## SECOND-GENERATION FISCAL RULES

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### Executive summary: purpose and main messages
- Fiscal rules are widely used to constrain discretion and promote fiscal discipline; more than 90 countries are using fiscal rules today.
- Main goals:
  - commit policymakers to fiscal sustainability;
  - enhance transparency;
  - signal to financial markets the course of fiscal policy;
  - catalyze broad agreements on sound fiscal strategies (political function).
- Criticisms:
  - too rigid and complicated;
  - poor track record of compliance;
  - potential to encourage creative accounting and compression of public investment and social spending.
- New evidence reported:
  - well-designed rules are effective in constraining excessive deficits;
  - successful rules generally have broad institutional coverage, are tightly linked to fiscal sustainability objectives, are easy to understand and monitor, and support countercyclical fiscal policy;
  - supporting institutions, like fiscal councils, are important;
  - poorly designed rules that do not align with country circumstances can be counterproductive;
  - novel empirical research finds that fiscal rules can reduce the deficit bias even when they are not complied with.
- Effective rules help build and preserve fiscal space while allowing sensible use:
  - encourage building buffers in good times;
  - allow fiscal policy to support the economy in bad times;
  - imply letting automatic stabilizers operate symmetrically and including escape clauses for discretionary support when needed;
  - by supporting credible commitment to fiscal sustainability, rules can create space for financing growth-enhancing reforms and inclusive policies.
- Three desired properties: simplicity, flexibility, and enforceability — very difficult to attain simultaneously.
- Second-generation reforms (post-GFC) expanded flexibility (for example, with new escape clauses) and improved enforceability (independent fiscal councils, broader sanctions, correction mechanisms), but incremental reforms made systems more complicated and compliance has not improved.
- Three guiding principles for future reforms:
  - replace incremental/piecemeal reform with a comprehensive strategy ensuring internal consistency between rules;
  - include a debt anchor establishing a medium-term objective combined with a small number of operational rules guiding annual policy;
  - simplify flexibility provisions (for example, clear escape clauses; greater emphasis on expenditure rules to allow automatic stabilizers);
  - promote compliance by raising reputational costs for noncompliers and creating more tangible benefits for compliers rather than relying predominantly on financial penalties.

### Evolution, definitions, and functions
- Definition and scope:
  - Numerical fiscal rules are lasting constraints on fiscal policy through fixed numerical limits (floors or ceilings) on fiscal variables set in legislation and binding for at least three years.
  - Distinct from procedural rules that set standards on how the annual budget is prepared and executed.
- Functions (three channels):
  - Commitment device: tie hands of government; noncompliance raises reputational/electoral costs and sometimes sanctions.
  - Signaling effect: enhance transparency and reveal government fiscal preferences to public and markets.
  - Political function: serve as focal points to facilitate formation and stability of political coalitions and enhance coordination.
- Role in correcting deficit bias:
  - Deficit bias arises from political incentives (common pool problems, reelection concerns).
  - Fiscal councils complement rules by magnifying reputational costs of breaches.
- Benefits and desired behavior:
  - Let automatic stabilizers operate in bad times and include escape clauses for discretionary support in special circumstances.
- Costs and risks of poorly designed rules:
  - Some rules (for example, nominal deficit caps) can be procyclical.
  - Rules silent on composition of adjustment can produce a composition bias away from investment toward visible current spending.
  - Adoption without political buy-in or sound PFM can reduce transparency via creative accounting or off-budget operations.

### From first- to second-generation rules and remaining challenges
- First-generation (pre-GFC):
  - Emphasized simplicity but lacked enforcement; added flexibility (cyclical adjustments) which complicated enforcement.
- Second-generation (post-GFC):
  - More enforceable, flexible, and operational; originated in Europe and spread worldwide.
  - Escape clauses more detailed; rules permitting automatic stabilizers became widespread.
  - Independent fiscal councils and upgraded enforcement in many jurisdictions.
- Remaining challenges:
  - Multiplication of rules: incremental amendments produced overlaps, inconsistencies, and confusion; trend toward more rules per country is global.
  - Complexity: movement from simple nominal rules toward complex rules with multiple clauses and adjustable thresholds.
  - Low compliance: breaches frequent and not diminished despite reforms.
    - European national rules complied with about half of the time between 1995 and 2015 (excluding escape clauses).
    - Focusing on budget balance rules, compliance was close to 50 percent in the past three decades (not correcting for escape clauses).
  - Reasons for noncompliance: long-lasting shocks (GFC, commodity price collapse), excessive complexity and multiplicity of inconsistent rules.

### Empirical evidence on effectiveness and heterogeneity
- Correlations and causality:
  - Countries with rules tend to have lower deficits and debt relative to countries without rules.
  - Representative dataset counts: With rule = 1,192 observations. Without rule = 344 observations.
  - Causality is difficult due to selection bias; rigorous estimations often find statistically insignificant average effects after controlling for country characteristics.
- Heterogeneous effects:
  - Rule design matters: indices of rule strength (coverage, independence of monitoring, statutory base, flexibility, correction mechanisms, sanctions) show more binding rules yield stronger discipline.
  - Example estimate: a rise in the IMF rule’s strength index from the first to the third quartile leads to an average improvement of 0.6 percentage point of GDP in the overall fiscal balance.
  - US state-level evidence: more binding nominal balance rules yield stronger discipline (with caveats).
- Distributional "magnet effect":
  - Rules concentrate deficits toward the middle of the distribution:
    - About one-fifth of observations move toward the middle, with 10 percent shifting from a deficit above 3 percent of GDP to below 3 percent.
    - In about three-quarters of European countries, fiscal deficits would, on average, have been larger without the rule.
  - Over time, the gap between actual deficit and the rule’s ceiling tends to diminish (symmetry): noncompliers improve and overperformers drift toward the ceiling.
- Interpretation:
  - Rules can act as focal points or de facto targets; calibration and communication matter.

### Financial-market perceptions and compliance signals
- Markets view rules through:
  - Commitment effect: change in current fiscal behavior.
  - Signaling effect: information about future fiscal policy.
- Empirical evidence:
  - Use of rules tends to lower sovereign spreads and decrease the response of spreads to fiscal variables.
  - EU Excessive Deficit Procedure (EDP) evidence: sovereign spreads of countries under EDP are on average higher by 50 to 150 basis points than in countries without EDP, correcting for other determinants.
  - Interpretation: EDP has not been fully credible as a correction mechanism; it may be revealing information about future policy instead.

