## wpiea2019070

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### Introduction: rationale for a rule-based fiscal framework
- Objectives of a rule-based fiscal framework:
  - improve policy credibility by building adequate fiscal buffers against tail risks;
  - avoid procyclical behavior;
  - make the conduct of fiscal policy transparent, accountable, and predictable;
  - keep the cost of borrowing low and thereby promote long-term growth and debt sustainability.
- Empirical premise: countries with well-designed and binding fiscal rules tend to have stronger fiscal performance and better access to funding.
- Recommended institutional and rule changes for the Philippines:
  - adopt a fiscal responsibility law (FRL) enshrining explicit fiscal rules for countercyclical policy and debt sustainability;
  - calibrate a combination of fiscal rules for the national government to anchor debt sustainability and formulate countercyclical fiscal policy;
  - adopt an expenditure rule allowing total spending (excluding targeted social assistance) to grow with nominal potential GDP growth to add stabilization properties and reduce procyclicality;
  - establish an independent fiscal council with a mandate to produce unbiased projections and evaluate compliance with fiscal rules to enhance transparency, accountability, and credibility.
- Calibrated targets reported:
  - optimal debt anchor: 45 percent of GDP;
  - structural primary deficit target for the national government: 2 percent of potential GDP.

### Data, potential output estimation, and measurement approach
- Dataset: annual observations covering the general government from domestic and international official sources.
- Potential output estimation approach:
  - follows Guajardo and Mano (2015) and applies various techniques; uses the Hodrick-Prescott (HP) filter for reported potential output growth numbers.
  - HP filter smoothing parameter on annual data: 6.25.
  - Potential output growth (HP filter) averaged at 3.6 percent over 1980–2016, accelerating from 3.6 percent during 1980–1999 to 5.2 percent between 2000 and 2016.
  - Potential growth rate is currently estimated to be 6.5 percent, implying the economy is operating close to potential with no significant output gap.

### Cyclical adjustment methodology and fiscal stance metrics
- Definitions and formulas:
  - CAB (cyclically-adjusted budget balance) as share of potential GDP:
    - CAB = [sum over i of T_i^CA − E^CA + X] / Y^*
    - where Y^* is potential output, X is non-tax revenues, E^CA is cyclically-adjusted government expenditures, and T_i^CA represents cyclically-adjusted tax revenues by category.
  - Implementation with elasticities:
    - T_i^CA = T_i * (Y^*/Y)^{ε_T}
    - E^CA = E * (Y^*/Y)^{ε_E}
  - CAPB (cyclically-adjusted primary budget balance) excluding interest payments and one-off operations:
    - CAPB = [sum T_i^CA − (E − I_p)^CA + (X − I_r − G)] / Y^*
    - where I_p and I_r denote interest payments and interest receipts, respectively, and G represents foreign grants.
- Aggregate elasticities used:
  - revenue elasticity with respect to the output gap: 1;
  - expenditure elasticity with respect to the output gap: 0.
- Fiscal impulse measurement:
  - fiscal impulse = change in CAPB scaled by potential GDP;
  - negative number = fiscal stimulus; positive number = withdrawal of fiscal stimulus.

### Empirical assessment of cyclicality and fiscal reaction
- Fiscal policy cyclicality definitions:
  - procyclical: CAPB deteriorates during expansions and improves during downturns;
  - countercyclical: fiscal stance moves against the business cycle.
- Fiscal reaction function estimated:
  - CAPB_t = α + β CAPB_{t−1} + δ OG_t + θ D_{t−1} + ε_t
  - where OG is the output gap and D is lagged national government debt-to-GDP ratio.
- Key empirical findings:
  - β (coefficient on lagged CAPB) is positive, indicating a high degree of persistence in fiscal policy.
  - δ (coefficient on output gap) is negative, suggesting discretionary fiscal policy was mildly procyclical over 1980–2016; this effect is not statistically significant.
  - θ (coefficient on lagged debt) is positive, indicating the necessary condition of fiscal sustainability is satisfied during the sample period.
- Historical example:
  - During 2009–2010 the Philippines implemented countercyclical fiscal policy by reducing the corporate tax rate and increasing infrastructure spending.
- Magnitude example of procyclicality:
  - a fiscal impulse of 1.2 percentage points of potential GDP on a cumulative basis during 2015–2016, implying a significant fiscal impulse during a period of strong economic growth.

