## wp1718

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---

### Political economy framework and scope
- Objective: analyze how political factors affected fiscal outcomes in the euro area between 1999 and 2015; question of whether rules themselves are well designed is beyond scope.
- Contributions:
  - Conceptual: extends political-economy analysis to the supranational (EA) level.
  - Empirical: documents policy biases and the relationship between country size and budget execution.
  - Normative: offers perspectives on fiscal governance reforms focused on correcting incentives.
- Data and period: two databases covering 19 EA countries over 1999–2015: AMECO and a real-time database based on vintages of Stability and Convergence Programs.

### National and supranational political-economy channels
- National-level fiscal objectives considered: Stabilization, Sustainability, Redistribution, Supply of public goods.
- Typical national fiscal distortions and drivers:
  - Outcomes: Procyclicality; Deficit bias; Inefficient composition.
  - Drivers: Common pool problem; Electoral cycles; Time inconsistency; Fiscal illusion.
  - Mechanisms: reelection concerns, partisanship, optimistic revenue forecasts, overspending from heterogeneous claimants, tendency to cut public investment during consolidation.
- Supranational institutional specifics and channels:
  - Small EU budget and staff; no general-budget borrowing or direct taxation by the EU; complex fiscal rules with weaker enforcement; strong cross-country spillovers.
  - Supranational factors: supranational common pool effects; distorted incentives from uninternalized cross-country spillovers; biased enforcement due to shared responsibility between EC and ECOFIN; deficit of democratic legitimacy and scapegoating of the center.
- Supranational outcomes: poor compliance and enforcement of rules; lack of evenhandedness; low public trust and confidence.

### Empirical evidence on fiscal policy biases (1999–2015)
- Overall finding: political-economy factors generated biases leading to excessive spending in good times, eroded buffers, procyclical adjustments in downturns, and compositional shifts unfavorable to growth.

A. Procyclicality and deficit bias
- Econometric specification (panel fixed effects):
  - Δsb_{i,t} = α_i + β × Δgap_{i,t} + γ × debt_{i,t−1} + ρ_t + ε_{i,t}
  - β < 0 implies procyclical discretionary fiscal policy.
- Key coefficients and statistics (Table 1, sample: 19 countries, 1999–2015):
  - Plans (one-year-ahead planned fiscal impulse; column (1)):
    - Initial Debt/GDP: 0.02 [0.01]
    - ΔOutput Gap: -0.12 [0.15]
    - Constant: -0.93 [1.72]
    - Observations: 105; Number of Countries: 19; R^2: 0.33
  - Actual, Real Time (outturn reported t|t+1; column (2)):
    - Initial Debt/GDP: 0.05*** [0.01]
    - ΔOutput Gap: -0.27* [0.16]
    - Constant: -3.88*** [0.79]
    - Observations: 102; Number of Countries: 19; R^2: 0.65
  - Actual, Ex Post (outturns reported t|2016; column (3)):
    - Initial Debt/GDP: 0.04*** [0.01]
    - ΔOutput Gap: -0.55** [0.19]
    - Constant: -3.27*** [0.90]
    - Observations: 224; Number of Countries: 19; R^2: 0.29
- Interpretation:
  - Plans were broadly acyclical (insignificant β in planned data).
  - Real-time and ex post outcomes were procyclical (negative and significant β), indicating slippage during implementation.
- Robustness:
  - Dynamic GMM confirms procyclicality but reduces sample size.
  - Including political variables (election dummies, fractionalization) does not materially affect results; interaction terms generally insignificant.
  - Results robust to exclusion of 2011–13 post-stimulus consolidation years.

- Asymmetric response (deficit bias) specification:
  - Δsb_{i,t} = α_i + β1 × Δgap_{i,t} × D(Δgap_{i,t} > 0) + β2 × Δgap_{i,t} × D(Δgap_{i,t} < 0) + γ × debt_{i,t−1} + ρ_t + ε_{i,t}
- Key coefficients (Table 2, 19 countries, 1999–2015):
  - Plans (column (1)):
    - Initial Debt/GDP: 0.01* [0.01]
    - ΔOutput Gap*D(>0): -0.45*** [0.07]
    - ΔOutput Gap*D(<0): 0.17 [0.26]
    - Observations: 105; R^2: 0.39
  - Actual, Real Time (column (2)):
    - Initial Debt/GDP: 0.06*** [0.01]
    - ΔOutput Gap*D(>0): -0.84*** [0.20]
    - ΔOutput Gap*D(<0): -0.13 [0.18]
    - Observations: 102; R^2: 0.67
  - Actual, Ex Post (column (3)):
    - Initial Debt/GDP: 0.04*** [0.01]
    - ΔOutput Gap*D(>0): -0.31 [0.30]
    - ΔOutput Gap*D(<0): -0.73*** [0.22]
    - Observations: 224; R^2: 0.3
- Interpretation:
  - Strong evidence of lax policies in good times (β1 negative and often significant), consistent with a deficit bias preventing buffer accumulation in expansions.
  - GMM and robustness checks support these conclusions.

