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Fiscal Rules to Reduce U.S. Federal Debt Lessons from Chile, Brazil, Germany, Sweden and Switzerland

November 2010

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Acknowledgement

This report was prepared for the National Academy of Sciences and National Academy of Public Administration, Washington, D.C. as a Capstone Project under the Master of Science in Public Policy and Management program of Carnegie Mellon University, Pittsburgh, U.S.A and Adelaide, Australia. The project team benefitted from the support, advice and guidance of. F. Stevens Redburn, Study Director at the National Academy of Sciences, Washington, D.C.

The team would like to thank a number of individuals for comments and advice. The project would not have been possible without the leadership of Terry Buss, Executive Director of Carnegie Mellon University, Australia, who was instrumental in introducing the team to the National Academy of Sciences. The team would also like to thank Paul Chapman, Irina Ferouleva, and William Kittredge for providing comments on previous drafts of this document, and Michel Lazare, Richard Hughes and Teresa Rose Curristine of the IMF Fiscal Affairs Division in Washington, D.C., and Robert Schwarz of South Australia‘s Department of Treasury and Finance, for sparing their time to provide insights and relevant information. The usual disclaimers apply.

The Capstone Project Team Danura Miriyagalla (Team Leader) Marie Antoniette Arenas Adilah Hudzari Arleen Mabale Aadil Mansoor Kevin Pugh Elvin Ivan Uy James Yeung Sana Zia

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Table of Contents Executive Summary ................................................................................................................................ 1 1. Introduction and Problem Statement................................................................................................... 6 1.1 Introduction ................................................................................................................................... 6 1.2 A Looming Fiscal Crisis in the United States ............................................................................... 7 2. Literature Review.............................................................................................................................. 10 2.1 Monetary vs. Fiscal Autonomy ................................................................................................... 10 2.2 History/Trends ............................................................................................................................ 10 2.3 What are Fiscal Rules?................................................................................................................ 11 2.4 Rationale in Support of Fiscal Rules........................................................................................... 12 2.4.1 Intergenerational equity and the deficit bias ........................................................................ 12 2.4.2 Fragmentation of budget decision costs and benefits .......................................................... 13 2.4.3 Market-like correction qualities ........................................................................................... 13 2.4.4 Empirical evidence of their effectiveness ............................................................................ 13 2.5 Rationale against fiscal rules....................................................................................................... 14 2.5.1 Information .......................................................................................................................... 14 2.5.2 Lack of flexibility................................................................................................................. 14 2.6 Types of Fiscal Rules .................................................................................................................. 15 2.6.1 Debt rules ............................................................................................................................. 15 2.6.2 Budget balance (or deficit) rules .......................................................................................... 15 2.6.3 Revenue rules ....................................................................................................................... 15 2.6.4 Expenditure rules ................................................................................................................. 16 2.7 Design Considerations ................................................................................................................ 16 2.8 Implementation Issues ................................................................................................................ 17 3. Fiscal Rules in Brazil, Chile, Germany, Sweden and Switzerland: A Synthesis of Findings ........... 19 3.1 Background ................................................................................................................................. 19 3.2 Debt Rules................................................................................................................................... 20 3.3 Budget Balance Rules ................................................................................................................. 22 3.4 Expenditure Rules ....................................................................................................................... 23 3.5 Use of Creative Accounting ........................................................................................................ 25 3.6 Fiscal Institutions ........................................................................................................................ 25 3.7 Transparency Rules ..................................................................................................................... 27

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3.8 Conclusion .................................................................................................................................. 29 4. Evaluation of Fiscal Rules ................................................................................................................ 31 4.1 Introduction ................................................................................................................................. 31 4.2 Analytical framework ................................................................................................................. 31 4.2.1 Multiple approaches ............................................................................................................. 31 4.2.2 Assessment criteria .............................................................................................................. 32 4.2.3 Economic effectiveness criteria ........................................................................................... 32 4.2.4 Transparency, simplicity and accountability criteria ........................................................... 33 4.3 Evaluation of Rules with the Analytical Framework .................................................................. 34 4.3.1 The framework ..................................................................................................................... 34 4.3.2 Summary findings ................................................................................................................ 35 4.4 The Multiple Rule Approach ...................................................................................................... 41 4.4.1 Multiple rules – key considerations ..................................................................................... 41 4.4.2 Multiple rules – a graphical representation .......................................................................... 41 4.5 Conclusion .................................................................................................................................. 45 5. Recommendations ............................................................................................................................. 46 5.1 Introduction ................................................................................................................................. 46 5.2 Proposed Design and Justifications............................................................................................. 47 5.2.1 Debt Rule ............................................................................................................................. 47 5.2.2 Expenditure Rule.................................................................................................................. 48 5.2.3 Budget Balance Rule............................................................................................................ 49 5.3 Analysis of Fiscal Rules in Combinations .................................................................................. 50 5.4 Implementation Considerations .................................................................................................. 51 5.4.1 Priority Setting ..................................................................................................................... 51 5.4.2 Credibility ............................................................................................................................ 52 5.4.3 Simplicity and Accessibility to the Public ........................................................................... 53 5.4.4. Multi-Year Budget Plan ...................................................................................................... 53 5.4.5. Enforcement Mechanism .................................................................................................... 54 5.4.6. Flexibility of Rule Implementation ..................................................................................... 55 5.4.7. Timing of the Rule Implementation .................................................................................... 55 5.4.8. Conclusion .......................................................................................................................... 56 Bibliography ......................................................................................................................................... 57

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Executive Summary Federal debt in the U.S. is estimated to be at 62% of GDP at the end of fiscal year 2010, having risen from 36% before the recession in fiscal year 2007. The Congressional Budget Office forecasts that, under current policy assumptions, the debt-to-GDP ratio will grow to 87% by 2020. The current course is widely viewed as unsustainable and could lead to a financial crisis unless a plan is adopted to stabilize the nation‘s finances. International experience indicates that recovery after a financial crisis will be slow given that confidence in the financial system has been shaken. In addressing its fiscal challenge, the U.S. can draw on the experience of other nations in applying fiscal rules, which are numerical targets for one or more budget components, coupled with enforcement mechanisms and reinforcing institutional changes.

Countries

which experienced high debt levels in the past, even more serious than that of the U.S. today, have used fiscal rules effectively to anchor expectations, enforce fiscal discipline, and reduce debt to sustainable levels. Multilateral financial institutions, notably the IMF, have long recommended that countries in fiscal distress adopt fiscal rules. Adhering to correctly defined rules can help leaders adopt and sustain policies that will improve fiscal health. We reviewed the experience of five countries – Brazil, Chile, Germany, Sweden and Switzerland – with a notable background in fiscal rules. In considering which nations to study, we also factored in the type of government institutions, history of fiscal imbalances, types of fiscal rules, size of the economy and relevance to the U.S. political and economic context. The five nations on which we alighted represent a set of countries which have moved from discretionary to rules-based fiscal regimes. Most have used a combination of rules rather than a single rule: the debt, budget balance and expenditure rules of Germany, Sweden and Brazil and debt and budget balance rules of the E.U. Stability and Growth Pact. The debt and budget balance rules keep the most important aggregates in check, while the expenditure rules contain growth and structural rigidities on the expenditure side. A credible rules-based framework requires independent monitoring of compliance and imposition of penalties to deter deviations from the fiscal rules. A rules-based regime must also contain transparent escape clauses that permit a government unable to comply with fiscal rules in the face of extraordinary macroeconomic, natural disaster or national emergency situations to suspend or modify their application.

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Alongside numerical fiscal rules, the five countries reviewed have implemented or introduced complementary institutional and budgetary reforms. These include adoption of medium-term budgetary frameworks to improve predictability and transparency of budgetary aggregates; top down budgeting where aggregates are set either by independent experts (Chile, Sweden and Germany) or the central Ministry of Finance; and enhanced parliamentary or congressional oversight, aided by dedicated panels of experts and subject to ongoing scrutiny through the media. Drawing on our review of the literature and country studies, we apply an evaluation framework to assess various fiscal rules, individually and in combination. The framework includes criteria assessing both effectiveness and accountability. Effectiveness criteria include debt sustainability, counter-cyclical stabilization, flexibility in responding to shocks, and capacity to address deficit bias. Accountability criteria include the clarity of targets and definition, vulnerability to creative accounting, simplicity of implementation, accessibility for the public, and government controllability. Applying this framework shows that individual debt, expenditure, and budget balance rules have numerous strengths and weaknesses and that rules do not tend to fare equally well across those economic and accountability criteria. This analysis further suggests that a well-designed combination of rules may be optimal for achieving fiscal sustainability, because the combined effects of multiple rules are superior across the range of criteria to those of any individual rule. A combination of fiscal rules appears to offer the best chance of containing unsustainable growth of U.S. federal debt. These would impose binding constraints on total federal debt and aggregate expenditure in the near term, and require structural budget balance once debt is lowered to a more sustainable level. Given the relative strengths and weaknesses of each type of rule, a combination approach is expected to achieve better fiscal outcomes, where, for instance, the budget balance rule will provide the required countercyclical response that the debt rule on its own will not. Likewise, any inherent tendency for government to grow in size – something that the debt and budget balance rules fail to control – can be contained by a complementary expenditure rule. Success of the rules-based fiscal regime will require enabling reforms that ensure simplicity and accessibility for the public, policy credibility in responding to macroeconomic shocks, binding and effective mediumterm budgetary projections, and a strong enforcement regime.

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The recommendations are made with cognizance of the idiosyncrasies of the U.S. federal system. In the U.S., annual spending is determined not through a single ‗budget‘ but by the combined effects of direct spending legislations, discretionary appropriations, and occasional changes to spending or tax laws. Authority is divided amongst various institutions, which necessitates coordination and collaboration between different branches and levels of government. This has become increasingly difficult given a polarized political environment and the seeming chasm between the federal and state governments. The recommendations are listed below: a) A combination of fiscal rules should be used, including imposition of a numerical ceiling on the total federal debt-to-GDP ratio at 60% in the medium term, while aiming to return to the U.S. long-term average since 1940 at about 45%. b) Separately, federal expenditures should be limited to a range of values measured as percentages of GDP, while allowing flexibility for counter-cyclical fiscal policy. That is, spending should be allowed to move toward the ceiling in a recession, and toward the floor in an expansion. The rule should apply to total federal spending (mandatory and discretionary spending, and tax expenditures), but to avoid unnecessary volatility and deviations from the rule, it should exclude national emergency and extraordinary defence spending from the annual calculations. c) A structural (cyclically adjusted) budget balance rule should become effective as soon as the federal government has met its 60% debt-to-GDP target. This rule should have the same coverage as the expenditure rule. d) For effective enforcement, the administration should set and seek congressional approval to annual and medium-term debt reduction targets along with the annual budget legislation. The debt reduction target should be based on economic and fiscal forecasts for the budget year, while following a steadily declining linear trend in the medium-term. e) The President and Congress should reach agreement on how to address long-term priorities while sustaining the country‘s fiscal future. Specifically, they need to build consensus on how additional revenue would be generated, and how discretionary capital investments and/or entitlement spending would be curtailed, while balancing

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the spending trade-offs between social and economic productivity enhancement programs. f) To ensure continued credibility through the medium- and long-term, responsibility for determining how to apply the rules framework within the business cycle should be assigned to an independent and non-partisan body. One option would be to give this responsibility to the Congressional Budget Office, which has a reputation for independence as well as the required skill set to undertake the task. An alternative is to establish an independent Fiscal Policy Council, which would take information gathered by the CBO to provide independent fiscal aggregate setting and monitoring, congruent with the public interest. g) A Law on Fiscal Transparency should be passed, requiring that fiscal data for revenues, expenditures and financing be published every quarter. We propose that Congress spearheads the process to enable the public to discuss the current fiscal problems with their representatives. Ensuring transparency and accountability from an early stage would help sustain a rules-based fiscal regime. h) A multi-year budget plan is essential to meeting the required spending and debt targets. As recommended in Peterson-Pew Commission (2010), the President should be required to submit a medium-term budget that adheres to the legislated fiscal rules and would remain in place until it becomes necessary to adjust the plan to reach the debt target. Adherence to the recommended fiscal rules can be bolstered in three ways. First, as Peterson-Pew Commission (2010) has recommended, the President should report on compliance with fiscal rules to a joint session of Congress at the end of each fiscal year. The CBO and the Congressional Budget Committees would then review the President‘s report and use it as the starting point for any corrective action (i.e. adjustments to the multi-year budget plan). The reports of the proposed Fiscal Policy Council would add neutrality and credence to the discussion. Second, regular and sustained oversight from the media and the public would hold both the President and Congress accountable to the statutory fiscal goals. The President‘s report to Congress and progress reviews from CBO and OMB would increase public

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awareness of the state of the federal government‘s fiscal position and its medium- and longterm outlooks. Third, and as a final recourse to deter, or increase the political cost of violations by the Executive or Congress, deviations from the rules should automatically trigger independent reviews of the implementation of fiscal rules, including subsequent legislation. Oversight powers may be delegated to the Fiscal Policy Council, allowing for a comprehensive assessment of the fiscal rules‘ progress, while keeping intact the final decision-making powers of the President and Congress. Difficult decisions have to be made to strengthen the long-term fiscal health of the U.S. This review of international experience shows that with the right set of rules, an implementation anchored on transparency and accountability, sufficient political will from leaders and broad public support, the U.S. can avert its looming fiscal crisis and retrace its path back to sustained prosperity and growth.

