1. FISCAL RULES REFLECTIONS ON SUCCESS FACTORS AND INHERENT CHALLENGES James A. Brumby Director Governance Global Practice 24 February 2016 PEMPAL 2016 BCoP PLENARY MEETING FISCAL RULES FOR EFFECTIVE AND SUSTAINABLE BUDGETING MINSK, BELARUS 24–26 FEBRUARY 2016

2. 1 Policy Challenge: Conflicting Objectives, Misshapen Policies Long-term development objectives Short-term political objectives Growth and employment generation Macro stability (counter-cyclical fiscal policies) Long-term debt sustainability Elections (political business cycles) Popularity (social largesse; reform aversion; high- visibility, low-impact investments) Fiscal policies that risk being growth-inhibiting, unsustainable, anchorless, ineffective, pro-cyclical

3. 2 Obvious Response: “Depoliticise Fiscal Policies!” Conceptually “ideal” fiscal rule: Balance budget at potential GDP so as to allow for debt sustainability and counter- cyclical policies during periods of recessions (deficits!) and of booms (surpluses!). Difficulty (Impossibility): Estimating and projecting “potential GDP”

4. 3 1991 2014 Source: IMF. … has largely followed an intense debate on the benefits of depoliticising governments’ economic decision-making processes— see, e.g., the blossoming “political business cycle” literature and its unfavourable description of politicians’ motives and findings of political manipulations of the economy by “opportunistic politicians”. From a social-welfare perspective, these political manipulations were regarded sub-optimal. The success of fiscal rules…

5. 4 Fiscal Rules Are (But) Performance Indicators Fiscal rules are generally understood as “a permanent constraint on fiscal policy, typically defined in terms of an indicator of overall fiscal performance” (Kopits and Symansky, 1998), which have been introduced to (i)signal commitment to fiscal discipline; (ii)contain policy discretion; and (iii)prevent pro-cyclical fiscal policies. Fiscal rules tend to be perceived by capital markets as improving long-term fiscal perspectives, thus leading to a reduction in sovereign risk premia and lower interest rates.

6. 5 “Useful But Not A Panacea” Effective designs of fiscal rules need to i.reflect authorities’ ownership for, and commitment to, the corresponding legal constraints (in letter and spirit!); ii.ensure (credibly) the commitment to medium-/long-term fiscal discipline; iii.allow for short-term flexibility and define mechanisms to deal with exceptional economic circumstances; iv.be consistent with complementary macro-economic objectives; and v.be understandable, implementable, monitorable, enforceable, and incentive compatible.

7. 6 (i) Ownership and Policy Commitment (1/4)

8. 7 (i) Ownership and Policy Commitment (2/4)

9. 8 (i) Ownership and Policy Commitment (3/4)

10. 9 (i) Ownership and Policy Commitment (2/4)

11. 10 (ii) Proper Long-Term Policy Anchors The Euro Area example illustrates that intrinsic inconsistencies in, and complex definitions of, fiscal rules weaken the likelihood of providing the long-term policy anchor of debt sustainability.

12. 11 (iii) Beyond Basic “Fair Weather” Rules (1/2) Against this backdrop—and especially importantly for smaller (post-)transition economies—“politically sustainable” fiscal rules need to define explicitly i.“exceptional economic circumstances” and ways to deal with them, both as short-term responses and medium- term corrective adjustments; ii.lumpy, high-impact “priority investments”, including criteria that would exempt them (partially) from applicable rules; and iii.the ability to “carry over” unused fiscal space from years with exceptionally favourable conditions or large privatisation receipts.

13. 12 (iii) The Proper Balance of Flexible Rigidities (2/2) Proper fiscal rules do not substitute for—but complement— policy-makers’ fiscal responsibility.

14. 13 (iv) Component of an Overarching Development Strategy Fiscal rules need to be consistent with a country’s overarching development objectives: Intertemporal aspects of “fiscal solvency”: restricting investments in productive public assets (to limit deficits) can entail significant costs in terms of a country’s permanently foregone growth potential:  early negative cash-flows vs. future returns of public investments and their impacts on a country’s fiscal solvency over a longer-term horizon;  Debt-financed productive expenditure does not necessarily jeopardise fiscal stability. One

15. 14 (v) Characteristics of “Good” Fiscal Rules (1/2) i.Easily understandable: preference for a single fiscal anchor aimed at ensuring public debt sustainability rather than a complex fiscal governance framework! ii.Implementable: focus on “fiscal actions” rather than “fiscal outcomes” (often beyond policy-makers’ control)! iii.Monitorable: consider the use of “outsourced” monitoring through some types of “Fiscal Policy Committees” à la Wyplosz and Eichengreen! iv.Enforceable: carefully consider options for sanctions  “ex ante” (at the budget preparation stage) and  “ex post” (at the budget implementation stage)! v.Incentive compatible: ensure constraints to recurrent expenditure items (such as public sector wages) and focus on impact-linked prioritisation criteria for capital expenditures!

16. 15 (v) Characteristics of “Good” Fiscal Rules (2/2) In the end, fiscal rules are (i)a useful policy instrument defining benchmarks of prudence and foresight; (ii)no panacea against politico-fiscal irresponsibility. For reasons of political sustainability, they need to (i)enjoy the “ownership” of the entire political spectrum and, as such, are best anchored in a country’s Constitution; (ii)be sufficiently simple, difficult to manipulate, easy to monitor, and embedded in the country’s overall growth and development strategy.

17. 16 One Suggestion For Such A Fiscal Rule } “Golden Rule” (pro-growth and not dependent on GDP or GDP growth estimates) } … ensuring public debt sustainability (with special rules for “exceptional economic circumstances”) Budgetary Deficit ≤ Public Investments subject to Public Debt ≤ Pre-specified Upper Limit