## sipea2022001

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---

### Introduction — Overview and purpose
- Fiscal rules help set permanent constraints on fiscal policy and—with the appropriate institutions—reduce uncertainty about future fiscal policy developments.
- Political and institutional environments can lead to distortions in fiscal policy; fiscal rules impose durable constraints through numerical limits on key budgetary aggregates or debt indicators.
- This paper evaluates options for fiscal rules for Lesotho. Section coverage:
  - Section 2: background on the fiscal situation in Lesotho and motivation for fiscal rules.
  - Section 3: review of types of fiscal rules and their pros and cons.
  - Section 4: institutional framework required to underpin a fiscal-rule framework.
  - Section 5: a possible fiscal-rule framework for Lesotho and a roadmap to introduce it.

### The macro-fiscal context in Lesotho: revenues — key findings and statistics
- Total revenues peaked at 66.5 percent of GDP in FY06/07 and have been on a declining trend since then.
- SACU transfers:
  - Contributed 44 percent of total revenues on average over the past 15 years.
  - Accounted for 85 percent of the decline in total revenues over the past 15 years.
  - Are the main driver of overall revenue volatility.
  - Contribute to growth four times more than the next largest revenue source (taxes on income, profits, and capital gains).
  - Contribute 10.0 percentage points to revenue growth on average; all else equal, expenditure would have to rise or fall by 10 percent from the previous year to avoid any impact on the fiscal balance due to SACU transfers’ volatility alone.
- Domestic revenues have been relatively stable at just under 25 percent of GDP but fell as a share of GDP in FY20/21 during the pandemic.

- Summary statistics on revenue sources (15 years from 2007/08 to 2021/22 (July 2021 forecast)):
  - Total revenues: Level 100.0; Average share of total revenue (%) 10.6; Average absolute contribution (ppts) 13.1
  - SACU receipts: Level 43.6; Average share (%) 10.0; Average absolute contribution (ppts) 13.9
  - Non-SACU receipts: Level 56.4; Average share (%) 5.9; Average absolute contribution (ppts) 6.8
  - Taxes on income, profits, and capital gains: Level 21.1; Average share (%) 2.4; Average absolute contribution (ppts) 2.2
  - General Taxes on Goods and Services: Level 13.9; Average share (%) 1.5; Average absolute contribution (ppts) 1.4
  - Grants: From international organisations: Level 7.2; Average share (%) 2.3; Average absolute contribution (ppts) 2.9
  - Water Royalties - LHDA: Level 5.0; Average share (%) 0.8; Average absolute contribution (ppts) 1.2
  - Rent: Level 2.3; Average share (%) 0.9; Average absolute contribution (ppts) 1.4
  - Dividends: Level 2.2; Average share (%) 1.7; Average absolute contribution (ppts) 2.4
  - Excise taxes: Level 1.9; Average share (%) 0.6; Average absolute contribution (ppts) 0.7
  - Grants: From foreign governments: Level 1.1; Average share (%) 0.6; Average absolute contribution (ppts) 0.8
  - Electricity 'Muela: Level 0.5; Average share (%) 0.2; Average absolute contribution (ppts) 0.4
  - Other revenues: Level 1.2; Average share (%) n/a; Average absolute contribution (ppts) n/a

### Expenditure patterns and rigidity — features and consequences
- Key features:
  - Wage spending is the largest component of both current spending (45 percent) and overall spending (30 percent).
  - Wage spending has been on an increasing trend over time and is politically protected, making it downwardly rigid.
  - When revenue constraints bind (for example, a dip in SACU revenues), capital spending is typically cut to accommodate wage and other protected spending.
  - The share of capital spending in total spending has been on a declining trend since FY12/13.
- Consequences:
  - Overall fiscal balance is heavily impacted by volatile SACU transfers.
  - The overall balance does not recover as quickly as SACU transfers because of spending rigidity; example: overall balance in FY19/20 was still deteriorating while SACU transfers recovered.
  - Total public and external debt have been increasing over the past decade, reaching close to 60 percent and 50 percent of GDP, respectively, and are projected to go beyond them in the next few years.