B. Compositional distortions: investment and adjustments
- During fiscal adjustment (2010–13) EA countries relied more on revenue measures and cut investment disproportionately relative to wages and other items.
- Investment gap analysis (15 EA countries with capital stock data):
  - Capital-stabilizing net investment ratio formula: y/(1+y) × k (y = real potential growth rate; k = initial stock of public capital as ratio of GDP).
  - As of 2015, the investment gap ranged between 0.35 percent and 3.7 percent of GDP, depending on the country.
- Implication: persistent underinvestment may deplete public capital stock and slow long-term potential, harming fiscal sustainability.

C. Compliance with fiscal rules and decomposition of slippages
- Simplified SGP numerical rules: 3 percent of GDP nominal deficit ceiling; 60 percent of GDP debt ceiling; MTO in structural terms; benchmark fiscal effort of at least 0.5 percent per year in structural terms when below MTO or under EDP.
- Stylized compliance findings (1999–2015):
  - MTO violated in 80 percent of observations; almost two-thirds of countries exceeded MTOs in every single year.
  - In 2009: MTO violated by 90 percent of countries; debt ceiling violated by 50 percent; deficit ceiling violated by 85 percent; required fiscal effort violated by 75 percent.
  - Share of countries with debt ratio > 60 percent increased from 35 percent in 1999 to 75 percent in 2015.
  - Governance reforms over 2005–13 did not show an evident impact on compliance in this simplified accounting.
- Decomposition identities (medians not additive):
  - Deficit rule: DEF_t|2016 − 3︱︱Ex post compliance = (DEF_t|t−i − 3)︱︱Ex ante compliance + (DEF_t|2016 − DEF_t|t−i)︱︱Execution
  - Debt rule: DEBT_t|2016 − 60︱︱Ex post compliance = (DEBT_t|t−i − 60)︱︱Ex ante compliance + (DEBT_t|2016 − DEBT_t|t−i)︱︱Execution
- Key empirical finding:
  - For the 60 percent debt-to-GDP rule and the 3 percent deficit rule, poor execution (slippages between plans and outcomes) is the main culprit.
  - Non-compliers planned to reduce debt by about 10 percent of GDP—from about 80 to 70 percent of GDP on average—within three years, but the debt ratio remained broadly unchanged ex post.
- Interpretation caveats:
  - Execution-stage deviations may reflect unexpected nominal growth shortfalls (e.g., negative inflation surprise), intentional biases, valuation changes, and statistical perimeter adjustments.

### Country size, EDP duration, and evenhandedness
- Research question: relation between country size and deviations from fiscal plans.
- Regression (equation (3), 1999–2015):
  - Δob_{i,t}|2016 − Δob_{i,t}|t−1 = α_i + β × Size_i,t + γ × Controls_i,t + ρ_t + ε_i,t
  - Size measured as share of nominal GDP of an EA member in total EA GDP.
- Main empirical result:
  - Size coefficient β negative and significant in most specifications: "when the share of a country in the EA GDP increases by 1 percent, the fiscal slippage of the overall balance increases by about 0.3 percent of GDP."
- Selected coefficient examples (Table 3):
  - Country Size (Percent): -0.32**, -0.30*, -0.29*, -0.23, -0.43***, -0.30**, -0.32***, -0.17, -1.64**, -0.63*, -0.30*, -0.35***, -0.32**, -1.99*
  - Observations: 187; Number of Countries: 19; R^2 vary by specification.
- Caveat: negative correlation could reflect other factors (larger fiscal multipliers, deeper financial markets, ECB responses), not necessarily uneven enforcement.
- EDP recommendations and country size (equation (4), sample of 39 EDP episodes, 2003–15):
  - Effort_i = α + β × Size_i + γ × Controls_i + ε_i
  - Table 4 results: β coefficients not significant in most regressions; in EA-only sample negative coefficient marginally significant without controls but significance vanishes with controls and in broader 28-EU sample.
  - Table 4 selected coefficients: -0.022*, -0.021*, -0.01, 0.00, -0.01, 0.00; Observations: 47 (columns (1)–(6)), 68 (columns (7)–(12)); R^2 range from 0.03 to 0.54 (EA columns).
- Summary: mixed evidence — bigger countries tend to deviate more from plans, but this behavior could be unrelated to the rules; smaller countries under EDP are not requested to adjust faster than bigger countries (with caveats on small sample sizes).