### International experience, fiscal rules taxonomy, and fiscal councils
- International adoption:
  - more than 90 countries operate under fiscal rules versus only five in 1990.
- Types of fiscal rules and properties:
  - Debt rules: safeguard solvency; limited countercyclical properties.
  - Budget balance rules: nominal rules are easy to monitor but procyclical; structural rules account for shocks but are harder to monitor due to output gap uncertainty.
  - Expenditure rules: operationally simple, provide clear guidance, and have stabilization properties; require reliable medium-term budget framework.
  - Revenue rules: no direct link to debt sustainability and may be procyclical without accompanying rules.
  - Practice: about 80 percent of countries with rule-based fiscal policy use a combination of two or more fiscal rules.
- FRL design features:
  - comprehensive coverage should include subnational governments, extra-budgetary funds, and SOEs;
  - escape clauses should allow temporary deviations under a limited set of exceptional circumstances with clear interpretation and return paths;
  - enforcement: specify automatic correction mechanisms and enforcement sanctions.
- Independent fiscal councils:
  - number rose to 38 as of end-2015 from 12 a decade earlier.
  - Key features: professionalism and political independence; exclusive focus on fiscal policy and debt sustainability; objectivity and transparency; clearly defined mandate.
  - Empirical evidence suggests fiscal councils improve fiscal outcomes in advanced and emerging economies.

### Calibrating fiscal rules for the Philippines: coverage, stochastic simulations, and targets
- Coverage choice:
  - focus on national government using unconsolidated data; gross debt preferred to net debt for transparency and to capture fiscal risks.
- Philippines fiscal context (selected figures):
  - Gross national government debt declined to 42.1 percent of GDP in 2016 from a peak of 74.4 percent in 2004.
  - Bond Sinking Fund (BSF) holds government debt amounting to 5.2 percent of GDP in 2016, reducing national government debt from 42 percent (gross) to 36.8 percent (net).
  - Consolidated net debt-to-GDP (including local governments and social security institutions) amounted to 33.8 percent of GDP as of end-2016.
  - Including nonfinancial public enterprises, consolidated nonfinancial public-sector debt stood at 44.1 percent of GDP in 2016.
- Stochastic simulation method:
  - draws shocks from symmetric normal distributions using annual data 1980–2016 and generates medium-term debt trajectories from the debt accumulation equation and an estimated fiscal reaction function.
  - assumes realization of contingent liabilities amounting to 7 percent of GDP over the medium term.
- Simulation result and rationale:
  - Optimal gross national government debt anchor: 45 percent of GDP.
  - Rationale: with a maximum limit of 60 percent of GDP, a debt target of 45 percent of GDP provides a safety margin of 15 percent of GDP and ensures the maximum limit is not breached with a probability of 5 percent over the medium-term horizon.
  - Equivalence: gross national government debt anchor of 45 percent of GDP ≈ general government net debt of about 35 percent of GDP.
  - Interpretation: current gross national government debt of 42 percent of GDP is just below the estimated debt anchor of 45 percent of GDP, indicating some fiscal space for increased public investment if paced with tax revenue efforts and absorption capacity.

### Structural budget balance, expenditure rule linkage, and operational targets
- CAPB target derivation:
  - CAPB target (b*) is derived from the debt anchor (d*) using the specified equation incorporating expected long-run nominal GDP growth, initial debt stock (d0), and convergence horizon N.
- Philippines calibration:
  - With the 45 percent gross debt anchor, estimated CAPB target: 2 percent of potential GDP.
- Expenditure rule linkage and implication:
  - For a given CAPB target (b*) and average tax pressure (r*), implied expenditure ratio e* = r* − b*; changes follow Δe* = Δr* − Δb*.
  - Assuming Δr* = 0 and compliance with CAPB (b = b* and Δb* = 0), the CAPB rule requires spending to grow at the same speed as nominal GDP growth (or remain constant as a share of GDP).
  - For the Philippines, with no significant cyclical component to expenditure and automatic stabilizers operating primarily on revenues, nominal and structural expenditure are effectively the same.
  - Optimal expenditure rule: limit the annual growth rate of total expenditures (excluding targeted social assistance) to nominal potential GDP growth.

