Fiscal Rules and the Budget Process

Fiscal Rules and the Budget Process
by Gian Maria Milesi-Ferretti

The issue of fiscal deficit reduction is a central concern for
policymakers. This concern is heightened by the perception that the conduct
of fiscal policy may have an inherent bias toward budget deficits. This
bias may have both an institutional and a political nature, the former
reflecting imperfections in the rules of the game governing the decision-
making process and the latter reflecting an inherent failure of the
political system to internalize fully all future consequences of current
policy decisions. These issues have shaped the policy debate on fiscal
adjustment in both industrial and developing countries and have led to the
consideration of legislative measures that would constrain government fiscal
policy decisions. This interest, exemplified by the proposal for a balanced
budget amendment in the United States and by the Maastricht criteria on the
size of public sector deficits and debt in the European Union, assumes
particular importance in a country like Italy, where existing fiscal
imbalances pose a serious threat to its early participation in a European
Monetary Union.

This paper discusses the theoretical and empirical literature on the
political economy of budget deficits and fiscal rules and examines in light
of this literature a number of proposals for budgetary reform that have been
put forward in Italy. The paper highlights how two complementary strands of
literature on fiscal rules have developed. The first has examined the
consequences of numerical limits on fiscal variables, such as budget
deficits or government spending. The second has focused instead on the
rules and regulations governing the various stages of the budget process:
the formation of the budget at the government level, its passage through
parliament, and its implementation. These two approaches are reflected in
different proposals for budgetary reforms, some suggesting constitutional
limits on budget deficits and others emphasizing the need to change budget

The current problems plaguing the Italian budget process--lack of
transparency at all its stages, excessive reliance on formal rules,
regulations, and controls, and diffuse accountability--suggest that the
simple reliance on a constitutional rule on budget deficit targets may have
limited effectiveness; it would introduce an additional element of legal
rigidity and create further incentives for creative accounting, unless it
were accompanied by an overall reform of the budget process. Ensuring that
the government's budget proposal reflects prudent fiscal behavior is not
particularly useful if parliament can modify the size of the budget with
relative ease, or if at the implementation stage the discretionary margins
are such that systematic divergences emerge between ex-ante budgeted
expenditures and ex-post actual ones. The paper thus concludes that lack of
transparency in the budget process reduces accountability, makes it more
difficult to monitor and control spending and tax decisions, and reduces the
significance of numerical rules.