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1. Introduction and Problem Statement 1.1 Introduction Fiscal policy in the United States is at a crossroads. At no other time since the Great Depression have decision makers faced such a difficult set of economic choices as they face today. Mounting federal debt, low revenues with an inefficient tax structure and high entitlement expenditures at a time of political division and economic distress will bring unprecedented challenges in the years ahead. Any decision is bound to be met with resistance, as it would mean short-term sacrifice by the political elite as well as the public. Policy experts in the U.S. have made known the critical importance of fiscal prudence. Calls for action and suggestions have come from prominent institutions such as the Peterson-Pew Commission on Budget Reform (2010), a joint committee of the National Academy of Sciences and National Academy of Public Administration, and broad crosscountry analyses such as that undertaken by the IMF (Kumar, et al. 2009). Officials from within the decision-making elite such as the Chair of the Federal Reserve Board have also made their views clear (Bernanke 2010). Underlying all these proposals is the need for political will to bring about hard and painful change. No change is possible without the will to do so. However, this report does not discuss how political consensus can be achieved for reforms, nor does it take into account the detailed reforms needed in health care or social security, nor give suggestions for changes to the budgetary process. Rather, the report proposes a framework for implementing a set of fiscal rules that would enhance the ability of the U.S. to prevent a future fiscal crisis based on insights from countries that faced large debts in the past and were able to prevent fiscal crisis. In essence, the framework is overarching and does not intersect with in-country debates on reforms, political consensus building or inefficient budgetary processes. The recommendations are informed by findings in respect of five European and South American nations, as well as by recent work of the multilateral financial institutions. The choice of the five countries (Brazil, Chile, Germany, Sweden, and Switzerland) is based on the diversity of their experiences, rather than on the extent to which they are representative of all countries that have been through a fiscal tightening process. Some may

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argue that experiences of these countries are irrelevant because their local contexts differ from that of the U.S. However, as will be detailed in Chapter 3, systemic weaknesses seen in other countries before fiscal management measures were put into place were not very different from what is currently seen in the U.S. There are, therefore, important lessons to be learnt from many smaller, but successful countries. This chapter explains the nature of the fiscal problem in the U.S. and shows how this justifies the need for a strong fiscal policy agenda in the U.S. The second chapter reviews the literature on fiscal rules, providing the theoretical foundation for recommendations. The third chapter documents the experiences of the five countries (Brazil, Chile, Germany, Sweden and Switzerland) and highlights the strengths and weaknesses of their fiscal rules. The fourth chapter provides an evaluation of the fiscal rules based on an analytical framework revolving around a set of nine criteria. The fifth chapter sets forth the recommendations to U.S. policymakers based on a proposed design that encompasses the learning of the previous chapters.

1.2 A Looming Fiscal Crisis in the United States Federal debt in the U.S. is estimated to be at 62% of GDP at the end of fiscal year 2010, having risen from 36% before the recession in fiscal year 2007 (CBO 2010a). The only other time U.S. debt-to-GDP went beyond 50% was at the end of World War II, when the federal debt was 109% of GDP. However, in the immediate aftermath of the war, the U.S. economy grew rapidly as the labor force was growing and inflation helped reduce the value of public debt (CBO 2010a). Similar conditions do not exist today. International experience indicates that recovery after a financial crisis will be slow given that the financial system has been hit. A large part of Federal government expenditure is driven by unsustainable commitments to Social Security, Medicare and Medicaid. As the population continues to age and average life expectancy improves, spending on healthcare and social security will continue to grow. Within 25 years, these programs would, if maintained, utilise all tax revenues. Health programs will be the most burdensome as spending on Medicare, Medicaid and others will double to 10.9% of GDP by 2035. The government will be compelled to

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either reduce the amount of healthcare or lower the cost of healthcare (Johnson and Kwak 2010). Primarily for this reason, with a current federal budget deficit of over $1.3 trillion (9.1% of GDP), the federal debt is projected to rise to over 69% of GDP in 2020 and 79% of GDP by 2035, according to the CBO‘s baseline scenario. Under an alternative scenario (CBO 2010b) – whereby the Bush tax cuts and limits to the alternative minimum tax (AMT) were to be extended, and annual appropriations were to grow in step with GDP as they do at present – the debt-to-GDP ratio would reach 185%. Dire projections, however, may be no more than mere conjecture, and financial markets may respond long before such numbers are reached. As Ben Bernanke, the Federal Reserve Board chairman notes: ―...fiscal adjustments sufficient to stabilize the federal budget will certainly occur at some point. The only real question is whether these adjustments will take place through a careful and deliberative process that weighs priorities and gives people plenty of time to adjust to changes in government programs or tax policies, or whether the needed fiscal adjustments will be a rapid and painful response to a looming or actual fiscal crisis.‖ (Bernanke 2010) The country‘s debt has increased sharply because of the stimulus measures taken since 2008 for economic stabilization. On the face of it, the deficit may decrease to about 4% of GDP once the current stimulus package comes to an end. But economic recovery has not been strong enough to suggest that further stimulus will not be needed (CBO 2010b). High debt levels will bring about several negative consequences. Firstly, debt servicing will reduce funds available for investment. Secondly, interest rates are more likely to rise, which would further hamper investment. Thirdly, government will find it increasingly difficult to respond to urgent fiscal needs through borrowing. (CBO 2010a) It is important to realise why acting now to contain the growth of debt is crucial, and understanding the potential consequences of inaction is key to this realization. High public debt shakes investor confidence, which causes interest rates to rise further increasing the value of debt, and so the cycle continues. Furthermore, high public debt will mean that traditionally low savings levels will persist and the country will depend more heavily on foreign capital. Finally, with a large trade deficit, the country will be caught between wanting to lower exchange rates to improve trade and the consequences that depreciation would have

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on capital flight. The effect will be compounded due to the continuing concerns about strength of the financial markets. To restore confidence, the government will be compelled to cut spending and increase taxes drastically, with severe repercussions for the economy. However, the current political environment is highly polarized and its players will likely defer such action. As a result, creditors lack the confidence that fiscal reforms will be undertaken, other than such changes as might emphasize short-term political gains. In essence, it is in the interest of the public to act now before the fiscal conditions further deteriorate. Continued escalation of debt levels will only make recovery more painful (CBO 2010a).

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2. Literature Review 2.1 Monetary vs. Fiscal Autonomy Governments in most developed nations have long divested themselves of the responsibility for monetary policy in what, for the profession, may constitute an uncharacteristically frank admission; namely, that elected representatives lack the disinterested objectivity to perform such a role effectively. The risks of endowing campaigning politicians with the power to set base rates or initiate quantitative easing are easy to appreciate. Independent monetary authorities operating at an arm‘s length from the political systems are commensurate with the notion that monetary policy is a positive issue, whereas the Executive is elected to make normative decisions. Fiscal policy, however, remains largely the domain of elected governments. Elections are won or lost on spending commitments, which necessarily advantage one constituency over another, and give preference to some political priorities over others. Such arrangements are commonplace and generally uncontroversial; more contentious, however, is the question of executive autonomy in regard to fiscal balance and debt position. Such decisions set the parameters for resource allocation decisions, which may be politically beneficial, but are highly critical for economic growth, stability and sustainability, the very impacts that justify putting monetary policy out of elected policymakers‘ reach. Compromise, however, between the complete freedom of fiscal autonomy, and the handcuffs of an independent monetary policy authority or central bank, has proven possible, and it is in this domain that we find an array of mechanisms to limit fiscal exuberance. These tools, which can take many forms, have come to be known, generically, as fiscal rules.

2.2 History/Trends While some examples of sub-national fiscal rules date back to the nineteenth century, they became more commonplace at the national level, in Europe and Japan, as part of postWWII stabilization initiatives (Kumar, et al. 2009). Later, in the 1970s and 1980s, take-up of fiscal rules regimes in Europe was part of a response to increasingly problematic deficit and

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debt (Hallerberg, Strauch and von Hagen 2004). Kumar, et al. (2009) also cites numerous examples of rules regimes, including: a) E.U.: Stability and Growth Pact (1997) b) E.U.: Maastricht Treaty (1992) c) Canada: Federal Spending Control Act (1991) d) U.S.: Budget Enforcement Act (1990) e) U.S.: Gramm-Rudman-Hollings Act (1985)

2.3 What are Fiscal Rules? Fiscal rules are binding principles that incorporate numerical targets, which are designed to limit government fiscal balance (or elements thereof), or to control public debt. Description of fiscal rules as a ―device to ensure fiscal discipline‖ captures perhaps two of the most vital elements of fiscal rules (Ter-Minassian 2007). They are a device in that they are more than purely a commitment; rather they are a commitment bound with a practical obstacle to breaking that commitment. They ensure fiscal discipline in a variety of ways, and are ordinarily designed to make indiscipline either difficult or impossible. Rules set limits variously on debt, spending, revenue or balance (or a combination thereof), but they do so in such a way that is designed to make breach a high cost strategy. Kopits and Symansky (1998) defined fiscal rules as ―permanent constraints in fiscal policy through simple numerical limits on budgetary aggregates‖ (Kumar, et al. 2009). While the framework of constraints is itself often permanent, and hardwired into political institutions, it generally allows some flexibility - for example, to withstand external shocks to public finances (design flexibility is discussed in more detail later in this paper). Rules can be introduced for various ends, not only for stabilising the fiscal aggregates (revenue, expenditure, deficit and debt), but also to make government more fiscally credible and their policies more sustainable (Kennedy and Robbins 2008). The former is important for the investment community both domestically and internationally; the latter to address important public objectives and to increase public confidence in the same. Fiscal rules can therefore be both politically and economically motivated and, at the same time, their absence may have both economic and political consequences. 11


2.4 Rationale in Support of Fiscal Rules 2.4.1 Intergenerational equity and the deficit bias Governments of the day are elected by those who pay taxes in the present. However, depending on the government‘s budget balance and net position, their spending programs may be funded by both current and future taxpayers. This can make for spending decisions with inequitable intergenerational outcomes, an inequity prolonged by the bias among elected policymakers to buy now, pay later. An IMF study conducted in 2000 suggests that the government short-sightedness means budgets will tend toward deficit by default, and that this factor justifies imposition of fiscal rules. The reason they may tend towards deficit is a matter of political calculation (Milesi-Ferreti 2000). The electorate consists of individuals with a variety of value systems (including the values they attach to self-interest and broader societal interest), with differing financial positions and capacity to withstand fiscal tightening, and with varying levels of education. Each of these factors is likely to influence an individual‘s reaction to fiscal discipline (or indiscipline) and, in the eyes of elected politicians, influence their voting patterns in response to fiscal stance. It is part of the politician‘s art to weigh up such factors when considering policy options. The survival choice the elected politician faces, then, is thus: will the net change in electoral response to tightening fiscal stance be more or less electorally beneficial than the net change following profligate spending commitments? If s/he estimates the benefits of exuberance to exceed those of prudence, the deficit bias prevails, as long as the rules of the game allow it (and where they do not, it is in any case of less concern to the lawmaker, as those constraints will apply equally to their political opposition). In this way, fiscal rules are not just a tool for safeguarding current generations of taxpayers against overspending by the elected leaders, but also a mechanism to protect the financial interests of taxpayers to come. This is not so much about not spending the children‘s inheritance, as not leaving them with unpaid bills.

