## sdnea2022002 — Chapter 3: Fiscal Rules, Sustainability, and Stabilization

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### Fiscal context and challenge
- Governments and central banks used exceptional actions during the pandemic; many activated escape clauses or suspended fiscal rules.
- Current environment features:
  - Record levels of debt.
  - Tightening monetary policies driven by spikes in inflation.
  - Deteriorated public debt dynamics as low borrowing-cost guarantees no longer hold.
  - Weaker growth prospects, large contingent liabilities from pandemic support, and rising risk premiums.
- MTFF objective: provide credible forward guidance to navigate tightened financing conditions and elevated debt vulnerabilities while preserving flexibility to respond to shocks.

### Key findings on fiscal rules, sustainability, and stabilization
- Decline in neutral interest rates allowed larger deficits and higher debt accumulation; future interest-rate trends are uncertain.
- High debt increases vulnerability to adverse shocks and market sentiment shifts that can sharply reduce fiscal space.
- Fiscal rules have not clearly prevented procyclical policies; they do not appear to make procyclicality worse relative to no-rule countries.
- Frequent deviations from numerical fiscal rules:
  - Countries exceeded deficit limits 50 percent of the time and debt limits 42 percent of the time on average since 2004.
  - In 2020 nearly 80 percent of countries with fiscal rules had rules suspended or modified.
  - Average deviation from debt limits rose to 50 percent of GDP for advanced economies in 2020.
  - About 40 percent of countries activated escape clauses during the pandemic.
- Fiscal councils expanded: of 51 fiscal councils in 2021, 37 were established after the GFC.

### Debt limits, model insights, and illustrative calibrations
- Model features: convenience yields for government bonds and an interest-rate increase as debt rises; identifies conceptual points:
  - Free-lunch zone (left of F).
  - Point F: maximum sustainable primary deficit.
  - Flipping point (F*): where interest-growth differential turns positive and surpluses are required.
  - Maximum sustainable-debt intersections (LL and L*).
- Illustrative upper-bound estimates for a typical advanced economy:
  - Assumed maximum primary surplus for Point LL: 2.5 percent of GDP.
  - Point LL corresponds to a debt limit close to 250 percent of GDP.
  - A prudent reference (sustainable long-term primary surplus about 0.5 percent of GDP) corresponds to Point L* about 200 percent of GDP.
- Typical emerging market illustrative debt level: 95 percent of GDP.
- Literature calibrations cited:
  - US (Mian, Straub, and Sufi (2022)): flipping point (F*) at 220 percent of GDP and LL at 272 percent of GDP.
  - US (Bi, Shen, and Yang (2022)): probability of default reaches 70 percent at 275 percent of GDP.
- Sensitivity scenarios:
  - Baseline debt-interest elasticity: 0.017.
  - Lower elasticity: 0.012.
  - Higher elasticity: 0.03.
  - High-elasticity and higher initial nominal interest rate (1.5 percentage point higher) scenario reduces debt thresholds substantially: thresholds fall by 100 percent of GDP for AEs and by 50 percent of GDP for EMs in the example reported.

### Empirical evidence on rules and stabilization in recessions
- Data/sample: 71 countries, 1985–2019; recessions defined via Harding and Pagan (2002) algorithm.
- Main empirical findings:
  - No significant difference in fiscal response to recessions between countries with and without fiscal rules on average.
  - Both groups tend to cut total expenditures following recessions; no evidence that rules lead to larger cuts in capital spending relative to no-rule countries.
  - Countries with more fiscal space have more countercyclical responses.
  - Pre-recession deficits closer to or above rule limits constrain spending relatively more.
  - Flexible rule features (cyclically adjusted targets, well-specified escape clauses, investment exemptions) are associated with less procyclical policy responses and better maintenance of capital spending.
- Robustness: results hold including the pandemic year, alternative methodologies (IPW multi-treatment), and alternate spending measures.

### Core elements and operational design of an upgraded MTFF
- MTFF components to balance flexibility and credibility:
  1. Medium-term fiscal plans that are feasible and stable.
  2. Flexibility in response to shocks with well-specified escape clauses.
  3. Transparent fiscal anchors and communicated rationale for anchor choice.
  4. Risk-based rules ensuring path to debt sustainability and buffer buildup.
  5. Checks and balances, including independent fiscal institutions.
- Operational guidance:
  - Center budget process on multiyear projections, costing of measures, and analysis of past outcomes.
  - Set clear medium-term anchors consistent with sustainability and communicate them.
  - Regularly review frameworks (for example every five years or after large shocks).
  - Use operational fiscal rules embedded in medium-term plans (binding for the plan period), e.g., multiyear expenditure ceilings.
  - Adjust limits periodically (say every three to five years) and manage cyclical variation within the MTFF.
  - Escape clauses should require a medium-term plan showing return to the rule or a revised anchor and can be time-bound or data-driven.
  - Use independent forecasts (fiscal councils or similar) to strengthen credibility and reduce optimism bias; include risk analysis and alternative scenarios.

### Risk-based buffers, long-term pressures, and transition guidance
- Buffers: frameworks should incentivize buffer buildup; buffer size depends on country risk profile and volatility of macro-fiscal variables.
- Long-term pressures:
  - Climate-related adaptation and mitigation costs: an additional 2-3 percent of GDP per year (IMF estimate referenced).
  - Aging-related pension spending increase: about 0.6 percent of GDP per year in advanced economies absent reforms (2021–2030 average pension rise for AEs).
- Practical guidance:
  - Countries exceeding safety margins should commit to medium-term paths to return to anchors; pace depends on risk assessment.
  - Commodity exporters and disaster-prone countries should build larger buffers; natural disasters can raise government expenditures by an average of 15 percent and lower revenue by 10 percent over five years.
- Green budgeting and “green” rules:
  - Cautions against numerical “green” golden rules due to classification, creative accounting, and incentive risks.
  - Recommend strengthening green public financial management (PFM) and integrating climate impacts into PFM and fiscal sustainability analysis.