### Case-study lessons: five features associated with successful rules
- Lesson 1 — Broad institutional and economic coverage:
  - Limit loopholes; example: Brazil’s primary balance targets covering central government, social security, subnational governments, and state-owned enterprises.
- Lesson 2 — Build buffers in upturns and allow support in downturns:
  - Save revenue windfalls; rules allowing automatic stabilizers (for example, expenditure ceilings or cyclically adjusted balances) preserve countercyclical policy.
  - Sweden and Switzerland: successful stabilization aided by independent experts and upgraded communication.
- Lesson 3 — Good calibration of thresholds:
  - Thresholds should be set prudently and updated regularly.
  - Critique of Maastricht: 3 percent deficit ceiling combined with 60 percent debt ceiling implies a deficit consistent with 60 percent debt should be below 2 percent of GDP given long-term nominal growth closer to 3 percent.
- Lesson 4 — Well-designed escape clauses for tail events:
  - Escape clauses need precise definitions covering events truly outside government control; India’s current escape clause is under revision.
- Lesson 5 — Supporting institutions foster compliance:
  - Fiscal councils enhance transparency and credible compliance assessment; error-correction procedures (for example, “debt brakes”) can chart adjustment paths after breaches.

### Guiding principles and policy recommendations
- Holistic strategy and internal consistency:
  - Replace incremental reforms with comprehensive frameworks ensuring internal consistency among a small number of rules.
  - Anchor frameworks with a debt objective plus a small number of operational rules; a single operational rule is generally preferable as default.
  - Observed statistics: about a quarter of countries with rules-based frameworks violate the anchoring principle:
    - Almost 10 percent of countries have a debt rule without an operational rule.
    - About 15 percent of countries have only operational rules (but no debt rule).
- Parsimony:
  - Parsimonious frameworks (a debt rule anchor plus a small number of operational variables) are easier to monitor and communicate.
- Calibration and correction mechanisms:
  - Set the debt ceiling first and calibrate operational rules from the debt ceiling.
  - Correction mechanisms should define the adjustment path after breaches to avoid drifting from the anchor.
- Flexibility made simpler:
  - Distinguish predictable events (handled via indicator definitions) from unpredictable fiscal risks (handled via well-defined escape clauses).
  - Recommend greater reliance on expenditure ceilings to let automatic stabilizers operate while simplifying implementation.
  - Cyclically adjusted balance rules: use caution; under real-time measurement errors they can overestimate fiscal space.
    - Euro area evidence 2003–16: output gap underestimated in real time by 1.3 percentage points on average, implying cyclically adjusted balance overestimated by 0.5 percentage points of potential GDP on average under certain elasticity assumptions.
- Expenditure rules advantages and downsides:
  - Advantages: allow automatic stabilizers, simpler, more transparent, resilient to measurement errors.
  - Downside: do not cover revenues and cannot ensure sustainability without complementary mechanisms.
- Flexibility provisions (escape clauses) should have:
  - (i) a limited and clearly defined set of triggering events;
  - (ii) time limits on deviation;
  - (iii) requirements to return to targets and possibly offset accumulated deviations.
- Country tailoring and sequencing:
  - Tailor rules to country needs and capacities; sequence institutional reforms (upgrade PFM before strict rules where capacity is weak).
  - Commodity exporters: adopt net wealth or precautionary buffer approaches; consider expert committees or fiscal councils for price projections.
  - Developing and low-income countries: emphasize self-insurance (stabilization funds, revenue split rules) and well-defined escape clauses.
- Promoting compliance:
  - Formal financial sanctions have limited effectiveness and credibility; a gradual sanctions regime is preferable where used.
  - Reputation-based mechanisms (fiscal transparency, well-resourced independent fiscal councils) appear more promising.
  - Strengthen tangible benefits for compliers (for example, conditional access to supranational funds or stabilization capacity).

### Implementation challenges and trade-offs
- Single operational rule challenges:
  - May require a debt feedback/correction mechanism to ensure the debt objective is met.
  - Risk of adverse composition effects (e.g., cuts to public investment).
  - If side effects large, consider two operational rules (for example, add a floor on capital expenditure or a ceiling on current expenditure).
- Measurement and monitoring issues:
  - Cyclically adjusted indicators are unobservable and subject to large real-time revisions; mandate simple methods or bind such rules ex ante.
  - Expenditure rules reduce measurement error risks but are sensitive to initial conditions; need calibration to sustainability.
- Flexibility in developing countries:
  - Limited access to credit markets implies self-insurance and buffering are critical; rules must not unduly constrain development financing.

### Empirical summary and caveats
- Empirical evidence suggests rules can be effective at tackling the deficit bias when well-designed; they do not have universal effects.
- Key design features enhancing effectiveness:
  - Broad coverage, saving in good times, prudent calibration, precise escape clauses, and supporting institutions enhancing transparency and accountability.
- Three guiding principles restated:
  - Holistic design with clear hierarchy (anchoring, parsimony, consistency);
  - Enhance flexibility through streamlined provisions and reliance on expenditure ceilings;
  - Favor reputation-based enforcement (transparency and fiscal councils) over formal financial sanctions.
- Caveats:
  - The Note is a first step; second-generation rules are recent and evolving, so definitive assessment is premature.

*Source: SECOND-GENERATION FISCAL RULES, IMF Staff Discussion Note (Executive Summary and selected excerpts).*

### EXECUTIVE SUMMARY ______________________________________________________________________________ 4

### SECOND-GENERATION FISCAL RULES

### Executive summary: purpose and main messages
- Fiscal rules are widely used to constrain fiscal policy discretion and promote fiscal discipline.
- More than 90 countries are using fiscal rules today.
- Main goals of fiscal rules:
  - commit policymakers to fiscal sustainability,
  - enhance transparency,
  - signal to financial markets the course of fiscal policy,
  - catalyze broad agreements on sound fiscal strategies (political function).
- Criticisms of fiscal rules:
  - too rigid and complicated,
  - poor track record of compliance,
  - potential to encourage creative accounting and compression of public investment and social spending.
- New evidence reported in this Note:
  - well-designed rules are effective in constraining excessive deficits;
  - successful rules generally have broad institutional coverage, are tightly linked to fiscal sustainability objectives, are easy to understand and monitor, and support countercyclical fiscal policy;
  - supporting institutions, like fiscal councils, are important;
  - poorly designed rules that do not align with country circumstances can be counterproductive;
  - novel empirical research finds that fiscal rules can reduce the deficit bias even when they are not complied with.
- Well-designed rules help build and preserve fiscal space while allowing its sensible use:
  - encourage building buffers in good times,
  - allow fiscal policy to support the economy in bad times,
  - imply letting automatic stabilizers operate symmetrically over the cycle and including escape clauses for discretionary support when needed,
  - by supporting credible commitment to fiscal sustainability, rules can create space for financing growth-enhancing reforms and inclusive policies.
- Three main properties for effective fiscal rules: simplicity, flexibility, and enforceability.
  - Achieving all three simultaneously is very difficult.
  - Second-generation reforms (post-GFC) expanded flexibility (for example, with new escape clauses) and improved enforceability (independent fiscal councils, broader sanctions, correction mechanisms), but incremental reforms have made systems more complicated and compliance has not improved.
- Three guiding principles proposed for future reforms:
  - replace incremental/piecemeal reform with a comprehensive strategy ensuring internal consistency between rules;
  - include a debt anchor establishing a medium-term objective combined with a small number of operational rules guiding annual policy;
  - simplify flexibility provisions (for example, clear escape clauses; greater emphasis on expenditure rules to allow automatic stabilizers);
  - promote compliance by raising reputational costs for noncompliers and creating more tangible benefits for compliers rather than relying predominantly on financial penalties.