### Past SGP reforms and policy options
- Four channels through which past reforms attempted to mitigate political-economy factors:
  - Foster evenhanded treatment (e.g., "reverse qualified majority" voting system adopted in 2011; European Fiscal Board operational since October 2016).
  - Make deviations more costly (earlier and stronger sanctions; Fiscal Compact; fiscal councils).
  - Bring more specificity to the application of the rules (criteria for flexibility).
  - Make framework more legitimate and homegrown (MTOs in national legislation; integration with national budget calendar).
- Limitations of past reforms:
  - Increasing complexity and reduced transparency.
  - Fiscal councils not immune to political interference; fiscal sustainability not central in public debate.
  - "Reverse qualified majority" may not fully guarantee evenhandedness because of EC interactions and possible political internalization.
  - Effectiveness of European Fiscal Board depends on independence and communication strategy.
- Short- to medium-term recommendations (principle: "Make fiscal rules work politically"):
  - Strengthen incentives on both sides: more credible sanctions and more tangible benefits for compliers.
  - Make sanctions more politically acceptable:
    - Emphasize sanctions under the preventive arm; consider nonpecuniary or administrative sanctions under the corrective arm.
    - Design gradual system: initial small sanctions for small deviations and heavier penalties for repeated/larger deviations.
  - Create tangible benefits for compliers:
    - Link structural funds and other EU subsidies to compliance; condition access to an EA stabilization capacity on past compliance.
    - Make clear link between compliance and a well-functioning EMU delivering price stability and robust growth.
  - Simplify the framework:
    - Reduce complexity to enhance democratic legitimacy and transparency; consolidate preventive and corrective arms and eliminate redundant/ill-designed rules.
- Long-term architecture options (continuum of two polar models):
  - Decentralized model with stronger market discipline:
    - Greater national autonomy; rely on markets to enforce discipline; prerequisites: mechanisms to manage state defaults; clear private creditor involvement rules; enhanced fiscal transparency; credible joint fiscal backstop in banking union.
    - Note: even strong market-discipline countries often have self-imposed fiscal rules.
  - Centralized model with deeper fiscal and political integration:
    - More central oversight and controls, resource pooling, joint decision-making, stronger center (e.g., EMU Minister of Finance); political integration needed for legitimacy and accountability.
  - Current EA framework: combines elements of both models without fully achieving either; no credible no-bailout enforcement; market discipline imperfect; member states retained most fiscal sovereignty while supranational enforcement tools remain limited.
- Governance implications:
  - Political integration would improve legitimacy of a stronger fiscal center and help shape Europe-wide interests; ECOFIN composition may bias decisions toward national interests, benefiting larger countries.
  - Further institutional reforms (ESM, banking union) increased risk sharing, but central executive authority and legal grounds from political union would be required for deeper integration.

### Conclusions and policy lessons
- Key findings:
  - Fiscal challenges in the EA are rooted in distorted political incentives at national and supranational levels.
  - Real-time data document procyclicality, excessive deficits, and compositional distortions.
  - Presence of national and supranational fiscal rules has not successfully alleviated these biases; they have continued following recent reforms.
  - Evidence on bias in applying rules by country size is "not as conclusive."
- Political-economy implications:
  - Distorted incentives are a simple but far-reaching result not fully acknowledged in reforms.
  - Perception that European fiscal governance releases countries from national responsibilities is dangerous; "fiscal policy is, first and foremost, a national responsibility."
  - Combination of that misperception with predominance of national politics is a "dangerous mix."
- Policy lessons:
  - Technical improvements necessary but insufficient; reforms must garner political and public support.
  - Continue efforts on two fronts: Right design and Right incentives.
  - Implement a stronger system of incentives: gradual and proportionate sanctions; clear benefits for compliers.
- Longer-term view:
  - A lasting solution must combine market discipline and stronger fiscal governance.
  - Fiscal union should be part of a comprehensive architecture accompanying bank and capital markets unions and reflect political choices in Europe.
- Methodological notes relevant to conclusions:
  - Empirical analysis uses real-time data and cross-checks with AMECO.
  - Sample: 19 euro area countries covering 1999–2015.
  - Robustness: some specifications exclude 2011–13; methods include panel OLS (fixed effects) and dynamic panel GMM.
  - Political-economy variables from Database of Political Institutions include legislative election (dummy), presidential elections (dummy), fractionalization (continuous between 0 and 1).

*Source: wp1718 — INTRODUCTION; 2016. Decomposition formula: 푫푬푭; CONCLUSION.*

### References ___________________________________________________________________________________________ 39

### References ___________________________________________________________________________________________ 39

### Figures
- 1. National Political Economy _________________________________________________________________________ 4
- 2. Supranational Political Economy ___________________________________________________________________ 8
- 3. Relationship between Changes in Structural Balances and Output Gaps __________________________ 11
- 4. Reliance on Revenue and Expenditure Measures in Fiscal Adjustment ____________________________ 16
- 5. General Government Expenditure Composition ___________________________________________________ 16
- 6. Share of Non-Compliers in the Euro Area _________________________________________________________ 18
- 7. Decomposition of Deficit Rule Slippages __________________________________________________________ 19
- 8. Decomposition of Debt Rule Slippages ____________________________________________________________ 20
- 9. Relationship between Country Size and EDP Length ______________________________________________ 23
- 10. Past SGP Reforms and Policy Biases ______________________________________________________________ 25