### Recommended FRL package, flexibility, and enforcement
- Recommended FRL package for the Philippines:
  - A gross debt target of 45 percent of GDP for the national government (equivalent to a general government net debt of about 35 percent of GDP).
  - A structural budget balance target defined as the cyclically-adjusted national government primary deficit of 2 percent of potential GDP.
  - An expenditure rule limiting the annual growth rate of total expenditures excluding targeted social assistance to nominal potential GDP growth.
  - A limit on the stock of contingent liabilities, including PPPs, set at 10 percent of GDP for the general government.
- Flexibility and escape clauses:
  - allow temporary deviations under: (i) a limited number of exceptional and unforeseeable exogenous events (natural disasters, severe financial crises, recessions); (ii) clear guidelines on interpretation and determination of such events; (iii) an unambiguous transition path to compliance during convergence.
- Enforcement and institutional measures:
  - introduce enforcement sanctions with reputational costs (e.g., public report to Congress) and a specific timetable to offset deviations.
  - establish an independent fiscal council to provide unbiased macro-fiscal projections and evaluate compliance, enhancing transparency, accountability, and credibility.

### Key statistics and figures (as reported)
- Potential output growth (HP filter) averaged at 3.6 percent over 1980–2016.
- Potential output growth: 3.6 percent during 1980–1999.
- Potential output growth: 5.2 percent between 2000 and 2016.
- Current potential growth rate estimate: 6.5 percent.
- HP filter smoothing parameter on annual data: 6.25.
- Revenue elasticity with respect to the output gap: 1.
- Expenditure elasticity with respect to the output gap: 0.
- Fiscal impulse example: 1.2 percentage points of potential GDP (cumulative, 2015–2016).
- Gross national government debt: 42.1 percent of GDP in 2016.
- Peak gross national government debt: 74.4 percent of GDP in 2004.
- Bond Sinking Fund (BSF) holdings: 5.2 percent of GDP in 2016.
- Net national government debt (after BSF): 36.8 percent of GDP in 2016.
- Consolidated net debt-to-GDP (including local governments and social security institutions): 33.8 percent of GDP as of end-2016.
- Consolidated nonfinancial public-sector debt including nonfinancial public enterprises: 44.1 percent of GDP in 2016.
- Assumed realization of contingent liabilities in simulations: 7 percent of GDP over the medium term.
- Maximum debt limit assumed for guidance: 60 percent of GDP.
- Optimal gross national government debt anchor: 45 percent of GDP.
- Equivalent general government net debt implied: about 35 percent of GDP.
- CAPB (structural primary deficit) operational target: 2 percent of potential GDP.
- Limit on contingent liabilities (including PPPs) recommended: 10 percent of GDP.
- International counts:
  - more than 90 countries operate under fiscal rules (source period);
  - about 80 percent of countries with rule-based fiscal policy use a combination of two or more fiscal rules;
  - fiscal councils rose to 38 as of end-2015 from 12 a decade earlier.

*Source: IMF staff analysis as presented in the supplied content unit.*

### References .............................................................................................................

### wpiea2019070 - References

### Introduction: rationale for a rule-based fiscal framework
- A rule-based fiscal framework can:
  - improve policy credibility by building adequate fiscal buffers against tail risks;
  - avoid procyclical behavior;
  - make the conduct of fiscal policy transparent, accountable, and predictable;
  - keep the cost of borrowing low and thereby promote long-term growth and debt sustainability.
- Empirical evidence cited indicates countries with well-designed and binding fiscal rules tend to have stronger fiscal performance and better access to funding (Debrun and others, 2008; IMF, 2009; Schaechter and others, 2012; IMF, 2013).
- Fiscal stance in the Philippines over 1980–2016 is found to be procyclical, with the degree of procyclicality having increased in recent years.
- Recommended institutional and rule changes for the Philippines:
  - adopt a fiscal responsibility law (FRL) enshrining explicit fiscal rules for countercyclical policy and debt sustainability;
  - calibrate a combination of fiscal rules for the national government to anchor debt sustainability and formulate countercyclical fiscal policy;
  - adopt an expenditure rule allowing total spending (excluding targeted social assistance) to grow with nominal potential GDP growth to add stabilization properties and reduce procyclicality;
  - establish an independent fiscal council with a mandate to produce unbiased projections and evaluate compliance with fiscal rules to enhance transparency, accountability, and credibility.
- Calibrated targets reported in the paper:
  - optimal debt anchor: 45 percent of GDP;
  - structural primary deficit target for the national government: 2 percent of potential GDP.

