## wpiea2019186-print-pdf

## Source details

**Canonical URL:** [wpiea2019186-print-pdf](https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019186-print-pdf.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/wp/2019/wpiea2019186-print-pdf.pdf.md)
- [Structured JSON version](/-/media/files/publications/wp/2019/wpiea2019186-print-pdf.pdf.json)

---

### I. Research question and main contributions
- Research question:
  - How should small, fragile island states in the Pacific formulate fiscal policy when vulnerable to shocks such as natural disasters, climate change, commodity price fluctuations, or uncertain donor grants?
- Main contributions:
  - Show how permanent natural disaster shocks or climate change affect the sustainable, steady-state debt-to -GDP ratio.
  - Propose a recurrent expenditure rule interdependently determined by government debt and budget balance targets, incorporating probabilistic disaster shocks.
  - Define a robust expenditure rule applicable to natural disasters, commodity price fluctuations, and uncertain revenue from donor grants.

### Objectives of fiscal policy and region-specific vulnerabilities
- Functional objectives:
  - Stabilize economic cycles by conducting countercyclical fiscal policy planning.
  - Redistribute national wealth across sectors and reduce poverty.
  - Support sustainable economic growth (including provision of public goods; investments in education, healthcare, and infrastructure).
- Pacific-specific considerations:
  - Need to make infrastructure more climate/disaster resilient.
  - High vulnerability to frequent and intense natural disasters (especially cyclones).
  - Fiscal authority roles after disasters: assess impact; provide emergency measures; recover damages by building disaster-resistant infrastructure.
- Fiscal impact determinants:
  - Frequency and magnitude of disasters.
  - Portion of economic impact covered by the fiscal authority.

### Natural disaster risk magnitudes and recent episodes (selected figures)
- Risk magnitudes cited:
  - "2.5 percent of GDP is expected every year and a substantial 23 percent every 50 years (Pacific Catastrophe Risk Assessment and Financing Initiative 2015)."
- Selected recent events and quantified impacts:
  - Cyclone Pam (March 2015) caused damage and loss equivalent to 64 percent of Vanuatu’s GDP (World Bank 2016).
  - Papua New Guinea El Niño drought (May 2015–March 2016) shut major mines for nine months; reduced exports and resource revenues; created foreign exchange shortage and revenue deficit.
  - Cyclone Winston (late February 2016) in Fiji: total loss 2 billion Fijian dollars, equivalent to 25 percent of GDP (World Bank 2017).
  - February 2018 PNG earthquake: magnitude "7.5", "the biggest earthquake in 100 years", estimated GDP loss "3 percent", suspension of LNG, crude oil, and gold mining operations.
- Distributional effects:
  - Natural disasters disproportionately affect poor households who are more likely to live in exposed areas and have less ability to migrate.
- Role of external flows:
  - Donor grants and remittances are important; remittances increase after severe disasters in low- and middle-income countries.

### Theoretical framework and fiscal-rule design
- Analytical aims:
  - Calibrate a debt-to-GDP target in presence of natural disaster shocks.
  - Study impact of unexpected climate change shocks (permanent natural disaster shocks) on debt sustainability.
  - Connect debt targets with probabilistic natural disaster shocks to fiscal balance, expenditure, and revenues.
  - Recommend a recurrent expenditure rule with desirable properties for small islands.
  - Provide a framework for commodity exporters to smooth consumption/savings volatility from natural resources.
- Key model features:
  - Government cash-flow constraint includes tax revenue, grants, other revenues, debt, money issuance, recurrent and capital expenditure, interest, and the government share of net fiscal cost of shocks (S_t N_t).
  - Debt dynamics and steady-state debt formula presented as:
    - d* = (ppp + μ − s n) { ((1 + r)(1 + y) −1) }⁄ .
  - Distinction between temporary natural disasters and permanent climate-change shocks; shocks can alter steady-state parameters (growth, interest rates, risk premia).