### Tables
- 1. Fiscal Policy Procyclicality _________________________________________________________________________ 12
- 2. Asymmetric Policy Response and Deficit Bias______________________________________________________ 15
- 3. Country Size and Fiscal Plan Execution ____________________________________________________________ 22
- 4. Country Size and EDP Recommendations _________________________________________________________ 24

### Annex Tables
- 1. Baseline Specification: Fiscal Policy Procyclicality __________________________________________________ 33
- 2. Baseline Specification: Asymmetric Policy Response and Deficit Bias ______________________________ 34
- 3. Including Political Economy Variables: Fiscal Policy Procyclicality __________________________________ 35
- 4. Including Political Economy Variables Asymmetric Policy Response and Deficit Bias ______________ 36
- 5. Excluding Periods of Fiscal Consolidation during the Global Financial Crisis: Fiscal Policy 
Procyclicality ___________________________________________________________________________________ 37
- 6. Excluding Periods of Fiscal Consolidation during the Global Financial Crisis: Asymmetric Policy 
Response and and Deficit Bias _________________________________________________________________ 38

*Source: wp1718 - References ___________________________________________________________________________________________ 39*

### INTRODUCTION

### INTRODUCTION

### Background and scope
- Euro area (EA) public-debt-to-GDP ratio increased from an average level of less than 60 percent of GDP in the early 1990s to more than 90 percent of GDP in 2015.
- The surge in debt was particularly pronounced in 2009 and 2010 at the peak of the global financial crisis; some countries were priced out of the market and contagion set in.
- Paper objective: analyze how political factors affected fiscal outcomes in the EA between 1999 and 2015, documenting fiscal policy biases and compliance with existing fiscal rules. The question of whether the rules themselves are well designed is explicitly beyond scope.

### Main contributions
- Conceptual: extends analysis of political economy factors and policy distortions from unitary-country contexts to the supranational (EA) level.
- Empirical: reviews a series of policy biases, including the relationship between country size and budget execution.
- Normative: offers a novel perspective on fiscal governance reforms focused on correcting incentives, complementing literature that emphasizes strengthening economic rationale for rules.

### Structure of the paper
- Section 2: political economy factors at national and supranational levels and resulting fiscal policy biases.
- Section 3: empirical evidence on policy biases and the effectiveness of fiscal rules.
- Section 4: review of past reforms and suggested options.
- Final section: conclusions.

### Data and period
- Empirical analysis relies mainly on two databases covering 19 EA countries over the period 1999–2015: AMECO and a real-time database based on vintages of Stability and Convergence Programs.

---

### Political economy perspective: definitions and channels
- Political economy is defined broadly as the analysis of interactions between the political environment and the economic system, including cross-country coordination and effects on public confidence.
- Fiscal policy objectives considered: Stabilization (automatic and discretionary), Sustainability, Redistribution and supply of public goods.

---

### Policy biases at the national level
- Typical fiscal outcomes from political economy distortions:
  - Procyclicality
  - Deficit bias
  - Inefficient composition
- Political economy factors driving these outcomes:
  - Common pool problem
  - Electoral cycles
  - Time inconsistency
  - Fiscal illusion
- Mechanisms and examples:
  - Reelection concerns and partisanship → short-term orientation, opportunistic pre-election spending, optimistic revenue forecasts.
  - Common pool problem among heterogeneous claimants (line ministries, levels of government, coalition parties) → overspending.
  - Fiscal composition bias in consolidation: tendency to cut public investment and favor tax increases or protect transfers.

---

### Policy biases at the supranational level
- EU institutional specifics that affect fiscal policy:
  - Small EU budget and staff relative to standard federal budgets; limited risk-sharing and redistribution.
  - No general-budget borrowing or direct taxation by the EU; resources from member-state contributions.
  - Complex fiscal rules with weaker enforcement than in federations; limited harmonization of tax and spending across states.
  - Strong cross-country fiscal spillovers due to trade linkages, confidence effects, high financial market integration, and single monetary policy.
- Supranational political economy factors identified:
  - Supranational common pool effects (e.g., integrated bond markets acting like a common financing pool until the crisis).
  - Distorted incentives regarding fiscal stance when countries do not internalize cross-country spillovers (positive spillovers → tendency toward overly restrictive policy; negative spillovers → opposite).
  - Biased enforcement of fiscal rules due to shared responsibility between the European Commission (EC) and ECOFIN; ECOFIN finalizes enforcement decisions and may provide preferential treatment or leniency, especially toward larger countries or because of implicit collusion (“sinners judging sinners”).
  - Deficit of democratic legitimacy and scapegoating of the center (limited remit of the European Parliament, limited transparency of intergovernmental decision-making, multiplicity of monitoring schemes).
- Supranational fiscal outcomes highlighted:
  - Poor compliance and enforcement of rules
  - Lack of evenhandedness
  - Low public trust and confidence

---

### Empirical evidence on fiscal policy biases in the euro area (1999–2015)
- Overall finding: political economy factors generate biases that lead to excessive spending in good times, eroded buffers, procyclical adjustments in downturns, and compositional shifts unfavorable to growth.