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2.4.2 Fragmentation of budget decision costs and benefits In addition to inter-temporal deficit bias, a geographical bias may also creep into lawmakers‘ thinking. Where elected to represent a defined geographical area, the political outcomes for any given politician are likely to correlate with budget outcomes for their own electoral area. As noted by Hallerberg, Strauch and von Hagen (2004), this induces policymakers to place a higher value on the benefits of expenditure than might be warranted. They may, in particular, overestimate the return on local program expenditure, relative to the actual benefit gained at the aggregated national level. While fiscal rules do not address the momentum of such parochial pressures – local interests will continue to be pushed regardless of fiscal regime – still their implementation enshrines a discipline better suited to resist these pressures than voluntary discipline alone. 2.4.3 Market-like correction qualities While market forces may exert their own discipline on governments‘ fiscal stance, Kopits points out that this correction is ineffective due to the lag in market response time. It may be, for example, that capital flight will hold back until after a tipping point has been reached, a scenario hardly consistent with a self-adjusting equilibrium (Kopits, Fiscal Rules: Useful Policy Framework or Unnecessary Ornament? 2001). He also provides an argument that rules may be able to ―mimic market pressures in a more rapid and efficient manner‖.

This idea is compatible with the reality that those

imposing rules regimes, or at least their advisors, are likely to be informed by their neoclassical economic training when setting those rules. 2.4.4 Empirical evidence of their effectiveness Available evidence from a number of studies suggests there may be an empirical basis to the notion that rules improve fiscal performance. Kumar, et al. (2009) has summarised the key elements of these reports‘ findings, some of which are as follows: a) In the EU, stricter rules regimes are indicative of superior fiscal balance outcomes (adjusted for the cycle);

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b) Rules encompassing either an overall balance or debt-to-GDP ratio tend to have superior outcomes; c) The relationship between rules and fiscal discipline is stronger at higher than at lower levels of government; and d) Among the most effective characteristics of fiscal rules are those enshrining their basis in law, and those enforcing compliance.

2.5 Rationale against fiscal rules Opponents of fiscal rules are quick to point out the difficulty in implementing fiscal rules effectively. However, these are a practical rather than theoretical consideration, and we will address such concerns under the heading of implementation issues below. In addition to the practicalities, though, there are also theoretical arguments against the fiscal rules. 2.5.1 Information One of the key theoretical arguments against fiscal rules stems from their dependence on information which may be of questionable reliability. As noted by Lindh & Ljungman (2007), the lack of certainty surrounding economic indicators such as the output-gap may undermine their suitability for informing decisions around fiscal policy. The extent of this problem is likely to vary across economies depending on the accuracy of measurement tools and methodologies. Related to this is the question of information lags, and even where confidence in output-gap measurement is high, the data may become available with a delay. 2.5.2 Lack of flexibility The global financial crisis constitutes for many economies the most significant economic shock since the Great Depression. Those opposing fiscal rules may argue that such shocks can only be successfully navigated if fiscal systems are able to react flexibly to accommodate the rapidly changing indicators. However, this argument only goes so far, as most fiscal rules are designed with built-in flexibility. The level of flexibility is a matter for fiscal rule design and implementation considerations, rather than a solid argument against their introduction.

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2.6 Types of Fiscal Rules Fiscal rules generally fall under one of the four broad headings: debt rules, budget balance rules, revenue rules and expenditure rules. These are not mutually exclusive, and nations may adopt multiple rules simultaneously. This section gives an overview of this typology. 2.6.1 Debt rules Debt rules aim at tackling debt sustainability, and often set target ceilings for debt-toGDP ratio. As pointed out by the IMF research team, debt rule is flexible enough to deal with significant shocks when current debt levels lie sufficiently far below the ceiling which has been set. But when debt lies at or just below the set limits, the debt rule could induce a procyclical response by restricting new debt for stimulus programs. The rule does not provide adequate guidance for fiscal policy where debt lies far below the ceiling (Kumar, et al. 2009). 2.6.2 Budget balance (or deficit) rules Budget balance rules directly address the deficit bias over the current period, and can reduce government‘s capacity to over-commit. However, the budget balance rule would tend to have procyclical policy stance, increasing public spending in economic expansion and reducing it in recession. This rule may force cuts in investment, which can compromise future growth and will ultimately fail to guarantee debt sustainability. This approach would result in highly volatile spending if overall balance targeting were implemented (Hausmann 2004). Arguably, a more robust rule would allow for countercyclical fiscal policy, by imposing binding constraints on primary balance (i.e. balance net of interest payments) or structurally adjusted balance over the cycle (i.e. balancing budgets in the medium term, running surplus in the expansionary phase and deficit in the recessionary phase). Targeting an overall balance is not a preferable option for the Keynesian economist, particularly in emerging economies due to the fluctuation of government revenue and debt service. 2.6.3 Revenue rules

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Revenue rules aim to optimise revenue by setting floors and ceilings, but have no provision to constrain spending (Gutierrez and Revilla 2010). These rules are not commonly used around the world, concentrate more on boosting GDP than on controlling public debt, and therefore have limited impact on deficit bias if not applied in conjunction with other rules. The advantage of this rule type is its ability to limit procyclicality during expansionary periods, when governments may be tempted to simultaneously increase revenue and expenditure. 2.6.4 Expenditure rules Expenditure rules set permanent limits on current spending or limits expenditure as a percentage of GDP, while limiting the growth of the government beyond certain thresholds (Kumar, et al. 2009). These rules have the advantage of tackling one of the primary causes of deficit bias – namely, the tendency to increase program spending in new areas without cutting others. Application of this rule encourages governments to adopt medium-term planning in a way that forces a reduction in procyclicality. The expenditure rule can also help in fiscal consolidation when combined with debt or budget balance rules.

2.7 Design Considerations Policymakers across the globe have developed various perspectives on the applicability of selected rules, and these viewpoints owe much to the differing institutional and political frameworks of their respective nations. A well-designed rule will impose binding constraints accompanied by mechanisms to ensure the credibility of the fiscal policy, while allowing a government enough flexibility to deal with shocks and rare events (Kumar, et al. 2009). The European Union has seen two key design elements emerge: soft rules and hard rules. Soft rules involve setting parameter targets in an annual budget. Hard rules, meanwhile, refer to approval processes designed to achieve soft rules, the process itself intended to deter any deviation from main objective (Hallerberg, Strauch and von Hagen 2004). However, hard rules may only be effective when accompanied by effective enforcement tools.

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There is also another dimension to soft rules and hard rules. In the European Union‘s context, soft rules refer to prevention mechanisms, while hard rules emphasize sanction or threat to counteract a fiscal problem. The EU fiscal framework suggests that any law should be introduced gradually; starting with soft law and shifting to stringent enforcement when it is fully embraced by the politicians and monitoring institutions are in place (Schuknecht 2004). Another institutional consideration for fiscal rule design is the extent to which a nation‘s budget is a top-down process. Ljungman (2009) holds that, through such an approach, government can be more effective in fiscal policymaking. The top-down approach often entails a Ministry of Finance determining a ceiling for aggregate spending and allocation among major policy areas, before considering the intra-sectoral allocation (i.e. to government agencies). By adopting this approach and implementing cost-benefit analysis for projects, governments can align expenditure with priorities (Ljungman 2009).

2.8 Implementation Issues According to Anderson & Minarik (2006) the successful implementation of a fiscal rule is largely a function of its simplicity, and of its transparency and resistance to manipulation. In regard to the former point, simple rules are more intuitively accessible to the average voter, their contravention is also easier for political opposition to bring to the electorate‘s attention; in regard to the latter, creatively accounting one‘s way out of compliance is more challenging where rules are more transparent. In this respect, as noted by Schuknecht (2004), it is important to ensure that rules are enforced based on political and social support. Dur, et al. (1997) argue that fiscal rules, even with the best of intentions, could lead to unintended consequences for infrastructure investment. Their idea is that capital investment for establishing and renewing infrastructure must compete for funding with other programs, often programs whose benefits will be more fully beneficial to the current generation, whereas infrastructure capital investment would benefit current and future taxpayers. Foregoing infrastructure spending for redistributive programs may, therefore, be a way for policymakers to circumvent the restrictions placed on the deficit bias by fiscal rules.

17


Creative accounting has been an issue, certainly in the U.S. For example, the states with constitutional ceilings on debt, as noted by Bunch (1991), exploit the non-government status of public authorities to exceed these limits; furthermore, ceilings on debt underwritten by the states, as highlighted by Kiewiet and Szakaty (1996), do not prevent states from building up debts which are not guaranteed (Milesi-Ferreti 2000). Kopits (2001) further points out those practices in Italy and the Netherlands have not inspired confidence in fiscal rules, with the constitutionally bound fiscal rule in the former being far too broad to pin governments down. Other examples where rules have been bypassed include: medium-term fiscal initiatives of the 1980s, including the Gramm-Rudman-Hollings Act in the U.S., as noted by Kopits (2001); and France‘s success in reducing its deficit by 0.5% of GDP in 1997, by securing a one-off payment from its national telecom utility, France-Télécom, in exchange for the government accepting liability for the enterprise‘s superannuation liabilities – the compensation was structured in such as way as to contribute to budget balance (Milesi-Ferreti 2000).

18


3. Fiscal Rules in Brazil, Chile, Germany, Sweden and Switzerland: A Synthesis of Findings 3.1 Background A growing number of countries have adopted rules-based fiscal management in recent years. A recent survey by the IMF notes that 80 countries have imposed fiscal rules on their central governments (Kumar, et al. 2009). Meanwhile, the economies of the European Union have resorted to supranational fiscal rules under the Stability and Growth Pact (SGP) of 1997. The recent global financial crisis put further stress on fiscal aggregates as governments have had to respond to the recession through large stimulus plans, mostly financed by issuing new debt. The emerging trend manifests the growing need and recognition among countries to anchor expectations for sustainable public finance through rules-based frameworks. For the purposes of this study, we chose five countries with notable experience of fiscal rules. Other elements considered in the selection process were the types of government institution, history of fiscal imbalances, types of fiscal rule, size of the economy, and relevance to the U.S. political and economic context. Clearly, the U.S. economy and institutions are rather idiosyncratic and have little in common with those of most other countries. As a result, any fiscal rules which have worked in other countries might not be readily transferable to the U.S. and may require considerable adjustment and fine-tuning. Yet, as is the case for most other nations, U.S. fiscal policy and budget institutions are also exposed to the well known and widely prevalent systemic weaknesses such as deficit bias, election cycles, short-term budgeting, the common pool problem, lack of oversight and deficiency in enforcement of fiscal discipline. The following subsections represent a synthesis of our country studies, broken down into analyses of debt rules, budget balance rules and expenditure rules, in addition to complementary reforms in fiscal transparency and institutional oversight. Revenue rules are not covered by the analysis as none of those countries included in our study has adopted such rules, perhaps because political processes have built-in mechanisms to contain revenue growth, and lower revenues can be addressed through the expenditure, budget balance and debt rules. Lessons from the country experiences with fiscal rules help envision some

19


plausible options, which are subsequently discussed for application in the U.S. to facilitate reduction of fiscal debt.