### Data and measurement approach
- Dataset: annual observations covering the general government obtained from the Department of Finance, the Bangko Sentral ng Pilipinas, the World Bank’s World Development Indicators database, and the IMF’s World Economic Outlook database.
- Potential output estimation:
  - The paper follows Guajardo and Mano (2015) and applies various techniques; it uses the Hodrick-Prescott (HP) filter for reported potential output growth numbers.
  - Potential output growth (HP filter) averaged at 3.6 percent over 1980–2016, accelerating from 3.6 percent during 1980–1999 to 5.2 percent between 2000 and 2016.
  - Potential growth rate is currently estimated to be 6.5 percent, implying the economy is operating close to potential with no significant output gap.
  - HP filter smoothing parameter used on annual data: 6.25.

### Cyclical adjustment methodology and fiscal stance metrics
- Cyclically-adjusted budget balance (CAB) defined as a share of potential GDP:
  - CAB = [sum over i of T_i^CA − E^CA + X] / Y^*
  - where Y^* is potential output, X is non-tax revenues, E^CA is cyclically-adjusted government expenditures, and T_i^CA represents cyclically-adjusted tax revenues by category.
- Implementation uses elasticities of revenue and expenditure with respect to the output gap denoted ε_T and ε_E:
  - T_i^CA = T_i * (Y^*/Y)^{ε_T}
  - E^CA = E * (Y^*/Y)^{ε_E}
- Cyclically-adjusted primary budget balance (CAPB) excludes interest payments and one-off operations:
  - CAPB = [sum T_i^CA − (E − I_p)^CA + (X − I_r − G)] / Y^*
  - where I_p and I_r denote interest payments and interest receipts, respectively, and G represents foreign grants.
- Aggregate elasticities used in the analysis:
  - revenue elasticity with respect to the output gap: 1;
  - expenditure elasticity with respect to the output gap: 0.
- Fiscal impulse measurement:
  - fiscal impulse = change in CAPB scaled by potential GDP;
  - negative number = fiscal stimulus; positive number = withdrawal of fiscal stimulus.

### Empirical assessment of cyclicality and fiscal reaction
- Fiscal policy cyclicality concept:
  - procyclical: CAPB deteriorates during expansions and improves during downturns (expansionary during booms, contractionary during recessions);
  - countercyclical: fiscal stance moves against the business cycle (contractionary during booms, expansionary during recessions).
- Fiscal reaction function estimated:
  - CAPB_t = α + β CAPB_{t−1} + δ OG_t + θ D_{t−1} + ε_t
  - where OG is the output gap and D is lagged national government debt-to-GDP ratio.
- Empirical findings from Table 1 and text:
  - β (coefficient on lagged CAPB) is positive, indicating a high degree of persistence in fiscal policy.
  - δ (coefficient on output gap) is negative, suggesting discretionary fiscal policy was mildly procyclical over 1980–2016; this effect is not statistically significant.
  - θ (coefficient on lagged debt) is positive, indicating the necessary condition of fiscal sustainability is satisfied during the sample period (consistent with Bohn (1998) model-based fiscal sustainability: a positive debt coefficient implies consideration of the intertemporal budget constraint).
- Historical policy example:
  - During 2009–2010 the Philippines implemented countercyclical fiscal policy by reducing the corporate tax rate and increasing infrastructure spending to mitigate the global financial crisis.

### Policy implications and recommendations summarized
- Adopt a fiscal responsibility law (FRL) to codify explicit, binding fiscal rules tailored to:
  - achieve countercyclical fiscal policy;
  - anchor debt sustainability at the national government level.
- Calibrated rule combination suggested:
  - debt anchor: 45 percent of GDP;
  - operational target: structural primary deficit of 2 percent of potential GDP for the national government.
- Complementary rule:
  - expenditure rule: allow total spending (excluding targeted social assistance) to grow with nominal potential GDP growth to reduce procyclicality and enhance stabilization.
- Institutional measure:
  - create an independent fiscal council mandated to produce unbiased projections and evaluate compliance with fiscal rules to strengthen transparency, accountability, and credibility.