### Strengthening fiscal councils and fiscal reporting
- Fiscal council status and recommendations:
  - Only 50 percent of countries with fiscal rules have fiscal councils.
  - About half of fiscal councils in OECD countries assess government assumptions; more than 40 percent analyze economic and fiscal scenarios.
  - Only 50 percent of fiscal councils are tasked to monitor escape-clause activation and implementation.
- Recommended mandates and safeguards:
  - Mandate independent forecasts, costing of measures, and risk assessments.
  - Guarantee full access to government information in a timely manner by legislation.
  - Ensure operational independence, sufficient budget resources, and protection from political interference.
  - Enhance accountability via public reporting, parliamentary hearings, and ex-post assessments by the supreme audit institution.
  - For EMs and LICs with capacity constraints, start with limited oversight committees focused on core tasks while strengthening capacity and transparency.

### Box on overoptimism and fiscal slippages
- Evidence:
  - Official forecasts systematically more optimistic than private forecasts (sample: 43 countries, 2000–19).
  - Fiscal slippages (difference between one-year-ahead announced plans and final outcomes) can persist for three consecutive years.
- Consequences:
  - Fiscal slippages are persistent and associated with faster debt accumulation and higher sovereign spreads.
- Recommendations:
  - Improve government finance statistics, adopt accrual accounting, compile comprehensive public sector balance sheets, and conduct systematic inventory of assets and liabilities.
  - Prioritize gradual reforms in low-income countries while focusing on public finance management and transparency.

### Key statistics and exact numeric values preserved from the chapter
- Percent of time exceeding rules since 2004: deficit limits 50 percent; debt limits 42 percent.
- In 2020: nearly 80 percent of countries with fiscal rules suspended or modified rules.
- Average deviation from debt limits for advanced economies in 2020: 50 percent of GDP.
- Share of fiscal councils established after the GFC: of 51 fiscal councils in 2021, 37 were established after the GFC.
- Climate-related policy costs: an additional 2-3 percent of GDP per year.
- Aging-related pension spending increase: about 0.6 percent of GDP per year in advanced economies absent reforms.
- Assumed maximum primary surplus for Point LL: 2.5 percent of GDP.
- Illustrative debt limits for a typical advanced economy: Point LL close to 250 percent of GDP; Point L* about 200 percent of GDP.
- Corresponding debt level for a typical emerging market: 95 percent of GDP.
- US calibrations cited: flipping point (F*) 220 percent of GDP; LL 272 percent of GDP.
- Probability of default estimate cited: 70 percent at 275 percent of GDP (United States).
- Typical AE calibrated pre-pandemic values: initial debt 100 percent of GDP, real long-term trend growth 1.5 percent, equilibrium inflation 2 percent, equilibrium nominal interest rate 2 percent.
- Typical AE mid-2000s values: initial debt 75 percent of GDP, real long-term trend growth 2.5 percent, equilibrium nominal interest rate 4 percent.
- Typical EM pre-pandemic calibrations: initial debt 50 percent of GDP, real long-term trend growth 3.5 percent, long-term inflation rate 4 percent, equilibrium nominal interest rate 6.5 percent.
- Typical EM mid-2000s calibrations: initial debt 40 percent of GDP, real long-term trend growth 6 percent, long-term inflation rate 6 percent, equilibrium nominal interest rate 11.5 percent.
- Debt-interest elasticity used in calibration: 0.017 (implying a 10 percent increase in debt-to-GDP raises interest rate by 17 basis points).
- High-elasticity alternative: 0.03; lower elasticity alternative: 0.012.
- Example policy impacts of disasters: natural disasters can raise government expenditures by an average of 15 percent and lower revenue by 10 percent over five years.

*Source: STAFF DISCUSSION NOTES — The Return to Fiscal Rules (sdnea2022002, Chapter 3).*

### Introduction ...........................................................................................................

### Introduction

### Fiscal context and the aftermath of the pandemic
- Governments and central banks took exceptional actions in response to the pandemic; many countries activated escape clauses or suspended fiscal rules to create flexibility for large fiscal responses.
- Current environment features:
  - Record levels of debt (see Figure 1).
  - Tightening monetary policies driven by spikes in inflation.
  - Deteriorated public debt dynamics as low borrowing-cost guarantees no longer hold.
  - Weaker growth prospects, large contingent liabilities from pandemic support, and rising risk premiums.
- Policy trade-offs are heightened by competing demands: addressing food and energy crises, advancing the green transition, managing aging populations, and meeting sustainable development goals.
- Credible and well-communicated fiscal frameworks are critical to reduce debt sustainability risks and support monetary policy in containing inflation.

### The challenge: designing a credible medium-term fiscal framework (MTFF)
- An MTFF must provide credible forward guidance to navigate tightened financing conditions and elevated debt vulnerabilities.
- Key objectives for an MTFF:
  - Ensure feasible and stable medium-term fiscal plans with transparent fiscal anchors.
  - Provide flexibility to respond swiftly to shocks while promoting the buildup of larger buffers in normal times.
  - Address fiscal-monetary interactions: fiscal policy is particularly effective when monetary policy is constrained (e.g., at the zero lower bound); when monetary policy tightens, fiscal policy must pay greater attention to debt sustainability.

### Limitations of past fiscal rules and rationale for reform
- Past rounds of fiscal-rule reforms improved some aspects but:
  - Deviations from numerical fiscal rules have been frequent and persistent.
  - After the global financial crisis, few countries significantly reduced debt despite reforms.
  - The long downward trend in long-term interest rates led some to question relevance of deficit and debt rules; however, at high levels of public debt countries are especially vulnerable to changes in market sentiment and disruptive fiscal crises.
  - Evidence indicates fiscal rules had limited impact in making fiscal policy less procyclical, particularly when fiscal buffers were limited.
- Returning to pre-pandemic rules may be difficult in cases with large deviations; there is an opportunity to rethink fiscal frameworks to incorporate lessons and tackle longstanding weaknesses.