### Existing fiscal principles and targets in Lesotho (BSP and DMPF) — rules, limits, and performance
- Budget Strategy Paper (BSP) principles and quantitative/qualitative objectives:
  - (i) Overall budget: "Adopt a Budget that is affordable, sustainable, and yet responsive to the needs of the country over the medium-term."
  - (ii.a) Overall fiscal balance: "Over the medium-term, bring the overall fiscal deficit to below 3 percent of GDP consistent with long-term GDP growth."
  - (ii.b) Wage bill: "The Government’s expenditure on wage bill should not be seen growing as a percentage of Gross Domestic Product (GDP) and must be reduced over the medium term alongside measures to streamline the civil service."
  - (ii.c) Ratio of recurrent to capital spending: "Consistently constraining the Government’s recurrent expenditure not to grow more than development expenditure."
  - (iii) Public financial management: "Improve monitoring, transparency, and accountability mechanisms to ensure expenditure efficiency."
  - (iv) Arrears: "Prioritize the elimination and curtailment of accumulation of arrears."
  - (v) Domestic revenue mobilization: "Expand domestic revenue mobilization to reduce reliance on volatile and shrinking transfers from SACU."
  - (vi) Golden rule: "Over the medium term, the Government’s borrowings shall be used only for the purpose of financing development expenditure and not for recurrent expenditure."
  - Safeguard the peg: "Adopt a Budget that is affordable, sustainable, and yet responsive to the needs of the country over the medium-term."
- Debt Management Policy Framework (DMPF) limits and triggers:
  - Ceilings on total public debt, including guarantees, will be 60 percent of GDP.
  - Public external debt will be limited to 40 percent of GDP.
  - Government guarantees will be subjected to an overall limit of 5 percent of GDP.
  - Trigger levels to prompt fiscal adjustment mechanisms:
    - Public debt (excluding guarantees) trigger level: 50 percent of GDP.
    - Public external debt trigger level: 35 percent of GDP.
    - Government guarantees trigger level: 3 percent of GDP.
- Performance and operational issues:
  - Since FY09/10, only one of the BSP principles has been met each year.
  - Under the current forward-looking medium-term fiscal framework, it would be very challenging to meet any of these principles in the coming three years.
  - The wage bill rule expressed in terms of GDP is potentially pro-cyclical and could undermine fiscal sustainability; between FY09/10 to FY20/21 the rule would have been met five times and missed seven times.
  - The recurrent-versus-capital spending principle (ii.c) has been met six times and missed six times between FY09/10 and FY20/21; over FY21/22–FY24/25 it is projected to be met twice and missed once.
  - The golden rule (vi) has been met comfortably every year between FY09/10 and FY20/21 due to large SACU transfers, and is projected to be met over FY21/22–FY24/25.
  - A deficit limit of 3 percent of GDP is consistent with stabilizing public debt at 60 percent of GDP over the medium term given nominal growth recovering to around 5 percent a year (since 3/60=0.05), but SACU size and volatility complicate a simple overall-balance-based fiscal rule.
  - The BSP does not set out 'escape clauses' or specify how quickly or by what means deviations from targets should be addressed; the draft PFM Bill incorporates a section on deviations from targets.

### Institutional and legal constraints
- Older legislated limits remain in force from the 1967 Loans & Guarantees Act and subsequent Amendments, which place a very high limit on debt by stating that it must not exceed the past three years’ recurrent revenues.
- The DMPF’s trigger mechanism requires initiation of a fiscal adjustment mechanism when outstanding debt breaches the trigger thresholds.

### Types of fiscal rules — definitions, examples, pros and cons
- Rule categories identified:
  - Expenditure rules: limit total, primary, or current spending, by ceiling on growth or ratio to GDP.
    - Examples: Namibia: public expenditure levels below 33 percent of GDP. Peru: real growth of current expenditure ceiling of 4 percent.
    - Pros: Clear operational guidance; steer the size of government; allow for economic stabilization; relatively easy to communicate and monitor.
    - Cons: Not directly linked to debt sustainability; could lead to unintended shifts in spending composition; not consistent with discretionary fiscal stimulus; excluding cyclically-sensitive items can increase distance to sustainability target.
  - Revenue rules: set ceilings or floors on revenues or determine use of windfall revenues.
    - Examples: Kenya: maintain revenues at 21-22 percent of GDP. France: determine ex ante the allocation of higher-than-expected tax revenues.
    - Pros: Can improve revenue performance; steer government size; clear operational guidance; easy to communicate and monitor.
    - Cons: Not directly linked to debt sustainability; no economic stabilization feature (can be pro-cyclical); revenues have large cyclical components.
  - Budget balance rules:
    - Overall/primary balance rules: constrain deficits and help ensure debt sustainability.
      - Pros: Clear operational guidance; allow for economic stabilization; easy to communicate and monitor; closely linked to debt sustainability.
      - Cons: Could be procyclical; headline balance can be affected by events outside government control.
    - Structural/cyclically-adjusted balance and "over-the-cycle" rules:
      - Over-the-cycle rule: requires attaining a given nominal budget balance ceiling on average over the cycle (IMF 2009); stronger stabilization properties than cyclically-adjusted rules (Caceres and Ruiz-Arranz 2010); can accommodate automatic stabilizers and discretionary measures; requires precise dating of the cycle and stable national accounts data (IMF 2018).
    - Investment-based "golden rule":
      - Targets overall balance net of capital expenditure; with zero ceiling, borrowing permitted only to finance investment.
      - Pros: Promotes and protects capital expenditure; consistent with intergenerational equity.
      - Cons: Risk of borrowing for low-return projects without proper investment management; creative accounting and reclassification of spending as investment; can weaken link between rule and debt dynamics (example: Mexico 2009 exclusion of capital expenditures).
    - "Pay-as-you-go" rules:
      - Require offsetting any deficit-raising measures in a deficit-neutral way; typically procedural and not counted as numerical fiscal rules in IMF dataset (Schaechter and others 2012).
  - Debt rules:
    - Definition: Explicit limit or target for public debt in percent of GDP.
    - Examples: Liberia, Poland: debt ceiling of 60 percent of GDP. Kosovo: debt ceiling of 40 percent of GDP.
    - Pros: Directly linked to debt sustainability; easy to communicate and monitor.
    - Cons: No clear short-term operational guidance as policy impact on debt is not immediate; vulnerable to "below-the-line" transactions; can be procyclical; debt affected by factors outside government control.