### PNG calibration example (numerical assumptions and implications)
- Assumed parameters (PNG illustrative calibration):
  - primary budget surplus "0.4 percent of GDP (ppp=0.004)"
  - money creation rate "0 percent (μ=0)"
  - real interest rate "4.5 percent (r=0.045)"
  - real potential growth rate "3.8 percent (y=0.038)"
  - expected natural disaster shock per year "0.2 percent of GDP (n=0.002, s=1)"
- Result:
  - steady-state debt "around 30 percent"
- Caveat:
  - Values are illustrative and sensitive to parameter choices; limited Pacific data constrains precision.

### Permanent-shock scenarios and debt-target implications
- Illustrative cases:
  - Unexpected permanent shock that increases long-term growth (e.g., post-catastrophe productivity boost): steady-state debt could be higher than before the shock.
  - Climate change that permanently dampens growth (e.g., sea-level rise reducing land): steady-state debt should be lower than earlier.
- Policy implication:
  - If an unexpected permanent shift in disaster probability or in government coverage (s_t) occurs, the debt target should be reconsidered or revised.

### Deriving budget balance targets from debt targets (formulas and PNG example)
- Budget balance identity used to derive steady-state budget balance:
  - Steady-state budget balance formula: p* = −γ (1 + γ)⁄ d*.
- PNG illustration:
  - assumed nominal GDP growth "5 percent (γ=0.05)"
  - debt target "d* = 0.3" → implied budget deficit target "1.4 percent of GDP" (p* = −0.014)
- Fiscal adjustment rule:
  - linear adjustment over an adjustment period λ: (p_t − p*) / λ, ∀ p_t ≠ p*.

### Expenditure rules: recommendations and operational design
- Rationale:
  - Expenditure rules are more effective than revenue rules for countercyclicality because revenues contain automatic stabilizers; expenditure control reduces procyclicality.
- Recommendation for Pacific islands:
  - Prefer expenditure rules defined as a percentage of stable revenue (non-resource, non-grant revenue) rather than GDP because:
    - GDP data are more volatile and slower to release.
    - Revenue-based rules use lagged income effects and are less immediately affected by current-year disaster shocks.
    - Direct link between expenditure and revenue simplifies computation and operational compliance.
- PNG numerical examples:
  - revenue-to-GDP target "14.8 percent" (consistent with PNG MTFS 2018–22)
  - with "5 percent" nominal GDP growth and a "1.4 percent" deficit → constant expenditure-to-GDP ratio "16.2 percent" (=14.8% + 1.4%) or an alternative ceiling of "5 percent" nominal expenditure growth if already consistent.
- Specific operational ceilings and formulations:
  - personnel emolument ceiling example: personnel emoluments / non-resource, non-grant revenue *100 < "40%".
  - recurrent spending rule formulation: E_t / R_t (non-resource, non-grant revenue) *100 < X% (investment-friendly recurrent spending rule; exclude net acquisition of non-financial assets).
- Practical advantages:
  - Recurrent spending rules allow government expenditure needed for recovery, do not require potential GDP estimates, and avoid prerequisites for steady-state initial positions.
- Classification risk mitigation:
  - If expenditure classification is susceptible to manipulation (e.g., constituency development funds misclassified as capital), it may be better to have a rule that includes all expenditure.

### Revenue-structure tailoring and commodity-exporter approach
- Tailoring by country type:
  - Commodity exporters (PNG; Timor-Leste): PIH-based approach; non-resource primary balance as % of non-resource GDP; PNG calibration suggests non-resource primary balance close to "−0.3 percent of non-resource GDP".
  - Fishing-dependent countries (Kiribati; Micronesia; Marshall Islands; Nauru; Tuvalu): fishing license fees are major revenue; excluding these from the revenue base may be infeasible.
  - Service-exporting/tourism countries (Fiji; Vanuatu; Palau; Samoa): tourism-related revenues matter.
  - Remittance-reliant countries (Tonga; Samoa): cyclical synchronization with Australia/New Zealand is relevant.
- Volatile resource revenue items (selected):
  - Kiribati: Fishing License Fees
  - Marshall Islands: Fishing License Fees
  - Micronesia: Fishing License Fees
  - Nauru: Fishing License Fees
  - Papua New Guinea: Mining and Petroleum Taxes; Mining, Petroleum and Gas Dividends
  - Solomon Islands: Logging Revenues; Fishing License Fees
  - Timor-Leste: Petroleum Revenue
  - Tuvalu: Fishing License Fees