### Introduction: context, objectives, and empirical approach
- Historical adoption and rationale:
  - Over the past 30 years, a growing number of countries have subjected fiscal policy to numerical rules.
  - Fiscal rules are lasting constraints on aggregate indicators of fiscal performance, such as the budget balance.
  - The main concern motivating rules is the “deficit bias,” linked to public debt buildup.
- Trade-offs and criticisms:
  - Adoption often coincides with stronger fiscal performance, but rules criticized for complexity, rigidity, and weak compliance.
  - Rigid rules may impede countercyclical fiscal support when monetary policy is constrained.
  - Efforts to achieve formal compliance have produced undesirable side effects (creative accounting, compression of investment and social spending).
- Focus and empirical contribution of the Note:
  - Primary focus: ability of fiscal rules to contain excessive deficits, based on new empirical analysis.
  - Evidence draws on six Background Papers covering a relatively long time horizon (three decades) and a broad cross-section of IMF members (advanced, emerging, and low-income economies).
  - Key contribution: systematically explore the causal relationship between adoption of fiscal rules and the level of the deficit, accounting for heterogeneity across rules and countries and addressing endogeneity concerns.

### From first- to second-generation rules: definitions, functions, and evolution
- Definition and scope:
  - Numerical fiscal rules: lasting constraints on fiscal policy through predetermined limits on aggregate fiscal indicators; generally defined as fixed numerical limits (floors or ceilings) on fiscal variables set in legislation and binding for at least three years (Lledó and others 2017).
  - Distinct from procedural rules, which set standards on how the annual budget should be prepared and executed.
  - Fiscal rules define a perimeter within which fiscal aggregates can freely evolve; they are constraints, not year-by-year targets.
- Functions of fiscal rules (three main channels):
  - Commitment device: tie the hands of government and limit fiscal discretion; noncompliance raises reputational/electoral costs and sometimes sanctions.
  - Signaling effect: enhance transparency and reveal government fiscal preferences and plans to public and markets.
  - Political function: serve as focal points to facilitate formation and stability of political coalitions and enhance coordination.
- Role in correcting deficit bias (Box 1 summary):
  - Deficit bias arises from political incentives (common pool problems, reelection concerns) that produce systematically larger deficits under discretion.
  - Rules are the instrument of choice to correct excessive deficits because delegation of fiscal instruments to independent agencies raises legitimacy issues and fiscal councils complement rather than substitute for rules.
  - Fiscal councils can magnify reputational costs of breaching rules, increasing effectiveness.
- Benefits and desired behavior:
  - By containing excessive deficits, rules build and preserve fiscal space necessary for stabilizing, growth-friendly, and inclusive policies.
  - Good rules should let automatic stabilizers operate in bad times to allow countercyclical fiscal response and include escape clauses for discretionary support in special circumstances (for example, protracted lack of demand or when monetary policy is constrained).
- Costs and risks of poorly designed rules:
  - Some rules (for example, nominal deficit caps) can be procyclical.
  - Rules silent on composition of adjustment can produce a composition bias (reallocation away from investment and longer-term benefits toward immediately visible but unproductive spending).
  - Rules adopted without sufficient political buy-in or solid public financial management can reduce transparency via creative accounting or off-budget operations.

### Evolution and challenges of second-generation rules
- Historical trajectory:
  - First-generation rules (before the global financial crisis, GFC):
    - Tried to combine simplicity and flexibility but lacked adequate enforcement mechanisms.
    - Enhanced flexibility (for example, cyclical adjustments) made rules harder to enforce.
  - Second-generation rules (since the GFC):
    - Attempt to strengthen enforceability while enhancing flexibility.
    - Enforcement and monitoring mechanisms upgraded almost everywhere.
    - Fiscal rule frameworks have become more complicated, often impeding their ability to frame and guide fiscal policy effectively.
- Tension highlighted:
  - The three desirable properties—simplicity, flexibility, enforceability—are difficult to achieve simultaneously; navigating trade-offs requires tailoring to country characteristics.

### Key prescriptions and design guidance (high-level)
- Holistic strategy and internal consistency:
  - Replace incremental and piecemeal reforms with comprehensive frameworks that ensure internal consistency between rules.
  - Include a debt anchor establishing a medium-term objective plus a small number of calibrated operational rules guiding annual fiscal policy.
- Simpler flexibility:
  - Simplify and increase transparency of flexibility provisions (for example, clear escape clauses).
  - Consider placing greater emphasis on expenditure rules to allow automatic stabilizers to operate.
- Promote compliance through incentives:
  - Strengthen reputational costs for noncompliance and create more tangible benefits for compliance.
  - Move beyond predominant reliance on financial penalties, which often lack credibility.

*Source: SECOND-GENERATION FISCAL RULES, IMF Staff Discussion Note (Executive Summary).*

### 13.      While the first principles motivating the adoption of fiscal rules are straightforward,

### SECOND-GENERATION FISCAL RULES

### Motivation and design trade-offs
- Fiscal rules aim to correct the deficit bias efficiently but face trade-offs among three desired properties: simplicity, flexibility, and enforceability.
- These properties are "very difficult to attain simultaneously." Waves of reforms reflect attempts to reconcile tensions among them.

### First-generation rules (pre-GFC)
- Early rules emphasized simplicity (e.g., balanced budget rules after World War II).
- Flexibility was progressively added via escape clauses and cyclical adjustments to avoid excessive rigidity.
- Increased flexibility complicated enforcement and weakened the rules’ role in anchoring expectations of debt sustainability.
- Examples:
  - Structural balance rule introduced in Chile in 2001 and in the European supranational fiscal framework in 2005.
- Enforcement and monitoring procedures were relatively underdeveloped prior to the GFC.