3.2 Debt Rules Considering the centrality of public debt, many countries have adopted rules to maintain public debt at sustainable levels. In the case of the five studied countries, three have adopted debt rules. Chile and Switzerland do not have explicit rules to control debt, as their budget balance rules aim to generate surpluses and deficits that offset each other over the cycle. Germany and Sweden have adopted debt rules that are enforced at a supranational level as part of the European Union‘s Stability and Growth Pact (SGP) of 1997. The SGP sets a debt ceiling at 60% of GDP along with a budget balance at 3% of GDP. The SGP covers the (consolidated) general government debt. GDP is used as the reference point because, firstly, it is the best estimate of a country‘s national income during the year and a proxy of the income against which debt is obtained, and secondly its expansion and contraction over time call for corresponding loosening or tightening of public debt. Brazil‘s Fiscal Responsibility Law sets debt-to-revenue limits for different levels of government: 3.5 times at the federal level, 2.0 times at the state level, and 1.2 times at the municipal level. Pegging debt-to-revenue flows is in line with commercial practice, where lenders make loans to individuals and firms according to their ability to repay, as reflected in the borrower‘s disposable income and cash flows. Instituting debt rules itself, however, does not promise maintenance of debt at sustainable levels. The country studies suggest that compliance by governments, traditionally known to be susceptible to time-inconsistent fiscal policies leading to unsustainable debt levels, would not be forthcoming unless strict enforcement regimes are put in place. In the case of the E.U., fiscal performance of the member countries, including compliance with debt and budget balance rules, is monitored by the E.U. Economic and Financial Affairs Council (Ecofin). The council reviews members‘ performance on a quarterly basis, and writes warning letters to non-compliant Member States, giving them time to address the violation. If non-compliance persists, however, Ecofin has the authority to impose pecuniary penalties.

20


In practice, Ecofin has abstained from imposing fines, despite recurring violations by several Member States including Germany and Sweden. In the wake of the recent fiscal crisis in Greece, Spain, Ireland, the E.U. is overhauling the SGP toward stronger enforcement and harsher penalties for violation of fiscal rules, including fines and even suspension of a state‘s E.U. membership. This has coincided with the development in several Member States of national fiscal rules and establishment of independent fiscal policy councils (e.g. Sweden, Germany, Switzerland) to monitor performance and enforce compliance. Brazil has strict enforcement mechanisms. Its Fiscal Responsibility Law holds governments and public officials responsible for violations, and provide for the imposition of fines as well as imprisonment. This partially contributed to the considerable improvement in Brazil‘s fiscal performance, with public debt declining from around 80% of GDP in 2004 to 66.8% in 2010 (IMF World Economic Outlook Database 2010). The credibility of rules will not be adversely affected if they allow for exit clauses which enable a government to exceed preset targets to address emergency situations induced by external factors, such as natural disasters or economic and financial crisis. Although the E.U. SGP, at the supranational level, does not have exit clauses, Ecofin does have discretion and flexibility in determining whether a violation warrants the issue of warning letters or imposition of penalties on Member States. At the national level, however, German and Swedish parliaments can allow their respective governments to breach the debt rules, in extremis, requiring them to submit an amortization plan specifying the expected breach period and steps that should be taken to return public debt within prescribed bounds. In Brazil, where there is a 1% reduction in GDP, parliament may opt to allow the government to breach the target limits for a specified period, though only after the government commits to a plan to return public finances to within permissible limits. Despite the existence of the SGP, Germany has frequently violated the debt rules. There was a prolonged recession at the dawn of the century, and Germany‘s public debt-toGDP ratio had exceeded 60% for several years, and currently stands at around 75%. Bound similarly by the SGP, Sweden has demonstrated impressive performance. It reduced its debtto-GDP ratio from a peak of 73% in the 1990s to about 42% in 2009. Switzerland, although not subject to the E.U. SGP, has reduced its debt-to-GDP ratio from 55% in 2003 to below 40% in 2010. Brazil, meanwhile, has reduced its debt-to-GDP ratio from around 80% in 2002

21


to about 69% in 2009, while Chile‘s commodity price boom has helped it maintain a debt-toGDP ratio well below 10%.

3.3 Budget Balance Rules A balanced budget over a business cycle is defined as ―zero budget deficit‖ on average in all states of economy. This implies that over a business cycle, the expenditures of the government should be equal to its revenues. However, in our country analyses, we have observed that different governments have different interpretations of what is classified as expenditure. Germany differentiates between current and investment spending and excludes the latter in the balanced budget equation. Switzerland and Brazil exclude extraordinary or unexpected expenditures (e.g. natural disasters) to achieve balanced budgets by treating such expenditures as off-the-balance-sheet items. Conversely, the Swiss debt brake rule was amended to include extraordinary spending as of 2010 (IMF 2009). Finally, Brazil limits only primary expenditures in balancing the budget. In our country studies, the key observation about budget balance rules relates to coverage. It was noticed that whereas Chile only applies its budget balance rule to central government, Brazil and Sweden also include state and municipal governments and Germany goes ]further to include government enterprises. These varying scopes are determined by a number of factors, including the power of central government, government structure and the level of political commitment. Switzerland, Germany and Chile have gone a step further and introduced a more specialized version of balanced budgets, referred to as ―structural budget balance‖. Structural budget balance is a countercyclical tool that takes into account the state of the business cycle in making budgetary decisions. The cyclical factor is calculated differently by each country but it usually reflects the state of the economy as a ratio of the level of trend real GDP to expected real GDP. The goal of this countercyclical rule is to allow for a deficit in case of a recession to be compensated by a surplus in a booming economy within a business cycle. The structural balance rule introduces automatic stabilizers which ensure that savings made in economic expansions are used to support the deficits in recessions. In the Swiss case, an ―adjustment account‖ provides the means by which surpluses can compensate deficits during recession. With the adoption of the ―debt-brake‖ rule in 2003, Switzerland achieved a 22


structural balanced budget in 2006, one year earlier than expected, and surpluses continued until 2009 (Swiss Federal Finance Administration 2010). However, determining business cycles with accurately and credibly is complex. Whereas Chile has achieved a high standard in this field, a number of other countries are still struggling in this regard. Another noteworthy observation regarding the budget balance rule is the concept of structural rigidities. Investments in funds such as pension schemes and unemployment benefits is considered a best practice approach to avoiding budget imbalances. In our study, it was noticed that all countries,except Brazil, have an ageing population and anticipate high expenditure on pension funds in the future. Countries which made use of structural balance (e.g. Chile) were more disciplined in saving money in specialized funds. This is a useful step towards achieving fiscal discipline. For example, in the case of Chile, savings accumulated in good times are being invested in specialized funds referred to as the ‘Pension Reserve Fund‗ and the ‘Economic and Social Stabilisation Fund‗ to better prepare the nation for fiscal responses in the future. Brazil has adopted a similar approach since 2008, and its fiscal savings are now deposited with the Sovereign Wealth Fund.

3.4 Expenditure Rules Expenditure rules set permanent limits on total, primary, or current spending in absolute terms, growth rates, or as a percentage of GDP. For Brazil, expenditure limits apply to a specific subset of expenditures, i.e., total personnel expenditures. In Sweden, ceilings apply on primary expenditures but different caps are set for individual program areas, while Germany caps its nominal expenditure growth rate. Chile has no direct limits on expenditures whereas Switzerland‘s expenditure limit is focused more on achieving its structural budget balance target (discussed earlier under budget balance rules). Brazil capped spending on total personnel expenditures as part of measures to address state governments‘ over-indebtedness in the 1990s. The states‘ payroll expenditures surpassed 80% of their current revenues during that period while debts grew at an average rate of almost 40% yearly (Melo, Pereira and Souza 2010). The enactment of the expenditure rule under the Fiscal Responsibility Law in 2000 resulted in a decline of personnel expenditure from over 70% of total expenditure to an average of 40% after 2000 (Luporini 2010). 23


In Sweden, targeting a ceiling on the central government‘s primary expenditures three years in advance, coupled with the nation‘s bi-annual monitoring approach, shows a mediumterm outlook that helps prevent debt consolidation in the future. In the absence of specific legislative provisions to underpin the rules, Sweden‘s strong ongoing political commitment to fiscal discipline has effectively institutionalized the arrangements. Since its introduction in 1996, Sweden has never breached the expenditure ceiling. For Germany, the limit on the nominal growth rate of expenditures was agreed upon on a yearly basis by the Financial Planning Council in the early 1980s.

In 1990, the

maximum limit was set at an average of 1%. This ceiling was breached in 2002, during a period of stagnation. In 2007, the rule became such that the growth rate of expenditures should be lower than that of revenues. Data shows that Germany‘s yearly deficit has been declining since 2004 from -3.8% to a surplus of 0.038% of GDP in 2008. (Please see Appendix 1.) Another area of concern affecting fiscal position is tax expenditures. Tax expenditures are a commitment of fiscal resources carried out through tax legislations, regulations and practices that reduce or defer taxes for some taxpayers (Villela 2010). From a policy development point of view, these are state intervention tools providing similar results to direct public spending. The concern, however, stems from the substantial foregone revenue costs which tax expenditures can represent. Further, tax expenditures are not integrated into the budget process and thus are not subject to the same review and scrutiny applied to expenditure budgets. Best practice suggests that tax expenditures should be included in the budget process and either fall within the expenditure limits or have specific limits applied to them (OECD 2010). Of the five countries, Brazil‘s Fiscal Responsibility Law is explicit that whenever a new tax expenditure is proposed, it should be accompanied by fiscal compensation measures; tax expenditures are then reported and integrated within the draft budget legislation. Germany‘s Federal Cabinet 2006 Guideline specifies that tax expenditures should be time limited or should decline over time. For Sweden, although it has no explicit rule on any tax expenditure limit, its budget process includes the presentation of a tax expenditure report, explicitly pointing out revenue and distributional effects, as well as the purpose of the new

24


tax expenditure. Similarly, Chile‘s tax expenditures are part of the Informe de Finanzas PĂşblicas (Public Finances Report) that accompanies the draft budget legislation. In cases of expenditure overruns, Brazil has corrective measures in place under its Fiscal Responsibility Law, with sanctions and penalties for non-compliance. Similarly, Sweden has explicit procedures to address the deficits within a specific timeframe, although no specific sanctions are given. For Germany, there is no pre-defined action for noncompliance.

3.5 Use of Creative Accounting To be seen as abiding by the numerical fiscal rules, governments resort to creative accounting and off-budget operations. In Brazil, personnel expenses were wrongly classified as income tax deductions or pension payments. In Sweden,

expenditure ceilings have

reportedly been circumvented by manipulating the timing of payments and recording of expenditures. In computing the Swiss budget balance, extraordinary expenditures (e.g. disaster relief) were excluded from the expenditure limit under the debt brake rule. Strong transparency rules can minimize creative accounting. Brazil, Sweden and Switzerland already have in place appropriate institutions and enforcement mechanisms. The increase in extraordinary expenses to CHF 11 billion as of 2008 prompted the Swiss authorities to include the expenditure limit under its structural budget balance target effective 2010.