### Fiscal rules in practice — coverage, trends, and combinations
- Adoption trends and coverage:
  - As of end-2021, about 105 economies have adopted at least one fiscal rule, 11 countries more than the last update in 2015 and 96 countries more than 1985 (Davoodi and others 2022).
  - Advanced countries were frontrunners; adoption increasingly common in EMDEs since late 2000s. As of end-2021, the number of EMDEs with fiscal rules was more than double the number of advanced economies.
- Number and combinations of rules:
  - The average number of fiscal rules per country rose to about three fiscal rules in 2021 up from about 2 in the early 2000s.
  - About 60 percent of countries with fiscal rules have a debt rule combined with operational limits on annual budget aggregates.
  - Of the 105 economies with fiscal rules in 2021:
    - one-third had a debt rule together with a deficit limit and an expenditure ceiling;
    - another quarter had a debt rule combined with a budget balance rule.
  - Expenditure rules are increasingly common, often as a ceiling on annual expenditure growth.
  - Revenue rules have been less used, reflecting revenue volatility over business cycles; they are often set as a ceiling on revenue-to-GDP ratio in advanced countries (Belgium, Denmark) and as a floor in low-income countries (WAEMU).
- Differences by income group:
  - Expenditure rules: about three-quarters of advanced economies have expenditure rules; less than a third of EMDEs adopted expenditure rules.
  - Debt rules: over 80 percent of EMDEs have adopted debt rules; most are debt limits/ceilings while about 10 percent use an anchor concept (Finland, Australia, United Kingdom).
  - Budget balance rules accounting for business cycles: more predominant in advanced economies (Czech Republic, Estonia) than in EMDEs (Chile, Colombia); EMDEs often rely on thresholds on actual activity rather than output gap concepts.

### Lessons from international experience — design priorities
- Key lessons:
  - An adequate public finance management (PFM) framework and political buy-in matter.
  - A good fiscal rule should balance simplicity, flexibility, and enforceability (Caselli and others 2018).
  - Cover a broad range of government fiscal activities to reduce scope for allocating spending to uncovered arrears or playing accounting tricks.
  - Incentivize building fiscal buffers during upturns and allow adequate fiscal support during downturns—ensure rules are counter-cyclical.
  - Calibrate fiscal rules in line with sustainability and stabilization objectives (e.g., deficits consistent with stable or falling debt/GDP ratio).
  - Given trade-offs, many countries combine two or more fiscal rules to address gaps (e.g., debt rule + expenditure rule; debt rule + cyclically adjusted budget balance rule).

### Institutional framework for fiscal rules — supporting arrangements
- Evolution and reforms:
  - Institutional frameworks were revised after the global financial crisis and the 2014–15 commodity price collapse to enhance flexibility, operational relevance, monitoring, and enforcement.
- Supporting arrangements:
  - Effective implementation and monitoring require supporting institutional arrangements to turn rule intent into budget policy and execution.
  - Fiscal rules can be reinforced by fiscal responsibility laws (FRLs) which set procedural and transparency requirements and sometimes numerical rules.
  - Independent bodies (e.g., fiscal councils) are increasingly used to enhance credibility and monitoring.
- Legal basis and trends:
  - In 2000, only 30 percent of countries established fiscal rules in legislation.
  - By 2021, the share more than doubled; currently more than 60 countries have fiscal rules featured at or above statutory levels (e.g., Fiscal Responsibility Law or constitutions).
  - As of 2021, over 40 percent of fiscal rules were supported by fiscal responsibility laws, doubled from a decade ago and particularly rising in EMDEs.

### Legislative level, escape clauses, and enforcement — principles and examples
- Legislative level and flexibility:
  - Rules enshrined in higher-level legislation:
    - Are more difficult to reverse and therefore tend to be longer lasting.
    - Confer more stability to the framework but may not enhance effectiveness if enforcement mechanisms and accountability procedures are weak.
  - For countries with weak institutions:
    - Simplicity of adoption and rapid implementation may be key factors in deciding which legislative framework to use.
- Escape clauses and triggers — design principles:
  - Include a very limited range of factors that allow such escape clauses to be triggered in legislation.
  - Provide clear guidelines on the interpretation and determination of events (including voting rules).
  - Specify the path back to the rule and treatment of accumulated deviations.
- Common triggers observed:
  - Recession or a significant growth slowdown.
  - Natural disaster (Brazil, Germany, Jamaica, Mauritius, Panama, Peru, Slovakia, Switzerland).
  - Banking system bailout (Slovakia).
- Enforcement and automatic correction mechanisms:
  - Formal enforcement (e.g., automatic corrections of ex post deviations) can raise rule credibility and is increasingly built into fiscal rules.
  - Clear specification of mechanisms and anchoring in legislation helps adherence, but political will remains decisive.

- Box 1 — Examples of correction mechanisms (summarized):
  - Switzerland and Germany: structural budget balance rules with automatic correction mechanisms (“debt brakes”).
    - Deviations are stored in a notional account; when accumulated deviation exceeds a threshold, improvements in the structural balance are required within a pre-defined timeframe.
    - Thresholds:
      - Germany: 1.0 percent of GDP in ordinary law and 1.5 percent per constitution.
      - Switzerland: 6 percent of expenditure.
    - Treatment differences:
      - Germany excludes deviations resulting from errors in real GDP growth projections from the notional account.
      - Switzerland tallies all misses (more transparent, less flexible).
    - Timeframe to eliminate excess in Switzerland: within the next three annual budgets.
    - Germany: overruns need to be reduced during an economic recovery and can be corrected via expenditure and revenue measures.
  - Poland and Slovakia: debt rule ceilings at 60 percent of GDP with intermediate triggers (Slovakia example):
    - At 50 percent of GDP: Minister of Finance must clarify debt increase to parliament and suggest reversal measures.
    - At 53 percent of GDP: cabinet shall pass a package of measures to trim the debt and freeze wages.
    - At 55 percent of GDP: expenditures would be cut automatically by 3 percent and next year's budgetary expenditures would be frozen, except for co-financing of EU funds.
    - At 57 percent of GDP: cabinet shall submit a balanced budget.
    - Caveat: triggers do not account for the cyclical position of the economy.
  - Sequesters (United States example):
    - Automatic spending cuts scheduled when political agreements fail; can be a one-time adjustment rather than a recurrent mechanism.
    - Tend to bias against capital spending.
  - Kenya:
    - Under the Fiscal Management Act: Minister of Finance must submit a compliance report to the National Assembly stating (a) reasons fiscal objectives/targets were not met; (b) remedial measures to ensure objectives/targets not met will be made good in the next quarter; and (c) any proposed Government policy decisions that may materially affect objectives and targets.

