## SCOPE FOR IMPROVING ICELAND’S FISCAL FRAMEWORK

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### A. Overview of the Fiscal Rules
- Rules-based, multi-year fiscal planning tool for the general government, consolidating municipalities into a medium-term policy decision exercise.
- Key legal/operational features:
  - Firm legal basis reflecting political consensus.
  - Comprehensive coverage of public sector institutions.
  - Medium-term orientation with five-year fiscal policy statements and annual five-year fiscal strategy plans.
  - Plans based on a medium-term macroeconomic forecast prepared by Statistics Iceland.
  - Annual budgets set nominal revenue projections consistent with the latest economic forecast and binding nominal spending appropriations.
  - Central government budget contains a general contingency reserve of at least 1 percent of total appropriations.
  - Some expenditure functions have additional contingency reserves amounting to up to 2 percent of the budget appropriations for that expenditure function.
- Fiscal rule bounds:
  - Five-year average of general government balances must be higher than zero and any eventual deficit must be less than 2.5 percent of GDP in any given year.
  - Net public debt must remain below 30 percent of GDP and any excess must decline on average (over three years) by at least 5 percent per year.
  - Net public debt excludes pension liabilities and accounts payable and subtracts currency and deposits.
  - Rolling five-year fiscal strategy plans set targets for the nominal increase in public spending and total government liabilities, including pensions, in percent of GDP.
  - Central government sets ceilings in real terms for 35 spending areas.
- Escape clause:
  - Framework allows an escape clause; it was invoked in 2019 following the collapse of WOW air.
  - Revisions included an uncertainty margin for the overall fiscal balance contingent on deviations from the macroeconomic forecast; use must be justified annually with the budget proposal submitted to parliament.

### B. Implications for Fiscal Sustainability
- Formal and algebraic expression of rules: five-year-average balance condition and debt ceiling (notation following Escolano (2010)).
- Empirical status:
  - The five-year average of overall general government balances became positive in 2016.
  - Net debt fell below the 30 percent threshold in 2018 (in 2018, net public debt stood below 28 percent of GDP).
- Dynamic debt relationship and illustrative steady state:
  - Debt evolution (AMt = 0 assumed): dt = (1/(1 + γt)) (dt-1 − bt), where γt is nominal GDP growth.
  - The ratio in parentheses averaged 0.93 in 1998–2018 (excluding 2008–9); standard deviation is 0.03; 67 percent of observations in that period are in the [0.9, 0.96] range.
  - Illustrative steady-state numbers: potential growth 2 percent and inflation around the 2.5 percent target imply the ratio would fluctuate around 0.956.
  - Implication: with steady-state nominal GDP growth at potential, a constant debt-stabilizing overall balance could be negative; illustrative deficit of 1.3 percent of GDP would stabilize public sector debt at a desired level once achieved.
- Fiscal space:
  - Rules that reduce public debt create fiscal space to respond to adverse shocks.
  - With the real interest rates and growth assumed in the illustration, the government could in principle run a deficit of 1.3 percent of GDP on average for five years without increasing the public debt ratio above 30 percent of GDP.
- Limits and discretion:
  - Rules provide wide boundaries but do not specify timing or composition of tax/spending changes.
  - To avoid frequent invocation of the escape clause, authorities need positive five-year average balances and lower public debt—i.e., higher surpluses provide more room to lower balances when needed.
  - The five-year averaging could encourage procyclicality during long cyclical fluctuations.

### C. Historical Procyclicality and Need for Additional Guidance
- Observed procyclicality:
  - Positive correlation between real primary spending growth and real GDP growth in Iceland over 1990–2018, indicating primary public spending has intensified cyclical fluctuations.
  - Iceland’s real GDP growth and volatility are slightly higher than the median in advanced European countries; Iceland experienced significantly larger outliers.
  - Primary spending growth has been higher and significantly more volatile in Iceland compared with the median peer country.
  - Primary spending has limited automatic stabilizers on the spending side; unemployment benefits are a relatively small share of total primary spending.
- Primary spending ratios and output gap:
  - Nominal public spending ratio was slightly countercyclical during 1990–2018, but less so than peer countries.
  - Correlation between primary spending and the output gap was slightly negative in Iceland in 1990–2018, but much more negative on average in other advanced European countries.
  - Structural primary spending ratio in Iceland was procyclical; in other Nordic countries structural spending was countercyclical.
  - Finland recorded the highest negative correlation among peers.