*Source: wpiea2019070 - References (excerpts).*

### 1.2 percentage points of potential GDP on a cumulative basis during 2015–2016, implying a

### wpiea2019070 - 1.2 percentage points of potential GDP on a cumulative basis during 2015–2016, implying a

### Procyclicality of Fiscal Policy and Fiscal Stance
- Discretionary fiscal policy was procyclical during 1980–2016, exacerbating business cycle fluctuations and risking undermining public finances over time.
- Example magnitude: a fiscal impulse of 1.2 percentage points of potential GDP on a cumulative basis during 2015–2016, implying a significant fiscal impulse during a period of strong economic growth.
- Implication: procyclical bias during upswings may leave budget deficits and debt accumulation unoffset in expansions, increasing volatility and fiscal vulnerability.

### International Experience with Fiscal Rules
- As of the source period, more than 90 countries operate under fiscal rules versus only five in 1990.
- Numerical fiscal rules place limits on deficits, debt, expenditures, or revenue and are typically supported by procedural rules to anchor policymaking and contain overspending pressures.
- FRLs (Fiscal Responsibility Laws) combine numerical and procedural rules in single legislation to enhance credibility, predictability, and transparency.

### Types of Fiscal Rules and Their Properties
- Debt rules:
  - Examples: ceiling on debt-to-GDP ratio, debt brake.
  - Strength: safeguard fiscal solvency by linking fiscal stance to medium-term debt sustainability.
  - Weakness: policy changes affect debt with a lag; limited countercyclical properties.
- Budget balance rules:
  - Nominal rules: easy to monitor/implement and support debt sustainability, but lack stabilization properties and tend to be procyclical.
  - Structural budget balance rules (e.g., CAPB): account for shocks and allow automatic stabilizers to operate; difficult to monitor/communicate due to output gap estimation uncertainty.
- Expenditure rules:
  - Examples: ceiling on nominal expenditure growth or expenditure as percent of GDP.
  - Strength: operationally simple, provide clear guidance, and have stabilization properties.
  - Requirement: reliable medium-term budget framework to avoid large deficits from persistent revenue shortfalls.
- Revenue rules:
  - Examples: floor or ceiling on revenues.
  - Weakness: no direct link to debt sustainability and may be procyclical without accompanying expenditure or deficit rules.
- Practice: about 80 percent of countries with rule-based fiscal policy use a combination of two or more fiscal rules to provide a medium-term anchor plus operational targets.
- Comprehensive coverage: fiscal rules should include subnational governments, extra-budgetary funds, and SOEs to avoid off-budget undermining of FRLs.
- Escape clauses: robust FRLs should allow temporary deviations under (i) a limited number of exceptional circumstances (e.g., natural disasters, severe downturns); (ii) clear event interpretation and determination guidelines; and (iii) an unambiguous transition path back to the rules.
- Enforcement: effective enforcement and automatic correction mechanisms are critical; FRLs should specify automatic correction mechanisms and enforcement sanctions (including reputational costs and mandated corrective actions).

### Advantages and Design Features of Independent Fiscal Councils
- Number of countries with fiscal councils rose to 38 as of end-2015 from 12 a decade earlier.
- Fiscal councils provide unbiased macroeconomic and budgetary projections and assess compliance with fiscal rules, improving accountability, transparency, and public debate.
- Successful fiscal councils share key features: (i) professionalism and political independence; (ii) exclusive focus on fiscal policy and debt sustainability; (iii) objectivity and transparency with unfettered information access; (iv) clearly defined institutional mandate.
- Empirical evidence suggests fiscal councils improve fiscal outcomes in advanced and emerging economies.