### Core elements of an enhanced post-pandemic rules-based fiscal framework
- A medium-term fiscal framework that combines standards, rules, and strengthened institutions to balance flexibility and credibility:
  - Feasible and stable medium-term fiscal plans with transparent fiscal anchors.
  - Flexibility to respond to shocks (including quick, exceptional fiscal measures when required).
  - Risk-based rules that ensure a path to debt sustainability and the buildup of fiscal buffers while accounting for changes in capacity to borrow.
- Reforms required to support these elements:
  - Reduce excessive reliance on annual budgets by strengthening medium-term planning.
  - Incorporate climate and aging pressures into the budget process.
  - Upgrade transparency and strengthen independent fiscal councils to enhance credibility and accountability.

### Policy implications and priorities
- When returning to rules-based frameworks, avoid relying solely on numerical rules or abandoning rules entirely:
  - Numerical-only approaches risk excessive complexity and ineffectiveness.
  - Broad standards without credible supporting institutions risk investor and public mistrust, especially when debt vulnerabilities are high.
- Strengthened MTFFs should:
  - Communicate a credible fiscal path to reduce debt sustainability risks and stabilize expectations.
  - Promote larger fiscal buffers in normal times to preserve capacity for swift and sizeable responses to large shocks.
  - Better integrate fiscal-monetary interaction considerations into the design and communication of fiscal policy.

*Source: STAFF DISCUSSION NOTES — The Return to Fiscal Rules (Introduction).*

### Chapter 3 explores questions on fiscal rules in two crucial areas: sustainability and stabilization. It

### sdnea2022002 - Chapter 3 explores questions on fiscal rules in two crucial areas: sustainability and stabilization. It

### Key findings on fiscal rules, sustainability, and stabilization
- The decline in neutral interest rates allowed governments to run larger deficits and accumulate significantly higher debt; the extent varies widely across countries and there is uncertainty around future interest rate trends given large recent shocks.
- At high levels of debt, governments become vulnerable to adverse shocks and changes in market sentiment, making debt rollover difficult and potentially leading to sharp reductions in fiscal space and debt distress.
- Fiscal rules have fallen short in preventing procyclical policies but do not appear to make procyclicality worse compared to countries without rules.
- Deviations from numerical fiscal rules have been frequent: countries exceeded deficit limits 50 percent of the time and debt limits 42 percent of the time on average since 2004.
- In 2020, nearly 80 percent of countries with fiscal rules had their rules suspended or modified.
- The average deviation from debt limits rose to 50 percent of GDP for advanced economies in 2020; deviations from budget balance limits also jumped for both advanced and emerging economies.
- About 40 percent of countries activated escape clauses to deviate or suspend fiscal rules during the pandemic.
- Fiscal councils expanded role and coverage: of the 51 fiscal councils in 2021, 37 were established after the GFC, peaking in 2014 (nine countries). New fiscal councils were established in Brazil, Chile, Iceland, Panama, Peru (pre-pandemic) and Costa Rica, Uruguay (2021).

### Aftermath of the pandemic: evolution and shortcomings of rules-based frameworks
- Rules-based fiscal frameworks increased over the last three decades to tackle “deficit bias”; early frameworks were intentionally rigid to constrain government actions.
- Post-GFC reforms introduced greater flexibility (escape clauses) to respond to large shocks but often increased complexity and reduced enforceability.
- Complexification: successive EU reforms added features making rules increasingly complex; the number of rules per country increased over the last two decades.
- Frequent rule changes and circumventions undermined credibility; some countries modified limits to avoid breaching rules.
- The pandemic reinforced the need for flexibility: many countries suspended or relaxed rules to protect firms and households—complicating return to prior anchors and prompting delays in reinstating rules (examples: Peru, Panama, EU).
- Fiscal councils provided rapid analysis of COVID-19 fiscal support (most frequent task) and less often analyzed transparency of measures.

### Debt limits and stabilization: how much can governments borrow?
- Long-term decline in interest rates, particularly the neutral rate in advanced economies, prompted debate on trade-offs between debt sustainability and fiscal deficits.
- The chapter uses a model incorporating “convenience yields” (liquidity premium, safety premium, or regulatory requirements) and an interest-rate increase as debt rises.
- Conceptual zones (as illustrated in Figure 6):
  - Below point F: a “free-lunch” zone where higher debt can be maintained with higher deficits.
  - At point F: the maximum sustainable primary deficit.
  - Beyond point F*: a point where fiscal surpluses are required to stabilize debt as the interest-growth differential turns positive.
- Upper-bound illustrative estimates (for a typical advanced economy):
  - Point LL (assuming maximum primary surplus of 2.5 percent of GDP, the median maximum five-year average structural primary balance in past decades) corresponds to a debt limit close to 250 percent of GDP.
  - A more prudent reference using a sustainable long-term primary surplus of about 0.5 percent of GDP corresponds to a sustainable debt level of about 200 percent of GDP (Point L*).
- For a typical emerging market, the corresponding debt level associated with similar considerations is 95 percent of GDP.
- Literature calibrations cited:
  - Mian, Straub, and Sufi (2022) calibration for the US: flipping point (F*) at 220 percent of GDP and 2.5 percent primary surplus (LL) at 272 percent of GDP.
  - Bi, Shen, and Yang (2022): probability of default reaches 70 percent at a debt level of 275 percent of GDP for the United States.

### Toward a revamped rules-based fiscal framework (policy recommendations)
- Move away from complex numerical fiscal rules that attempt to balance conflicting objectives with limited success; emphasize enhanced medium-term fiscal frameworks instead.
- International experience suggests effective fiscal frameworks should include:
  1. Fiscal plans that are feasible and stable.
  2. Flexibility in response to shocks.
  3. Transparent fiscal anchors.
  4. Risk-based rules that ensure a path to debt sustainability and buildup of fiscal buffers.
  5. Checks and balances to promote accountability.
- Implementation priorities:
  - Strengthen institutions and fiscal reporting.
  - Move away from excessive emphasis on annual budgets and adopt medium-term perspectives.
  - Allow greater flexibility in reacting to shocks while signaling commitment to fiscal discipline.
  - Incorporate structural issues such as climate-related policies and demographic trends (climate adaptation and mitigation costs of an additional 2-3 percent of GDP per year; aging-related increase in pension spending of about 0.6 percent of GDP per year in advanced economies absent reforms) within credible fiscal frameworks.
  - Build larger fiscal buffers in normal times to prepare for large crises and expanded fiscal modalities.