### D. Counterfactual Simulations — Assumptions and Examples
- Common simulation assumptions:
  - Potential growth is constant at 2 percent.
  - Actual GDP = potential output × gross output gap; output gap time series taken from the Central Bank of Iceland’s QMM database published at end-August 2019 with initial period 1998.
  - Nominal GDP growth assumes inflation at the 2.5 percent target.
  - Real interest rates start at 3.44 percent and gradually decline to 2 percent.
  - Initial real interest rate level delivers the prevailing 6 percent nominal interest rate in the treasury’s bond portfolio.
  - Interest rate burden assumes public debt ratio starts at the 2018 net public debt level.
  - Primary revenue to GDP ratio does not change during the period (unit revenue elasticity to the output gap).
  - Starting structural primary surplus is 2.1 percent of GDP.
  - Output gap fluctuations used correspond to Iceland’s experience over the last twenty years; a peak-to-trough difference of 7 percentage points in the output gap is noted.
- Balanced Budget Rule simulation:
  - Overall balance set to zero complies with the fiscal rules (five-year average = 0; net public debt below upper bound).
  - Net public debt ends at about 10 percent of GDP at the end of the twenty-year period.
  - Declining interest rate burden associated with declining debt levels and assumed declining real interest rates provides scope for increasing primary spending over time.
  - Outcome characteristics:
    - Reduces public debt while gradually increasing public spending.
    - Policy is clearly procyclical: real primary spending moves closely with GDP and structural primary spending moves with the output gap.
- Regime switching rule:
  - Alternates between a balanced budget and a 1-percent of GDP surplus when the output gap switches from negative to positive.
  - Key outcomes:
    - Reduces procyclicality.
    - Meets fiscal rules: the 5-year overall government balance by construction never below zero and public debt below the threshold.
    - Net public debt ratio will fall faster than under the balanced budget rule because overall balances are on average larger.
    - Primary spending fluctuates but remains on an upward trend in line with the declining interest rate bill.
- Acyclical fiscal rule (real spending in line with potential GDP):
  - Policy specification implies spending-to-GDP ratio falls with a positive output gap and increases with a negative one.
  - Simulation outcomes:
    - Consistent with Icelandic fiscal rules.
    - Overall balance experiences large fluctuations but remains positive on average; despite being negative in one year, the 5-year average remains above zero over the whole period.
    - Net public debt falls faster than in earlier exercises; net debt becomes negative (a net asset position).
    - Interest rate expense becomes net interest rate income.
    - Upward trend in primary spending disappears; procyclicality is eliminated with real spending at the assumed constant rate of potential growth.
    - Structurally adjusted primary spending is uncorrelated with the output gap.
- Countercyclical fiscal rule (structural primary spending linked to output gap):
  - Policy specification links structural primary spending linearly to the output gap; slope used in simulation: -0.82 (benchmark estimated from Finland over 1990–2018).
  - Simulation outcomes:
    - Rule would require invoking the escape clause in one period with a large negative output gap.
    - Overall balances would fluctuate sharply, ranging from -3 to about 6 percent of GDP.
    - A large average overall balance would sharply reduce public debt and deliver a net asset position in less than a decade.
    - Primary spending would fluctuate without a clear trend; the policy is countercyclical by design.
- Debt-stabilizing, countercyclical fiscal policy:
  - Concept: once public debt reaches a desired safe low level d*, adjust the fiscal rule to keep public debt on average at d* while maintaining countercyclical stance.
  - Exercise adjustments:
    - Change the 5-year average minimum to -2 percent of GDP.
    - Achieved in the simulation by reducing the revenue burden on the economy.
  - Corresponding algebraic expressions for overall and primary balances reported in the source.