A. Macro-fiscal performance under the Stability and Growth Pact (SGP)
- SGP design intent:
  - Prevent negative spillovers from national fiscal policies.
  - Allow automatic stabilizers to operate while limiting discretionary policy through structural-balance MTOs (medium-term objectives).
  - Benchmark MTO commonly referenced: structural deficit ceiling of 0.5 percent of potential GDP combined with a 3 percent nominal deficit ceiling.

Evidence of procyclical fiscal policy
- Descriptive: scatter of changes in output gaps and changes in cyclically adjusted fiscal balances (19 countries, 1999–2015) shows a negative association in more than half of observations (discretionary loosening in booms and tightening in recessions).
- Econometric specification used (panel fixed effects):
  - Δsb_{i,t} = α_i + β × Δgap_{i,t} + γ × debt_{i,t−1} + ρ_t + ε_{i,t}
  - β < 0 implies procyclical discretionary fiscal policy.
- Table 1 (Fixed Effects Estimator) — key coefficients and statistics (sample: 19 countries, 1999–2015):
  - Plans (one-year-ahead planned fiscal impulse; column (1)):
    - Initial Debt/GDP: 0.02 [0.01]
    - ΔOutput Gap: -0.12 [0.15] (insignificant)
    - Constant: -0.93 [1.72]
    - Observations: 105; Number of Countries: 19; R^2: 0.33
  - Actual, Real Time (outturn reported t|t+1; column (2)):
    - Initial Debt/GDP: 0.05*** [0.01]
    - ΔOutput Gap: -0.27* [0.16] (negative and significant at * p < 0.1)
    - Constant: -3.88*** [0.79]
    - Observations: 102; Number of Countries: 19; R^2: 0.65
  - Actual, Ex Post (outturns reported t|2016; column (3)):
    - Initial Debt/GDP: 0.04*** [0.01]
    - ΔOutput Gap: -0.55** [0.19] (negative and significant at ** p < 0.05)
    - Constant: -3.27*** [0.90]
    - Observations: 224; Number of Countries: 19; R^2: 0.29
  - Notes: columns (1) and (2) use Stability Program data; column (3) uses AMECO; dependent variable overall structural balances; all regressions include time and country fixed effects.
- Interpretation:
  - Plans were broadly acyclical (insignificant β in planned data), but real-time and ex post outcomes were procyclical (negative and significant β), indicating slippage during implementation.
- Endogeneity and robustness:
  - Dynamic GMM estimations (using lagged variables and trade-weighted output gaps as instruments) confirm procyclicality but reduce sample size.
  - Including political variables (election year dummies, political fractionalization) does not materially affect results; interaction terms generally insignificant — suggesting supranational factors may contribute.
  - Results robust to exclusion of 2011–13 post-stimulus consolidation years.

Evidence of deficit bias
- Asymmetric response test specification:
  - Δsb_{i,t} = α_i + β1 × Δgap_{i,t} × D(Δgap_{i,t} > 0) + β2 × Δgap_{i,t} × D(Δgap_{i,t} < 0) + γ × debt_{i,t−1} + ρ_t + ε_{i,t}
  - β1 (good times) and β2 (bad times) capture asymmetric reactions.
- Table 2 (Fixed Effects Estimator) — key coefficients (19 countries, 1999–2015):
  - Plans (column (1)):
    - Initial Debt/GDP: 0.01* [0.01]
    - ΔOutput Gap*D(>0): -0.45*** [0.07]
    - ΔOutput Gap*D(<0): 0.17 [0.26]
    - Observations: 105; R^2: 0.39
  - Actual, Real Time (column (2)):
    - Initial Debt/GDP: 0.06*** [0.01]
    - ΔOutput Gap*D(>0): -0.84*** [0.20]
    - ΔOutput Gap*D(<0): -0.13 [0.18]
    - Observations: 102; R^2: 0.67
  - Actual, Ex Post (column (3)):
    - Initial Debt/GDP: 0.04*** [0.01]
    - ΔOutput Gap*D(>0): -0.31 [0.30]
    - ΔOutput Gap*D(<0): -0.73*** [0.22]
    - Observations: 224; R^2: 0.3
  - Interpretation:
    - Strong evidence of lax policies in good times (β1 negative and often significant), consistent with a deficit bias that prevents buffer accumulation in expansions.
    - GMM and robustness checks support these conclusions.