3.6 Fiscal Institutions The effectiveness of fiscal rules depends as much on their design as on their application, which is contingent upon the structures in place to oversee budget preparation and approval processes and monitor the enforcement of the fiscal rules. In all five countries studied, government budgets are prepared by the executive branch of the government. The process is highly centralized, whereby the most senior executives determine the priorities of various expenditure programs. In Brazil, the federal government is

25


vested with power under the Fiscal Responsibility Law to propose limits for debt ceilings. To ensure that the budget is based on a fair assessment of the prevailing economic conditions, Chile relies on the Panel of Output Growth to determine the growth rate of each of the three variables necessary for the calculation of trend output for the following five years: total factor productivity, investment and the labor force. As the country‘s economy is significantly affected by its copper exports, there is a Panel for Copper Prices to provide objective estimates on the average copper price for the following ten years. The budget preparation process of Sweden is divided into two steps: first assessing the economic conditions of the country, then finalizing the detailed budget. The Swedish Fiscal Policy Council is invited to provide independent comment on the administration‘s proposals before Parliament‘s approval is sought. The Council has eight members with six academic economists, two ex-politicians, and two foreign experts. Although it is a body appointed by the Swedish administration for a fixed term of three years, the Council is respected for its impartiality in assessing business cycles, evaluating the government‘s economic forecasts, and in providing ex-ante opinion on the effectiveness of the proposed budget and economic policy. It is highly regarded by the public and the Swedish Parliament. Budgets prepared by the administration are similarly submitted to the legislature for approval in all the five countries. It is however interesting to note the difference in authority granted by law to the legislative bodies. In Brazil and Switzerland, the legislature has unfettered power to amend the budget subject to adherence to the fiscal rules but in case of the former, the President has a veto power. In Sweden, the Parliament is more powerful; besides full authority in amending the budget proposed by the administration, it has the authority to set a ceiling on each expenditure area, to which the administration must adhere. In contrast, the power of the Chilean Congress is limited. It may either approve or reject a budget proposed by the administration, but it has no authority to vary revenue estimates, to increase expenditure or to reapportion any allocations from one program to another. In approving the budget, it can only reduce expenditure items which are not designated by legislation. Moreover, its power is confined by a tight time-frame. According to the Chilean Constitution, the Congress has only 60 days to discuss and pass the budget, beyond which the administration‘s original budget proposal becomes law.

26


Monitoring of the budget execution is necessary for fiscal rules to follow through. All five countries have audit offices. It is interesting to note the super-power granted to the Tribunais de Contas da União in Brazil. It can impose sanctions in respect of illegalities of expenditures or irregularities of accounts. In the case of Sweden, its Fiscal Policy Council also plays an important role in evaluating how the administration has achieved its fiscal policy objectives in the previous year (an example of ex-post evaluation). Germany is in the process of setting up a Stability Council to monitor public finances and issue early warnings with regard to possible deviations from projected performance.

3.7 Transparency Rules Ensuring transparency increases the effectiveness of fiscal rules. Transparent rules clarify budget choices, enhance public understanding of those choices, and encourage recognition by policymakers of the broader fiscal consequences of their decisions (Bernanke 2010). The study involved an assessment of the five nations‘ transparency rules per se, as well as of how these were applied in practice. The evaluation was based on the following criteria: the establishment of rules focusing on transparency; the extent of fiscal management oversight; the availability and quality of information to the public; the involvement of independent panels of experts in the fiscal management process; and other relevant measures of transparency. A strong legal basis requiring transparency in fiscal management enhances the design features and increases the beneficial impact of fiscal rules. While each country under our analysis follows guidelines on the budget process, only Brazil has established a law with specific provisions to ensure transparency in fiscal management. Brazil‘s Fiscal Responsibility Law enforces responsible fiscal management by providing rules for transparency, control and oversight, while setting clear guidelines on the Audit Courts under the Legislative Branch, providing a solid platform for the enforcement of Brazil‘s fiscal rules. Providing timely and comprehensive information to the public facilitates policy analysis and promotes accountability. Fiscal information on public debt and budget documents are made available to the public in all five countries, as required under their existing regulations. Most of these documents are issued in electronic public media and can

27


be accessed through government websites. In addition, their availability is enhanced through subscription to the respective IMF Special Data Dissemination Standard (SDDS). Public availability of information is explicitly stated in the Fiscal Responsibility Law of Brazil. The legislation also encourages public participation by requiring the government to hold public hearings during preparation and discussion of the plans, budgetary directives, laws and budgets. In the case of Chile, an estimation methodology for the structural balance rule is published, as are statements identifying the members of expert panels (Panel for Output Growth and Panel for Copper) and documentation of the panels‘ findings (IMF 2003a). Information on the funds created under the Fiscal Responsibility Law (Pension Reserve Fund and Economic and Social Stabilisation Fund) is also made publicly available on a quarterly basis (Oxford Analytica 2006). Transparency is enhanced through institutions that monitor the fiscal management process. All five countries have supreme audit institutions authorized to scrutinize fiscal conduct and investigate the accounts of government bodies.

On top of this, separate

institutions were established to monitor public finances and oversee the implementation of fiscal rules in countries. For Brazil, the Fiscal Responsibility Law explicitly authorized the Legislative Branch (directly or through the Audit Courts and the internal control system of each Branch and the Head of the Office of Public Prosecutor) to inspect compliance with the fiscal rules.

The National Audit Court (or Tribunal de Contas da União (TCU)) has

constitutional power to judge and impose penalties on budget organisations for irregularities, errors, abuses, mismanagement, and waste of public resources. (Oxford Analytica 2005). Brazil‘s Fiscal Crimes Law of 2000 complements the penalties under the Fiscal Responsibility Law to deter misrepresentations on fiscal management and improve credibility and quality of information. For Germany, the establishment of a Stability Council is under consideration to control the fiscal policies of all tiers of government. However, it seems to lack independence from the Executive Branch, as it will be composed of the federal finance minister, finance ministers of the state governments, and the federal economy minister (Feld and Baskaran 2009). Participation of experts independent of the government improves transparency and the credibility of fiscal information. The cases of Chile and Sweden have been discussed in the preceding section. The Swiss political system gives its citizens the right to vote on changes in tax legislation, allowing for direct participation with regard to fiscal policy. The debt brake

28


rule was enacted through a change in the Federal Constitution, approved by 84.7% of voters in 2001 (Bodmer 2006). Among the mechanisms employed by the Swiss in participating in policy decision making are popular initiatives and referendums. With signatures of 100,000 people collected within 18 days, a popular initiative can initiate a change of the Federal Constitution. On the other hand, people can voice their disagreement through a referendum with 50,000 signatures collected within 100 days of publication of the new legislation. It is similar to a veto, wherein amendments adopted by parliament or the government can be blocked, thereby delaying final policy decisions. (Swiss Confederation 1999). For Chile, clear guidelines are set in the Fiscal Responsibility Law regarding the use of fiscal savings (i.e. capitalization of the Central Bank, contribution to the Economic and Social Stabilization Fund, and voluntary debt repayment). This reduces policy discretion and provides information to the public on how fiscal savings are utilized.

3.8 Conclusion The country analysis suggests that, even though countries are increasingly moving from discretionary to rules-based fiscal regimes, the impacts on fiscal outcomes have remained mixed. Switzerland, Sweden and Chile are among the high-income countries which have evolved fiscal rules by imposing constraints on deficit, debt and expenditure either through supranational frameworks (Sweden E.U. SGP 1997) or through national fiscal rules (Switzerland 2003 and Chile 2000), or a combination of both (Sweden 2007). Even though Germany and Brazil also have adopted fiscal rules (the supranational E.U. SGP 1997 in Germany and Fiscal Responsibility Act 2000 by Brazil), the impact on their deficits and debtto-GDP ratios has been neutral at best. Many countries have used a combination of rules rather than a single rule: the debt, budget balance and expenditure rules of Germany, Sweden and Brazil and debt and budget balance rules of E.U. SGP. Although debt and budget balance rules keep the most important indicators in check, while allowing fiscal policy flexibility, these may not be effective in containing expenditure growth and structural rigidities. As the deficiencies of the E.U. SGP suggests, a credible rules-based framework requires independent monitoring of government

29


compliance and the imposition of penalties to deter deviations from fiscal rules. A rulesbased regime must also contain escape clauses to help ensure transparency when a government is unable to comply with fiscal rules in extraordinary macroeconomic or national disaster situations. Under such situations, the statutes (notably in Brazil, Germany and Sweden) require parliamentary approval along with specification of steps and timeline to return to full compliance. Alongside the numerical fiscal rules, the five countries have also implemented or introduced complementary institutional and structural budgetary reforms. These include adoption of medium-term budgetary frameworks to improve predictability and transparency of the budgetary aggregates, top down budgeting where aggregates are set either by independent experts (Chile, Sweden and Germany) or the central Ministry of Finance, and enhanced parliamentary or congressional oversight aided by dedicated panels of experts and media.

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4. Evaluation of Fiscal Rules 4.1 Introduction Having explored on-the-ground application of various fiscal rules in the five country studies in the previous chapter, the current chapter turns to evaluation of fiscal rules in the broader sense. Drawing on the issues explored in earlier chapters, this section draws up an analytical framework for evaluating fiscal rules. It begins by explaining the criteria employed and its rationale, and then uses the framework to score individual rule types. The scores are then used to compare individual rule evaluations, following on to exploring the effects of combining rules. The section concludes by advocating a combination of three rule types: a debt rule, expenditure rule, and balanced budget rule.

4.2 Analytical framework 4.2.1 Multiple approaches When evaluating fiscal rules, a variety of evaluation methodologies and criteria preferences may be considered. In an October 2010 speech to the Rhode Island Public Expenditure Council, Federal Reserve Chairman Ben Bernanke noted that a fiscal rule should be transparent; be ambitious in dealing with the problems it seeks to address; comprise factors within the government‘s control; and be accompanied by adaptive political leadership and public education. Anderson and Minarik (2006) cited a range of possible criteria, including: government control over debt; credibility; transparency; ease of implementation and enforcement; and political viability. They also said that: ―Because of the multi-dimensional objectives of fiscal rules, the apparent superiority of any rule on the basis of one criterion is not a sufficient justification for adoption.‖ In the evaluation of the existence of a link between numerical fiscal rules and budgetary outcomes of its Member States, the European Commission provided an assessment of the individual rule types with respect to the different possible economic objectives,

31


including the effect on the deficit bias; effect on macroeconomic stabilisation; effect on the quality of government finances; and other properties. Cottarelli (Kumar, et al. 2009) explored the properties of fiscal rule types with respect to debt sustainability, economic stabilization and government size. He further commented that an effective fiscal should: consistently link set targets and policy objectives; remain flexible enough to accommodate short-term, unforeseen shocks; and be accompanied by a corrective enforcement mechanism. Whichever criteria are employed, however, potential always exists for contradiction between different rule criteria, and some trade-off may be necessary. For example, a rule that contributes to economic effectiveness may need to be adjusted on an ongoing basis to account for economic cycles, and is therefore likely to be characterised by complexity. That same complexity, however, may cut across transparency and simplicity objectives. However, modifying the rule in favour of simplicity, for example by moving from a cyclically adjusted budget balance rule to an overall budget balance rule, may result in a rule which everyone understands but which is too rigid to be economically effective. 4.2.2 Assessment criteria Having considered the above and other works (some of which are commented on in Chapter 3), and the lessons from the five country case studies, this paper chooses to score rules according to nine criteria falling into the categories of economic effectiveness and transparency, simplicity and accountability. The criteria within these categories (four in the former, five in the latter), and the rationale for choosing them, are as follows. 4.2.3 Economic effectiveness criteria Fiscal sustainability This is defined as the continuing ability of government to sustain budget commitments flowing from current or anticipated policies. The principal operational test is whether revenues and spending are projected to remain closely aligned on average over a long period, so that debt stabilizes or declines as a percentage of the economy.

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Counter-cyclical stabilization This is the facility of a rule to peg deficit spending as expansionary gaps open up, and to permit deficit spending at the onset of recessionary gaps. Where possible, a rule‘s target levels should be flexible to allow for the business cycle, not only to accommodate a looser approach in leaner times, but also to enforce higher levels of discipline during surplus periods. In that manner, it will fund higher recessionary spending and take some steam out of an expansionary economy. Flexibility in responding to shocks In the wake of external price shocks or financial crises, rules with limited flexibility may exacerbate adverse impacts on growth. Inflexibility can be both an intrinsic property of a fiscal rule‘s structural or cyclical nature, as well as a design consideration (i.e. the decision as to whether to include an escape clause). Capacity to address deficit bias As the political benefits of deficit for lawmakers exceed the political costs it incurs, a bias toward deficit spending tends to prevail. While addressing this intrinsic behavioural tendency is beyond any fiscal rule, an appropriate fiscal rule framework would subdue the tendency of running up deficits indefinitely. By setting long term targets that bind future governments in advance, this criterion rectifies the bias. It also reduces the political pressure on the government for cutting down public expenditure or increasing taxes. 4.2.4 Transparency, simplicity and accountability criteria Clarity of target definitions Those portions of debt, expenditure and revenue to which targets pertain should be clearly defined and consistently applied (escape clauses notwithstanding). If targets and other important constituents of a rule are not clearly defined, there will be ambiguity in interpretation; if the definitions are not consistently applied, the trajectories tracking will be undermined.