### Key statistics and exact numeric values preserved from the chapter
- Percent of time exceeding rules since 2004: deficit limits 50 percent; debt limits 42 percent.
- In 2020: nearly 80 percent of countries with fiscal rules suspended or modified rules.
- Average deviation from debt limits for advanced economies in 2020: 50 percent of GDP.
- Share of fiscal councils established after the GFC: of 51 fiscal councils in 2021, 37 were established after the GFC.
- Climate-related policy costs: an additional 2-3 percent of GDP per year.
- Aging-related pension spending increase: about 0.6 percent of GDP per year in advanced economies absent reforms.
- Assumed maximum primary surplus for Point LL: 2.5 percent of GDP (median maximum five-year average structural primary balance).
- Illustrative debt limits for a typical advanced economy: Point LL close to 250 percent of GDP; Point L* about 200 percent of GDP.
- Corresponding debt level for a typical emerging market: 95 percent of GDP.
- US calibrations cited: flipping point (F*) 220 percent of GDP; LL 272 percent of GDP.
- Probability of default estimate cited: 70 percent at 275 percent of GDP (United States).

*Source: sdnea2022002 - Chapter 3 explores questions on fiscal rules in two crucial areas: sustainability and stabilization. It*

### 1. Typical Advanced Economies 2. Typical Emerging Market Economies

### 1. Typical Advanced Economies 2. Typical Emerging Market Economies

### Long-term decline in neutral interest rates and fiscal space
- The long-term decline in neutral interest rates increased governments’ ability to borrow over time.
- Two-period comparison (mid-2000s versus pre-pandemic year baseline) shows outward shift in debt–fiscal space tradeoff due to lower global interest rates.
- Key quantified changes:
  - For a typical AE, the maximum sustainable deficit tripled from 0.5 to 1.5 percent of GDP.
  - For a typical AE, the maximum sustainable debt level increased by almost 100 percentage points.
  - For emerging markets, the maximum sustainable debt level rose from 70 to 95 percent of GDP.

### Fiscal limits, heterogeneity, and time variation
- Fiscal limits depend on structural factors beyond neutral rates: quality of institutions, policy frameworks, and policy decisions.
- Long-term fiscal pressures (climate change and population aging) could affect governments’ ability to run large surpluses to stabilize debt.
- Short-run factors that can shift fiscal limits considerably:
  - Changing market conditions and investor risk perceptions can sharply change what is a safe debt level.
  - High shares of short-maturity debt or foreign-currency-denominated public debt heighten rollover risks.
  - Tightening global financing conditions can reduce attractiveness of government debt, especially for EMs, and trigger capital outflows; some AEs may benefit from safe-asset preference during crises.
- Policy implication: select a prudent debt anchor sufficiently distanced from debt limits.

### Sensitivity of debt thresholds to interest-rate elasticity and interest-rate level (scenario analysis)
- Baseline and alternative elasticities used:
  - Baseline elasticity: 0.017
  - Lower elasticity: 0.012
  - Higher elasticity: 0.03
- “Higher elasticity and higher interest rate” scenario: elasticity = 0.03 and the initial nominal interest rate is 1.5 percentage point higher than the baseline.
- Under the high-elasticity scenario:
  - Debt thresholds decline significantly for both AEs and EMs.
  - Thresholds fall by 100 percent of GDP for AEs and by 50 percent of GDP for EMs (purple bars in Figure 7 example).
- Interpretation: large differences across countries and over time in perceived safe debt levels; countries need periodic reassessment of borrowing capacity and comprehensive risk assessment.

### Price stability, inflation, and sovereign borrowing costs
- The current context of high inflationary pressures underscores the importance of price stability to protect government bond attractiveness.
- Historical example: successful control of inflation since the early-1980s improved attractiveness of US government bonds and contributed to long-term decline in US interest rates.
- Empirical notes:
  - Positive correlation between central bank independence and lower sovereign borrowing costs (Annex 2).
- Model implication:
  - Temporary unexpected increase in inflation: direct impact on fiscal limits is positive (inflation lowers the real value of public debt).
  - If investors lose confidence in central bank actions, fiscal space shrinks as investors demand higher premiums.
  - Resorting to unorthodox policies (financial repression) will impair attractiveness of government bonds and decrease future fiscal space.

### Empirical assessment: Are fiscal rules too restrictive?
- Critique: fiscal rules may constrain desirable government policies, especially fiscal response to adverse shocks.
- The analysis (71 countries, 1975 to 2019; recessions as exogenous shock episodes) uses panel local projection methods and difference-in-difference approaches to address endogeneity.
- Main empirical findings:
  - No significant difference in fiscal policy response to recessions between countries with and without fiscal rules (Figure 9).
  - In both groups, total expenditures tend to fall following a recession.
  - No evidence that countries with rules cut more capital spending than those without rules.
  - Countries with more fiscal space tend to have more countercyclical policy responses.
  - Countries with pre-recession deficits closer to or above their rule limits constrained spending relatively more, highlighting the importance of building buffers (Figure 10).
  - Countries with low pre-recession debt levels (and interest bills) tend to spend relatively more during recovery.
- Confidence and robustness:
  - Error bands correspond to 90 percent confidence intervals.
  - Results are robust to alternative methodologies, samples, and rule types.

### Flexibility of rules matters
- Among countries with fiscal rules, those with flexible features (cyclically adjusted targets and/or well specified escape clauses) tend to have more countercyclical fiscal responses (Figure 11).
- Compared to not having a rule, countries with flexible rules:
  - Better maintain capital spending levels during recessions.
  - Constrain government expenditure by less in the recovery phase, starting two years after the recession.
- Conclusion: flexible design features reduce procyclicality and preserve space for stabilizing policies.