### GIMF Simulations — Model Setup and Findings
- Model and calibration:
  - IMF’s Global Integrated Monetary and Fiscal Model (GIMF), dynamic general equilibrium with monetary and fiscal interactions; Ricardian equivalence does not hold.
  - Version calibrated with three blocks: Iceland, the Euro area, and the rest of the world; yields macro ratios resembling Iceland’s.
- Baseline and shock scenario:
  - In the steady state, a 1.1 percent of GDP fiscal surplus results in a net asset position.
  - Simulation assumes an adverse shock raising public debt to about 25 percent of GDP.
  - Fiscal policy rule: maintain a fixed overall balance of 1.1 percent of GDP (consistent with original 2018–2022 fiscal policy statement).
  - Economy experiences a sequence of shocks opening a negative output gap, later positive, and finally a very negative one.
- Composition and multiplier findings:
  - Countercyclical policy via lump-sum transfers:
    - Overall balance moves one-to-one with the output gap when implemented mainly through transfers.
    - Little impact on GDP growth; fiscal multipliers for transfers are close to zero.
    - Policy affects public debt but has negligible effects on output gap, growth, or the golden ratio.
  - Countercyclical policy via government consumption or public investment:
    - Changes in government consumption and investment affect economic activity and can help smooth cyclical fluctuations.
    - Discretionary changes in government consumption require greater increases in transfers to deliver the same overall balance as when discretionary public investment is used.
    - Impact on public debt is similar across government consumption and public investment instruments.
    - Both instruments have clear effects on economic growth and output, quantitative effects differ across instruments and depend on the shock.

### Policy Options, Implementation Issues, and Long-run Stance
- Policy options within fiscal rules:
  - Procyclical if managed at the boundaries of the fiscal rules.
  - Acyclical by holding on average overall fiscal balances of about 2 percent of GDP.
  - Countercyclical by holding higher overall fiscal balances than for an acyclical stance.
- Implications of moving stance:
  - Higher overall balances on average.
  - Lower public debt achieved at a faster rate.
  - Shift away from historical procyclical public spending pattern observed over the last 20 years.
- Alternative protocols:
  - Establish escape-clause protocols triggered by the size of a negative output gap so overall balances would be higher than the boundary but may not fully insure against very large negative output gaps.
  - Would imply slower reduction in net public debt but could still guarantee sustainability if overall balances exceed the debt-stabilizing overall deficit.
- Structural-rule option and challenges:
  - Adding a primary structural balance rule would ensure countercyclicality but adds significant complexity.
  - Design possibility: countercyclical structural primary balance plus acyclical stance for permanent components; transitory components (e.g., investment) drive countercyclical response.
  - Practical challenges: complexity in calibration and operation; uncertainties in output gap and multiplier estimation; transparency concerns requiring close scrutiny by the Fiscal Council.
- Rule adjustment:
  - Once net public debt reaches a socially desirable level, fiscal rule parameters may be modified to keep net public debt fluctuating around that level.

### Annex I — Reasons to Expect Falling Interest Rate Burden in Iceland
- Iceland’s effective interest rate largely exceeds market rates; the difference was about 2.8 percentage points in September 2019.
- Iceland has one of the highest interest rate burdens in percent of GDP, reflecting a very high implicit effective interest rate despite low gross public debt.
- Effective rate expected to decline as outstanding bonds mature and new ones are issued at lower market rates.
- Outstanding Icelandic bonds are not callable, so they cannot be repaid without an upfront cost; net present value of income stream from outstanding bonds implies they are equivalent to higher debt at current market interest rates than registered at book value.
- Debt management operations that reduce outstanding bonds would realize this difference upfront and lower debt service obligations, improving borrowing capacity and reducing borrowing costs for all Icelandic borrowers.