Evidence of suboptimal fiscal composition
- During fiscal adjustment (2010–13) EA countries relied more on revenue measures and cut investment disproportionately:
  - Figures indicate reliance on revenue and expenditure measures in fiscal adjustment and rebased expenditure composition (capital spending, wages, goods and services, interest, other spending) showing capital spending fell relative to wages and other items.
- Investment gap analysis (proxy: difference between observed public investment and investment that would stabilize public capital/GDP):
  - Capital-stabilizing net investment ratio formula: y/(1+y) × k (y = real potential growth rate; k = initial stock of public capital as ratio of GDP).
  - As of 2015, the investment gap ranged between 0.35 percent and 3.7 percent of GDP, depending on the country (analysis for 15 EA countries with available capital stock data).
- Implication: persistent underinvestment may deplete public capital stock and slow long-term potential, hurting fiscal sustainability.

B. Compliance with fiscal rules
- SGP numerical rules considered for compliance analysis (simplified): 3 percent of GDP nominal deficit ceiling; 60 percent of GDP debt ceiling; MTO in structural terms; benchmark fiscal effort of at least 0.5 percent per year in structural terms when below MTO or under Excessive Deficit Procedure (EDP).
- Figure 6 (share of “non-compliers”, 1999–2015) — stylized findings:
  - MTO violated in 80 percent of observations; almost two-thirds of countries exceeded MTOs in every single year.
  - In 2009: MTO rule violated by 90 percent of countries; debt ceiling violated by 50 percent; deficit ceiling violated by 85 percent; required fiscal effort violated by 75 percent.
  - Share of countries with debt ratio > 60 percent increased from 35 percent in 1999 to 75 percent in 2015.
  - Governance reforms over 2005–13 did not show an evident impact on compliance in this simplified accounting.
- Decomposition of poor ex post compliance:
  - Outcome − Target (ex post compliance) = (Plan − Target) (ex ante compliance) + (Outcome − Plan) (execution)
  - For the 3 percent deficit rule (country-years with deficit/GDP > 3 percent) over three-year planning horizon:
    - Main driver of poor ex post compliance was weak execution (slippages) rather than lack of intent in plans.
    - Non-compliers planned to reduce deficits below 3 percent in projected years, but execution slippages produced a median upward deviation from the ceiling of up to 2 percent of GDP by end of the third year.
  - Interpretation: execution shortfalls and weak enforcement (absence of fines/sanctions by EC) are central to non-compliance.

---

*Source: INTRODUCTION (wp1718), covering political economy perspectives and empirical analysis of fiscal policy biases and SGP compliance in the euro area for 1999–2015.*

### 2016. Decomposition formula: 푫푬푭

### 2016. Decomposition formula: 푫푬푭

### Decomposition of Slippages: Deficit and Debt Rules
- Decomposition identity (deficit rule):
  - 푫푬푭풕|ퟐퟎퟏퟔ − ퟑ︱︱푬풙 풑풐풔풕 풄풐풍풍풍풌풊풂풏풄풆 = (푫푬푭풕|풕−풊 − ퟑ)︱︱푬풙 풂풏풕풆 풄풐풍풍풍풌풊풂풏풄풆 + (푫푬푭풕|ퟐퟎퟏퟔ − 푫푬푭풕|풕−풊)︱︱푬풙풆풄풖풕풊풐풏
  - Note: "The three components (ex post compliance, ex ante compliance, and execution) do not add up because of the use of medians."
- Decomposition identity (debt rule):
  - 푫푬푩푻풕|ퟐퟎퟏퟔ − ퟔퟎ︱︱푬풙 풑풐풔풕 풄풐풍풍풍풌풊풂풏풄풆 = (푫푬푩푻풕|풕−풊 − ퟔퟎ)︱︱푬풙 풂풏풗풆 풄풐풍풍풍풌풊풂풏풄풆 + (푫푬푩푻풕|ퟐퟎퟏퟔ − 푫푬푩푻풕|풕−풊)︱︱푬풙풆풄풖풕풊풐풏
- Key empirical findings:
  - For the 60 percent debt-to-GDP rule, "poor execution is the main culprit."
  - Non-compliers planned to reduce debt by about 10 percent of GDP—from about 80 to 70 percent of GDP on average—within three years, but "the debt ratio remained broadly unchanged ex post."
  - Sample and data notes for Figure 8: "The sample includes 19 euro area countries, over 1998-2013. Reported are medians. Sample includes country-years with debt/GDP>60 percent."
- Interpretation caveats:
  - "The fact that most of the deviations occurred at the execution stage should not necessarily be interpreted as evidence of unintended budgetary slippages."
  - Possible reasons for ex post deviations include unexpected nominal growth shortfalls (e.g., negative inflation surprise), intentional biases (deliberate underestimation of the fiscal deficit), valuation changes, and statistical adjustments in the perimeter of the fiscal aggregate.

