the rule and its objectives?

Ex-post assessment: Ex-post assessment: Was the rule implemented?Was the rule implemented?

• Analysis of underlying policiesAnalysis of underlying policies• Certification role: track attempts to resort to Certification role: track attempts to resort to

creative accountingcreative accounting• Assessment of ex-post adjustments to the target Assessment of ex-post adjustments to the target

(CABs,…), activation of escape clauses, etc.(CABs,…), activation of escape clauses, etc.

A key pre-requisiteA key pre-requisite

Budgetary transparency:Budgetary transparency: Fiscal data need to be accessible, timely, and Fiscal data need to be accessible, timely, and

reliablereliable Comprehensive periodic reporting requirementsComprehensive periodic reporting requirements Clarity about the budget preparation and Clarity about the budget preparation and

execution proceduresexecution procedures Clarity about roles and responsibilities of Clarity about roles and responsibilities of

different levels of governmentdifferent levels of government

Fiscal councilsFiscal councils

Independent institutions withIndependent institutions with country-specific mandatescountry-specific mandates adequate and highly qualified staffadequate and highly qualified staff guaranteed multi-year budget.guaranteed multi-year budget.

Can contribute to greater Can contribute to greater transparency transparency and accountabilityand accountability of fiscal policy. of fiscal policy.

Can help monitoring and enforcing a rule.Can help monitoring and enforcing a rule.

The case of ChileThe case of Chile Fiscal institutional setup designed to buttress fiscal Fiscal institutional setup designed to buttress fiscal

sustainability and dampen cyclical fluctuations.sustainability and dampen cyclical fluctuations.

RuleRule: maintain a structural surplus of 1 percent of GDP : maintain a structural surplus of 1 percent of GDP for the central government. Fiscal expenditures follow for the central government. Fiscal expenditures follow the dynamics of structural revenue.the dynamics of structural revenue.

Two Two independent expert panelsindependent expert panels provide key projections: provide key projections:1.1. the inputs (growth of the labor force, real investment, and total the inputs (growth of the labor force, real investment, and total

labor productivity) for estimating trend GDPlabor productivity) for estimating trend GDP2.2. ten-year forecasts of the price of copper.ten-year forecasts of the price of copper.

Independent panels enhance policy credibility, while Independent panels enhance policy credibility, while allowing some policy flexibility. allowing some policy flexibility.

The case of the Netherlands The case of the Netherlands

The Central Planning Bureau plays a key role in The Central Planning Bureau plays a key role in the budgetary process:the budgetary process: Provides projections and forecastsProvides projections and forecasts Estimates desired structural budget balanceEstimates desired structural budget balance Vets the programs of all political parties (which are Vets the programs of all political parties (which are

thus subject to reputational sanctions)thus subject to reputational sanctions) Undertakes analysis of specific budgetary projects.Undertakes analysis of specific budgetary projects.

High credibility borne out of tradition High credibility borne out of tradition

Fiscal Rules: Fiscal Rules: International Experience International Experience

Stylized facts for EU (EC database: annual Stylized facts for EU (EC database: annual data over 1990-2005), and the rest of the data over 1990-2005), and the rest of the world (IMF-FAD database on the design world (IMF-FAD database on the design and implementation of fiscal rules)and implementation of fiscal rules)

Worldwide: 81 countries identified as Worldwide: 81 countries identified as having fiscal policy rules, with complete having fiscal policy rules, with complete information for 77 of them information for 77 of them

Growing appetite for fiscal rules (EU)Growing appetite for fiscal rules (EU)

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Raw

inde

x

EU-15

Euro-11

NMS

Big-4

Maastricht SGP EMU

Emerging Market and LICs are Emerging Market and LICs are catching up with industrial countriescatching up with industrial countries

Number of fiscal rules by category of countries: 1990-2008

0

10

20

30

40

50

60

70

80

1990 1995 2000 2008

Industrial

EU-27

Emerging

LIC's

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

Number of countries with at least one fiscal policy rule (by type of rule)

0

10

20

30

40

50

60

70

80

1990 1995 2000 2008

Budget balance

Debt

Expenditure

Revenue

Expenditure and revenue rules are thus relative newcomersExpenditure and revenue rules are thus relative newcomers

Median duration of existing fiscal rules (in years)