*Source: IMF staff chapter "SCOPE FOR IMPROVING ICELAND’S FISCAL FRAMEWORK" (December 4, 2019).*

### References ______________________________________________________________________________ 21

### SCOPE FOR IMPROVING ICELAND’S FISCAL FRAMEWORK

### A. Overview of the Fiscal Rules
- The fiscal framework is a rules-based, multi-year fiscal planning tool for the general government, consolidating municipalities into a medium-term policy decision exercise.
- Key legal/operational features:
  - Firm legal basis reflecting political consensus.
  - Comprehensive coverage of public sector institutions.
  - Medium-term orientation with five-year fiscal policy statements and annual five-year fiscal strategy plans.
  - Plans based on a medium-term macroeconomic forecast prepared by Statistics Iceland.
  - Annual budgets set nominal revenue projections consistent with the latest economic forecast and binding nominal spending appropriations.
  - Central government budget contains a general contingency reserve of at least 1 percent of total appropriations.
  - Some expenditure functions have additional contingency reserves amounting to up to 2 percent of the budget appropriations for that expenditure function.
- Fiscal rule bounds:
  - Five-year average of general government balances must be higher than zero and any eventual deficit must be less than 2.5 percent of GDP in any given year.
  - Net public debt must remain below 30 percent of GDP and any excess must decline on average (over three years) by at least 5 percent per year.
  - Net public debt excludes pension liabilities and accounts payable and subtracts currency and deposits.
  - Rolling five-year fiscal strategy plans set targets for the nominal increase in public spending and total government liabilities, including pensions, in percent of GDP.
  - Central government sets ceilings in real terms for 35 spending areas.
- Escape clause:
  - The framework allows for an escape clause; it was invoked in 2019 following the collapse of WOW air. Revisions included an uncertainty margin for the overall fiscal balance contingent on deviations from the macroeconomic forecast; use must be justified annually with the budget proposal submitted to parliament.

### B. Implications for Fiscal Sustainability
- Formal expression of rules (as described):
  - The five-year-average balance condition and debt ceiling are summarized algebraically in the text (notation following Escolano (2010)).
- Empirical status:
  - The five-year average of overall general government balances became positive in 2016.
  - Net debt fell below the 30 percent threshold in 2018 (in 2018, net public debt stood below 28 percent of GDP).
- Dynamic relationship between overall balance and net public debt:
  - Debt evolution relation (with AMt = 0 assumed): dt = (1/(1 + γt)) (dt-1 − bt), where γt is nominal GDP growth; implying that when nominal GDP growth is positive and general government accounts are balanced or in surplus, public debt ratio will fall.
  - The ratio in parentheses averaged 0.93 in 1998–2018 (excluding 2008–9); standard deviation is 0.03; 67 percent of observations in that period are in the [0.9, 0.96] range.
  - Illustrative steady-state numbers: potential growth 2 percent and inflation around the 2.5 percent target imply the ratio would fluctuate around 0.956.
  - Implication: with steady-state nominal GDP growth at potential, a constant debt-stabilizing overall balance could be negative; illustrative deficit of 1.3 percent of GDP would stabilize public sector debt at a desired level once achieved.
- Fiscal space:
  - Because rules tend to reduce public debt, they create fiscal space to respond to adverse shocks.
  - With the real interest rates and growth assumed in the illustration, the government could in principle run a deficit of 1.3 percent of GDP on average for five years without increasing the public debt ratio above 30 percent of GDP.
- Limits and discretion:
  - The rules provide wide boundaries but do not specify timing or composition of tax/spending changes.
  - To avoid frequent invocation of the escape clause, authorities need positive five-year average balances and lower public debt—i.e., higher surpluses provide more room to lower balances when needed.
  - The five-year averaging could encourage procyclicality during long cyclical fluctuations.