### Country Size and Fiscal Outcomes
- Research question: "Is there a relationship between country size and deviation from fiscal plans?"
- Regression specification (EA countries, 1999–2015):
  - Δobi,t|2016 − Δobi,t|t−1 = αi + β × Sizei,t + γ × Controlsi,t + ρt + εi,t  (equation (3))
  - Dependent variable: difference between outcome and plan for the change in the overall-balance-to-GDP ratio.
  - Size measured as share of nominal GDP of an EA member in total EA GDP.
  - Controls: forecast errors in macro variables, initial fiscal positions (debt ratio, distance from the MTO), election cycle, EDP status, etc.
  - Estimation: panel ordinary least squares with time and country fixed effects; sample includes 19 euro area countries; actual data from AMECO; plans from Stability and Convergence Programs; first differences used to mitigate data vintage definition changes.
- Main empirical result:
  - "The estimation results do not invalidate the hypothesis of a systematic difference of behavior between large and small countries in their deviations from fiscal plans."
  - The size coefficient β is negative and significant in most specifications: "when the share of a country in the EA GDP increases by 1 percent, the fiscal slippage of the overall balance increases by about 0.3 percent of GDP."
- Selected regression output and sample statistics (Table 3 highlights):
  - Example coefficient estimates for Country Size (GDP as a Share of EA GDP, Percent): -0.32**, -0.30*, -0.29*, -0.23, -0.43***, -0.30**, -0.32***, -0.17, -1.64**, -0.63*, -0.30*, -0.35***, -0.32**, -1.99*
  - Standard errors and significance indicators reported in table; R^2 values vary by specification (e.g., 0.20, 0.22, 0.33, 0.35, 0.36, 0.71).
  - Observations: 187 (in many specifications); Number of Countries: 19.
- Interpretation caveats:
  - Caution urged: negative correlation could reflect other factors (e.g., larger fiscal multipliers, deeper financial markets, ECB responses), not necessarily uneven enforcement.
- EDP modalities and country size:
  - Evidence that "larger countries have tended to stay longer under EDP than smaller countries" (Figure 9; sample includes 19 euro area countries for 2003–16).
  - Regression of EDP recommended Effort:
    - Efforti = α + β × Sizei + γ × Controlsi + εi  (equation (4))
    - Effort = average required annual fiscal effort (structural terms) for EDP countries; sample: 39 EDP episodes, 2003–15; data from EC (2015).
    - Results: "The estimation results reported in Table 4 do not confirm this hypothesis: β coefficients are not significant in most regressions."
    - In EA-only sample the negative coefficient is marginally significant without controls, but significance vanishes with controls and in broader 28-EU sample.
  - Table 4 highlights:
    - Sample size: 39 EDP episodes.
    - Selected coefficient examples: -0.022*, -0.021*, -0.01, 0.00, -0.01, 0.00 (EA columns); similar patterns in 28 EU countries columns.
    - Observations: 47 (columns (1)–(6)); 68 (columns (7)–(12)); R^2 ranges from 0.03 to 0.54 in EA columns and 0.02 to 0.49 in EU columns.
- Summary conclusion on evenhandedness:
  - Mixed evidence: "Bigger countries tend to deviate more from their fiscal plans than smaller countries, but this behavior could be unrelated to the rules. Smaller countries under EDP are not requested to adjust excessive deficits faster than bigger countries," with caveats about small sample sizes.