### Emergence of second-generation rules (post-GFC)
- Defined in this Note as rules introduced since the GFC; originated in Europe and spread worldwide.
- Characterized as more enforceable, flexible, and operational than predecessors.
- Reforms sought to enhance flexibility and enforceability, often at the expense of simplicity.
  - Escape clauses became more detailed, covered a broader range of circumstances, and provided guidance on the path back to numerical limits.
  - Rules permitting automatic stabilizers to operate freely (via cyclically adjusted deficits or expenditure ceilings) became widespread.
  - Flexibility introduced to accommodate policies with short-term fiscal cost but long-term benefits (e.g., public investment under the European Stability and Growth Pact).
- Enforcement enhancements:
  - Independent fiscal councils tasked with monitoring compliance and limiting circumvention (overoptimistic forecasts, manipulation of cyclically adjusted indicators).
  - European Union: reduced political interference in SGP enforcement, expanded reach of potential sanctions, and introduced formal correction mechanisms.

### Remaining challenges with second-generation rules
- Three main problem areas:
  - Problems associated with the combination (multiplication) of rules:
    - Incremental, partial amendments produce overlaps, inconsistencies, and confusion.
    - Undermines credibility by fueling the perception that rules can be changed when inconvenient.
    - Trend toward more rules per country is global.
  - Complexity of more flexible rules:
    - Movement from simple nominal rules toward complex rules with multiple clauses and adjustable thresholds.
    - Growing sophistication has accelerated in the past decade.
  - Low compliance:
    - Breaches have been frequent and have not diminished despite reforms.
    - In Europe, national rules complied with about half of the time between 1995 and 2015, excluding escape-clause circumstances (Reuter 2017).
    - At the supranational level, EU countries have been under Excessive Deficit Procedures about half of the time.
    - Global assessment is harder due to diversity; focusing on budget balance rules, compliance was close to 50 percent in the past three decades (not correcting for escape clauses and contingencies).
- Reasons for persistent noncompliance:
  - Long-lasting fiscal impacts of the GFC and commodity price collapse.
  - Reforms address prior shortcomings but fail to anticipate future challenges.
  - Excessive complexity and multiplicity of inconsistent rules make compliance with the whole framework harder.

### Effectiveness: empirical evidence and interpretation
- At first glance, rule adoption correlates with stronger fiscal positions and more stabilizing policies:
  - Countries with rules tend to have lower fiscal deficits and debt compared with countries without rules.
  - IMF (2015b) finds that, in advanced economies, adoption of rules "more than doubles the negative correlation between government size and output volatility" (a proxy for stabilizing effect of automatic stabilizers).
  - Example dataset counts: With rule = 1,192 observations. Without rule = 344 observations.
- Causality is difficult to establish due to selection bias (e.g., societal preference for fiscal prudence).
  - Meta-analysis by Heinemann, Moessinger, and Yeter (2017) finds positive average effect but rigorous estimations often fail to identify systematic differences once country characteristics are controlled.
  - Second Background Paper (Caselli and Reynaud) on a global panel of 142 countries over 1985–2015 finds the effect of rule adoption on the fiscal deficit is statistically insignificant after addressing endogeneity.
- Heterogeneity matters: an “average” rule in an “average” country may be ineffective; well-designed rules in suitable contexts can perform better.

### Heterogeneous effects across rule designs and countries
- Rule design matters: stronger, better-designed rules tend to reduce fiscal deficits.
  - Studies using strength indices (institutional coverage, independence of monitoring/enforcement bodies, statutory base, flexibility, correction mechanisms, sanctions) find more binding rules have stronger disciplinary effects.
  - Example estimates: a rise in the IMF rule’s strength index from the first to the third quartile leads to an average improvement of 0.6 percentage point of GDP in the overall fiscal balance (second Background Paper).
  - US state-level evidence: more binding nominal balance rules yield stronger discipline (with caveats: rainy day funds, federal stabilization role).
- Distributional impacts and the "magnet effect":
  - Rules affect the distribution of deficits—concentrating deficits toward the middle:
    - Third Background Paper (Caselli and Wingender) finds the distribution of deficits is more concentrated among rule adopters: fewer very high deficits and fewer very high surpluses versus counterfactual nonadopters.
    - Empirical movements: about one-fifth of observations move toward the middle of the distribution, with 10 percent shifting from a deficit above 3 percent of GDP to below 3 percent.
    - In about three-quarters of European countries, fiscal deficits would, on average, have been larger without the rule.
  - Over time, the gap between actual deficit and the rule’s ceiling tends to diminish, showing symmetry: noncompliers improve and overperformers drift toward the ceiling (fourth Background Paper, Lledó and Reuter, sample of 49 advanced and developing countries over 1985–2015).
  - The magnet effect is stronger when breaches are large and infrequent; weaker for small and frequent deviations that can be accommodated within flexibility provisions.
- Interpretation:
  - Rules may act as focal points or de facto targets rather than mere ceilings; calibration should account for the possibility that ceilings are treated as targets.
  - Communication of rule intent and clarity on which elements are binding matter for outcomes.

### Policy implications and guidance
- Calibrate ceilings conservatively to account for the magnet effect, recognizing political challenges in adopting conservative thresholds.
- Clearly communicate the rule’s intent and explicitly identify which elements of the framework are truly binding.
- Improve coherence of the rule set to avoid overlaps, inconsistencies, and perceived ease of amendment.
- Balance flexibility and enforceability while reducing unnecessary complexity that impedes compliance.
- Strengthen independent monitoring and enforcement mechanisms (e.g., fiscal councils, formal correction mechanisms) to limit circumvention via forecast manipulation or cyclically adjusted indicator manipulation.

*Source: Excerpt from sdn1804-on-second-generation-fiscal-rules.pdf*

### 28.      Another test of fiscal rules’ effectiveness is whether their adoption affects perceptions

### 28.      Another test of fiscal rules’ effectiveness is whether their adoption affects perceptions of fiscal sustainability

### Financial-market perceptions and empirical evidence
- Financial markets view fiscal rules as credibility-enhancing devices through two channels:
  - “commitment effect”: the ability of rules to change current fiscal behavior.
  - “signaling effect”: the ability of rules to convey useful information about future fiscal policy.
- Empirical findings:
  - A significant empirical literature shows that the use of rules tends to lower sovereign spreads and decrease the response of spreads to fiscal variables.
  - Representative citations in the literature include Bayoumi, Goldstein, and Woglom 1995; Poterba and Rueben 1999; Johnson and Kriz 2005; IMF 2009; Iara and Wolff 2010; Feld and others 2017.

