1 A New Fiscal Rule Karnit Flug Research department The Bank of Israel May, 2009

2 Outline The starting point: what is the current fiscal position ( high debt/GDP, inconsistency between Gov’ decisions) Where should the new rule help us get to? Desired attributes of a new rule Controls, escape clauses, and updates The proposed rule The projected path of main fiscal aggregates under the proposed rule

3 Fiscal Indicators at the starting point: International Comparison ( average)

4 The Path of the Debt/GDP * Source: Based on Bank of Israel data.. *consistent with -1.5% and 1.0% growth rate in 2009 and 2010 respectively, and from 2011 and onwards a higher growth rate of around 4.0% per annum. **consistent with -1.5% and 0.0% and 1% growth rate in respectively, and a recovery starting from 2012.

5 At the Starting Point: Inconsistency Between Decisions The current ceiling on growth of real government expenditure (1.7%) is inconsistent with a set of specific programs adopted by the government and “automatic” growth in budgets. The adoption of a new rule should include the reorganization of commitments so as to make them consistent with the new rule and include a mechanism to prevent the emergence of new gaps.

6 Where should the New Rule Take us? Our debt/ GDP ratio is relatively high; The risks we face are relatively high, thus we should aim at a debt/GDP ratio which is lower than the standard in developed economies. We should aim at 60% of GDP as an intermediate target, and continue reducing the ratio to 50 %, albeit at a slower pace thereafter.

7 What Should a Rule be Based on? Long term targets that reflect policy goals regarding: 1.Main fiscal aggregates (debt, expenditure, taxes) 2.The level of government services and redistribution 3.The risks the economy is exposed to The speed at which these targets should be achieved. From these, short term operative targets should be derived.

8 What are the Attributes of the Desired Rule? Will lead to the target debt ratio within the decided time frame Will facilitate fiscal discipline within the fiscal process Will not lead to a pro-cyclical policy (or facilitate counter-cyclical policy) Will be credible and sustainable Will be simple and transparent Will be based on variables that are known in real time.

9 Why Spending Rule? Expenditure ceiling is directly controlled by the government Expenditure is not affected unexpectedly, like the deficit, by changes in economic activity A ceiling on spending allows the automatic stabilizers to operate Expenditure ceiling is consistent in the medium/long term with a debt- ratio target if average growth is consistent with estimates and tax reductions are dealt with within the rule’s framework

10 Control, Escape Clauses and Update mechanisms For a deviation of growth over time from estimates For a consistent deviation of tax receipts from long term relationships with macro-economic variables For extreme circumstances such as war, natural disasters or extreme world economic conditions The credibility that has been accumulated allows for short term deviations, but without a corrective mechanism it might be eroded.

11 The Proposed Rule The real growth in government expenditure will be based on the estimated potential growth, corrected for the distance between last year’s debt/GDP ratio and the intermediate target of 60%. The further we are from the target, the lower will the expenditure growth be. PE gr = GDP_POT gr - a*((D/Y) t-2 *100-60) +2 Where PE is government expenditure GDP_POT gr is the estimated potential growth D is the public debt and Y is the GDP The parameter a is a fixed number (say 6%) that defines the extent of the correction of expenditure growth as a function of the debt ratio from its target. When the debt/GDP reaches 60% it becomes zero.

12 Technical aspects of the proposed Rule The potential long term growth is based on the average per-capita 10 year growth rate and the CBS projected population growth Potential long term growth estimate will be updated every 4 years based on growth in the previous 10 years. The ceiling will refer to overall expenditures including those of the Social Security, transfers to the health HMOs and contingent expenditures. Expenditures fully financed by foreign governments will be exempt from the ceiling. Interest payments will be calculated according to the EU(?)/SNA standards 2 percent will be added to the calculated ceiling to compensate for price increase.

13 Treatment of Changes in Tax Rates The rule is based on a long term target of reducing the debt/GDP ratio, therefore: –To avoid circumventing the spending ceiling, all tax benefits that are defined as tax reductions to particular groups or sectors, will be treated as expenditure and will be subject to the ceiling –The Cost of changes in the general tax rates, beyond those needed to keep constant tax burden will be offset from the ceiling on expenditure growth

14 Macro Economic Scenarios for Analyzing Fiscal Aggregates Under the Proposed Fiscal Rule * Source: Based on Bank of Israel data Basic Scenario Growth of 4 percent from Delayed Recovery

15 The Path of Government expenditure (percent of GDP) * Source: Based on Bank of Israel data.. %

16 The Path of Deficit (percent of GDP) * Source: Based on Bank of Israel data.. %

17 * Source: Based on Bank of Israel data.. % The Path of the Debt/GDP

18 Thank you