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Vulnerability to creative accounting This factor is an assessment of the degree that a rule is exposed to manipulation in terms of misinterpretation or circumvention in the course of implementation. By nature some fiscal rules are more prone to manipulation and circumvention but it can also be a design and institutional issue. Simplicity of implementation This criterion relates largely to measurability. Where a rule comprises straightforward and undisputed components, it may not be easy to achieve, but its success should be easy to measure. However, where a rule involves an equation with terms that are subject to time lags or measurement difficulties, its relative effectiveness will be hard to accurately capture. Accessibility for the public Some fiscal rules are easier for the lay persons to understand than others. A rule with high accessibility will be easier to sell at point of introduction. It also makes it harder for lawmakers to obfuscate over whether targets have been met. Government controllability Success against fiscal rule targets is influenced by factors more firmly within the government‘s control, such as expenditure, as well as factors which are subject to economic growth rates, such as revenue. The extent to which success against any rule target can be effectively managed by government should, therefore, be considered.

4.3 Evaluation of Rules with the Analytical Framework 4.3.1 The framework Having established the criteria against which we will evaluate the rules, we now present those evaluations in tables 4.1 and 4.2. Each rule is evaluated against each criterion under ‗economic effectiveness‘ and ‗transparency, simplicity and accountability‘ respectively. A score between 0 (for poor) and 3 (for high), is given in each box, and a short rationale for each score is also given.

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The rules evaluated are debt rule, expenditure rule and budget balance rule. The first two are evaluated generically, such that the score may apply to slightly different versions of debt and expenditure rule. With the third however, where appropriate a separate score and evaluation is given for differing types of budget balance rule, e.g. overall budget balance rules (which are straightforward and rigid) versus adjusted balance rules (with structural or cyclical flexibility), or versions of either rule where debt repayment is included or excluded, since all these factor variations hold different properties and often lead to quite different outcomes. 4.3.2 Summary findings Debt rules - key strengths The debt rule‘s greatest strength lies in its ability to tackle debt head on. Where debt management is the main objective, a debt rule is designed to keep delivery against this objective on track. Debt rules are quite easy to understand for the public, and have a low vulnerability to creative accounting; even where ways and means have been found to move expenditures off budget, it is a more significant challenge to declassify the contribution of any such spending to aggregate debt. Debt rules - key weaknesses These rules tend to be pro-cyclical. When expansionary gaps open up, increases in GDP may reduce the debt-to-GDP ratio, thus improving a nation‘s performance against the rule by default, and opening up scope for further borrowing within the confines of the rule, even at a time where it is not warranted. A recessionary gap may have the opposite effect; a drop in GDP increasing the ratio, further reducing scope for borrowing, at a time when borrowing may not only be justified but prudent. Expenditure rules - key strengths These rules contribute more fully to simplicity and transparency than to economic effectiveness. They are easy for the public to understand, and they more intuitively symbolize fiscal restraint than a budget balance rule (which still allows for profligate spending if accompanied by heavy taxation).

35


Expenditure rules - key weaknesses Spending rules can, however, be ineffective and lead to suboptimal economic results because they ignore revenues; so spending caps can be met but debt can still rise. The problem becomes further complicated if interest payments are excluded from the rule, given their volatility. Moreover, spending rules pegged to GDP will move procyclically unless they are allowed to fluctuate counter to the economic trend.

TABLE 4.1: RULE PERFORMANCE IN ECONOMIC EFFECTIVENESS

FISCAL SUSTAINABILITY

DEBT

EXPENDITURE

BUDGET BALANCE

RULE

RULE

RULE

(3)

(1)

(3)

Debt rule directly tackles

Less effective in

a) (with debt) Can help

the cumulative debt

reducing debt since debt

check the growth of debt

burden. It is effective to

repayment is not

where repayment of debt

ensure convergence to a

included, and does not

is included as an

debt target.

prevent increase in

expenditure item

revenues.

(2) b) (without debt) Less effective in reducing debt where debt repayment is not included.

(0)

(2)

(0)

Debt rule is inherently

Expenditure rules can be

a) (overall balance) As

pro-cyclical: during

designed to be counter-

the overall balance rule

recession when debts are

cyclical by cyclically-

(―golden rule‖) is closely

needed, the ceiling

adjusting expenditure

tied to GDP performance,

imposed by the debt rule

caps according to the

it is pro-cyclical in nature.

COUNTER−

prevents the government

projected economic

CYCLICAL

from borrowing; during

situation.

STABILIZATION

(3)

expansion when GDP

b) (structural balance) If

grows and hence the debt

the rule is set to balance

ceiling is higher there is,

the budget over a cycle or

however, less need to

to balance structurally, it

borrow.

may carry a countercyclical effect.

36


(0)

(0)

(2)

No inherent capability to

No inherent capability to

Structural balance budget

respond to economic

respond to economic

mitigates effects of

shocks and business

shocks and business

shocks by initiating both

conditions (escape clause

conditions (escape clause

revenue and expenditure

notwithstanding)

notwithstanding).

stabilizers.

(2)

(1)

(3)

The rule prevents deficit

It indirectly addresses

Budget balance rule

CAPACITY TO

bias by setting limits to

deficit bias.

directly addresses deficit

ADDRESS DEFICIT

debt accumulation when

bias. Efficacy depends on

debt levels are higher than

aggressiveness of the

target levels.

targets and design of the

FLEXIBILITY IN RESPONDING TO SHOCKS

BIAS

rule.

Key:

0 - poor

1 - partial

2 - moderate

3 - high

TABLE 4.2: RULE PERFORMANCE IN TRANSPARENCY, SIMPLICITY & ACCOUNTABILITY

CLARITY OF TARGET DEFINITIONS

DEBT

EXPENDITURE

BUDGET BALANCE

RULE

RULE

RULE

(2)

(3)

(2)

Give a clear and

The definitions are

The definition of

transparent target for the

generally clear, i.e. in

expenditure is often

government to achieve,

respect of which

narrow, with investment

but the debt target is

expenditures are or are

and unexpected

arbitrarily set and subject

not to be capped.

expenditure often not

to challenge, due to

subject to the rule. If

empirical uncertainty

unexpected expenditure is

about optimal debt ratio.

significant, the rule will be less effective.

VULNERABILITY TO CREATIVE ACCOUNTING

(2)

(1)

(0)

Low vulnerability; not

Can be vulnerable to off-

Vulnerable to creative

easy to circumvent.

budget operations.

accounting where expenditure items are excluded from the scope of a balanced budget.

37


(2)

(3)

(1)

The administration may

The expenditure rule

a) (overall balance) An

use any means to bring

links directly to the

overall budget balance is

down the debt level.

budget process. As this

simple to implement.

There are no restrictions;

rule may go into detail

implementation is simple.

about individual program

(0)

SIMPLICITY OF

areas, it will face a lot of

b) (structural balance)

IMPLEMENTATION

debate regarding how the

With a structural or

targets should be set.

cyclically adjusted budget

Once the targets are set,

balance, business cycle

it is simple to

and output gap

implement.

measurement problems can emerge.

(2)

(3)

(2)

The target is transparent

Expenditure caps are

a) (overall balance) The

and simple. The public

easy for the public to

concept of overall budget

can easily play a

understand and monitor.

balance is easy to

monitoring role.

It is however necessary

understand by the

for the administration to

layperson.

ACCESSIBILITY

lay down clearly what is

FOR THE PUBLIC

included in the scope of

(0)

expenditure.

b) (structural balance) With a structural or cyclically adjusted budget balance, the determination of a ‗cycle‘ may be difficult to understand.

GOVERNMENT CONTROLLABILITY

(0)

(2)

(1)

The outcome is difficult

Expenditure is largely

Revenue is less

to control because it can

controllable, though

controllable than

be affected by many

shocks may partly hinder

expenditure, due to its

external factors.

original plan. Careful

pro-cyclical tendency.

setting of expenditure targets may, however, assist medium−term planning by attacking the baseline.

Key:

0 - poor

1 - partial

2 - moderate

3 – high

38


Budget balance rules - key strengths These rules offer the best combination of fiscal restraint and cyclical flexibility, minimising the impact of rule adherence on stable and adaptable economic growth, while addressing deficit bias. Budget balance rules - key weaknesses The mechanisms employed to adapt to the cycle are complex, and not only are they tough for the public to understand, they are by no means foolproof even in the hands of public economists. In view of their complexity, and their coverage of the expenditure and revenue streams, avenues for creative accounting abound. 4.3.3 Some fundamental challenges While the arguments and comments above highlight some key rule features, there are some fundamentally challenging questions regarding fiscal sustainability which warrant serious consideration by policymakers before contemplating fiscal rule introduction. As noted above, fiscal sustainability needs must be balanced with considered public investment choices. On the one hand, given that we are examining budget aggregates at the national level, infrastructure renewal expenditure, if well managed, should in general balance out across expenditure streams – i.e. at the aggregated level – each year. However, investment requirements are more a matter of innovative positioning than replacement. In such instances, there may be a risk of forgone new paradigm investment today, whose net present value in years to come might surpass the costs of rule non-compliance today. This also applies to investment in education and research and development, since the value of these investments is realized through their contribution to future productivity and income, and therefore has a positive impact on fiscal sustainability. How that process is managed is an infrastructure coordination challenge beyond the scope of fiscal rule design, but the potential impact that a rule‘s introduction could have in this respect would require attention at the central level. While one possibility might be to exclude investment from balance targets, this could open up an easy avenue for abuse, and overnight the definition of investment might broaden considerably. There are no easy

39


solutions to this problem, and it is one of the key policy trade-offs for any government to consider in adopting a fiscal rule such as may constrain public investment. Even considering the above, however, a target debt-to-GDP ratio may itself be quite arbitrary. While controlling the increase in debt may be prudent, is the EU SGP 60% necessarily an optimal level, or might 70 or 80% be optimal? If one of these higher ratios were optimal, then constraining the ratio at 60% may result in suboptimal investment. As noted by Committee on the Fiscal Future of the United States (2010), while there is a widely held belief that the U.S. should save and invest more than it does at present, the level at which that balance should be struck is not known. This is unsurprising due to the breadth of influencing factors, and the circular causality involved. For example: a) the optimal level of debt, is dependent on b) the stage of a country‘s development; c) the rate of return on investments being funded by said debt; and d) the interest rates incurred on those investments, which are linked to e) default risk, which in turn is a function of b) above, as well as of accumulated debt levels and ratios which, at any given point in time, may influence the optimal debt level in a) above. Other factors coming into play include asset base, political stability, and the velocity of change in debt-to-GDP ratio across years. Given this level of uncertainty around optimality, therefore, together with the social impacts which debt rule-driven restraint can bring to bear on a nation, a case could be made that the costs of a debt-to-GDP ratio may outweigh the benefits. Each of these issues warrants detailed consideration in their own right, and is beyond the broad scope of this paper. But even as we now turn to consider rule combinations, these underlying challenges should be borne in mind.