### Rule compliance and market responses (EDP evidence)
- Evidence from the fifth Background Paper (Diaz Kalan, Popescu, and Reynaud) on European Union countries:
  - Sovereign spreads of countries under Excessive Deficit Procedures (EDP) are on average higher by 50 to 150 basis points than in countries without EDP, correcting for other determinants of spreads.
  - The difference in spreads is larger for countries with multiple EDP episodes.
- Interpretation:
  - Higher spreads under EDP suggest the EDP has not been fully credible as a correction mechanism (weakening the commitment channel).
  - Alternatively, the EDP may be revealing information about future fiscal policy and national preferences beyond current fundamentals, implying the SGP operates primarily through the signaling channel.
- Note: If the correction mechanism were fully credible, markets should not penalize countries under EDP and may even interpret the procedure positively by lowering spreads.

### Overarching message on effectiveness
- Fiscal rules are not a panacea but can reduce the deficit bias depending on country circumstances and design features.
- “Well-designed” rules appear more impactful than inadequate ones, motivating granular exploration of rule characteristics and country circumstances.

### Case-study lessons: features associated with successful rules (summary of five key lessons)
- Source case studies: Botswana, Brazil, Chile, India, the Netherlands, Norway, Sweden, Switzerland (success defined as effectiveness rather than strict legal compliance).
- Lesson 1 — Broad institutional and economic coverage:
  - Limitations in coverage open loopholes and encourage circumvention.
  - Examples of coverage practices: budget-balance rules defined as overall balance rather than current balance; expenditure rules including tax expenditures; coverage of state-owned enterprises with significant budget risks.
  - Brazil: primary balance targets cover central government, social security, subnational governments, and state-owned enterprises.
- Lesson 2 — Design that builds buffers in upturns and allows support in downturns:
  - Importance of saving revenue windfalls to avoid ratcheting up debt.
  - Nominal budget balance rules can trigger procyclical policies (example: Brazil and India).
  - Rules allowing automatic stabilizers (for example, expenditure ceilings) can preserve countercyclical policies.
  - Sweden and Switzerland: successful stabilization with over-the-cycle or cyclically adjusted balance rules; success aided by independent experts and upgraded communication.
- Lesson 3 — Good calibration of the threshold:
  - Thresholds should be set prudently to preserve buffers for shocks.
  - Calibration should be guided by economic analysis and updated regularly, though ad hoc tinkering has been common.
  - Example critique: Maastricht Treaty’s 3 percent of GDP deficit ceiling combined with a 60 percent public debt ceiling reflected early 1990s European averages; with long-term nominal growth closer to 3 percent, the deficit consistent with a 60 percent of GDP long-term debt anchor should be below 2 percent of GDP.
- Lesson 4 — Well-designed escape clauses for tail events:
  - Without precise escape clauses, rules are often suspended or governments use ad hoc measures after large shocks.
  - Escape clauses need precise definitions covering events truly outside government control.
  - India: current escape clause allows deviations “as the central government may specify” and is under revision.
- Lesson 5 — Supporting institutions to foster compliance:
  - Fiscal councils can enhance budget transparency, credibility of accounts and forecasts, and provide long-term sustainability assessments (example: the Netherlands).
  - Fiscal councils can estimate structural balances (example: Chile) and publicly assess compliance with over-the-cycle rules (example: Sweden).
  - Error-correction procedures (for example, “debt brakes”) can chart adjustment paths after a breach; Switzerland records spending overruns in a notional account that must be rebalanced through subsequent expenditure adjustments once cumulative slippages exceed a certain level.

### Enabling factors for successful rules
- Two instrumental enabling factors:
  - Sound public financial management systems (improved budget planning, execution, accounting, reporting).
  - Sufficient political buy-in and public support for the rule’s objectives to prevent creative accounting and circumvention.
- Example: Sweden’s respect for rules reinforced by broad public and political consensus after large deficits in the early 1990s.

### Country tailoring and sequencing
- Rule features must be tailored to country needs and capacities:
  - Cyclically adjusted balance rules are difficult for many developing countries with irregular business cycles; ad hoc rules to save windfalls may be more practical (IMF 2018c).
  - Commodity exporters need calibration that reflects short- and long-term commodity price uncertainty (Appendix 2).
  - Reform of supporting institutions should be sequenced: countries with weak public financial management should upgrade systems first so the budget constrained by the rule effectively guides execution and revenue collection.

### Guiding principles for future reforms (three general principles)
- Reform objectives: better combine simplicity, flexibility, and enforceability; address challenges in combining multiple rules consistently and transparently, achieving flexibility without excessive complication, and enhancing compliance.
- Principle A — A Holistic Approach to Rules-Based Fiscal Frameworks:
  - Partial and incremental reforms create overlaps and inconsistencies; a comprehensive and predictable approach is preferable.
  - Regularly scheduled reviews should assess whether the fiscal framework achieves its objectives and inform whether rules should be kept, revised, or abandoned; reviews could be conducted by independent experts or bipartisan committees to avoid politicization.
  - Need for a set of principles for multiple rules within a holistic framework—this Note identifies three essential and interdependent properties: anchoring, parsimony, and consistency.
- Anchoring:
  - Fiscal frameworks should be anchored by a debt objective (a specific debt ceiling) to preserve fiscal sustainability and inform medium-term expectations.
  - The debt anchor is not meant to provide short-term guidance; operational rules (expenditure or fiscal balance) provide variables under government control and have a predictable link to debt dynamics.
  - Observed statistics at time of writing:
    - About a quarter of countries with rules-based frameworks violate the anchoring principle:
      - Almost 10 percent of countries have a debt rule without an operational rule.
      - About 15 percent of countries have only operational rules (but no debt rule).
  - Hierarchy between the anchor and operational rules:
    - The anchor should not be binding for the annual budget; aim is to bring predicted public debt at or below the ceiling over the medium term.
    - Operational rules should be binding for the annual budget; distinction between rules that bind ex ante only versus those that also bind ex post.
    - Ex post binding rules should concern indicators under policymakers’ control (for example, an expenditure growth ceiling).
    - Operational rules based on hard-to-measure indicators (for example, cyclically adjusted balance) could bind ex ante only or bind ex post with correction mechanisms.
  - Balance-sheet coverage:
    - Where possible, frameworks should encompass both sides of the government balance sheet.
    - “Net debt” can be used when countries can sell liquid financial assets; requires regular and accurate balance sheet updates.
    - Currently, only the United Kingdom has a rule on net debt; fiscal strategies of Australia and New Zealand contain net debt objectives.
    - Commodity exporters may impose net wealth targets accumulated in funds.
- Parsimony:
  - Fiscal frameworks with multiple rules are difficult to manage; second-generation frameworks often include too many rules.
  - Parsimonious frameworks (a debt rule anchor plus a small number of operational variables) are easier to monitor and communicate.
  - A single operational rule is generally preferable, with the choice country-specific and grounded in economic analysis.
  - Example proposal: replacing a complex set of European operational rules with a single expenditure growth rule (Andrle and others 2015).