### Stabilization funds, cash buffers, and calibration trade-offs
- Purpose:
  - Save fiscal surpluses during good years in a stabilization/natural disaster fund to finance emergency relief and reconstruction when borrowing capacity is constrained.
- Practical constraints:
  - Increased frequency of natural disasters makes achieving fund targets more difficult.
  - Opportunity costs and limited capacity for large buffer accumulation must be weighed against expected fiscal costs and borrowing constraints.
- Cash buffer examples:
  - Tonga: cash deposits equivalent to "three months of recurrent spending".
  - Solomon Islands: similar cash buffer rule during recent IMF program.
- Calibration guidance:
  - IMF (2018e) recommends buffer size depend on expected fiscal costs, ability to borrow, opportunity cost, and post-disaster funding needs.

### Empirical volatility evidence (select figures)
- Papua New Guinea:
  - GDP unit standard deviation "18.77"
  - Revenue SD "3.74"
  - Expenditure SD "4.48"
  - Expenditure/GDP SD divided by average "0.12"
  - Expenditure/Revenue SD divided by average "0.15"
- Vanuatu:
  - GDP SD "22.09"
  - Revenue SD "7.00"
  - Expenditure SD "8.77"
  - Expenditure/GDP SD divided by average "0.23"
  - Expenditure/Revenue SD divided by average "0.10"
- Implication:
  - For eight of thirteen Pacific countries, expenditure rules defined as a percentage of GDP would exhibit higher volatility than rules defined relative to revenue.

### Escape clauses, procedural issues, and institutional design
- Escape clauses:
  - Well-defined and predetermined escape clauses may help budget execution when unexpected massive natural disaster shocks occur.
  - If a disaster is too large to be covered by the stabilization fund, the escape clause should be applied and debt targets/fiscal rules can be recalculated.
  - Governments may breach fiscal rules only in events of unexpected disasters or severe economic shocks, which should be clearly defined in law beforehand.
  - Triggering an escape clause involves a costly review; an escape clause is generally optimal if:
    - the cost of review is cheap,
    - the volatility of shocks is high,
    - and the government deficit bias is severe (Yared 2018).
  - Evidence is mixed: some studies find escape clauses do not affect cyclical fiscal stance; others find escape clauses can be harmful in high-debt countries.
  - Recommended operational approach: require a forward-looking explanation mechanism (similar to inflation targeting), with the fiscal authority providing the future fiscal path and medium-term consolidation plan after triggering.
- Procedural and institutional priorities:
  - Strong political leadership and good communication to adopt fiscal rules.
  - Periodic review of rules, with revisions insulated from political cycles.
  - Transparency and simplicity for easier communication and monitoring.
  - Strong legal and institutional arrangements and independent monitoring/enforcement bodies increase compliance.
  - Fiscal councils and independent enforcement bodies can improve rule adherence and allow outsiders to review proposals.

### Policy recommendations (summary)
- Core recommendations:
  - Start with a debt ceiling or target as a practical anchor.
  - Derive operational budget balance and expenditure rules consistent with the debt target.
  - Prefer expenditure rules defined against stable revenue (non-resource, non-grant revenue) rather than GDP.
  - Implement recurrent spending rules that exclude net acquisition of non-financial assets to allow post-disaster reconstruction.
  - Use personnel emolument ceilings where binding operational guidance is needed (example: personnel emolument / non-resource, non-grant revenue *100 < "40%").
  - For commodity exporters, apply PIH-style non-resource primary balance targets (calibrated to preserve intergenerational equity).
  - Build stabilization funds and cash buffers where feasible, calibrated to expected fiscal costs, borrowing constraints, and opportunity costs.
- Institutional recommendations:
  - Ensure simplicity and ease of monitoring given limited institutional capacity.
  - Design rules with escape clauses or flexibility for natural disasters and permanent shocks, but apply escape clauses cautiously.
  - Strengthen public financial management to enforce expenditure controls and manage buffers effectively.