### C. Historical Procyclicality and Need for Additional Guidance
- Observed procyclicality:
  - Real primary spending growth and real GDP growth correlation was positive in Iceland over 1990–2018, indicating that primary public spending has intensified cyclical fluctuations.
  - Iceland’s real GDP growth and volatility are slightly higher than the median in advanced European countries; Iceland experienced significantly larger outliers.
  - Primary spending growth has been higher and significantly more volatile in Iceland compared with the median peer country.
  - Primary spending has limited automatic stabilizers on the spending side; unemployment benefits are a relatively small share of total primary spending.
- Primary spending ratios and output gap:
  - Nominal public spending ratio was slightly countercyclical during 1990–2018, but less so than peer countries.
  - Correlation between primary spending and the output gap was slightly negative in Iceland in 1990–2018, but much more negative on average in other advanced European countries.
  - Structural primary spending ratio in Iceland was procyclical; in other Nordic countries structural spending was countercyclical.
  - Finland recorded the highest negative correlation among peers.

### D. Counterfactual Simulations — Assumptions and Examples
- Common simulation assumptions:
  - Potential growth is constant at 2 percent.
  - Actual GDP = potential output × gross output gap; output gap time series taken from the Central Bank of Iceland’s QMM database published at end-August 2019 with initial period 1998.
  - Nominal GDP growth assumes inflation at the 2.5 percent target.
  - Real interest rates start at 3.44 percent and gradually decline to 2 percent, as public debt matures and is replaced with lower interest rate debt.
  - Initial real interest rate level delivers the prevailing 6 percent nominal interest rate in the treasury’s bond portfolio.
  - Interest rate burden assumes public debt ratio starts at the 2018 net public debt level.
  - Primary revenue to GDP ratio does not change during the period (unit revenue elasticity to the output gap).
  - Starting structural primary surplus is 2.1 percent of GDP.
  - The output gap fluctuations used correspond to Iceland’s experience over the last twenty years; a peak-to-trough difference of 7 percentage points in the output gap is noted (and is smaller than the median range for European OECD countries during 1990–2018).
- Balanced Budget Rule simulation:
  - Setting the overall balance to zero complies with the fiscal rules (five-year average = 0; net public debt below upper bound).
  - Under the simulation, net public debt ends at about 10 percent of GDP at the end of the twenty-year period.
  - Declining interest rate burden associated with declining debt levels and assumed declining real interest rates provides scope for increasing primary spending over time.
  - Outcome characteristics:
    - Reduces public debt while gradually increasing public spending.
    - Policy is clearly procyclical: real primary spending moves closely with GDP and structural primary spending moves with the output gap.

*Source: IMF staff chapter "SCOPE FOR IMPROVING ICELAND’S FISCAL FRAMEWORK" (December 4, 2019).*

### 17.      These dynamics follow from the relationship between the fiscal aggregates. Given the

### These dynamics follow from the relationship between the fiscal aggregates.

### Relationship between fiscal aggregates and implications
- Given positive nominal growth and the balanced budget, the public debt ratio will be declining.
- The interest rate burden will decline, allowing for real spending to grow faster than real GDP given the fixed revenue to GDP ratio.
- Variables and notation from the source:
  - p_t is the primary balance as a ratio to GDP at time t;
  - Revenue_t and Spending_t refer to the primary revenue and spending;
  - P_t stands for the GDP deflator.

### Counterfactual simulations — Balanced budget rule
- Balanced budget rule: with positive nominal growth and fixed revenue/GDP, net public debt ratio declines.
- Net public debt falls and interest burden declines, enabling upward trend in primary spending in line with declining interest expense.
- Procyclicality is reduced but not eliminated under the balanced budget rule.

### Regime switching rule (alternates balanced budget and surplus)
- Rule specification: alternates between a balanced budget and a 1-percent of GDP surplus when the output gap switches from negative to positive.
- Key outcomes:
  - Reduces procyclicality.
  - Meets fiscal rules: the 5-year overall government balance by construction never below zero and public debt below the threshold.
  - Net public debt ratio will fall faster than under the balanced budget rule because overall balances are on average larger.
  - Primary spending fluctuates but remains on an upward trend in line with the declining interest rate bill.
  - Procyclicality is reduced but not eliminated.