*Source: https://www.imf.org/-/media/files/publications/sdn/2018/sdn1804-on-second-generation-fiscal-rules.pdf*

### 47.      Implementation of a single operational rule may nonetheless be challenging in certain

### Implementation of a single operational rule may nonetheless be challenging in certain cases

### Challenges of single operational rules
- Some operational rules (such as an expenditure rule that does not bind revenue) cannot achieve the debt objective without an adjustment or correction mechanism.
- Example: In the context of Israel, Debrun, Epstein, and Symansky (2008) suggested an expenditure growth cap anchored in a target path for public debt; anchoring the expenditure rule requires a debt feedback mechanism to revise the expenditure ceiling when there are deviations from the desired debt path.
- Relying on a single operational rule risks large side effects, such as changes in budget composition (for example, cuts in public investment to comply with the rule).
- If side effects are alarmingly large, two operational rules could be considered (for example, adding a floor on capital expenditure or a ceiling on current expenditure, as discussed in IMF 2018c).

### Consistency and calibration of rules
- Consistent calibration is essential to ensure unambiguous guidance to policy and effectively anchor expectations.
- Relationships between thresholds of the fiscal anchor and operational rule(s) should be transparent and grounded in economic analysis.
- Pragmatic calibration approach (IMF 2018b): 
  - Set the debt ceiling first, taking into account sustainability considerations and the need to build sufficient buffers to absorb shocks to the public sector’s balance sheet (Ostry and others 2010; IMF 2016a).
  - Calibrate operational rules (on the fiscal balance and expenditure) from the debt ceiling to ensure consistency.
- Correction mechanisms can set the adjustment path following a breach to avoid drifting away from the anchor.
  - Without a correction mechanism, repeated breaches can cause debt to drift up and away from its long run objective.
  - Designing credible correction mechanisms requires balancing keeping the anchor and avoiding abrupt corrections, especially when they could imperil an economic recovery.
  - Example: The German “debt brake” requires corrective action only during periods of economic expansion.

### Flexibility Made Simpler
- Fiscal frameworks must be sufficiently flexible, while remaining simple and transparent.
- Distinction: predictable events (e.g., business cycle fluctuations) vs. unpredictable fiscal risks.
  - Unpredictable risks: address with well-defined escape clauses.
  - Predictable events: handle with adequate definition of fiscal indicators subject to numerical limits.
- Rules allowing automatic stabilizers include ceilings on the cyclically adjusted deficit and caps on expenditure growth.
- Codified flexibility invites complexity, which can thwart implementation, monitoring, and communication.

Subsection: Cyclically adjusted balance rules — difficulties and mitigation
- Caution advised for cyclically adjusted balance rules, especially in countries with less predictable economic fluctuations and weak monitoring capacity.
- Implementation issues:
  - The cyclically adjusted balance is not observable and must be estimated.
  - No consensus on adequate methodologies to capture precisely the budgetary impact of the business cycle and other cycles (asset or commodity prices).
  - Methodological issues open avenues to circumventing the rule and complicate internal policy coordination in decentralized settings.
  - Mitigation option: mandate a simple and transparent cyclical adjustment technique (for example, the Hodrick-Prescott filter) or make the rule binding only ex ante.
- Monitoring and communication:
  - Communication of such rules is challenging.
  - Independent fiscal councils staffed by experts can verify compliance and enhance credibility.
- Policy errors:
  - Defining a rule in terms of a non-observable indicator risks policy errors.
  - Real-time estimates of the output gap are subject to large and unpredictable measurement errors.
  - In European countries, the output gap is often underestimated in real time and revised upward later, giving an overoptimistic view of fiscal performance and encouraging complacent expenditure plans (Appendix 4).
  - Fiscal councils can reduce risk of mistakes; fiscal forecasts they produce or monitor are, on average, less biased and more precise (IMF 2013).
  - Recommendation: adopt cyclically adjusted balance rules only if strong public financial management systems exist and cycles are moderate and predictable.

Subsection: Expenditure rules and flexibility provisions
- Flexibility can be achieved more effectively and easily through expenditure rules and well-defined flexibility provisions.
- Expenditure ceilings:
  - By placing a ceiling on expenditure while allowing revenue to fluctuate, expenditure ceilings let most automatic stabilizers operate freely (IMF 2018c).
  - They avoid procyclicality in good times by preventing higher-than-expected revenues from being spent.
  - Advantages: simpler, easier to communicate, less prone to calibration challenges.
  - Main downside: because they do not cover the revenue side, an expenditure ceiling alone cannot ensure fiscal sustainability.
  - Some versions (like the European expenditure benchmark) take into account revenue measures in defining the ceiling or add a debt brake mechanism; these refinements increase complexity.
- Flexibility provisions (escape clauses):
  - Allow use of fiscal space outside numerical constraints to react to unforeseen circumstances and absorb costs of critical growth-enhancing reforms.
  - To avoid abuse, provisions must be well-defined and subject to independent scrutiny.
  - An escape clause should have:
    - (i) a limited and clearly defined set of triggering events,
    - (ii) time limits on how long fiscal policy can deviate from the rule,
    - (iii) a requirement for fiscal policy to return to targets after the clause is terminated and possibly offset accumulated deviations.

Subsection: Flexibility in developing countries
- Creating flexibility in developing countries is challenging due to imperfect access to international credit markets and lack of financial depth, which often prevent borrowing in downturns (Caballero and Krishnamurthy 2004; Konuki and Villafuerte 2016).
- Self-insurance as a second-best option (IMF 2018c):
  - Build financial buffers in good times (for example, set aside revenue windfalls in a stabilization fund using simple numerical or procedural rules) and draw on them in bad times.
  - Self-insurance allows a smaller degree of expenditure smoothing compared with countries with unconstrained access to financial markets.
- Another aspect: financing of development needs should not be excessively constrained by the rule in low-income economies.

### Promoting compliance through stronger incentives
- Compliance can be enhanced by raising the cost of breaches and the benefits associated with fiscal discipline; political economy considerations are critical (Eyraud, Gaspar, and Poghosyan 2017).
- Strengthen incentives by:
  - Raising costs of noncompliance.
  - Creating more tangible benefits for compliers.