### Post-pandemic guidance: upgraded medium-term fiscal frameworks (MTFFs)
- Rationale: rising debt vulnerabilities and tightening financial conditions make it urgent to communicate a credible fiscal path to reduce sustainability risks and support monetary policy in controlling inflation.
- Trade-offs:
  - Reverting to previous rigid numerical rules has limitations.
  - Broad principles/standards offer flexibility but risk lower market/public trust absent transparency and accountability mechanisms.
- Recommended approach: an upgraded MTFF combining flexible rules and strengthened institutions to balance goals.

### Core elements of an effective MTFF and operational design
- Key elements MTFFs should include:
  1. Medium-term fiscal plans that are feasible and stable.
  2. Flexibility in response to shocks (well-specified escape clauses).
  3. Transparency on fiscal anchors and rationale for anchor choice.
  4. Risk-based approach to ensure a path to debt sustainability and buildup of fiscal buffers.
  5. Checks and balances, including independent fiscal institutions.
- Additional operational guidance:
  - Medium-term fiscal plans should be central to the budget process, providing multiyear projections of expenditures, revenues, and balances, analysis of past outcomes, and costing of new measures.
  - Set clear medium-term anchors consistent with policy goals and fiscal sustainability; communicate the choice and rationale.
  - Regular reviews of the framework (for example every five years or after large shocks) to preserve relevance without undermining credibility.
  - Establish operational fiscal rules via medium-term plans (binding for the plan period) rather than relying on long-lasting complex numerical rules; example: multiyear expenditure ceilings.
  - Adjust limits periodically (say every three to five years) based on baseline economic scenarios; manage cyclical variations within the MTFF.
  - Escape clauses to accommodate exceptional circumstances and large adverse shocks.
  - Use independent forecasts to strengthen credibility and reduce systematic optimism in projections:
    - Fiscal councils or similar bodies can provide independent macro forecasts and estimates of fiscal measure effects (examples cited where fiscal councils already produce estimates).
    - Risk analysis and alternative scenarios should be included to better reflect uncertainties and surprises.

*Source: IMF staff estimates (sdnea2022002).*

### Box 1. The Perils of Overoptimism

### Box 1. The Perils of Overoptimism

### Evidence of overoptimism in projections
- Official forecasts are systematically more optimistic than private forecasts.
- The sample analyzed consists of 43 countries including advanced and emerging market economies in Europe, the Americas, and Asia during 2000–19.
- Fiscal slippages are measured by the difference between the government’s announced plans (one-year ahead) and final fiscal outcomes.
- “Slippages” refer to the cases where fiscal slippages repeated for three consecutive years.
- Private forecasts are proxied by Consensus Forecast.

### Economic implications of overoptimistic forecasts
- Overoptimistic growth and fiscal projections generate fiscal slippages when growth disappoints.
- Fiscal slippages tend to be persistent in some countries.
- Fiscal slippages are associated with faster debt accumulation over the medium term—over and above the level which a similar fiscal balance path would have delivered without slippages.
- Larger fiscal slippages could be related to higher sovereign spreads associated with those slippages.
- Surprises to growth that were not perceived by either official or private forecasts do not fully account for larger forecast errors by official projections, implying government fiscal actions are partly responsible for fiscal slippages.

### Key empirical notes and data context
- Sources cited: Consensus Economics; national authorities; IMF, World Economic Outlook; and IMF staff estimates.
- Data labels use International Organization for Standardization (ISO) country codes.
- Panel references: Box Figure 1.1, panel 1 shows Official vs. Private Forecasts; panel 2 shows Repeated Fiscal Slippages and Implications.

### Recommendations to strengthen fiscal reporting and planning
- Revamp the quality of government finance statistics, improving coverage and timeliness.
- Adopt accrual accounting methods as the norm.
- Move toward a comprehensive public sector balance sheet approach to provide a full view of government actions and risk exposures.
- Conduct a systematic inventory of assets and liabilities to improve monitoring of government net worth and valuation of public sector investments.
- Improve transparency and governance through better fiscal reporting and monitoring of risks from state-owned enterprises and extra-budgetary activities.
- Low-income countries with significant capacity constraints should pursue gradual improvements of their fiscal frameworks while prioritizing measures to strengthen public finance management systems and increase transparency in reporting.

### Risk-based fiscal frameworks and buffers
- Fiscal buffers needed to manage adverse shocks may be larger than previously thought given the new role of fiscal policy in managing large crises.
- Global debt surged in 2009 and 2020 as countries, hit by sharp economic contractions, took large and unprecedented fiscal measures.
- Announcements of large fiscal measures in 2020 helped stabilize economies during crises but rely on strong public finances to be credible and not generate concerns with future fiscal sustainability.
- Borrowing constraints could severely impair the ability to respond to shocks.
- Large debt surges can lead to persistently lower economic growth especially if initial debt levels are high.

*Source: Box 1. The Perils of Overoptimism (sdnea2022002).*

### 2. COVID-19 Fiscal Measures

### 2. COVID-19 Fiscal Measures

### Risk-based fiscal plans and rules
- Fiscal plans should emphasize risk assessment with three guiding principles:
  - Plans and rules should be tighter and envisage more ambitious fiscal consolidation paths, depending on the degree of risks to debt sustainability in the short and medium term.
  - Rules should incentivize buildup of buffers over time even if there is no immediate, high risk of debt distress.
  - Rules should incorporate well-defined escape clauses to allow greater flexibility when hit by shocks.
- The design and calibration of fiscal rules should be linked to assessments of fiscal sustainability risks using a comprehensive set of indicators such as market financing conditions (for example, spreads), macro and fiscal conditions, and structural factors.
- Debt sustainability analyses should capture multidimensional risks and paths for fiscal variables under different scenarios but require strengthened risk analysis.

