Fiscal Rules: Key Concepts and Approaches Jason Harris PEMPAL 2016 BCoP Plenary Meeting FISCAL RULES FOR EFFECTIVE AND SUSTAINABLE BUDGETING Minsk, February 2016

Fiscal Rules and Objectives Outline of Presentation I.Concept, Definition and Key Ingredients II.Characteristics of Good Fiscal Rules III.Incorporating fiscal rules into process IV.Mapping Fiscal Rules V.Current state of the debate and new frontiers 2

3 Permanent constraint on fiscal policy, typically defined in terms of an indicator of overall fiscal performance –Budget Balance, surplus or deficit –Expenditure –Debt –Revenue Can be more or less complicated –Budget balance -> cyclically adjusted balance -> structural balance –Expenditure ceiling -> real spending growth -> exp growth adjusted for policy Can account for resource issues –Non-oil/non-resource fiscal balance –Permanent Income Hypothesis approach –Sovereign wealth fund Concept, Definition, and Key Ingredients

Common pool problem –Benefits of new spending are tangible and enjoyed by a clearly defined group –Costs are shared by all, or even by future generations Short-sightedness –Election cycles Imperfect information –Benefits visible, costs are not –Tendency for overoptimistic growth projections Evidence that the problem is largest during good times 4 Concept, Definition, and Key Ingredients

What makes rule effective? Rules are commitment-devices: make the costs of deviating from the target too large for such deviations to be an optimal strategy for policymakers. Rules are signaling tools: reduce public’s uncertainty about policymakers’ genuine commitment to sustainable and stabilizing policies. Signaling effect is likely to be present when the adoption of rules follows episodes of inadequate policies. Overall, effective rules anchor expectations, limiting time- inconsistency problems.

II. Characteristics of Good Fiscal Rules 1.Simplicity The rule should understood by decision-makers and the public. 2. Sustainability Compliance with the rule should ensure long-term sustainability. 3. Stabilization Following the rule should not add to economic volatility. 4. Operational Guidance It should be possible to translate the rule into clear guidance in the annual budget process. 5. Stable & Robust Rule should be in place for a sustained period of time to build credibility, and be robust to shocks 6. Verification It should be possible to verify if the government has complied with the rule with regular intervals. 6

I. Assessing Fiscal Rules Overall Balance 7 1.Simplicity Intuitive and conceptually straight forward 2. Sustainability Balance determines future debt levels 3. Stabilization  Simple balance is pro-cyclical 4. Operational Guidance  Gives guidance for planning, but requires adjustment during execution 5. Verification Nominal balance available quickly, but often several revisions of GDP Classic rule The golden rule Primary balance

I. Assessing Fiscal Rules Cyclically Adjusted Balance 8 1.Simplicity  Theoretical and difficult to explain 2. Sustainability Temporary fluctuations do not affect long- run sustainability 3. Stabilization Allows the actual balance to vary in response to the cycle 4. Operational Guidance  Temporary variation does not require adjustment … but hard to know 5. Verification  No consensus of CAB, and revisions are made for a long time Measures the underlying fiscal position Various estimation techniques Not observable

I. Assessing Fiscal Rules Over the Cycle balance 9 1.Simplicity Easy to Explain and observe 2. Sustainability Temporary fluctuations do not affect long- run sustainability 3. Stabilization Allows the actual balance to vary in response to the cycle 4. Operational Guidance  Little practical guidance to policy maker 5. Verification  Difficult to verify: what is the cycle Uses the overall fiscal balance Requires an idea of where in the cycle No clear guidance or verification

I. Assessing Fiscal Rules Expenditure 10 1.Simplicity Simple to understand and justify 2. Sustainability  Has to be coordinated with a sustainable level of the balance 3. Stabilization Allows variations of revenue (e.g. resource revenue); prevents windfalls to be spent 4. Operational Guidance Targets what the government controls; can control absorption constraints 5. Verification Quick and straight forward Addresses directly a main source of deficit bias and expenditure drift Requires well developed monitoring and control Should apply both to planning and execution

I. Assessing Fiscal Rules Debt 11 1.Simplicity Simple to understand and justify 2. Sustainability Direct relationship 3. Stabilization  No room for expansion if above threshold 4. Operational Guidance  If above threshold: many paths back; if below threshold: no clear guide 5. Verification Nominal debt available quickly, but often several revisions of GDP Key indicator of sustainability The result of past policy decisions Can vary for reasons not related to fiscal policy

III. Incorporating Fiscal Rule into Process “Good Practice” in Macro-Fiscal Frameworks 12 Medium-term Fiscal Strategy 12 Principles of fiscal management Fiscal rule (numerical / procedural) Escape clause 3-5 Year macroeconomic forecast 3-5 Year fiscal forecast Fiscal risk analysis Medium-term fiscal target 3-Year expenditure ceiling 3-Year ministerial allocations Contingency & planning margins Performance indicators/targets Updated 3-5 Year MTFS & MTEF Explanation of changes from MTFS/MTEF Detailed annual appropriations ElementContent Medium-term Expenditure Framework Annual Budget Timing Permanent FY - 6 mo Budget Orientation Debate FY - 5 mo FY - 3 mo Scrutinize macro forecast Vote MT fiscal target Vote expenditure ceiling Fiscal Council Fiscal Rule or FRL

IV. Mapping Fiscal Rules As of end

IV Mapping Fiscal Rules What type of rules? 14

IV Mapping Fiscal Rules Combinations of rules 15 Advanced economiesEM and developing economies

IV Mapping Fiscal Rules 16 Rules in PEMPAL

IV Mapping Fiscal Rules Shift towards flexibility 17 Note: Rules refer to national budget balance rules. They are considered to take into account the cycle if their target is specified in cyclically adjusted or structural terms or if they are associated with a well-specified escape clause.

V Current State of the Debate Fiscal rules often have a bad name  too flexible or too tight, simplistic or too complicated… Main complaint #1: Low compliance rates 18

V Current State of the Debate Main complaint #2: Complexity (too many with overlapping aims). 19 Euro area fiscal governance

V Current State of the Debate Main complaint #3: Difficult to operationalize –Real-time estimates of output gaps are unreliable… –…leading to sizable revisions in structural balances… 20

V New Frontier Keep complex rules but introduce independent fiscal agencies: –Reduce loopholes in implementation of complex rules (e.g. biased forecasts leading to unrealistic budgets)  better compliance. –Explain complex rules to the public and other stakeholders (MPs): alleviate concerns about operational guidance and transparency. 21 Mean forecast error: FCs that provide or assess forecasts Mean forecast error: FCs with high media impact

V New Frontier Forget about compliance, effectiveness matters. –Simple, prescriptive rules of thumb (analogous to Taylor rule in monetary policy) associated with a comply or explain obligation  overreliance on checks and balances and public scrutiny? –Example: EC “rule of thumb” proposal. 22

V New Frontier Ditch the output gap  improve the flexibility-simplicity trade-off. –Rule = Anchor (e.g. debt) + operational target (e.g. expenditure ceilings) + error-correction. –Set the rule in first difference  cyclical adjustment term boil down to difference between actual and potential growth. The equivalent budget balance rule then takes the generic form: 23 Smoothing termAdjustment term

Conclusions Clear characteristics for good fiscal rules Difficult to meet all of them: trade-offs exist Fiscal rules are only part of the macro-fiscal framework Fiscal Rules are widely used… …but concerns around using them effectively New frontier looking at addressing these challenges 24