### Key characteristics of Lesotho’s fiscal situation — implications for rule design
- Factors to consider:
  - The importance of safeguarding the exchange rate peg;
  - The volatility of SACU transfers;
  - The downward rigidity of spending: current spending is driven by a large public sector wage bill;
  - Insufficient room for capital spending, which is nonetheless very large and inefficient relative to SACU peers;
  - Weak institutional capacity;
  - Political instability.
- Implication: rules should be
  - Countercyclical,
  - Easy to operate,
  - Easy to enforce.

### Recommended rule types for Lesotho — institutional approach and core rules
- Institutional approach:
  - Authorities are considering including requirements to set fiscal principles, objectives, and numerical targets in primary legislation (PFMA Bill), with definitions left to underlying regulations or the BSP.
  - Advice: In a difficult political environment, do not define objectives and targets in primary legislation to avoid undermining credibility and incentivizing off-budget activities or creative accounting.
- Recommended core rules:
  - A debt rule to safeguard the exchange rate peg:
    - Convert existing debt ceilings into a fiscal rule.
    - Ceilings proposed:
      - Total public debt, including guarantees: 60 percent of GDP.
      - Public external debt: 40 percent of GDP.
      - Government guarantees: overall limit of 5 percent of GDP.
    - Setting body example: Parliament, e.g., PFM regulations.
  - A budget balance rule (two options proposed):
    - Option A — Structural balance rule:
      - Use overall balance excluding SACU transfers and external grants as a proxy for the structural balance (given estimation difficulty).
      - Assumptions:
        - SACU transfers expected to remain at around 14–16 percent of GDP.
        - Grants expected to remain at around 2–3 percent of GDP.
        - A 3 percent overall balance is consistent with trend growth.
      - Possible target:
        - Overall balance excluding SACU and grants of around negative 20 percent of GDP.
      - Notes:
        - Target to be revisited periodically as more information on SACU transfers becomes available.
        - Arrears should be treated as an adjustor to the efficacy of this rule.
      - Setting body example: Parliament, e.g., PFM regulations.
    - Option B — Overall balance rule combined with an expenditure rule:
      - Overall deficit below 3 percent of GDP plus total spending below a certain percent of GDP (to be calibrated).
      - Rationale: SACU transfers are volatile and combined with rigid, increasing spending produce a volatile and growing deficit; an expenditure rule can limit expenditure growth to less than nominal GDP growth or limit current expenditure to a certain percentage of GDP.
      - Setting body example: Parliament, e.g., PFM regulations.

- Arrears and adjustors:
  - Introduce a formal target for limiting domestic arrears.
  - Treat arrears as an adjustor in calculating the budget balance: adjust the budget balance upward (downward) by the amount of increase (decrease) of arrears.

- Additional analysis:
  - Undertake analysis to determine the most useful budget balance rule and calibrate numerical targets consistent with trend growth.

### Supplementary numerical targets to improve expenditure quality
- Proposed cabinet-level targets (e.g., BSP):
  - Wage bill:
    - Switch the wage bill target to a share of domestic revenue from a share of GDP.
    - Rationale: avoids some pro-cyclicality of a GDP-based target and allows addressing via domestic revenue mobilization as well as wage restraint.
    - Proposed goal: gradually reduce to and then not to exceed 60 percent of domestic revenue.
  - Capital expenditure:
    - Make the existing capital expenditure target explicit once fiscal position has been restored.
    - Example: consider setting an explicit target for capital or development expenditure (e.g., not to fall below “core” SACU transfers).

### Summary recommendation for Lesotho
- Recommend two fiscal rules supplemented by two numerical targets to rationalize the composition of expenditures.
- Once the fiscal position has been restored, consider a stabilization fund to manage volatility in SACU revenues.

### Roadmap to introduce fiscal rules in Lesotho — next steps
a. Develop and enact PFM fiscal rule regulations that characterize the fiscal rules.
  - Include requirements to set fiscal principles, objectives, and numerical targets in primary legislation (PFMA Bill) but leave specifications to PFM regulations.
  - Calibrate precise numerical fiscal targets consistent with preserving debt sustainability and safeguarding the peg.
b. Establish mechanisms to ensure fiscal policies are set consistent with fiscal rules.
  - Set up monitoring, transparency, and reporting arrangements to ensure fiscal outcomes align with fiscal rules.
c. Define what should happen when rules are missed.
d. Ensure political buy-in.

*Source: sipea2022001 (IMF).*

### Introduction

### Introduction

### Overview and purpose
- Fiscal rules help set permanent constraints on fiscal policy and—with the appropriate institutions—reduce uncertainty about future fiscal policy developments.
- Political and institutional environments can lead to distortions in fiscal policy; fiscal rules impose durable constraints through numerical limits on key budgetary aggregates or debt indicators.
- This paper evaluates options for fiscal rules for Lesotho. Section coverage:
  - Section 2: background on the fiscal situation in Lesotho and motivation for fiscal rules.
  - Section 3: review of types of fiscal rules and their pros and cons.
  - Section 4: institutional framework required to underpin a fiscal-rule framework.
  - Section 5: a possible fiscal-rule framework for Lesotho and a roadmap to introduce it.