### Building buffers, debt limits, and anchors
- For countries with high debt vulnerabilities, especially in the short term, fiscal plans and rules should prioritize reducing public debt and impose less flexibility.
- Fiscal anchors should be consistent with buildup of sufficient fiscal buffers:
  - Buffers are needed to manage normal volatility of macro variables affecting fiscal accounts and to ensure governments can act decisively in large crises.
  - The framework should incentivize accumulation of appropriate buffers over time; their size depends on risk assessment and governments’ degree of risk aversion (for example, cost of fiscal adjustment).
  - A medium-term anchor consistent with a safe debt level should be set so that, even if hit by an adverse shock, debt would stay below a level (limit) where the risk of debt distress increases significantly.
- On estimating debt limits and safety margins:
  - Estimating debt limits is challenging and depends on several factors including credibility of fiscal plans; given high uncertainty, it is advisable to choose a prudent debt limit.
  - Safety margins (buffers) should be defined such that government debt exceeds their limit only with a low probability when accounting for risks.
  - Countries could set an explicit medium-term debt anchor that is lower than the debt limit by at least the estimated size of the safety margin, or set medium-term anchors (for example, overall balance) that lead to buffer buildup.
  - The size of buffers depends on country-specific volatility of key macro-fiscal variables (for example, economic growth, interest rates, exchange rates), debt management (composition of debt), and trade-offs with other policy priorities.
  - Low-income countries may focus more on development needs and less on fiscal buffers; lower buffers limit ability to adopt countercyclical policies and manage large shocks.
- Countries whose debt level exceeds the safety margin should commit to a medium-term fiscal path to return to the anchor; the pace of adjustment should be based on risk assessment—the higher the risk, the faster the adjustment.
- Commodity exporters and countries vulnerable to natural disasters should design anchors and rules accounting for specific shocks and generally build larger buffers:
  - Commodity exporters should have frameworks resilient to large positive terms of trade shocks and use good periods to build larger buffers.
  - Natural disasters can raise government expenditures by an average of 15 percent and lower revenue by 10 percent over the five years.

### Escape clauses and transition arrangements
- Escape clauses should be well-defined and include transition paths guiding fiscal policy after large shocks:
  - At a minimum require presenting a medium-term plan showing return to the rule or setting a revised medium-term fiscal anchor.
  - Escape clauses could be time-bound or data-driven; data-driven approaches may provide more credibility when time-bound returns are too restrictive.
- Two options when deviations from rules are large:
  1. Set a transition period based on operational targets over the medium-term and gradually converge back to the rules (limits on fiscal balances or expenditure ceilings can be used and may include state-dependent transition periods, such as guardrails linked to job market conditions).
  2. Recalibrate a medium-term fiscal anchor if the old rules are no longer relevant or feasible; recalibration should be clearly communicated to the public.

### Integrating long-term challenges: climate change and aging
- Fiscal frameworks need to better incorporate long-term challenges with large fiscal implications, especially climate change and population aging.
  - IMF (2022a) estimates that among advanced economies between 2021 and 2030, annual pension spending will rise by about 0.6 percent on average, and some countries will see rises in pensions by more than 1 percent of GDP (for example, Belgium, Italy, Korea, New Zealand).
  - Health care spending is also expected to increase substantially in the same period, with high uncertainty; in some cases the rise in health care spending will be substantially larger than that of pensions (for example, Japan, United Kingdom, United States).
- Governments should prepare long-term projections and assessments of climate-related fiscal impacts, including costs of adaptation and mitigation under different policy choices, to inform fiscal sustainability analyses and medium-term plans.
- Budget processes should be strengthened to better monitor and assess budget programs and their environmental (“green”) impact; long-term projections for aging-related items (pensions, health care) can help design fiscal plans and calibrate fiscal rules.
- Governments may define paths or triggers for aging-related expenditures (for example, adjust pensions or increase taxes if outturns are higher than projections).

### The debate on “green” fiscal rules and green public financial management (PFM)
- Proposals for “green” golden rules (excluding green public investments or other spending from deficit calculations) face significant practical challenges:
  - Defining and classifying green spending is difficult and raises risks of creative accounting (“greenwashing”); most spending items can have a green component and countries have heterogeneous definitions and procedures.
  - Protecting some green programs a priori could create wrong incentives and prioritize large public investment projects even if better alternatives exist.
  - Excluding substantial parts of the budget risks undermining fiscal rules’ objective of promoting fiscal sustainability and increases complexity of implementation and monitoring.
  - Green rules could undermine the budget process and broader policy discussions about priorities and financing constraints.
- Recommended approach: adapt budget processes and fiscal frameworks rather than create numerical “green” rules:
  - Develop comprehensive frameworks to address climate change and integrate climate priorities through green public financial management (PFM).
  - Green budgeting involves making PFM practices environment and climate sensitive, evaluating environmental impacts of budgetary and fiscal policies, and assessing coherence with national and international commitments.
  - Many countries have underdeveloped green PFM; some advanced economies have adopted ambitious green PFM practices (France in 2019) but green PFM remains underdeveloped in most countries.

### Enhancing the role of independent fiscal councils
- The number of fiscal councils has increased but with varying independence and responsibilities; important weaknesses remain:
  - About half of fiscal councils in OECD countries assess assumptions in government fiscal plans.
  - More than 40 percent of fiscal councils conduct analysis on economic and fiscal scenarios.
  - Escape clauses have proved valuable after the pandemic but only 50 percent of fiscal councils are tasked to monitor activation and implementation of escape clauses.
  - Only 50 percent of countries with fiscal rules have established fiscal councils.
  - More developed fiscal councils (Canada, The Netherlands, United Kingdom) provide ex-ante analysis including independent forecasts, costing of measures, and risk assessments; ex-ante analysis is not unique to advanced economies (examples: Chile, Georgia).
- Strengthening fiscal councils can build credibility of medium-term fiscal plans, especially in enhanced rules-based frameworks with greater flexibility:
  - Mandates: extend mandates to include independent forecasts on key macro variables, assessment of budgetary impact of new measures or reforms, and risk assessments for use in medium-term plans and budgets.
  - Access to timely information: legislation should guarantee full access to all relevant information at no cost and in a timely manner from government and public entities.
  - Operational independence and capacity: fiscal councils need sufficient budget resources commensurate with their remit and protection from political interference; legislation can secure resources and enshrine operational independence.
  - Accountability, transparency, and communications: fiscal councils should be accountable to the public and Parliament through peer-reviews, regular hearings, timely public release of reports, and ex-post assessments of mandate fulfillment and resource use by the supreme audit institution.
  - In emerging markets and low-income countries with capacity constraints, independent oversight committees focused on fewer core tasks can serve as an interim role while capacity is strengthened; priority should be given to increasing transparency in reporting and improving macro-fiscal projections and the quality and timeliness of fiscal statistics.