*Source: wpiea2019186-print-pdf*

### References _______________________________________________________________________________________ 23

### wpiea2019186-print-pdf - References _______________________________________________________________________________________ 23

### I. Introduction and paper contributions
- Research question: How should small, fragile island states in the Pacific formulate fiscal policy when vulnerable to shocks such as natural disasters, climate change, commodity price fluctuations, or uncertain donor grants?
- Main contributions of the paper:
  - To show how permanent natural disaster shocks or climate change affect the sustainable, steady-state debt-to -GDP ratio.
  - A proposal for a recurrent expenditure rule interdependently determined by government debt and budget balance targets, incorporating probabilistic disaster shocks.
  - Defining a robust expenditure rule for not only natural disasters but also commodity price fluctuations and uncertain revenue from donor grants.

### Objectives of fiscal policy in Pacific Islands
- Functional objectives (three main):
  - Stabilize economic cycles by conducting countercyclical fiscal policy planning.
  - Redistribute national wealth across sectors and reduce poverty.
  - Support sustainable economic growth (including provision of public goods to address market failures; investments in education, healthcare, and infrastructure).
- Region-specific additional factors for Pacific island countries:
  - Need to make infrastructure more climate/disaster resilient.
  - High vulnerability to natural disasters and climate change, with frequent and intense events (especially cyclones).

### Vulnerabilities and fiscal responsibilities
- Two important points about natural disasters in the Pacific region:
  - Natural disasters are frequent in the Pacific region (especially, cyclones).
  - Their economic impact tends to be intense compared with similar events in large countries.
- Fiscal authority roles following disasters:
  - Assess impact.
  - Provide emergency measures.
  - Recover damages by building disaster-resistant infrastructure.
- The fiscal impact of disasters depends on:
  - Frequency and magnitude of disasters.
  - Portion of economic impact covered by the fiscal authority.

### Box 1 — Recent Episodes of Natural Disasters in the Pacific Islands (selected cases and quantified impacts)
- Natural disasters in the Pacific Islands include storms, earthquakes, volcanic activity, floods, droughts and landslides.
- Case summaries with exact impacts:
  - Cyclone Pam struck Vanuatu, Tuvalu, and Kiribati in March 2015. This cyclone caused damage and loss equivalent to 64 percent of Vanuatu’s GDP (World Bank 2016).
  - Papua New Guinea (PNG) experienced a severe drought caused by El Niño phenomena from May 2015 to March 2016, with negative impact on agricultural and minerals production. Operations at major mines were shut down for nine months because low river-water levels affected shipments. The drought reduced exports and resource revenues, creating a shortage of foreign exchange and revenue deficit for the government (Nakatani 2018). Moreover, the drought adversely affected food supplies and increased inflationary pressure.
  - In late February 2016, Cyclone Winston hit Fiji, and the total loss from the damage amounted to 2 billion Fijian dollars, equivalent to 25 percent of the country’s GDP (World Bank 2017).

### Analytical focus and policy implications (implicit in text)
- Analytical focus:
  - Quantify effects of permanent natural disaster/climate shocks on steady-state debt-to-GDP.
  - Design recurrent expenditure rules that jointly consider debt targets, budget balance targets, and probabilistic disaster shocks.
  - Extend robust expenditure rules to manage volatility from commodity prices and uncertain donor revenue.
- Policy implications for fiscal authorities in Pacific islands:
  - Incorporate probabilistic natural disaster shocks into fiscal-rule design.
  - Strengthen fiscal disciplines (fiscal rules) to enhance counter-cyclicality and fiscal sustainability given recurrent, large shocks.
  - Prioritize investment in climate/disaster-resilient infrastructure as part of sustainable growth and disaster-preparedness strategies.