### Acyclical fiscal rule (real spending in line with potential GDP)
- Policy specification (equation (e)):
  - *t Pot_t Spending / P = φ_t  (as presented in the source)
- Rewritten implication (equation (f)): the spending-to-GDP ratio falls with a positive output gap and increases with a negative one.
- Simulation outcomes:
  - The acyclical fiscal policy is consistent with Icelandic fiscal rules.
  - Overall balance experiences large fluctuations but remains positive on average; despite being negative in one year, the 5-year average remains above zero over the whole period.
  - Net public debt falls faster than in earlier exercises; net debt becomes negative (a net asset position).
  - Interest rate expense becomes net interest rate income.
  - Upward trend in primary spending disappears; procyclicality is eliminated with real spending at the assumed constant rate of potential growth.
  - Structurally adjusted primary spending is uncorrelated with the output gap.

### Countercyclical fiscal rule (structural primary spending linked to output gap)
- Policy specification (equation (g) in source):
  - Structural primary spending linked linearly to the output gap; the intercept is the desired structural spending ratio and slope is degree of countercyclicality.
- Calibration detail:
  - Slope used in simulation: -0.82 (benchmark estimated from Finland over 1990–2018).
  - Finland regression example reported: y = -0.8241x + 50.471, R² = 0.5577.
- Simulation outcomes:
  - Such a rule would require invoking the escape clause in one period with a large negative output gap.
  - Overall balances would fluctuate sharply, ranging from -3 to about 6 percent of GDP.
  - A large average overall balance would sharply reduce public debt and deliver a net asset position in less than a decade.
  - Primary spending would fluctuate without a clear trend; the policy is countercyclical by design.

### Debt-stabilizing, countercyclical fiscal policy
- Concept: once public debt reaches a desired safe low level d*, adjust the fiscal rule to keep public debt on average at d* while maintaining countercyclical stance.
- Historical note: public debt had fallen to less than 20 percent before the 2008–9 crisis but rose sharply with the capitalization of a new banking system.
- Policy adjustments in the exercise:
  - Change the 5-year average minimum to -2 percent of GDP.
  - Achieved in the simulation by reducing the revenue burden on the economy.
- Notation and expressions from the source:
  - Overall balance could be changed to average (h) involving d* and parameter γ* (as in the source).
  - Corresponding primary balance equation (i) and identity (j) are reported in the source text.

### GIMF simulations — model setup and baseline
- Model: IMF’s Global Integrated Monetary and Fiscal Model (GIMF), a dynamic general equilibrium model with monetary and fiscal interactions and features that imply Ricardian equivalence does not hold.
- Calibration and structure:
  - Version uses model structure described in Kumhof and others (2010) with three economic-area blocks: Iceland, the Euro area, and the rest of the world.
  - Calibration yields macroeconomic ratios resembling Iceland’s.
- Baseline assumptions:
  - In the steady state, a 1.1 percent of GDP fiscal surplus results in a net asset position.
  - Simulation assumes the economy has suffered an adverse shock raising public debt to about 25 percent of GDP.
  - Assumed fiscal policy rule: maintain a fixed overall balance of 1.1 percent of GDP (consistent with original 2018–2022 fiscal policy statement).
  - The economy experiences a sequence of shocks that open a negative output gap, later turn positive, and finally end in a very negative one.
  - Simulations change different types of public spending to assess composition effects.

### GIMF simulation findings on fiscal composition and countercyclicality
- Countercyclical fiscal policy implemented via lump-sum transfers:
  - Results in overall balance moving one-to-one with the output gap when implemented mainly through transfers.
  - Little impact on GDP growth; fiscal multipliers for transfers are close to zero.
  - Policy affects public debt but has negligible effects on output gap, growth, or the golden ratio.
- Countercyclical policy implemented via government consumption or public investment:
  - Changes in government consumption and investment affect economic activity and can help smooth cyclical fluctuations.
  - Discretionary changes in government consumption require greater increases in transfers to deliver the same overall balance as when discretionary public investment is used.
  - Impact on public debt is similar across government consumption and public investment instruments.
  - Both instruments have clear effects on economic growth and output, but the quantitative effects differ across instruments and depend on the shock.