### The macro-fiscal context in Lesotho: revenues
- Total revenues peaked at 66.5 percent of GDP in FY06/07 and have been on a declining trend since then.
- SACU transfers:
  - Contributed 44 percent of total revenues on average over the past 15 years.
  - Accounted for 85 percent of the decline in total revenues over the past 15 years.
  - Are the main driver of overall revenue volatility.
  - Contribute to growth four times more than the next largest revenue source (taxes on income, profits, and capital gains).
  - Contribute 10.0 percentage points to revenue growth on average; all else equal, expenditure would have to rise or fall by 10 percent from the previous year to avoid any impact on the fiscal balance due to SACU transfers’ volatility alone.
- Domestic revenues have been relatively stable at just under 25 percent of GDP but fell as a share of GDP in FY20/21 during the pandemic.

- Summary statistics on revenue sources (15 years from 2007/08 to 2021/22 (July 2021 forecast)):
  - Total revenues: Level 100.0; Average share of total revenue (%) 10.6; Average absolute contribution (ppts) 13.1
  - SACU receipts: Level 43.6; Average share (%) 10.0; Average absolute contribution (ppts) 13.9
  - Non-SACU receipts: Level 56.4; Average share (%) 5.9; Average absolute contribution (ppts) 6.8
  - Taxes on income, profits, and capital gains: Level 21.1; Average share (%) 2.4; Average absolute contribution (ppts) 2.2
  - General Taxes on Goods and Services: Level 13.9; Average share (%) 1.5; Average absolute contribution (ppts) 1.4
  - Grants: From international organisations: Level 7.2; Average share (%) 2.3; Average absolute contribution (ppts) 2.9
  - Water Royalties - LHDA: Level 5.0; Average share (%) 0.8; Average absolute contribution (ppts) 1.2
  - Rent: Level 2.3; Average share (%) 0.9; Average absolute contribution (ppts) 1.4
  - Dividends: Level 2.2; Average share (%) 1.7; Average absolute contribution (ppts) 2.4
  - Excise taxes: Level 1.9; Average share (%) 0.6; Average absolute contribution (ppts) 0.7
  - Grants: From foreign governments: Level 1.1; Average share (%) 0.6; Average absolute contribution (ppts) 0.8
  - Electricity 'Muela: Level 0.5; Average share (%) 0.2; Average absolute contribution (ppts) 0.4
  - Other revenues: Level 1.2; Average share (%) n/a; Average absolute contribution (ppts) n/a

### Expenditure patterns and rigidity
- Key features:
  - Wage spending is the largest component of both current spending (45 percent) and overall spending (30 percent).
  - Wage spending has been on an increasing trend over time and is politically protected, making it downwardly rigid.
  - When revenue constraints bind (for example, a dip in SACU revenues), capital spending is typically cut to accommodate wage and other protected spending.
  - The share of capital spending in total spending has been on a declining trend since FY12/13.
- Consequences:
  - Overall fiscal balance is heavily impacted by volatile SACU transfers.
  - The overall balance does not recover as quickly as SACU transfers because of spending rigidity; example: overall balance in FY19/20 was still deteriorating while SACU transfers recovered.
  - Total public and external debt have been increasing over the past decade, reaching close to 60 percent and 50 percent of GDP, respectively, and are projected to go beyond them in the next few years.

### Existing fiscal principles and targets in Lesotho (Budget Strategy Paper and Debt Management Policy Framework)
- The Budget Strategy Paper (BSP) sets principles that are a mix of quantitative and qualitative objectives:
  - (i) Overall budget: "Adopt a Budget that is affordable, sustainable, and yet responsive to the needs of the country over the medium-term."
  - (ii.a) Overall fiscal balance: "Over the medium-term, bring the overall fiscal deficit to below 3 percent of GDP consistent with long-term GDP growth."
  - (ii.b) Wage bill: "The Government’s expenditure on wage bill should not be seen growing as a percentage of Gross Domestic Product (GDP) and must be reduced over the medium term alongside measures to streamline the civil service."
  - (ii.c) Ratio of recurrent to capital spending: "Consistently constraining the Government’s recurrent expenditure not to grow more than development expenditure."
  - (iii) Public financial management: "Improve monitoring, transparency, and accountability mechanisms to ensure expenditure efficiency."
  - (iv) Arrears: "Prioritize the elimination and curtailment of accumulation of arrears."
  - (v) Domestic revenue mobilization: "Expand domestic revenue mobilization to reduce reliance on volatile and shrinking transfers from SACU."
  - (vi) Golden rule: "Over the medium term, the Government’s borrowings shall be used only for the purpose of financing development expenditure and not for recurrent expenditure."
  - Safeguard the peg: "Adopt a Budget that is affordable, sustainable, and yet responsive to the needs of the country over the medium-term."
- Debt Management Policy Framework (DMPF) limits:
  - Ceilings on total public debt, including guarantees, will be 60 percent of GDP.
  - Public external debt will be limited to 40 percent of GDP.
  - Government guarantees will be subjected to an overall limit of 5 percent of GDP.
  - Trigger levels to prompt fiscal adjustment mechanisms:
    - Public debt (excluding guarantees) trigger level: 50 percent of GDP.
    - Public external debt trigger level: 35 percent of GDP.
    - Government guarantees trigger level: 3 percent of GDP.
- Performance and operational issues:
  - Since FY09/10, only one of the BSP principles has been met each year.
  - Under the current forward-looking medium-term fiscal framework, it would be very challenging to meet any of these principles in the coming three years.
  - The wage bill rule expressed in terms of GDP is potentially pro-cyclical and could undermine fiscal sustainability; between FY09/10 to FY20/21 the rule would have been met five times and missed seven times.
  - The recurrent-versus-capital spending principle (ii.c) has been met six times and missed six times between FY09/10 and FY20/21; over FY21/22–FY24/25 it is projected to be met twice and missed once.
  - The golden rule (vi) has been met comfortably every year between FY09/10 and FY20/21 due to large SACU transfers, and is projected to be met over FY21/22–FY24/25.
  - A deficit limit of 3 percent of GDP is consistent with stabilizing public debt at 60 percent of GDP over the medium term given nominal growth recovering to around 5 percent a year (since 3/60=0.05), but SACU size and volatility complicate a simple overall-balance-based fiscal rule.
  - The BSP does not set out 'escape clauses' or specify how quickly or by what means deviations from targets should be addressed; the draft PFM Bill incorporates a section on deviations from targets.