*Source: IMF, Database of Country Fiscal Measures in Response to the COVID-19 Pandemic; IMF staff.*

### Conclusion

### Conclusion

### Main findings and recommendations
- Countries should seize the opportunity to upgrade their medium-term fiscal frameworks as they return to fiscal rules.
- Rationale:
  - The macroeconomic landscape has shifted as countries recover from the pandemic.
  - Governments face difficult trade-offs amid growing concerns about debt sustainability and pressures to address immediate needs (for example, the significant cost-of-living shock due to rising energy and food prices) and long-term challenges.
  - Large deviations from pre-pandemic fiscal rules, and longstanding weaknesses in fiscal frameworks, imply returning to old rules is often difficult and undesirable.
- Policy recommendations to improve balance between flexibility and credibility:
  - Anchor fiscal policy around medium-term fiscal plans.
  - Strengthen risk management.
  - Enhance checks and balances through a bigger role for independent fiscal institutions and greater transparency.
  - Build wide public support for sound public finances based on a set of principles and rules to guide the budget process.
- Objective: prepare for future crises and promote a consistent mix of fiscal and monetary policies.

### Annex 1 — Economic Costs of Overoptimistic Projections: data and empirical findings
- Data description:
  - Sample of 43 countries, comprising of 23 advanced economies and 20 emerging market countries, during 2000–19.
  - Official projections on growth and fiscal balance collected from countries’ official annual budget documents, Bloomberg Finance L.P., and mid-year budget reviews or revised budgets when available.
  - Private forecasts from Consensus Economics and Bloomberg.
  - Macroeconomic controls from the IMF World Economic Outlook database; sovereign spreads from Bloomberg Finance L.P. and Refinitiv Datastream; uncertainty measures from the World Uncertainty Index (WUI) and CBOE Volatility Index (VIX); fiscal rules and institutions from the IMF database on fiscal rules and fiscal councils.
- Key empirical approach:
  - Fiscal slippages proxied by errors in official forecasts of fiscal balances (difference between official projections and fiscal balance outcomes).
  - Panel regression links fiscal slippages to past forecast errors, growth surprises (errors in growth forecasts), and controls including prior fiscal balance, public debt, WUI, IMF program review indicator, upcoming election, fiscal rules, fiscal councils, and fixed effects.
  - Panel regression links medium-term (three-year horizon) changes in public debt to average fiscal slippages and fiscal balances, controlling for initial debt, average growth, WUI, and fixed effects.
- Principal findings:
  - Fiscal slippages are persistent (high autocorrelation coefficient).
  - Fiscal slippages are positively correlated with growth surprises, indicating overly optimistic macroeconomic projections are a major source of fiscal slippages.
  - Fiscal slippages tend to be smaller on average in countries with fiscal rules, especially with expenditure rules, and in countries with fiscal councils.
  - Fiscal slippages are associated with faster debt accumulation over the medium-term (three-year horizon), above the level implied by similar fiscal balance paths without slippages.
  - Larger fiscal slippages are associated with higher sovereign spreads (vis-à-vis the US 10-year sovereign yields).
- Notes on regression table and sample:
  - Panel regressions use a sample of 43 countries during 2000–19.
  - The variable “fiscal slippages” is calculated as the difference between budgetary plans for year t from the budget in t – 1 and actual fiscal outcome at t.
  - Columns (1)–(5) examine patterns of fiscal slippages; Column (6) examines relation to debt accumulation over the medium-term (three-year horizon); Column (7) examines relation to sovereign spreads.
  - Definitions: Negative (positive) fiscal slippages imply over-performance (fiscal slippages).

### Annex 2 — Safe Assets and Debt Limits: model and calibration
- Model summary:
  - Based on Mian, Straub, and Sufi (2022); continuous-time deterministic model with three agents: government, representative household, and monetary authority.
  - Households draw convenience yields from holding government bonds; monetary authority follows an inflation-targeting rule with a zero lower bound (ZLB) on nominal interest rate.
  - Two key features:
    - Low neutral interest rate arises from demand for government bonds due to convenience yields, possibly generating a negative interest-growth differential.
    - Endogenous relationship between interest rate and public debt: interest rates increase with the level of public debt (downward-sloping demand curve for government bonds).
  - Sustainable combinations of primary deficit and debt (percent of GDP) derived from z(b) = G(b) − R(b) · b, where z(b) is primary deficit required to stabilize debt at b; G(b) and R(b) are equilibrium growth and interest rates depending on debt-to-GDP.
  - Deficit-debt diagram implications:
    - “Free-lunch” zone to the left of point F: low debt allows higher primary deficits without sustainability concerns.
    - Flipping point (Point F*): beyond this, a primary surplus is required to stabilize debt-to-GDP.
    - Maximum debt limit (Point LL): intersection of maximum sustainable primary surplus and diagram; debt above this is unsustainable.
- Calibration (baseline, matching AEs and EMs):
  - Aggregation: typical AE and EM variables weighted by economic size; mid-2000s scenario uses sample 2000–2009; pre-pandemic scenario uses sample 2019.
  - Typical AE calibrations:
    - Pre-pandemic: initial level of debt of 100 percent of GDP, real long-term trend growth of 1.5 percent, equilibrium inflation rate 2 percent, equilibrium nominal interest rate 2 percent.
    - Mid-2000s scenario: initial debt 75 percent of GDP, real long-term trend growth of 2.5 percent, equilibrium nominal interest rate 4 percent.
  - Typical EM calibrations:
    - Pre-pandemic: initial level of debt of 50 percent of GDP, real long-term trend growth of 3.5 percent, long-term inflation rate 4 percent, equilibrium nominal interest rate 6.5 percent.
    - Mid-2000s scenario: initial debt 40 percent of GDP, real long-term trend growth of 6 percent, long-term inflation rate 6 percent, equilibrium nominal interest rate 11.5 percent.
  - Debt-interest elasticity: assumed 0.017, implying a 10 percent increase in the debt-to-GDP ratio leads the interest rate to increase by 17 basis points.
- Additional notes:
  - Annex Figure 2.1 shows variation of long-term interest volatility across advanced economies in the euro area, implying debt limits differ even among AEs.
  - Empirical analysis of 23 AEs and 25 EMs shows positive correlation between central bank independence and lower sovereign borrowing costs (Annex Table 2.2).