*Source: Author’s simulations and text from the provided IMF chapter/section.*

### 27.      The Icelandic fiscal framework shares most elements of successful fiscal frameworks

### The Icelandic fiscal framework shares most elements of successful fiscal frameworks

### Overview
- The fiscal framework is backed by a firm legal basis, covers the consolidated general government, and is based on sound accounting practices and budget management arrangements (Hughes and others, 2019).
- There is scope to enhance the framework by providing more structured guidance to fiscal policy in dealing with cyclical fluctuations.

### Current parameters and implications
- The current policy-rule parameters have a bias to reduce net public debt and gradually build fiscal space to deal with adverse shocks.
- By 2018, Icelandic net public debt was below the median level in advanced European countries but was above its own historical minimum and the median in Nordic countries.
- International experience and theoretical models suggest that lower net public debt levels should be expected to reduce effective real interest rates on public debt (Annex I).
- The sharp reduction in public debt over the last five years has already reduced interest rates for public debt remaining in the market but remain to be fully incorporated into the interest bill of the government.

### Policy options, scenarios, and quantitative targets
- Within the fiscal rules, fiscal policy can be:
  - Procyclical if managed to remain at the boundaries of the fiscal rules.
  - Acyclical by holding on average overall fiscal balances of about 2 percent of GDP.
  - Countercyclical by holding higher overall fiscal balances than for an acyclical stance.
- Moving to acyclical or countercyclical policies implies:
  - Higher overall balances on average.
  - Lower public debt achieved at a faster rate.
  - A shift away from the historical procyclical public spending pattern observed in Iceland over the last 20 years.
- Alternative protocol: establish escape-clause protocols triggered by the size of a negative output gap so that overall balances would be higher than the boundary but may not fully insure against very large negative output gaps.
  - This would imply a slower reduction in net public debt but could still guarantee public debt sustainability as long as overall balances exceed the debt-stabilizing overall deficit.
  - Could involve contingent relaxation in overall balances depending on the size of the output gap expected each year.

### Structural-rule option and implementation issues
- Adding a primary structural balance rule would ensure a countercyclical fiscal policy but would add significant complexity.
  - Possible design: a countercyclical rule for the structural primary balance plus an acyclical stance for permanent components within the primary accounts.
  - Permanent components (for example, hiring of personnel or changes in taxation) would grow with potential output to ensure stability.
  - Transitory components (such as investment) would drive the countercyclical response and focus on components with the highest multipliers on economic activity.
- Practical challenges:
  - Significant complexity in calibration and operation.
  - Uncertainties in estimation of the output gap and fiscal multipliers.
  - Transparency concerns requiring close scrutiny by the Fiscal Council.

### Rule adjustment and long-run stance
- Once net public debt reaches a socially desirable level, fiscal rule parameters may be modified to keep net public debt fluctuating around that level.

### Annex I — Reasons to expect falling interest rate burden in Iceland
- Iceland’s effective interest rate largely exceeds market rates; the difference was about 2.8 percentage points in September 2019.
- Iceland has one of the highest interest rate burdens in percent of GDP, reflecting a very high implicit effective interest rate despite low gross public debt.
- The effective rate is expected to gradually decline as outstanding bonds mature and new ones are issued at lower market rates.
- Outstanding Icelandic bonds are not callable, so they cannot be repaid without an upfront cost; the net present value of the income stream from outstanding bonds implies they are equivalent to higher debt at current market interest rates than registered at book value.
- Debt management operations that reduce outstanding bonds would realize this difference upfront and lower debt service obligations, improving borrowing capacity and reducing borrowing costs for all Icelandic borrowers.

*Source: 1islea2019002 - 27. The Icelandic fiscal framework shares most elements of successful fiscal frameworks*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1islea2019002.pdf_