### Institutional and legal constraints
- Older legislated limits remain in force from the 1967 Loans & Guarantees Act and subsequent Amendments, which place a very high limit on debt by stating that it must not exceed the past three years’ recurrent revenues.
- The DMPF’s trigger mechanism requires initiation of a fiscal adjustment mechanism when outstanding debt breaches the trigger thresholds.

*Source: sipea2022001 - Introduction (IMF).*

### 16.      Countries committed to a medium-term fiscal framework typically anchor fiscal policy on a

### 16.      Countries committed to a medium-term fiscal framework typically anchor fiscal policy on a 

### Types of fiscal rules
- The literature identifies 5 types of fiscal rules (Table 4): expenditure rules, revenue rules, budget balance rules, structural/over-the-cycle variants (including "golden rule" and "pay-as-you-go"), and debt rules.
- Expenditure rules
  - Definition: Limit total, primary, or current spending, by ceiling on growth or ratio to GDP.
  - Examples: Namibia: public expenditure levels below 33 percent of GDP. Peru: real growth of current expenditure ceiling of 4 percent.
  - Pros: Clear operational guidance; steer the size of government; allow for economic stabilization; relatively easy to communicate and monitor.
  - Cons: Not directly linked to debt sustainability (no constraint on revenue side); could lead to unintended shifts in spending composition; not consistent with discretionary fiscal stimulus; excluding cyclically-sensitive items can increase distance to sustainability target.
- Revenue rules
  - Definition: Set ceilings or floors on revenues or determine use of windfall revenues.
  - Examples: Kenya: maintain revenues at 21-22 percent of GDP. France: determine ex ante the allocation of higher-than-expected tax revenues.
  - Pros: Can improve revenue performance; steer government size; clear operational guidance; easy to communicate and monitor.
  - Cons: Not directly linked to debt sustainability (no constraint on expenditure side); no economic stabilization feature (can be pro-cyclical); revenues have large cyclical components.
- Budget balance rules
  - Overall/primary balance rules
    - Constrain deficits and help ensure debt sustainability.
    - Pros: Clear operational guidance; allow for economic stabilization; easy to communicate and monitor; closely linked to debt sustainability.
    - Cons: Could be procyclical; headline balance can be affected by events outside government control.
  - Structural/cyclically-adjusted balance and "over-the-cycle" rules
    - Account for the business cycle and are counter-cyclical.
    - Over-the-cycle rule: requires attaining a given nominal budget balance ceiling on average over the cycle (IMF 2009); stronger stabilization properties than cyclically-adjusted rules (Caceres and Ruiz-Arranz 2010); can accommodate automatic stabilizers and discretionary measures; requires precise dating of the cycle and stable national accounts data (IMF 2018).
  - Investment-based "golden rule"
    - Targets overall balance net of capital expenditure; with zero ceiling, borrowing permitted only to finance investment.
    - Pros: Promotes and protects capital expenditure; consistent with intergenerational equity.
    - Cons: Risk of borrowing for low-return projects without proper investment management; creative accounting and reclassification of spending as investment; can weaken link between rule and debt dynamics (example: Mexico 2009 exclusion of capital expenditures).
  - "Pay-as-you-go" rules
    - Require offsetting any deficit-raising measures in a deficit-neutral way; typically procedural and not counted as numerical fiscal rules in IMF dataset (Schaechter and others 2012).
- Debt rules
  - Definition: Explicit limit or target for public debt in percent of GDP.
  - Examples: Liberia, Poland: debt ceiling of 60 percent of GDP. Kosovo: debt ceiling of 40 percent of GDP.
  - Pros: Directly linked to debt sustainability; easy to communicate and monitor.
  - Cons: No clear short-term operational guidance as policy impact on debt is not immediate; vulnerable to "below-the-line" transactions; can be procyclical; debt affected by factors outside government control.