*Source: wpiea2019186-print-pdf - References _______________________________________________________________________________________ 23*

### 2.5 percent of GDP is expected every year and a substantial 23 percent every 50 years (Pacific

### wpiea2019186-print-pdf - 2.5 percent of GDP is expected every year and a substantial 23 percent every 50 years (Pacific

### Natural disaster risk and macroeconomic impacts
- Pacific-specific risk magnitudes cited:
  - "2.5 percent of GDP is expected every year and a substantial 23 percent every 50 years (Pacific Catastrophe Risk Assessment and Financing Initiative 2015)."
- Recent event example:
  - February 2018 earthquake in PNG: magnitude "7.5", "the biggest earthquake in 100 years", estimated GDP loss "3 percent", suspension of LNG, crude oil, and gold mining operations.
- Distributional effects:
  - Natural disasters disproportionately affect poor households; poor households are more likely to reside in exposed areas and have less ability to migrate.
- Role of external flows in mitigation:
  - Donor grants and remittances are important; remittances increase after severe disasters in low- and middle-income countries (substitution for less developed local financial systems).

### Higher macroeconomic volatility and procyclicality
- Drivers of volatility:
  - Limited scope for economic diversification increases vulnerability to terms-of-trade or commodity price shocks.
  - Default fiscal frameworks in many disaster-prone states are procyclical because limited borrowing capacity and budget balance rules translate revenue volatility into expenditure volatility.
  - Lack of timely macroeconomic data weakens capacity for countercyclical policy.
- Empirical points:
  - "65 percent of developing countries show a procyclical fiscal policy" (Frankel et al. 2013).
  - Fiscal balance positively correlates with output in developing countries (Nakatani 2019).

### Theoretical framework: incorporating natural disasters into fiscal rules
- Analytical aims (paper’s contributions):
  - Show how to calibrate a debt-to-GDP target in the event of natural disaster shocks.
  - Study impact of unexpected climate change shocks (permanent natural disaster shocks) on debt sustainability.
  - Connect debt target with probabilistic natural disaster shocks to fiscal balance, expenditure, and revenues.
  - Recommend a recurrent expenditure rule with desirable properties for small islands.
  - Provide a framework for commodity exporters to smooth consumption/savings volatility from natural resources.
- Key model features:
  - Government cash-flow constraint includes tax revenue, grants, other revenues, debt, money issuance, recurrent and capital expenditure, interest, and the government share of net fiscal cost of shocks (S_t N_t).
  - Debt dynamics expressed in GDP-share notation and steady-state debt formula: d* = (ppp + μ − s n) { ((1 + r)(1 + y) −1) }⁄ .
  - Distinction between temporary natural disasters and permanent climate-change shocks; shocks can alter steady-state parameters (growth, interest rates, risk premia).

### PNG calibration example and quantitative assumptions
- Steady-state calculation yields steady-state debt "around 30 percent" under assumed parameters:
  - primary budget surplus "0.4 percent of GDP (ppp=0.004)"
  - money creation rate "0 percent (μ=0)"
  - real interest rate "4.5 percent (r=0.045)"
  - real potential growth rate "3.8 percent (y=0.038)"
  - expected natural disaster shock per year "0.2 percent of GDP (n=0.002, s=1)"
- Caveat: these values are illustrative and sensitive to parameter choices; limited Pacific data constrains precision.

### Permanent shocks scenarios and implications for debt targets
- Two illustrative cases:
  - Unexpected permanent shock that increases long-term growth (example: catastrophic event catalyzes infrastructure improvements and productivity): steady-state debt could be higher than before the shock.
  - Climate change that permanently dampens growth (example: sea-level rise reducing land for economic activity): steady-state debt should be lower than earlier.
- Policy implication: if an unexpected permanent shift in disaster probability or in government coverage (s_t) occurs, the debt target should be reconsidered or revised.

### Deriving budget balance targets from debt targets
- Debt change and budget balance identity used to derive steady-state budget balance:
  - Steady-state budget balance formula: p* = −γ (1 + γ)⁄ d*.
- PNG illustration:
  - assumed nominal GDP growth "5 percent (γ=0.05)"
  - debt target "d* = 0.3" → implied budget deficit target "1.4 percent of GDP" (p* = −0.014)
- Fiscal adjustment rule:
  - linear adjustment over an adjustment period λ: (p_t − p*) / λ, ∀ p_t ≠ p* (simple linear rule; other nonlinear rules possible).

