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Fiscal Rules Can Help Improve Fiscal Performance

Customer in Geneva, Switzerland, which introduced “debt brake” rule in 2003 to stabilize public debt level (photo: Martin Reutschi/Newscom)

Fiscal Policy

Fiscal Rules Can Help Improve Fiscal Performance

Manmohan S. Kumar, Emanuele Baldacci, and Andrea Schaechter
IMF Fiscal Affairs Department

December 22, 2009

  • Fiscal rules can help strengthen public finances
  • Financial crisis has strained fiscal rules, with several countries modifying or suspending them
  • Countries with large consolidation needs could design and announce rules now; implementation might need to wait

The use of fiscal rules has been generally associated with improved fiscal performance and more successful fiscal consolidations, although the current financial crisis has strained fiscal rules, says a new study by the IMF’s Fiscal Affairs Department.

The study, “Fiscal RulesAnchoring Expectations for Sustainable Public Finances,” which was discussed by the IMF’s Executive Board in early December as part of the institution’s ongoing analytical research on economic strategies to be adopted after the crisis, argues that fiscal rules can play an important role in helping to strengthen public finances, support fiscal consolidation, and ensure debt sustainability.

In recent years, an increasing number of countries—especially emerging market and low-income economies—have relied on fiscal rules to guide policy. Fiscal rules are numerical targets on fiscal aggregates (the budget balance, public debt, expenditure, or revenue) that are expected to be in place over a long period. Rules aim to correct distorted incentives in policy making, in particular governments’ tendencies to shortsightedness in light of election cycles and competing demands from special interest groups, by binding policy makers to medium-term objectives.

Fiscal rules globally

Fiscal rules have become more common in recent years. Based on a new database spanning the entire Fund membership, 80 countries had national and/or supranational rules in place as of early 2009 (see box). Of these, 21 are advanced economies, 33 emerging markets, and 26 low-income economies. In contrast, in 1990, only seven countries had fiscal rules.

About the database

The new database compiled by IMF staff spans the whole Fund membership and identifies 80 advanced, emerging, and low-income economies with fiscal rules. Data cover national (but not subnational) as well as supranational rules.

The database was compiled on the basis of responses to questionnaires by IMF area departments, an assessment of national fiscal framework legislation, the European Commission’s “Domestic Fiscal Governance Database” for EU countries, and information provided by country authorities. The data cover several dimensions of fiscal rules, such as legal origin of rules, numerical targets and year of adoption, coverage of fiscal aggregates, and the flexibility to respond to shocks.

An index of strength of fiscal rules was also constructed. The index represents the strength of various rules’ dimensions, including coverage, enforcement, flexibility, and supporting procedures.

The rapid expansion over the past decade reflects the adoption of national rules, particularly in Europe and Latin America, as well as the institution of rules embodied in supranational treaties (such as the Stability and Growth Pact in Europe, the West African Economic and Monetary Union, and the Central African Economic and Monetary Community).

According to the study, rules most commonly target the budget balance and government debt. This reflects countries’ preferences for rules with a close link to fiscal sustainability. However, use of expenditure rules has recently increased. In combination with budget balance or debt rules, this may indicate a preference for fiscal adjustment to be implemented by containing or reducing the size of government.

Most fiscal rules had wide coverage and applied either to the general or central government. In countries with strong decentralized structures, strict targets at the regional or local level contributed to anchoring general government budgetary performance and thereby to the success of large fiscal adjustments.

Rules-based fiscal policy is statistically associated with better fiscal performance. While this in itself does not prove that rules are responsible for improved outturns, the increased use of rules over the past few years suggests that countries find them useful for instilling fiscal discipline and for undertaking large adjustments. However, rules adopted without the authorities’ commitment are unlikely to be sustained and may end up undermining policy credibility. Supporting institutions, such as appropriate public financial management systems and independent fiscal agencies, can also enhance the effectiveness of rules.

However, the study notes that rules are not the only way to have strong fiscal performance: fiscal frameworks that do not involve formal rules but focus on transparent and credible strategies backed by proper fiscal institutions can also support fiscal discipline.

Design and implementation

To be effective, fiscal rules should include three components. These components are particularly relevant in today’s environment of weakened public finances and heightened uncertainties about economic and fiscal developments:

An unambiguous and stable link between the numerical target and the ultimate objective, such as public debt sustainability.

Sufficient flexibility to respond to shocks so that the rule does not exacerbate their adverse economic impact. Depending on country circumstances, flexibility might be needed to deal with output, inflation, interest rate and exchange rate volatility, and other unanticipated shocks (for example, natural disasters).

A clear institutional mechanism to map deviations from the numerical targets into incentives to take corrective action. For example, the rule could include a mechanism mandating the correction of deviations over a well-defined time frame (raising the cost of deviations), and an explicit enforcement procedure.

When is it the best time to introduce fiscal rules? According to the paper, fiscal rules should be introduced when countries have already made at least some initial progress toward fiscal consolidation and economic stability. Prior consolidation makes the establishment of the rule more credible. That said, it may not be advisable, in general, to introduce fiscal rules in an excessively uncertain economic environment, as frequent need to modify or violate the rule in response to developments could undermine its credibility.

Application of rules in the current environment

The current financial crisis has strained fiscal rules. In over half the countries with only national fiscal rules, existing frameworks were able to deal with the crisis, aided by flexibility built into numerical constraints or escape clauses. But about a quarter of the countries with national rules modified or suspended them in response to the crisis. For the rest of the countries, a conflict between the fiscal rules and the desired policy response was noted, and it was expected that the rules in these countries would also be modified or suspended. That said, no supranational laws have been changed in response to the crisis.

Looking ahead, the paper noted that rules-based frameworks could play an important role in enhancing confidence and anchoring expectations regarding fiscal sustainability. However, it was essential for these frameworks to be tailored to countries’ circumstances. In countries where the fiscal consolidation needs are large, early implementation of a rule appropriate in the long run could entail an excessively sharp adjustment in the short run. In these cases, it may be helpful to design and announce early on a credible rules-based framework (or the return to an existing one), even though its implementation would need to await a return to more normal economic conditions.

Comments on this article should be sent to imfsurvey@imf.org


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