### Fiscal rules in practice (coverage, trends, and combinations)
- Adoption trends and coverage
  - As of end-2021, about 105 economies have adopted at least one fiscal rule, 11 countries more than the last update in 2015 and 96 countries more than 1985 (Davoodi and others 2022).
  - Advanced countries were frontrunners; adoption increasingly common in EMDEs since late 2000s. As of end-2021, the number of EMDEs with fiscal rules was more than double the number of advanced economies.
- Waves of expansion
  - Expansion in rules often followed large shocks and supranational rule adoption (early 2000s increase driven by national rules in emerging markets and supranational rules in low-income developing countries).
  - National rules in emerging markets often aimed to commit to fiscal adjustments after crises, lock in reform gains, or avoid procyclical spending amid volatile resource prices.
- Number and combinations of rules
  - The average number of fiscal rules per country rose to about three fiscal rules in 2021 up from about 2 in the early 2000s.
  - About 60 percent of countries with fiscal rules have a debt rule combined with operational limits on annual budget aggregates.
  - Of the 105 economies with fiscal rules in 2021:
    - one-third had a debt rule together with a deficit limit and an expenditure ceiling;
    - another quarter had a debt rule combined with a budget balance rule.
  - Expenditure rules are increasingly common, often as a ceiling on annual expenditure growth.
  - Revenue rules have been less used, reflecting revenue volatility over business cycles; they are often set as a ceiling on revenue-to-GDP ratio in advanced countries (Belgium, Denmark) and as a floor in low-income countries (WAEMU).
- Differences by income group
  - Expenditure rules: about three-quarters of advanced economies have expenditure rules; less than a third of EMDEs adopted expenditure rules.
  - Debt rules: over 80 percent of EMDEs have adopted debt rules; most are debt limits/ceilings while about 10 percent use an anchor concept (Finland, Australia, United Kingdom).
  - Budget balance rules accounting for business cycles: more predominant in advanced economies (Czech Republic, Estonia) than in EMDEs (Chile, Colombia); EMDEs often rely on thresholds on actual activity rather than output gap concepts.

### Lessons learned from international experience
- Key lessons:
  - An adequate public finance management (PFM) framework and political buy-in matter.
  - A good fiscal rule should balance simplicity, flexibility, and enforceability (Caselli and others 2018).
  - Cover a broad range of government fiscal activities to reduce scope for allocating spending to uncovered arrears or playing accounting tricks.
  - Incentivize building fiscal buffers during upturns and allow adequate fiscal support during downturns—ensure rules are counter-cyclical.
  - Calibrate fiscal rules in line with sustainability and stabilization objectives (e.g., deficits consistent with stable or falling debt/GDP ratio).
  - Given trade-offs, many countries combine two or more fiscal rules to address gaps (e.g., debt rule + expenditure rule; debt rule + cyclically adjusted budget balance rule).

### Institutional framework for fiscal rules
- Evolution and reforms
  - Institutional frameworks were revised after the global financial crisis and the 2014–15 commodity price collapse to enhance flexibility, operational relevance, monitoring, and enforcement.
- Supporting arrangements
  - Effective implementation and monitoring require supporting institutional arrangements to turn rule intent into budget policy and execution.
  - Fiscal rules can be reinforced by fiscal responsibility laws (FRLs) which set procedural and transparency requirements and sometimes numerical rules.
  - Independent bodies (e.g., fiscal councils) are increasingly used to enhance credibility and monitoring.
- Legal basis and trends
  - In 2000, only 30 percent of countries established fiscal rules in legislation.
  - By 2021, the share more than doubled; currently more than 60 countries have fiscal rules featured at or above statutory levels (e.g., Fiscal Responsibility Law or constitutions).
  - As of 2021, over 40 percent of fiscal rules were supported by fiscal responsibility laws, doubled from a decade ago and particularly rising in EMDEs.

*Source: sipea2022001 - 16.      Countries committed to a medium-term fiscal framework typically anchor fiscal policy on a (selected issues paper).*

### 26.      The desirable legislative support depends on country-specific circumstances. Rules enshrined

### 26.      The desirable legislative support depends on country-specific circumstances. Rules enshrined

### Legislative level and flexibility
- Rules enshrined in higher-level legislation:
  - Are more difficult to reverse and therefore tend to be longer lasting.
  - Confer more stability to the framework but may not enhance effectiveness if enforcement mechanisms and accountability procedures are weak.
- For countries with weak institutions:
  - Simplicity of adoption and rapid implementation may be key factors in deciding which legislative framework to use.

### Escape clauses and triggers
- Design principles for escape clauses:
  - Include a very limited range of factors that allow such escape clauses to be triggered in legislation.
  - Provide clear guidelines on the interpretation and determination of events (including voting rules).
  - Specify the path back to the rule and treatment of accumulated deviations.
- Common triggers observed:
  - Recession or a significant growth slowdown (present across listed countries).
  - Natural disaster (Brazil, Germany, Jamaica, Mauritius, Panama, Peru, Slovakia, Switzerland).
  - Banking system bailout (Slovakia).
- Countries with formal escape clause provisions for budget balance (and debt rules) include:
  - Brazil, Colombia, Germany, Mauritius, Mexico, Jamaica, Panama, Peru, Romania, Slovakia, Spain, and Switzerland.

### Enforcement and automatic correction mechanisms
- Formal enforcement (e.g., automatic corrections of ex post deviations) can raise rule credibility and is increasingly built into fiscal rules.
- Clear specification of mechanisms and anchoring in legislation helps adherence, but political will remains decisive.