40


4.4 The Multiple Rule Approach 4.4.1 Multiple rules – key considerations As has been shown in tables 4.1 and 4.2 and the accompanying discussion, each rule has its own strengths and weaknesses. A debt rule is particularly robust at addressing debt sustainability. A balance rule adds greatest value across numerous economic criteria, including counter-cyclicality and its capacity to remove the conditions for deficit bias. Expenditure rules, meanwhile, offer more under clarity, simplicity and accessibility, this rule type generally being the easier one to define and describe to the broader community. At the same time, each rule also has its weaknesses. In some instances, it may be possible that the weakness of one rule is mitigated when combined with another rule; for example, scope for creative accounting in the balance rule might be limited when combining it with a debt rule, which is more robust in that respect. On the other hand, the public accessibility of an expenditure rule may serve little purpose, if at the same time a baffling budget balance rule is in place. In yet other cases, the extent of mitigation may depend on design considerations; for example, while budget balance rules are pro-cyclical, it is difficult for a government combining such a rule with a debt rule to achieve pro-cyclical outcomes – unless, that is, the debt rule itself has cyclical adjustment design characteristics. 4.4.2 Multiple rules – a graphical representation In order to illustrate the effects of combining rules, two graphs have been prepared: a) Figure 1 represents the extent to which individual evaluation criteria are addressed by individual rules; b) Figure 2 indicates whether the combination has a neutral effect on delivery against objective (when compared with the performance of the highest scoring individual rule against that objective) or whether the combination actually increases or decreases delivery against that objective. The combinations chosen have only been those incorporating a debt rule, since the current report is exploring fiscal rules in the context of debt sustainability. Furthermore the budget balance rule evaluations – both individual and in combination – relate to structurally and cyclically adjusted rules, in view of the rather crude properties of the overall balance

41


rule. From this point forward, therefore, where we refer to budget balance rules, we are referring to structurally / cyclically adjusted rules. In parallel with the scoring in tables 4.2 and 4.2 of each rule against each criterion as either poor, partial, moderate or high, figure 4.1 represents this scoring visually, with a lighter shade for a lower score, and a deeper shade for a higher score. As can be seen from figure 4.1 below, debt and budget balance rules tend to score more highly on economic effectiveness and transparency, simplicity and accountability criteria. This is a reflection of expenditure rules being something of a blunt instrument, yet one that is relatively straightforward to implement and to understand for the public. Budget balance rules, on the other hand, score more highly on economic grounds than on the openness categories. They are necessarily complex, to accommodate fluctuating cycles, but this complexity compromises their transparency. Debt rules are the single best measure of net position, and for this reason alone should be included in any combination. Their greatest weakness if their pro-cyclicality and lack of flexibility; however, the chart assumes no cyclical adjustment in this target, as is the norm, but the authors note that adding cyclical features in debt rule design may overcome some of the most severe shortcomings.

42


In figure 4.2 below, we have explored the impacts of combinations on delivery against criteria, and this has thrown up some interesting questions. In particular, in the absence of cyclical flexibility (or an appropriate escape clause), a debt rule, when combined with either or both other rules, may counteract those rules‘ counter-cyclicality. For example, if all three rules must be met under severe recessionary conditions, the flexibility of a budget balance rule will not be exercisable if not mirrored in a debt rule.

Figure 4.2: Effects of rule combinations against key objectives

Debt +

Debt+Structural

Expenditure

Balance

All 3Rules

Fiscal sustainability Counter−cyclicality Flexibility in responding to shocks Capacity to address Deficit Bias Clarity of target definitions Vulnerability to creative accounting Simplicity of implementation Accessibility for the public Controllability

KEY: Detrimental

Neutral

Beneficial

Another key point to note is the impact of combination in respect of simplicity and accessibility. Meeting fiscal rule targets requires careful planning and reprioritising, and numerous factors and inputs must be considered. The co-existence of numerous rules may add to the complexity of such planning activities, as the requirement to meet additional fiscal rules adds to the challenge in meeting any given fiscal rule target. For example, while expenditure rules may serve a useful purpose, such caps may limit the flexibility inherent in budget balance rules adopted in isolation. Furthermore, a plethora of fiscal rules may detract from public understanding and engagement. For example, as structural budget balance rules are the least accessible, adding these to either or both of the other two rules may detract from

43


overall understanding. Furthermore, the sheer multiplicity of regimes may itself serve to confuse, regardless even of what the individual regime components are. One point of note where the combination appears to add to robustness is in respect of creative accounting. Debt aggregates are generally very clearly defined and standardised, and as such there is least risk of obfuscation in respect of debt rules. While balance and spending targets may be subject to gaming, the debt aggregates do not lie, and creative accounting in the flows is likely to be exposed in the stocks. Finally, it is important to point out that the debt rule assumed for the analysis has been one lacking cyclical adjustability or escape clauses, as this represents the norm. However, since the authors propose that a debt rule with a cyclical feature, or with an escape clause, offers greater flexibility, we have drawn up an alternative to figure 4.2 (figure 4.2a, below), allowing for such characteristics in a debt rule. As displayed in the revised graphic, the detrimental effects of combining debt rules with other rules are mitigated where the debt rule in question has cyclical adjustment features or an escape clause, at least in respect of economic effectiveness criteria. Challenges would still remain under certain transparency criteria, and a question to be asked in this respect is whether such risks are outweighed by other benefits of the combinations.

Figure 4.2.a: Effects of rule combinations (with cyclical debt rule or escape clause)

Debt +

Debt+Structural

Expenditure

Balance

All 3Rules

Fiscal sustainability Counter−cyclicality Flexibility in responding to shocks Capacity to address Deficit Bias Clarity of target definitions Vulnerability to creative accounting Simplicity of implementation Accessibility for the public Controllability

KEY: Detrimental

Neutral

Beneficial

44


4.5 Conclusion Following a review of the wider literature and more focused case study research, the authors have alighted on an evaluation framework for fiscal rules categorised, broadly, into economic and transparency criteria. That framework has shown that debt, expenditure and budget balance rules have numerous strengths and weaknesses individually, and in particular that rules do not tend to fare equally well across those economic and transparency criteria. However, we have also found that while no rule addresses all criteria, combinations of rules can have unintended consequences. The challenge of how to design and implement combination of rules that minimises the negative crossover effect, together with some fundamental debt sustainability questions, is among the key challenges facing policymakers wishing to explore fiscal rule introduction.

45


5. Recommendations 5.1 Introduction To contain the unsustainable growth of the U.S. public debt, we propose a combination of fiscal rules that impose binding constraints on total federal debt and aggregate expenditure in the near term, and structural budget balance once debt is lowered to a more sustainable level. Given the relative strengths and weaknesses of each type of rule, a combination approach is expected to achieve better fiscal outcomes, where, for instance, the budget balance rule will provide the required countercyclical response that the debt rule on its own will not. Likewise, the inherent tendency of the government to grow in size – something that the debt and budget balance rules fail to control – can be contained by a complementary expenditure rule. Moreover, the success of the rules-based fiscal regime will require enabling reforms that ensure simplicity and accessibility for the public, policy credibility in responding to macroeconomic shocks, binding and effective medium-term budgetary projections, and a strong enforcement regime. The subsequent recommendations are made with cognizance of the idiosyncrasies of the U.S. federal system. Annual spending is determined not through a single ‗budget‘ but by the combined effects of direct spending legislations, discretionary appropriations, and occasional changes to spending or tax laws. Authority is divided amongst various institutions, which necessitates coordination and collaboration between different branches and levels of government. This has become increasingly difficult given a highly polarized political environment, and the seeming chasm between the federal and state governments. While the recommendations largely build on the experiences of the five countries included in this study, differences in context and applicability are noted and discussed whenever appropriate. These are explained in detail in the following subsections.

46


5.2 Proposed Design and Justifications 5.2.1 Debt Rule The proposed combination of fiscal rules must include imposition of a numerical ceiling on the total federal debt-to-GDP ratio. In keeping with the international best practice, including that of the European Union, the U.S. should set its medium term debt-to-GDP ratio at 60%, but target a return to the U.S. long-term average (since 1940) of debt as 45% of the GDP (Peterson-Pew Commission on Budget Reform 2010). It is noted that these target are more to provide a limit to aim for rather than being an end in itself. Essentially, targets can be arbitrary based on justification, but there is no doubt that the set limits are useful in achieving fiscal prudence. In order to attain the target debt-to-GDP ratio, the administration must set and seek congressional approval to annual and medium-term debt reduction targets along with the annual budget bill. The annual debt reduction target must be based on economic and fiscal forecasts for the budget year, while following a steadily declining linear trend in the medium term. Benchmarking the debt targets with national income (GDP) directly and visibly enforces self-discipline in fiscal policy, a strength that partly compensates for market failure in responding to debt expansion in time and by raising interest rates on debt. Some economists argue for pegging debt to the public revenues, but that indicator is neither easily understood nor widely used to track public debt. On the other hand, the debt-to-GDP ratio is frequently used in the U.S., Europe and other OECD countries, which lends it to international comparisons (Kumar, et al. 2009). However, debt being a stock indicator has weak responsiveness to business cycles. When a fiscal rule imposes numerical ceiling on debt, governments would tend to tread as close as possible to the upper limit. In the absence of an adequate cushion, government would find itself unable to comply with the fiscal rule when there is a recession. A recession would trigger automatic stabilisers through lower tax collection and higher public spending, and the resultant budget deficit would push up the public debt to GDP ratio beyond the threshold. This could compromise the credibility of the fiscal policy and weaken the enforcement of the fiscal rules (Kumar, et al. 2009). The vulnerability to economic shocks can be reduced in two ways. First, the rule must bind the government to reduce the debt-to-GDP ratio well below the upper limit of 60% 47


through reinforcing the long-term target of 45% of GDP, especially when economy is in an expansionary phase. Second, the rule must contain escape clauses that are triggered automatically when, for instance, the GDP declines or stagnates for two consecutive quarters. The escape provisions must be accompanied by mandatory clauses that bind the government to seek congressional approval to a plan outlining specific targets and actions that would return the debt-to-GDP ratio within the allowable limits in a specified period of time (Kumar, et al. 2009). 5.2.2 Expenditure Rule We recommend imposing a statutory limit to overall federal spending. As elaborated in the previous chapter, any suggested fiscal rule should incorporate some element of constraining government spending to enhance effectiveness. Adding limits to federal expenditure complements the introduction of a debt rule. It is however vital to determine which expenditures must be included to achieve the best fiscal outcomes. While Brazil and Sweden have adopted rules that imposed explicit numerical targets either on primary or current spending, the scale of the U.S. debt burden requires discipline on overall federal spending covering both mandatory and discretionary programs. By introducing expenditure limits that confine total disbursement (similar to Switzerland), there would be adequate pressure on policymakers to ensure overall target is not exceeded. Policymakers may have to reform entitlement programs that comprise nearly 57% of total projected outlays of fiscal year 2011 (Office of Management and Budget 2010). Discretionary spending would also be in tight scrutiny, with the President and Congress compelled to reduce allocations for both defence and non-defence expenditures. The limit on U.S. total federal expenditure will be set according to a percentage of GDP, a similar measurement to debt burden. Exact percentages will not be rigidly set, as the federal government has to take into account counter-cyclicality considerations. When the economy is in recession, expenditures (as a percentage of GDP) have to be set higher than normal condition in order to offset the reduction in economic output. During periods of expansion however, the reverse would apply. This action would provide an avenue for the federal government to maintain fiscal stability and restrain deficit bias of public officials. The Swiss Central Government debt reduction model provides a clear example on how expenditure rule can be implemented successfully when judiciously enforced.

48


In responding to economic shocks beyond the normal business cycles, the federal government have to outline triggers and escape clauses to loosen this rule. For example, rules may be relaxed in times of crisis such as natural disasters. Easing the rule temporarily nevertheless does not mean opening doors for creative accounting. The federal government would be held accountable for each expenditure items during those periods, and the expenditure ceiling could only be modified with Congressional approval. 5.2.3 Budget Balance Rule In terms of budget balance rules, we recommend the use of structural balanced budget after the federal government meet its 60% debt-to-GDP target. Imposing a deficit constraint along with the debt and expenditure limits will overburden policymakers in the near term, and may lead to suboptimal levels of investments in growth drivers such as infrastructure, education, and research and development. When a budget balance rule is introduced, it should apply to total federal spending (mandatory and discretionary spending, and tax expenditures). In order to avoid unnecessary volatility and deviations from the rule, spending for war and other emergencies should be excluded from the annual budget balance calculations because they are funded through supplemental appropriations or enabling laws. However, continuing appropriations for these emergency programs should be internalized in the budget in the succeeding years. The structural balance budget is suggested on the basis of its ability to respond to output shocks (Kumar, et al. 2009). Given the cyclically adjusted nature of this rule, it will take into account the state of the economy and allow the government to invest in times of need. The rules should focus on including all the core expenditures that are within the control of the government and are also easy to forecast and predict. Extraordinary expenditures like defence and emergency spending are highly uncertain and are also likely to cause unavoidable deviation from the numerical targets. Such deviations will make it difficult for the government to build the budget credibility and fiscal discipline that can assist in anchoring macroeconomic expectations. Therefore, more volatile aspects of the budget should be handled through specific and well-defined identification of escape clauses and their triggers. In case an escape clause is invoked, it should be mandatory for the government to come up with an adjustment plan within a defined time frame to bring the economy back on track. Although this approach can lead to increased budget deficit, recommended debt rule

49


will keep the former in check. In addition, the escape clauses will ensure that the deficits are recovered through adjustment plans within defined time periods to allow the budget balance to be zero over the business cycle.