0

1

2

3

4

5

6

7

8

9

10

Budget balance Debt Expenditure Revenue

Same trends in EU sampleSame trends in EU sample

0

10

20

30

40

50

60

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Revenue Rules

Expenditure rules

Debt Rules

Budget balance rules

Budget balance rules appear stronger and have wider coverageBudget balance rules appear stronger and have wider coverage

Selected features of rules-based fiscal frameworks by type of rule (common features only)

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Independentenforcement (relative

frequency)

Independentmonitoring (relative

frequency)

Coverage (medianrelative to maximum

possible score)

Statutory basis (medianrelative to maximum

possible score)

Budget balance

Debt

Revenue

Expenditure

This is reflected in synthetic measures This is reflected in synthetic measures of strength and coverageof strength and coverage

Indices of strength (max= 6) and of coverage (max=4) by type of rule

0

0.5

1

1.5

2

2.5

3

Budget balance Revenue Debt Expenditure

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0Strength

Coverage

Strength and coverage relatively similar across countriesStrength and coverage relatively similar across countries

Indices of strength (max= 6) and of coverage (max=4) by country category

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Industrial Resource rich LICs Emerging markets

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0Strength Coverage

Features by country groupsFeatures by country groups

Selected features of rules-based fiscal frameworks (relative frequencies by country groups)

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Independentenforcement

procedure (allrules)

MTEF(relative to

BBR and DR)

Independentforecasts (all

rules)

FRL (all rules) Provision(s)for fiscal

stabilization(relative to

BBR)

Exclusion ofhigh-quality

spending(relative to

BBR and ER)

Independentmonitoring (all

rules)

Industrial Emerging LIC's Resource-rich

Fiscal rules lower interest rates (EU-25)Fiscal rules lower interest rates (EU-25)Estimator:

Long-term interest rate (lagged) 0.55 *** 0.35 *** -0.11 0.53 *** 0.47 *** 0.31 *** 0.39 *** 0.39 *** 0.56 *** 0.13(8.77) (4.26) (-1.44) (5.67) (9.98) (6.35) (4.52) (4.58) (6.41) (1.53)

Short-term interest rate 0.26 *** 0.58 *** 0.50 *** 0.23 *** 0.26 *** 0.50 *** 0.40 *** 0.23 *** 0.12 0.43 ***(4.23) (16.99) (10.52) (3.07) (11.32) (13.49) (4.29) (2.56) (0.92) (6.93)

Cyclically-adjusted primary balance -0.08 ** -0.01 0.00 -0.03 -0.07 * -0.04 -0.07 -0.05 0.03 -0.04(-2.44) (-0.03) (-0.26) (-0.39) (-1.77) (-0.82) (-1.34) (-0.88) (0.56) (-0.72)

Public debt (lagged) 0.01 0.00 -0.01 0.00 0.01 0.00 0.02 ** 0.01 0.00 0.01(0.73) (0.22) (-0.85) (0.27) (0.46) (0.08) (2.04) (0.61) (-0.29) (0.88)

Real GDP growth 0.13 *** -0.01 0.04 ** 0.11 ** 0.26 *** 0.04 0.06 ** 0.09 0.07 0.11 *(3.04) (-0.06) (2.14) (2.38) (4.29) (0.91) (1.93) (1.39) (1.63) (1.80)

Inflation 0.22 ** -0.07 * 0.11 ** 0.22 * 0.45 *** -0.04 0.01 0.33 *** 0.26 * 0.09(2.10) (-1.77) (2.12) (1.92) (4.22) (-1.07) (0.17) (2.70) (1.88) (1.18)

Enlargement (dummy) … … … 0.03 … … … -0.61 … …(0.07) (-1.40)

Election year (dummy) … … 0.08 ** 0.38 … … 0.26 0.28 0.47 * 0.02(2.17) (1.40) (1.48) (1.00) (1.76) (0.11)

Stability and Growth Pact (dummy) … … … … … … … -0.29 0.13 -0.96 **(-1.30) (0.56) (-2.13)

Government stability … … -0.03 ** -0.17 * -0.21 *** 0.03 -0.18 *** -0.16 0.14 -0.08(-1.89) (-1.85) (-3.75) (0.24) (-3.69) (-1.61) (0.59) (-1.19)