Box 1 — Examples of correction mechanisms (summarized)
- Switzerland and Germany: structural budget balance rules with automatic correction mechanisms (“debt brakes”).
  - Deviations are stored in a notional account; when accumulated deviation exceeds a threshold, improvements in the structural balance are required within a pre-defined timeframe.
  - Thresholds:
    - Germany: 1.0 percent of GDP in ordinary law and 1.5 percent per constitution.
    - Switzerland: 6 percent of expenditure.
  - Treatment differences:
    - Germany excludes deviations resulting from errors in real GDP growth projections from the notional account.
    - Switzerland tallies all misses (more transparent, less flexible).
  - Timeframe to eliminate excess in Switzerland: within the next three annual budgets.
  - Germany: overruns need to be reduced during an economic recovery and can be corrected via expenditure and revenue measures.
- Poland and Slovakia: debt rule ceilings at 60 percent of GDP with intermediate triggers (Slovakia example):
  - At 50 percent of GDP: Minister of Finance must clarify debt increase to parliament and suggest reversal measures.
  - At 53 percent of GDP: cabinet shall pass a package of measures to trim the debt and freeze wages.
  - At 55 percent of GDP: expenditures would be cut automatically by 3 percent and next year's budgetary expenditures would be frozen, except for co-financing of EU funds.
  - At 57 percent of GDP: cabinet shall submit a balanced budget.
  - Caveat: triggers do not account for the cyclical position of the economy.
- Sequesters (United States example):
  - Automatic spending cuts scheduled when political agreements fail; can be a one-time adjustment rather than a recurrent mechanism.
  - Tend to bias against capital spending.
- Kenya:
  - Under the Fiscal Management Act: Minister of Finance must submit a compliance report to the National Assembly stating (a) reasons fiscal objectives/targets were not met; (b) remedial measures to ensure objectives/targets not met will be made good in the next quarter; and (c) any proposed Government policy decisions that may materially affect objectives and targets.

### Key characteristics of Lesotho’s fiscal situation (to consider when choosing rules)
- Factors to consider (listed):
  - The importance of safeguarding the exchange rate peg;
  - The volatility of SACU transfers;
  - The downward rigidity of spending: current spending is driven by a large public sector wage bill;
  - Insufficient room for capital spending, which is nonetheless very large and inefficient relative to SACU peers;
  - Weak institutional capacity;
  - Political instability.
- Implication: rules should be
  - Countercyclical,
  - Easy to operate,
  - Easy to enforce.

### Recommended rule types for Lesotho
- Institutional approach:
  - Authorities are considering including requirements to set fiscal principles, objectives, and numerical targets in primary legislation (PFMA Bill), with definitions left to underlying regulations or the BSP.
  - Advice: In a difficult political environment, do not define objectives and targets in primary legislation to avoid undermining credibility and incentivizing off-budget activities or creative accounting.

- Recommended core rules:
  - A debt rule to safeguard the exchange rate peg:
    - Convert existing debt ceilings into a fiscal rule.
    - Ceilings proposed:
      - Total public debt, including guarantees: 60 percent of GDP.
      - Public external debt: 40 percent of GDP.
      - Government guarantees: overall limit of 5 percent of GDP.
    - Setting body example: Parliament, e.g., PFM regulations.
  - A budget balance rule (two options proposed):
    - Option A — Structural balance rule:
      - Use overall balance excluding SACU transfers and external grants as a proxy for the structural balance (given estimation difficulty).
      - Assumptions:
        - SACU transfers expected to remain at around 14–16 percent of GDP.
        - Grants expected to remain at around 2–3 percent of GDP.
        - A 3 percent overall balance is consistent with trend growth.
      - Possible target:
        - Overall balance excluding SACU and grants of around negative 20 percent of GDP.
      - Notes:
        - Target to be revisited periodically as more information on SACU transfers becomes available.
        - Arrears should be treated as an adjustor to the efficacy of this rule.
      - Setting body example: Parliament, e.g., PFM regulations.
    - Option B — Overall balance rule combined with an expenditure rule:
      - Overall deficit below 3 percent of GDP plus total spending below a certain percent of GDP (to be calibrated).
      - Rationale: SACU transfers are volatile and combined with rigid, increasing spending produce a volatile and growing deficit; an expenditure rule can limit expenditure growth to less than nominal GDP growth or limit current expenditure to a certain percentage of GDP.
      - Setting body example: Parliament, e.g., PFM regulations.

- Arrears and adjustors:
  - Introduce a formal target for limiting domestic arrears.
  - Treat arrears as an adjustor in calculating the budget balance: adjust the budget balance upward (downward) by the amount of increase (decrease) of arrears.

- Additional analysis:
  - Undertake analysis to determine the most useful budget balance rule and calibrate numerical targets consistent with trend growth.

### Supplementary numerical targets to improve expenditure quality
- Proposed cabinet-level targets (e.g., BSP):
  - Wage bill:
    - Switch the wage bill target to a share of domestic revenue from a share of GDP.
    - Rationale: avoids some pro-cyclicality of a GDP-based target and allows addressing via domestic revenue mobilization as well as wage restraint.
    - Proposed goal: gradually reduce to and then not to exceed 60 percent of domestic revenue.
  - Capital expenditure:
    - Make the existing capital expenditure target explicit once fiscal position has been restored.
    - Example: consider setting an explicit target for capital or development expenditure (e.g., not to fall below “core” SACU transfers).

### Summary recommendation for Lesotho (in brief)
- Recommend two fiscal rules supplemented by two numerical targets to rationalize the composition of expenditures.
- Once the fiscal position has been restored, consider a stabilization fund to manage volatility in SACU revenues.

### Roadmap to introduce fiscal rules in Lesotho — next steps
a. Develop and enact PFM fiscal rule regulations that characterize the fiscal rules.
  - Include requirements to set fiscal principles, objectives, and numerical targets in primary legislation (PFMA Bill) but leave specifications to PFM regulations.
  - Calibrate precise numerical fiscal targets consistent with preserving debt sustainability and safeguarding the peg.

b. Establish mechanisms to ensure fiscal policies are set consistent with fiscal rules.
  - Set up monitoring, transparency, and reporting arrangements to ensure fiscal outcomes align with fiscal rules.

c. Define what should happen when rules are missed.

d. Ensure political buy-in.

*Source: sipea2022001 - Selected Issues Paper (IMF).*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2022/english/sipea2022001.pdf_