5.3 Analysis of Fiscal Rules in Combinations The first layer of fiscal rules relates to public expenditure, primarily aimed at containing the size of the government from expanding beyond a specified level. These rules will come into play based on the state of the business cycle. Under an economic boom, the expenditure growth would be constrained within a quantified range to prevent pro-cyclicality. Similarly, in case of a recession, public expenditure should be able to finance stimulus to counteract the shock. However, in this situation, the economy would be allowed to run deficits as long as there is an adjustment plan to offset it with surpluses in good times. There are two options of expenditure rule enforcement. The rule can be binding regardless of the economy‘s stage in the cycle. However, this will force the government spending to be pro-cyclical and the only fiscal policy tool left with the government would be on the revenue side (increasing or reducing taxes). In such situations, the government can use tax breaks to incentivize economic activity. The other option is to make expenditure rules sensitive to business cycle by allowing it to operate within a range that varies according to the state of the economy. Both these options will ensure that the size of the government is kept in check. Given that expenditure rules fail to capture the revenue side, it is useful to combine expenditure limits with budget balance rules. These rules allow more flexibility to the government as it can change both taxes and government spending to respond to economic changes. By capping the overall deficit balance (this doesn‘t have to be zero balance) using structural balance budgets, the government will be able to ensure that both revenues and expenditures respond to the economic realities. Along with managing behavioural deficit bias, this added flexibility due to budget balance rules allows the government to create an environment of economic stabilization. However, even with binding expenditure and budget balance rules in place, there may be scenarios under which both these rules will not be able to contain growing public spending

50


leading to mounting public debt. These usually come in the form of extraordinary expenditures including natural disasters and security threats. These types of expenditures are usually kept as supplementary budgets and hence may not be captured through budget balance rules. There can also be instances of creative accounting, i.e. distinguishing between current and investment spending, which may not be captured through the expenditure rules. Given the probability of such scenarios, it is important to combine expenditure rules and budget balance rules with public debt rules to control the debt stock. According to Peterson-Pew Commission (2010), the average debt-to-GDP ratio since 1940 is 45% with notable increases in the past two decades. In the short run, the government should be provided with enough leeway to ease towards the 60% debt burden target as it continues efforts to reinvigorate the U.S. economy.

5.4 Implementation Considerations 5.4.1 Priority Setting It is essential that, despite the existing political polarization within the country, the President and Congress agree on the long-term priorities to advance the country‘s fiscal future. Specifically, there is a need for clarity on how additional revenue would be generated through, for example, new tax measures and/or tax reforms. Prioritization of reduced discretionary capital investments and/or entitlement spending would also be critical. Specifically, there must be clarity on prioritisation of ―economic‖ investments vis-à-vis ―social‖ spending. Healthcare and social security expenditures are only two of the many spending classes that would need careful review. There are no easy answers, but early agreement on long-term priorities would assist in short- and medium-term decision-making. In all countries studied, political consensus paved the way for eventual change. Any set of policy options would involve varying degrees of political risks and would demand widely distributed personal sacrifices from the citizens in one way or another, making political consensus especially challenging. Given this, prior substantive agreement spanning the two branches and leaders of both major parties is essential to timely and orderly management of the fiscal challenge. The same can be said for

51


agreement on a set of fiscal rules: for it to be reached and then sustained, it must be rooted in broad political consensus. 5.4.2 Credibility Sustaining a rules-based fiscal regime requires that the public and elected leaders continue to see their implementation as fair and true to the spirit of their adoption. To ensure continued credibility from the short term through the long term, responsibility in determining how to apply the rules framework within the business cycle must be assigned to an independent and non-partisan body. One option would be to give this responsibility to the Congressional Budget Office, which has a reputation for independence as well as the required skill set to undertake the task. Moreover, the institution already exists and the bureaucratic hurdles required in establishing a new institution could be avoided. Independence legitimizes the government‘s economic outlook and fiscal targets and lends credence to the overall rules regime. However, there may be a concern that the CBO with its current mandate of budget scoring cannot provide such an overarching policy analysis role. Others may also feel that the CBO, despite its reputation for independence, still reports to Congress and thus may not be fully independent. A second option, therefore, may be establishment of an independent and elite Fiscal Policy Council, which would take information gathered by the CBO to provide independent monitoring role that is congruent with public interest. It could be accountable to both the President and to Congress. The Council would not have enforcement powers, but would be in a position to objectively provide advice on future implications of different policy scenarios. Moreover, strengthening the capacity of the body to provide independent and credible advice, mandated by law, would provide elected officials the ―political cushion‖ to implement difficult decisions. The Swedish Fiscal Policy Council is a model that could be used to assess the strengths of an independent oversight body. The Swedish FPC is invited to provide independent comment on the administration‘s proposals before Parliament‘s approval is sought (in the U.S., one can think of the President‘s proposals being vetted before submission to Congress). As mentioned in Chapter 3, reports of the Council serve as ex-ante external evaluation of the government‘s proposals and ex-post evaluation of the government‘s

52


performance as against the targets. The Council has maintained impartiality and is thus highly regarded by the public as well as the Parliament‘s Finance Committee (Calmfors 2010). 5.4.3 Simplicity and Accessibility to the Public Combining the three fiscal rule types increases the likelihood of success and sustained fiscal discipline, but it does so at the risk of making the system more opaque to the broader public. Peterson-Pew Commission (2010) prescribes a set of changes to improve transparency through ―better use of budget concepts‖. Budget presentations would start with a discussion on proposed changes relative to current year levels and the rationale behind the changes. The current method reports changes only from a baseline of a current law; this leads to unclear information about the status of specific spending programs and the overall budget itself. Budget submissions would also include a short report that analyses the long-term fiscal outlook of the country. We propose that a Law on Fiscal Transparency be established. As mentioned in Chapter 3, in Brazil, for example, the Fiscal Responsibility Law requires that fiscal data for revenues, expenditures and financing be disseminated. Moreover, a Fiscal Management Report has to be published three times a year, with consolidated information on debt, credit operations, human resources allocations and social security. Importantly, the Ministry of Finance is required to maintain a centralised and updated electronic record of internal and external public debt with mandatory public access. (Oxford Analytica 2005). Please see Appendix 4. We also propose that Congress spearheads the design of a mechanism for public participation that enable the public, if they choose to do so, to discuss the current fiscal problems with their respective representatives. Given the gravity and long-term nature of the problems that U.S. citizens would face, ensuring that transparency and accountability are ingrained in a formal system from an early stage would be beneficial to all and help sustain a rules-based fiscal regime. 5.4.4. Multi-Year Budget Plan A multi-year budget plan is essential to meeting the required spending and debt targets. As recommended in Peterson-Pew Commission (2010), the President would be required to submit a budget that adheres to the legislated fiscal rules. This multi-year budget

53


plan would remain in place until it becomes necessary to adjust the plan to reach the debt target. To support the transition from the current single-year budget regime to the proposed multi-year framework, we also recommend strengthening the congressional budget process. Specifically (and in keeping with the Commission‘s recommendations), memberships in the Senate and House Budget Committees would include congressional leaders along with the chairs and ranking members of the appropriations, revenue, and other significant authorizing committees. 5.4.5. Enforcement Mechanism Adherence to the recommended fiscal rules can be bolstered in three ways. First, compliance monitoring processes must be adequate and strong.

We adopt the

recommendation of Peterson-Pew Commission (2010) that the President report to a joint session of Congress, at the end of each fiscal year, the effects of that year‘s budget and the federal government‘s progress towards reducing its debt. The CBO and the Congressional Budget Committees of each chamber would then be responsible for reviewing the President‘s report, and use the latter as the starting point for any corrective action (i.e. adjustments to the multi-year budget plan). The proposed Fiscal Policy Council can contribute to the discussion, although they would have no direct involvement in the enactment of budgets. Second, regular and sustained oversight from the media and the general public would hold both the President and Congress accountable to the statutory fiscal goals. The President‘s report to Congress as well as progress reviews from CBO and OMB, respectively, would increase public awareness of the state of the federal government‘s fiscal position and its medium- and long-term outlooks. The proposed new mechanism for public participation would ensure more informed public opinion on matters, thus ensuring greater accountability. Third, and as a final recourse to deter or increase the political cost of violations by the Executive or Congress, deviations from the rules should automatically trigger independent reviews of the implementation of fiscal rules, including subsequent legislation. Such oversight powers may be delegated to the Fiscal Policy Council, allowing for a comprehensive and authoritative assessment of the fiscal rules‘ progress, whilst keeping intact the final decision-making powers of the President and Congress. Importantly, these

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independent reviews would increase the political cost of digressing from prudent policymaking and provide formal deterrence to non-compliance. 5.4.6. Flexibility of Rule Implementation Given the constitutional division of powers in the U.S. system of governance, the relationship between the President and Congress is a key to successful implementation of fiscal rules. There must be enough legal constraints to prevent political manipulation of the rules, but they must not be overly binding. Indeed, at present it must be recognized that the economy has not yet fully recovered to provide the foundation for immediate implementation of permanent fiscal rules. At the present time, one or more overly binding limits could lead to suboptimal economic performance or failure to address critical needs, including national security and other emergencies. Nor should there be a situation where, because the rules are too rigid, ―emergencies‖ are used to circumvent them. If the rules embody the right level of flexibility, then such tactics as reclassifying non-emergency spending as ―emergencies‖ or using other devices to circumvent the rules can be discouraged through regular monitoring by the OMB, CBO, and the proposed Fiscal Policy Council. There are no universal standards for the ―right‖ level of flexibility as this depends heavily on the specific context a country finds itself in. However, whilst one allow for flexibility early on as the tightening of the rules takes place, there must be public education that the kind of sacrifice that is required is large. There must be consensus on what the definition of an ―emergency‖ is so that simple hardship is not used by politicians to call for loosening of the rules. Flexibility must not come at the expense of credibility. 5.4.7. Timing of the Rule Implementation Different thresholds and combinations of rules make more sense at different debt levels and therefore at different times. For example, immediate implementation of a budget balance rule, even one adjusted for economic cycles, may be impractical. It may well make sense therefore for the U.S. to first stabilize its debt at a high level short of requiring budget balance, then gradually lower it later to a safer level if economic growth and other circumstances allow for near-zero annual deficits on average. Ensuring that the country is first put on a path for economic recovery is at the heart of implementation. How this recovery should be stimulated is open for discussion, but deficit-based financing should not be used for social spending at the expense of long-term economic growth. 55


The depth of the problem is such that legislation for fiscal rules must be put in place immediately to support and sustain substantive policy shifts required to stabilize the debt. However, the too-early introduction of a fully binding rules-based regime could stall economic recovery and ultimately undermine the goal of debt reduction. This could weaken the new rules regime before it is well established. After legislation is passed, therefore, introduction of such rules must be staggered, in synch with the increase in economic performance as well as the emergence of a supporting political consensus. 5.4.8. Conclusion Difficult decisions have to be made to strengthen the long-term fiscal health of the U.S. However, as this report has indicated, past international experience shows that with the right set of rules, an implementation anchored on transparency and accountability, and sufficient political will from leaders and broad public support, the U.S. can avert its looming fiscal crisis and retrace its path back to sustained prosperity and growth.

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Fiscal Rules to Reduce U.S. Federal Debt