Subsection: Enforcement mechanisms
- Formal enforcement mechanisms (financial sanctions) have shown limited effectiveness.
  - National rules: credible enforcement is largely illusory except for strict constitutional clauses, which limit flexibility.
  - Self-imposed sanctions are unlikely to be implemented by policymakers (Reuter 2017 finds no evidence sanctions raise compliance with European national rules).
  - Supranational level: federations and currency unions have broader toolkits (sanctions and correction actions) but these mechanisms lack credibility because:
    - Financial sanctions exacerbate difficulties of distressed governments, limiting appropriateness in bad times.
    - High-profile sanctions carry stigma and high political cost, making application unlikely.
  - Suggested approach: a more gradual sanctions regime:
    - Initial/small deviations should entail small financial costs to encourage compliance without strong opposition.
    - Repeated/larger deviations could be penalized more heavily (Ostrom, 1990).
  - Even with a measured approach, enforcement of sanctions at the supranational level is likely to remain contentious.

Subsection: Reputation costs, fiscal transparency, and fiscal councils
- Raising reputational costs through enhanced fiscal transparency and fiscal councils appears more promising.
  - Fiscal transparency: comprehensiveness, clarity, reliability, and timeliness of public reporting on public finances—critical for accountability.
  - Fiscal councils: provide information and analysis to alert the public when policymakers are on an undesirable fiscal trajectory.
  - Well-resourced and truly independent fiscal councils can enhance signals about policymakers’ competence, raising reputational costs of breaching the rule (Beetsma, Debrun, and Sloof 2017).
  - If social preferences for fiscal prudence are established, reputational effects can extend to the ballot box.
  - Recent empirical evidence suggests fiscal councils increase likelihood of compliance with fiscal rules (Reuter 2017), though experience is limited.

Subsection: Tangible benefits for compliers
- Benefits of complying with rules are often medium-term or apparent only in hindsight, while political costs of restraint are borne short-term by elected officials.
- Potential immediate benefit: lower sovereign financing costs due to more credible commitment to responsible fiscal policy; but in a low-interest-rate environment and sovereign spread compression, markets may not sufficiently discriminate across country risks.
- Measures to strengthen positive incentives, particularly in currency unions:
  - Since 2014, access to European structural and investment funds requires, in principle, compliance with EDP recommendations under the corrective arm.
  - This model could be better enforced and extended to other services at the European level.
  - Discussion exists about establishing a stabilization capacity in the euro area; in some variants, access to central fiscal capacity would be conditional on past compliance with rules (IMF 2016b; Arnold and others, 2018).

### From guiding principles to country-specific advice (Box 2) — tailored implementation
- Advanced economies:
  - Holistic approach often implies reducing number of rules, particularly in Europe.
  - IMF (2015a) recommends focusing on two rules: a fiscal anchor (public debt-to-GDP) and an operational target (an expenditure growth rule linked to debt dynamics).
  - Regarding flexibility, balance benefits/risks of cyclically adjusted balance rules; consider expenditure rules when implementation challenges are acute.
  - Independent fiscal councils can facilitate enforcement if carefully designed (sufficient financial and human resources, functional independence, access to information) and with broad political support for fiscal sustainability (Horvath 2017).
- Emerging markets:
  - Holistic approach promotes greater consistency among rules; existing rules often mutually incompatible and arbitrarily calibrated.
  - Challenge: calibrate debt ceiling to balance containing debt distress risk and leaving space for development financing.
  - Commodity exporters should consider future commodity revenues in fiscal anchor calibration (see Appendix 2).
  - Greater reliance on expenditure rules is suitable given simplicity and stabilization properties.
  - Cyclically adjusted balance rules less warranted due to elusive output gap in economies subject to large supply shocks.
  - To prevent compression of public investment, IMF (2018c) proposes adding a cap on current outlays.
  - Enforcement would benefit from greater fiscal transparency through comprehensive, clear, and timely reporting.
- Low-income countries and small states:
  - Holistic approach should ensure fiscal frameworks include both a debt rule and adequate operational rule(s).
  - Many frameworks lack an operational rule and/or have ill-calibrated debt rules with thresholds too high to guide medium-term strategies.
  - Macroeconomic stabilization is harder and less of a concern relative to other fiscal objectives; flexibility should be primarily in the form of well-designed escape clauses (natural disasters, large shocks).
  - Cyclically adjusted balance or expenditure rules are often difficult to implement due to need to borrow in bad times and might weaken revenue mobilization and public investment.
  - Self-insurance via saving revenue windfalls (possibly in stabilization funds) and using them in bad times is often desirable; can be achieved with simple revenue split rules (IMF 2018c).
  - Enforcement: countries with low capacity should improve budget management procedures (planning, execution, auditing) and data quality so the annual budget is an effective instrument to control public finances.

### Conclusion — overview findings
- Fiscal discretion must be constrained to mitigate the deficit bias; numerical fiscal rules generally accomplish this as delegation to unelected decision makers with a simple mandate is unfeasible and undesirable.
- Fiscal rules have become more complex over time, raising doubts about their ability to guide policy.
- Ideally, fiscal rules should be simple, flexible, and enforceable, but these three properties are difficult to satisfy simultaneously.
- Earlier rules were simple but too rigid; second-generation rules are more sophisticated but can be complicated, conflicting, and raise effectiveness concerns, compounded by low compliance.

*International Monetary Fund — SECOND-GENERATION FISCAL RULES (excerpt)*

### 60.      Empirical evidence suggests that rules can be effective at tackling the deficit bias

### Empirical evidence suggests that rules can be effective at tackling the deficit bias

### Effectiveness of fiscal rules: summary findings
- Empirical evidence suggests that rules can be effective at tackling the deficit bias provided that they are well-designed.
- Rules do not have a universal effect on fiscal performance: while some rules effectively enhance fiscal discipline, others end up being counterproductive.
- Key features that can greatly enhance rules’ effectiveness:
  - Broad institutional and economic coverage.
  - A design that incentivizes savings in good times.
  - Calibration of the threshold based on economic principles.
  - Precise escape clauses.
  - Institutions that enhance fiscal transparency and accountability.

### Three guiding principles for future reforms (policy recommendations)
- Design and reform fiscal frameworks holistically:
  - Ensure internal consistency among a small number of rules with a clear hierarchy between them.
  - Include a fiscal anchor, usually a debt rule, and a very small number of operational rules (one as a default option).
- Enhance flexibility while accounting for implementation risks:
  - Streamline the design of features that make the rule flexible.
  - Increase reliance on expenditure ceilings and well-defined flexibility provisions.
- Reconsider formal enforcement procedures in favor of reputation-based mechanisms:
  - Reputation costs tend to be more effective than financial sanctions.
  - Leverage reputational and electoral benefits of compliance through enhanced fiscal transparency and independent monitoring.
  - Recognize that formal mechanisms, like sanctions, often lack credibility.