### Past Reforms and Policy Options (Past reforms, near-term and long-term)
- Assessment of past SGP reforms (objectives and outcomes):
  - Four channels by which reforms attempted to mitigate political economy factors:
    - Fostering evenhanded treatment of countries (e.g., "reverse qualified majority" voting system adopted in 2011; European Fiscal Board operational since October 2016).
    - Making deviations from rules more costly (earlier and stronger sanctions; Fiscal Compact and fiscal councils).
    - Bringing more specificity in the application of the rules (criteria for flexibility).
    - Making the framework more legitimate and homegrown (MTOs in national legislation; integration with national budget calendar).
  - Limitations of past reforms:
    - Complexity and reduced transparency from successive changes.
    - Fiscal councils' influence may be limited (not immune to political interference; fiscal sustainability not currently central in public debate).
    - "Reverse qualified majority" may not fully guarantee evenhandedness because of EC interactions with national authorities and possible political internalization.
    - Effectiveness of European Fiscal Board depends on independence from the EC and political pressures and on its communication strategy.
- Policy recommendations within existing framework (short to medium term):
  - Principle: "Make fiscal rules work politically" by strengthening incentive structures on both sides: more credible sanctions and more tangible benefits for compliers.
  - Make sanctions more politically acceptable:
    - Problems identified: financial sanctions exacerbate distress; sanctions carry stigma and political cost; enforcement constrained by national sovereignty and international law.
    - Recommendations: place more emphasis on sanctions under the preventive arm; consider nonpecuniary or administrative sanctions under the corrective arm; design a more gradual system with initial small sanctions for small deviations and heavier penalties for repeated/larger deviations.
  - Create tangible benefits for compliers:
    - Observation: current framework is heavily tilted toward negative incentives; positive benefits underdeveloped.
    - Options: link volume of structural funds and other EU subsidies to compliance; condition access to a proposed EA stabilization capacity on past compliance; design fiscal rules to make clear link between compliance and a well-functioning EMU that delivers price stability and robust growth.
  - Simplify the framework:
    - Rationale: increasing complexity reduces transparency and public communication; simplification would enhance democratic legitimacy, reduce loopholes and political games; may require consolidating preventive and corrective arms and eliminating redundant or ill-designed rules.
- Toward a more comprehensive (long-term) approach:
  - Argument: SGP reforms alone unlikely to eliminate policy biases; problems rooted in broader EA architecture (fiscal, monetary, banking, financial).
  - Two polar models for long-term architecture (continuum):
    - Decentralized model with stronger market discipline:
      - Greater national autonomy; rely on markets to enforce discipline (examples: Canada, United States).
      - Prerequisites: mechanisms to manage state defaults; clear rules for private creditor involvement; avoid bailouts or confine them within a clear framework; enhance fiscal transparency and government balance-sheet disclosure; credible joint fiscal backstop in banking union to weaken sovereign-bank links.
      - Note: even where market discipline is strongest, institutional arrangements (fiscal rules) exist and are often self-imposed.
    - Centralized model with deeper fiscal and political integration:
      - More central oversight and controls (e.g., federal tax powers, stricter borrowing/spending limits on subcentral governments).
      - Would require member states to surrender some fiscal sovereignty; more resource pooling and joint decision making; stronger center (e.g., Minister of Finance of EMU).
      - Potential benefits: better management of EA aggregate fiscal stance, improved distribution of fiscal efforts, use of fiscal space to increase public investment, mitigation of common-pool problems and cross-country spillovers.
      - Political integration needed to underpin legitimacy and accountability (democratic feedback mechanisms, enhanced role for directly elected institutions).
  - Current EA position:
    - "The EA framework combines elements of both models without bringing either of them to fruition."
    - No credible no-bailout enforcement; market discipline has not worked properly; member states retained most fiscal sovereignty while supranational enforcement tools remain limited.
  - Political economy and governance implications:
    - Strengthening political integration would improve legitimacy of a stronger fiscal center and help shape Europe-wide interests; ECOFIN’s composition (national finance ministers) may bias decisions toward national interests, benefiting larger countries.
    - Further institutional reforms (ESM, banking union) have increased risk sharing, but central executive authority and legal grounds from political union would be required for deeper integration.

*Source: wp1718 - 2016. Decomposition formula: 푫푬푭*

### CONCLUSION

### CONCLUSION

### Key findings on fiscal biases
- Fiscal challenges in the euro area (EA) are rooted in distorted political incentives at both national and supranational levels.
- Using real-time data from stability programs, the paper documents a range of fiscal policy biases:
  - Procyclicality.
  - Excessive deficits.
  - Compositional distortions.
- Presence of national and supranational fiscal rules has not successfully alleviated these biases; they have continued to prevail following recent reforms of the fiscal framework.
- Evidence on bias in applying the rules (as a function of country size) is "not as conclusive."

### Political-economy implications
- Distorted incentives are a simple but far-reaching result that has not been fully acknowledged in fiscal institution reform.
- A dangerous manifestation of these distortions is the perception among many analysts that European fiscal governance releases countries from their national responsibilities; the paper stresses that "fiscal policy is, first and foremost, a national responsibility."
- The combination of this misperception with the predominance of the national dimension of politics is identified as a "dangerous mix."
- Further political integration could take the form of a supranational political union or tighter intergovernmental coordination.

### Policy lessons and recommendations
- Technical improvements in the design of the framework are necessary but insufficient: reforms must also garner political and public support.
- Reform of the SGP has strengthened the economic basis of the rules, but efforts should continue on two fronts:
  - Right design.
  - Right incentives.
- It is possible and desirable to have a stronger system of incentives, including:
  - Gradual and proportionate sanctions.
  - Clear benefits for compliers.

### Longer-term architecture and solution
- A lasting solution must combine market discipline and stronger fiscal governance.
- Fiscal union, if it happens, should be part of a comprehensive architecture accompanying bank and capital markets unions and would reflect political choices in Europe.
- The paper frames fiscal union as an element of a broader institutional and political solution rather than a purely technical fix.

### Annex and data coverage (methodological notes relevant to conclusions)
- Empirical analysis uses real-time data and cross-checks with AMECO where structural balances are unavailable.
- Sample details used in annex tables include "19 euro area countries covering the period 1999–2015."
- Some robustness checks exclude specific periods—for example, several specifications exclude "2011–13" to omit periods of fiscal consolidation during the Global Financial Crisis.
- Estimation approaches reported include panel ordinary least squares (fixed effects) and dynamic panel GMM (generalized method of moments).
- Political-economy variables referenced come from the Database of Political Institutions and include:
  - Legislative election (dummy).
  - Presidential elections (dummy).
  - Fractionalization (continuous variable between 0 and 1).

*Source: CONCLUSION, wp1718 - CONCLUSION*

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_Source: https://www.imf.org/-/media/files/publications/wp/wp1718.pdf_