### Annex 3 — Fiscal Rules and Countercyclical Fiscal Policy in Recessions: data, methods, and results
- Data and sample:
  - Unbalanced panel of 71 countries (22 advanced economies and 49 emerging market economies) during 1985–2019.
  - Recessions defined as contiguous blocks of years with negative real GDP growth (Harding and Pagan’s 2002 algorithm).
  - Primary focus on real government spending (better reflects discretionary fiscal policy); also consider current and capital spending subcomponents, real government consumption, and gross fixed capital formation (GFCF).
- Empirical strategy:
  - Panel local projections estimated with two-way (country and time) fixed effects to implement a difference-in-difference framework comparing countries with versus without fiscal rules in recessions.
  - Specification includes lags of dependent variable, rules, and GDP growth; clusters standard errors at country level.
  - Robustness checks use a multi-treatment effect estimation with inverse probability weighting (IPW) to jointly model probability of entering a recession and adopting a fiscal rule, addressing endogeneity.
- Main results:
  - On average, countries entering a recession with a fiscal rule do not conduct more procyclical fiscal policies than countries without a rule.
  - Both countries with and without rules cut government spending following a recession; cuts occur in both current and capital spending with no difference between rulers and non-rulers on average.
  - Results robust to:
    - Extending sample to 2020 to include the pandemic response.
    - Multi-treatment effect methodology addressing endogeneity.
    - Alternative spending measures: real government consumption (for current spending) and gross fixed capital formation (for capital spending).
    - Small recessions and downturns (episodes where real GDP growth is above zero but at least 2 percentage points below the previous year).
- Heterogeneous effects and role of design and fiscal space:
  - Countries with more fiscal space and more flexible rules tend to have a more countercyclical policy response.
  - Evidence:
    - Countries with lower pre-recession debt burdens spend relatively more during the recovery period.
    - Countries with a higher pre-recession deficit relative to the rule limit tend to constrain spending growth, whereas debt levels more persistently exceed the limit.
    - Among countries with fiscal rules, those with flexible features (for example, cyclically adjusted targets, well-specified escape clauses, exempting investment) are, on average, able to conduct a less procyclical fiscal policy response.
    - Compared to not having a rule, countries with flexible rules are able to maintain capital spending levels when hit by recessions and constrain government spending by less in the recovery period starting two years after the recession.
- Methodological notes on flexibility:
  - Flexible rule dummy equals 1 if a flexible rule (at least one feature among cyclically adjusted targets, well-specified escape clauses, or investment exemptions) is in place at time t; 0 if rule is rigid.
- Availability:
  - Additional results and robustness checks are available from the authors upon request.

*Source: STAFF DISCUSSION NOTES — The Return to Fiscal Rules (Conclusion and Annexes).*

### Annex Figure 3.1. Impact of Fiscal Rule on Governments’ Total Spending and Capital Spending

### Annex Figure 3.1. Impact of Fiscal Rule on Governments’ Total Spending and Capital Spending

### Subcomponent in Response to Recessions
- Source: IMF staff estimates.
- The figure reports the cumulative effect of a recession on the outcome variable for countries with vs without fiscal rules.
- The error bands correspond to 90 percent confidence intervals.

### Impact of Recession on Real Government Consumption and Investment (Annex Figure 3.2)
- Source: IMF staff estimates.
- The figure reports the cumulative effect of a recession on the outcome variable for countries with versus without fiscal rules.
- The error bands correspond to 90 percent confidence intervals.

### Impact of Recession on Total Real Government Spending—Small Recessions (Annex Figure 3.3)
- Source: IMF staff estimates.
- The figure reports the cumulative effect of a small recession on the outcome variable for countries with versus without fiscal rules.
- The error bands correspond to 90 percent confidence intervals.

### Role of Debt Levels (Annex Figure 3.4)
- Source: IMF staff estimates.
- The figure reports the cumulative effect of a recession on the outcome variable for countries with fiscal rules and high versus low debt levels and interest bills (that is, 75th vs. 25th percentiles), relative to countries without fiscal rules.
- The error bands correspond to 90 percent confidence intervals (CI).

### Role of Distance from Fiscal Rule Limit (Annex Figure 3.5)
- Source: IMF staff estimates.
- The figure reports the cumulative effect of a recession on the outcome variable for countries with fiscal rules and high versus low debt and deficit levels compared to the rule limits (75 vs. 25 percentiles), relative to countries without fiscal rules.
- 90 percent confidence intervals (CI) bands are shown.

### Role of Flexible vs. Rigid Rules (Annex Figure 3.6)
- Source: IMF staff estimates.
- The figure reports the cumulative effect of a recession on the outcome variable for countries with flexible versus rigid fiscal rules.
- The error bands correspond to 90 percent confidence intervals (CI).

### Role of Flexible Rules vs. No Rules (Annex Figure 3.7)
- Source: IMF staff estimates.
- The figure reports the cumulative effect of a recession on expenditures for countries with flexible rules versus no fiscal rules.

*Source: IMF staff estimates. The Return to Fiscal Rules, Staff Discussion Note No. SDN/2022/002.*

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_Source: https://www.imf.org/-/media/files/publications/sdn/2022/english/sdnea2022002.pdf_