### Expenditure rules: design and operational recommendations
- Rationale:
  - Expenditure rules are more effective than revenue rules for countercyclicality because revenues contain automatic stabilizers; expenditure control reduces procyclicality.
- Recommendation for Pacific islands:
  - Prefer expenditure rules defined as a percentage of stable revenue (non-resource, non-grant revenue) rather than GDP, because:
    - GDP data are more volatile and slower to release.
    - Revenue-based rules use lagged income effects and are less immediately affected by current-year disaster shocks.
    - Direct link between expenditure and revenue simplifies computation and operational compliance.
- PNG numerical examples:
  - revenue-to-GDP target "14.8 percent" (consistent with PNG MTFS 2018–22)
  - with "5 percent" nominal GDP growth and a "1.4 percent" deficit → constant expenditure-to-GDP ratio "16.2 percent" (=14.8% + 1.4%) or an alternative ceiling of "5 percent" nominal expenditure growth if already consistent.
- Specific expenditure ceilings:
  - personnel emolument ceiling example: personnel emoluments / non-resource, non-grant revenue *100 < "40%".
  - recurrent spending rule formulation: E_t / R_t (non-resource, non-grant revenue) *100 < X% (investment-friendly recurrent spending rule; exclude net acquisition of non-financial assets).
- Operational points:
  - recurrent spending rules allow government expenditure needed for recovery, do not require potential GDP estimates, and avoid prerequisites for steady-state initial positions.

### Revenue structure and rule tailoring
- Different Pacific country revenue structures require tailored rules:
  - commodity exporters (PNG; Timor-Leste): PIH-based approach; non-resource primary balance as % of non-resource GDP; PNG calibration suggests non-resource primary balance close to "−0.3 percent of non-resource GDP".
  - fishing-dependent countries (Kiribati; Micronesia; Marshall Islands; Nauru; Tuvalu): fishing license fees are major revenue; excluding these from revenue base may be infeasible.
  - service-exporting/tourism countries (Fiji; Vanuatu; Palau; Samoa): tourism-related revenues matter.
  - remittance-reliant countries (Tonga; Samoa): cyclical synchronization with Australia/New Zealand is relevant.
- Volatile resource revenue items (selected listing):
  - Kiribati: Fishing License Fees
  - Marshall Islands: Fishing License Fees
  - Micronesia: Fishing License Fees
  - Nauru: Fishing License Fees
  - Papua New Guinea: Mining and Petroleum Taxes; Mining, Petroleum and Gas Dividends
  - Solomon Islands: Logging Revenues; Fishing License Fees
  - Timor-Leste: Petroleum Revenue
  - Tuvalu: Fishing License Fees

### Stabilization funds and cash buffers
- Purpose:
  - Save fiscal surpluses during good years in a stabilization/natural disaster fund to finance emergency relief and reconstruction when borrowing capacity is constrained.
- Practical constraints:
  - Increased frequency of natural disasters makes achieving fund targets more difficult.
  - Opportunity costs and limited capacity for large buffer accumulation must be weighed against expected fiscal costs and borrowing constraints.
- Cash buffer examples in practice:
  - Tonga: cash deposits equivalent to "three months of recurrent spending".
  - Solomon Islands: similar cash buffer rule during recent IMF program.
- Calibration guidance:
  - IMF (2018e) recommends buffer size depend on expected fiscal costs, ability to borrow, opportunity cost, and post-disaster funding needs.

### Empirical volatility evidence (select figures from Table 2)
- Papua New Guinea:
  - GDP unit standard deviation "18.77"
  - Revenue SD "3.74"
  - Expenditure SD "4.48"
  - Expenditure/GDP SD divided by average "0.12"
  - Expenditure/Revenue SD divided by average "0.15"
- Vanuatu:
  - GDP SD "22.09"
  - Revenue SD "7.00"
  - Expenditure SD "8.77"
  - Expenditure/GDP SD divided by average "0.23"
  - Expenditure/Revenue SD divided by average "0.10"
- Implication: for eight of thirteen Pacific countries, expenditure rules defined as a percentage of GDP would exhibit higher volatility than rules defined relative to revenue.