### Caveats and scope of the Note
- This Note is a first step toward understanding benefits and implementation challenges of second-generation reforms.
- The new rules are very recent and evolving; it is too early to provide a definitive assessment.
- The objective is to contribute to the debate and provide directions for future reforms.

### Appendix 1 — Problems created by the combination of rules
- Using multiple rules may create various problems:
  - Inconsistency between the rules’ ceilings:
    - The operational rule’s ceiling may be too loose or too tight to achieve the debt anchor.
    - Example: a very low public debt ceiling may be inconsistent with a budget balance rule allowing very high deficits.
    - Reference to the inconsistency between the 3 percent deficit rule and the 60 percent debt rule in the European supranational framework (paragraph 34).
  - Overlap between rules:
    - Occurs when two rules apply to the same fiscal aggregate but constrain it to differing degrees.
    - Examples of subtle overlap:
      - An expenditure ceiling combined with a cyclically-adjusted balance rule.
      - National rules transposing supranational rules with small design modifications.
      - Rules on both the overall balance and the change in public debt.
  - Overdetermined system:
    - Adding too many constraints impairs policy implementation and undermines credibility.
    - Evidence that governments may favor capital spending cuts to comply with rules given difficulty to compress current expenditure (Cordes and others 2015).

### Appendix 2 — Toward a second generation of rules for commodity exporters
- Appropriate fiscal anchor: a comprehensive indicator of government wealth that encompasses resource wealth (net wealth = net financial wealth + resource wealth).
- Central challenge: allocation of net wealth across generations given exhaustibility and uncertain future commodity prices.
- Traditional calibration: based on fiscal sustainability and intergenerational equity (Permanent Income Hypothesis: preserve government net wealth at its initial level; spend a constant share of net wealth annually).
- Risk-based approaches:
  - Incorporate long-term commodity price uncertainty; require larger and more durable buffers.
  - Structural balance rules or rules based on reference prices smooth short-term volatility but do not guard against long-term large persistent shocks (e.g., 2014–15 collapse in commodity prices).
- Precautionary financial buffers:
  - Several methods to compute required net financial wealth buffers (size depends on resource dependence, risk level, and risk tolerance).
  - IMF (2012) uses a value-at-risk approach and a model-based approach to estimate minimum buffers to absorb tail risks.
  - Another method (IMF 2015c) calibrates financial savings so investment returns cover possible revenue losses and avoid large fiscal adjustment.
- Policy examples and trends:
  - No commodity exporter explicitly calibrates its net wealth target using the probabilistic methods described, but some countries set sovereign wealth fund floors or reduce withdrawal rates for precautionary reasons.
  - Kazakhstan revised its oil reserve fund in 2016 to increase the minimum balance from 20 to 30 percent of GDP.
  - Norway reduced the withdrawal rate from its oil fund in 2017 from 4 to 3 percent of the fund’s value.
- Long-term price projection methods:
  - Automatic formula (moving average of past and futures prices) versus expert committee.
  - Automatic formulas may deliver poor forecasts under sudden large shocks; expert committees (e.g., Chile since 2002) may be better positioned under high uncertainty.
  - Tasks of such committees could be assigned to a fiscal council with legal and operational independence.

### Appendix 3 — Criteria for net debt rules in fiscal frameworks
- Net debt: useful indicator of fiscal sustainability but usually not well suited as the primary debt rule; gross debt is more common.
- Net debt should be a complementary fiscal indicator; only countries with comprehensive and precise public finance statistics should consider moving from gross to net debt rules.
- Four criteria for including assets in “net debt” measures:
  - Control: government must be able to sell the assets if necessary.
  - Liquidity: assets should be sellable quickly without significant discount.
  - Fair valuation: assets must be valuated accurately on a regular basis.
  - Timely valuation: asset valuations must be updatable within several months after fiscal year-end.
- Data capacity considerations:
  - More than three-quarters of advanced economies reported a balance sheet with financial assets to the IMF Government Finance Statistics Yearbook (GFSY) in 2016.
  - Fewer than one-third of emerging and developing economies were able to report their balance sheets to the GFSY in 2016.
  - Countries in the European Union, Canada, the United States, and Turkey update balance sheets with financial assets on a quarterly basis.
  - Most other countries compile an annual balance sheet within nine months from fiscal year-end, which may not be sufficiently timely for use in rules.

### Appendix 4 — Comparing cyclically adjusted balance and expenditure rules
- Measurement error in cyclically adjusted balance rules:
  - Cyclically adjusted balances rely on output gap estimates that are subject to revisions due to technical, statistical, and political economy factors.
  - Analysis of the euro area over 2003–16 indicates the output gap was underestimated in real time by 1.3 percentage points on average.
  - Under an assumption of revenue elasticity to output = 1, expenditure elasticity to output = 0, and average expenditure ratio = 45 percent of GDP in European countries, an underestimation of the output gap by 1.3 percentage points implies the cyclically adjusted balance was overestimated by 0.5 percentage points of potential GDP on average.
  - Implication: a cyclically adjusted balance rule relying on real-time estimates would tend to allow excessively large deficits (exceeding their targeted values ex post by about 0.5 percentage point per year), risking a permanent drift of public debt without a correction mechanism.
- Expenditure growth rules as substitutes:
  - Some expenditure rules are used as substitutes for cyclically adjusted balance rules (example: European preventive arm’s use of an expenditure benchmark and a cyclically adjusted balance approach).
  - Broad equivalence: a ceiling on expenditure growth equal to trend GDP can be equivalent to a cyclically adjusted balance rule if the government is initially compliant and no new revenue measures are introduced.
  - Advantages of expenditure rules:
    - Allow automatic stabilizers to operate.
    - More transparent and more resilient to measurement errors.
    - Easier to communicate to the public.
    - Use of potential (or trend) growth makes them more robust to measurement errors, as revisions to potential growth tend to be smaller.
  - Downsides:
    - More sensitive to initial conditions; if initial expenditure is inconsistent with sustainability, growth equal to trend GDP may lead to unsustainable public finances.
    - European expenditure benchmark addresses this by calibrating a wedge between expenditure growth and trend GDP growth, but this complicates the rule formula.
- Illustration:
  - Andrle and others (2015) compare expenditure growth rules and cyclically adjusted balance rules in counterfactual simulations for France and Italy, showing smaller differences between real-time and ex post debt paths under the expenditure rule.

*Source: sdn1804-on-second-generation-fiscal-rules - Empirical evidence suggests that rules can be effective at tackling the deficit bias.*

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*International Monetary Fund*

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_Source: https://www.imf.org/-/media/files/publications/sdn/2018/sdn1804-on-second-generation-fiscal-rules.pdf_