### Calibrating Fiscal Rules for the Philippines — Coverage and Rationale
- Focus: national government using unconsolidated data, with gross debt preferred to net debt for transparency and to capture fiscal risks.
- Philippine context:
  - Gross national government debt declined to 42.1 percent of GDP in 2016 from a peak of 74.4 percent in 2004.
  - Bond Sinking Fund (BSF) holds government debt amounting to 5.2 percent of GDP in 2016, reducing national government debt from 42 percent (gross) to 36.8 percent (net).
  - Consolidated net debt-to-GDP (including local governments and social security institutions) amounted to 33.8 percent of GDP as of end-2016.
  - Including nonfinancial public enterprises, consolidated nonfinancial public-sector debt stood at 44.1 percent of GDP in 2016.
- Debt threshold guidance: commonly-used emerging market range of 50 to 70 percent of GDP; author assumes a “maximum debt limit” of 60 percent of GDP for the Philippines and estimates a lower debt anchor to provide a safety margin.

### Stochastic Simulation Methodology and Results
- Method:
  - Use joint distribution of macroeconomic variables and multiple simulations (Baum and others methodology) with annual data 1980–2016.
  - Simulations draw shocks from symmetric normal distributions and generate medium-term debt trajectories from the debt accumulation equation and an estimated fiscal reaction function (FRF).
  - Assumes realization of contingent liabilities amounting to 7 percent of GDP over the medium term.
- Key simulation result:
  - Optimal gross national government debt anchor: 45 percent of GDP.
  - Rationale: with a maximum limit of 60 percent of GDP, a debt target of 45 percent of GDP provides a safety margin of 15 percent of GDP and ensures the maximum limit is not breached with a probability of 5 percent over the medium-term horizon.
  - Equivalence: gross national government debt anchor of 45 percent of GDP ≈ general government net debt of about 35 percent of GDP.
- Interpretation:
  - The current gross national government debt of 42 percent of GDP is just below the estimated debt anchor of 45 percent of GDP, indicating some fiscal space for increased public investment if paced with tax revenue efforts and absorption capacity.

### Structural Budget Balance, Expenditure Rule, and Operational Targets
- Derivation:
  - CAPB target (b* ) is derived from the debt anchor (d* ) via the specified equation in the source text, incorporating expected long-run nominal GDP growth, initial debt stock (d0), and convergence horizon N.
- Philippines calibration:
  - With the 45 percent gross debt anchor, estimated CAPB target: 2 percent of potential GDP.
- Expenditure rule linkage:
  - For a given CAPB target (b*) and average tax pressure (r*), implied expenditure ratio e* = r* − b*; changes follow Δe* = Δr* − Δb*.
  - Assuming Δr* = 0 and compliance with CAPB (b = b* and Δb* = 0), the CAPB rule requires spending to grow at the same speed as nominal GDP growth (or remain constant as a share of GDP).
  - For the Philippines, with no significant cyclical component to expenditure and automatic stabilizers operating primarily on revenues, nominal and structural expenditure are effectively the same.
  - Optimal expenditure rule: limit the annual growth rate of total expenditures (excluding targeted social assistance) to nominal potential GDP growth.

### Recommended Combination of Fiscal Rules for the Philippines
- Based on the stochastic simulation exercise, recommended FRL package:
  - A gross debt target of 45 percent of GDP for the national government (equivalent to a general government net debt of about 35 percent of GDP).
  - A structural budget balance target defined as the cyclically-adjusted national government primary deficit of 2 percent of potential GDP.
  - An expenditure rule limiting the annual growth rate of total expenditures excluding targeted social assistance to nominal potential GDP growth.
  - A limit on the stock of contingent liabilities, including PPPs, set at 10 percent of GDP for the general government.
- Flexibility and escape clauses:
  - FRL should allow temporary deviations under: (i) a limited number of exceptional and unforeseeable exogenous events (natural disasters, severe financial crises, recessions); (ii) clear guidelines on interpretation and determination of such events; (iii) an unambiguous transition path to compliance during convergence.
- Enforcement and fiscal council:
  - Introduce enforcement sanctions with reputational costs (e.g., public report to Congress) and a specific timetable to offset deviations.
  - Establish an independent fiscal council to provide unbiased macro-fiscal projections and evaluate compliance, enhancing transparency, accountability, and credibility.

*Italic: Source: IMF staff analysis as presented in the supplied content unit.*

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_Source: https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019070.pdf_