### Policy recommendations (summarized)
- Adopt fiscal rules tailored for disaster-prone small islands:
  - Start with a debt ceiling or target as a practical anchor.
  - Derive operational budget balance and expenditure rules consistent with the debt target.
  - Prefer expenditure rules defined against stable revenue (non-resource, non-grant revenue) rather than GDP.
  - Implement recurrent spending rules that exclude net acquisition of non-financial assets (to allow post-disaster reconstruction).
  - Use personnel emolument ceilings where binding operational guidance is needed (example: personnel emolument / non-resource, non-grant revenue *100 < "40%").
  - For commodity exporters, apply PIH-style non-resource primary balance targets (calibrated to preserve intergenerational equity).
  - Build stabilization funds and cash buffers where feasible, calibrated to expected fiscal costs, borrowing constraints, and opportunity costs.
- Institutional and operational priorities:
  - Ensure simplicity and ease of monitoring given limited institutional capacity.
  - Design rules with escape clauses or flexibility for natural disasters and permanent shocks.
  - Strengthen public financial management to enforce expenditure controls and to manage buffers effectively.

*Italic: Source — wpiea2019186-print-pdf (excerpts provided).*

### 2014. This is quite important because some countries may misclassify constituency development

### wpiea2019186-print-pdf - 2014. This is quite important because some countries may misclassify constituency development funds as capital expenditure rather than recurrent expenditure. If expenditure is misclassified, or classification is susceptible to manipulation, it may be better to have a rule that includes all expenditure (IMF 2018d). Note that capping expenditure does not discourage tax collection efforts because our proposed recurrent expenditure rule allows recurrent spending, provided the government collects more stable revenues.

### Recurrent expenditure rule and classification risks
- Some countries may misclassify constituency development funds as capital expenditure rather than recurrent expenditure.
- If expenditure is misclassified, or classification is susceptible to manipulation, it may be better to have a rule that includes all expenditure (IMF 2018d).
- Capping expenditure does not discourage tax collection efforts because the proposed recurrent expenditure rule allows recurrent spending, provided the government collects more stable revenues.

### B. Escape Clauses
- Well-defined and predetermined escape clauses may help budget execution in the presence of unexpected massive natural disaster shocks.
- If the size of a natural disaster shock is too big to be covered by the stabilization fund, the escape clause should be applied.33
- In such a situation, the debt target and fiscal rules can be recalculated as elaborated in Figure 3.
- The government may breach fiscal rules only in the event of an unexpected disaster or a severe economic shock, which should be clearly defined in the law beforehand.
- Flexibility provisions (such as escape clauses) could complicate the budget process by allowing fiscal targets to change with circumstances.
- Triggering an escape clause involves a costly review process in practice; it is generally optimal to have an escape clause if:
  - the cost of review is cheap,
  - the volatility of shocks is high,
  - and the government deficit bias is severe (Yared 2018).
- Evidence on escape clauses is mixed:
  - Guerguil et al. (2017) find that escape clauses in fiscal rules do not seem to affect the cyclical stance of fiscal policy and public spending.
  - Combes et al. (2017) find that fiscal rules with escape clauses are harmful for stabilization in high-debt countries by making fiscal policy more procyclical.
- Recommendation: Country authorities should be very careful when applying escape clauses to violate fiscal rules.
- Suggested operational approach:
  - Have a forward-looking explanation mechanism similar to inflation targeting regimes in monetary policy.
  - If an unexpected and devastating natural disaster triggers an escape clause, fiscal authorities should provide the future fiscal path to explain how fiscal targets will be met over the medium term.
  - The fiscal authority should analyze and explain how natural disasters affect revenues, expenditures, and debt projections in the medium term and what kind of fiscal consolidation plan is required to meet the target over time.
  - This forward-looking approach will increase the credibility of fiscal policy.