Ideological range of governing coalition … … -0.02 0.13 * … … -0.14 0.11 *** 0.10 0.15(-1.53) (1.90) (-1.42) (2.71) (1.52) (1.65)

Fiscal Rule Index -0.16 0.10 -0.09 * -0.16 -0.17 -0.31 ** -0.10 -0.41 ** -0.06 -0.43(-1.58) (0.10) (-1.63) (-0.93) (-1.37) (-2.48) (-1.06) (-2.03) (-0.50) (-1.59)

Number of observations 213 47 72 155 107 153 72 148 148 104Number of countries 15 10 12 25 15 22 9 19 24 21Test for 2nd order autocorrelation (p-value) 2/ 0.93 0.16 0.10 0.38 0.25 0.21 0.55 0.45 … …Sargan test (p-value) 3/ 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 … …

Note: The t-statistics are reported in parentheses (with superscripts *, **, and *** denoting statistical significance at the 10, 5 and 1 percent levels respectively). They are robust to cross-sectional heteroskedasticity. All models include a constant and country effects (not reported). The latter are jointly significant at conventional confidence levels in all equations. The enlargement dummy is equal to 1 for new member states, after they joined the EU. The SGP dummy is equal to 1 for euro area member states after 1998.1/ Arellano-Bond estimation could not be obtained for one of the subsamples (lagged dependent variable highly insignificant and evidence of second-order autocorrelation). The comparison is thus based on fixed-effects estimates.2/ Arellano-Bond test of the null hypothesis of no autocorrelation of residuals.3/ Test of the null hypothesis that identifying restrictions are valid.

Unstable gov.

High debt Low debt

Arellano-Bond Fixed effects 1/

Table 2. Determinants of Long-Term Interest Rates in the EU-25 (1990–2005): Selected Sub-Samples

EU-15 Non-EU15 Euro Non-euro DelegationNo

delegationStable gov.

Debrun and Joshi (2008)

Specific dimensions of fiscal rules as captured by sub-indices:

Statutory basis -0.47 **(-2.07)

Independent body monitoring the rule's implementation -0.48 **(-2.07)

Independent body contributing to rule's enforcement -0.52 **(-2.01)

Strength of enforcement procedure -0.40 **(-2.03)

Media impact of the rule -0.47 **(-2.23)

Memorandum items:

Overall fiscal rule index -0.45 **(-2.09)

Expenditure rule index 0.05(0.29)

Notes: The t-statistics are reported in parentheses (with superscripts *, **, and *** denoting statistical significance at the 10, 5 and 1 percent levels respectively).Given that subindices are only available for the overall fiscal rule index and theexpenditure rule index, the results, obtained with model (6) in Table 1, use the overall index but control for the effect of expenditure rules.

Table 3. Impact of the Fiscal Rules on Long-Term Interest Rates: Specific Features of the Rule (EU-25, 1990–2005, Non-Excessive Public Debt)

All key dimensions All key dimensions mattermatter Effective rules deliver lower deliver lower interest rates.interest rates.

Debrun and Joshi (2008)

Fiscal rules lower interest rates (EU-25)Fiscal rules lower interest rates (EU-25)

LessonsLessons Historical preference for deficit and debt ruleHistorical preference for deficit and debt rule

But recently emergence of expenditure rules (in But recently emergence of expenditure rules (in combination with BBRs and DRs)combination with BBRs and DRs)

What explains the trends for more rules and What explains the trends for more rules and more expenditure rules?more expenditure rules? Increasing realization that purely discretionary fiscal Increasing realization that purely discretionary fiscal

policies are inconsistent with sustainability (growing policies are inconsistent with sustainability (growing public debt)public debt)

Mounting pressures from long-term issues: aging, Mounting pressures from long-term issues: aging, global warming, etc.global warming, etc.

Regional monetary unions.Regional monetary unions.

ConclusionsConclusions

Well-designed fiscal rules can help improve Well-designed fiscal rules can help improve fiscal performance on averagefiscal performance on average… …

……thus lowering risk-premia and interest rates on thus lowering risk-premia and interest rates on long-term government bonds.long-term government bonds.

But:But: political commitment is key political commitment is key

As are adequate public financial management, As are adequate public financial management, monitoring and enforcing systems.monitoring and enforcing systems.