- Footnotes and literature notes in this section:
  - 29 The frequency and severity of natural disasters in low-income countries and small states are expected to increase (Bettin and Zazzaro 2018).
  - 30 Nishizawa et al. (2019) discuss how fiscal buffers should be saved against natural disasters.
  - 31 Marto et al. (2018) show that the preemptive policy by building fiscal buffers in the contingency fund leads to lower public debt levels than the post-disaster reactive policy adopted in Vanuatu.
  - 32 This combination of an expenditure rule and debt target is also supported empirically for other types of economy (e.g. see Bruck and Zwiener [2006] for the case of European Monetary Union). Bergman et al. (2016) find that multiple fiscal rules enhance fiscal solvency.
  - 33 Jalles (2018) find that escape clauses reduce counter-cyclicality of fiscal policy in developing countries.

### C. Procedural Issues
- Strong political leadership with good communication is needed for the government to adopt fiscal rules.
- Fiscal rules should be reviewed periodically because the assumptions on which they are based may be subject to change; however, the revision process should be made as non-political as possible to avoid damaging the credibility of the rules-based approach.
- Regular intervals for amendment should not be linked to the election cycle to keep the fiscal rules independent from changes in the government.34
- Transparency of the process is extremely important. Designing fiscal rules that can be easily communicated has more significance; people often use a debt-GDP rule because of its simplicity and good understanding.
- Strong legal and institutional arrangements are important to commit and implement fiscal rules.
- Recent literature highlights the importance of independent monitoring or enforcement bodies for better compliance:
  - Reuter (2019) finds that covering larger parts of general government finance and independent enforcement bodies issuing real-time alerts significantly increases the likelihood of compliance with fiscal rules.35
  - Beetsma et al. (2019) find that the presence of a fiscal council promotes greater compliance with fiscal rules; a fiscal council could act as an enforcer and revise the rules (Wyplosz 2011).
  - It is recommended that proposals for fiscal rules be published for transparency so that outsiders—such as academic professionals—can provide inputs as independent opinions.
  - Bergman and Hutchison (2015) find that government efficiency is important for the effectiveness of fiscal rules to reduce procyclicality of fiscal policy.

- Footnotes and literature notes in this section:
  - 34 Tóth (2019) shows that fiscal rules contribute to disciplined fiscal policy after a change in government.
  - 35 According to Reuter (2015), introduction of fiscal rules leads to a strong tendency of the constrained fiscal variables toward the numerical targets in the EU even if countries do not comply with the rules.

### V. CONCLUSION
- Scope and focus:
  - Fiscal rules for small island economies vulnerable to natural disasters and commodity price fluctuations as well as foreign aid are discussed, using the Pacific island countries as an example.
  - The Pacific island countries are highly vulnerable to natural disasters and climate change shocks.
- Key proposals and contributions:
  - Propose fiscal rules that include the expected impact of shocks on fiscal balances.
  - Provide an analytical framework to calibrate the debt and budget balance targets and expenditure rules.
  - The theoretical framework shows that an appropriate level of debt target depends on individual country parameters; these parameters can be affected by unexpected permanent climate change shocks.
  - Discuss alternative fiscal rules for commodity exporters based on PIH.
  - Demonstrate practical application of the fiscal rule framework using the example of PNG.
- Main argument and policy recommendation:
  - A recurrent expenditure rule may be the most useful fiscal rule in the Pacific Islands as a countercyclical policy tool to handle natural disasters, volatile resource revenues, and uncertain foreign grants.
  - The recurrent expenditure rule should be used together with the debt target, which is linked to the budget balance target.
  - It would be useful to apply similar analytical methods to other Pacific, Caribbean, or Indian Ocean countries.

*Italic source attribution: wpiea2019186-print-pdf - 2014. This is quite important because some countries may misclassify constituency development funds as capital expenditure rather than recurrent expenditure. If expenditure is misclassified, or classification is susceptible to manipulation, it may be better to have a rule that includes all expenditure (IMF 2018d). Note that capping expenditure does not discourage tax collection efforts because our proposed recurrent expenditure rule allows recurrent spending, provided the government collects more stable revenues.*

---


_Source: https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019186-print-pdf.pdf_