## _pdp02 - Section III argues that fiscal rules are important to stem time-inconsistent, short-sighted

## Source details

**Canonical URL:** [_pdp02 - Section III argues that fiscal rules are important to stem time-inconsistent, short-sighted](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2005/_pdp02.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2005/_pdp02.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2005/_pdp02.pdf.json)

---

### Key argument: role of fiscal rules
- Fiscal rules are important to stem time-inconsistent, short-sighted policies and to coordinate policies across countries in a currency union.
- An effective rules-based fiscal framework can constrain policymakers’ discretion and foster credible, time-consistent policies.
- Rules also play a crucial role in coordinating fiscal policies across different jurisdictions.

### Assessment of EMU’s fiscal framework (Sections IV–V)
- The basic design of the Stability and Growth Pact (SGP) and the Excessive Deficit Procedure (EDP) basically meets the requirements of a model fiscal rule, though some limited adjustments could improve operation.
- No case seen for major changes to Europe’s fiscal rules; scope exists for limited reforms to improve operation.
- There is no compelling case for rewriting SGP regulations that call for “close to balance or in surplus” (CBS) fiscal targets over the medium run; the present legal text offers sufficient flexibility to accommodate country-specific concerns.
- The EDP’s design is appropriate, but operational improvements are recommended:
  - Provide more flexibility in setting deadlines to better distinguish policies (defined narrowly to refer exclusively to budgetary policies) from economic circumstances.
  - Make the debt criterion in the EDP operational.
  - Preserve the EDP’s operational simplicity and transparency if procedures are changed.
- National Stability Programs should be debated formally in the context of national budgets to strengthen their authority, ownership, and enforcement over the medium run.
- Policies have improved following adoption of the SGP, but continue to fall short primarily due to deficiencies in enforcement (particularly during upswings) and weaknesses in ownership of the Pact.

### Specific numeric constraints and interpretations
- The Maastricht Treaty limits: 3 percent and 60 percent of GDP respectively (deficit and debt limits).
- The CBS rule has been interpreted as ruling out deficits that are systematically larger than ½ percent of GDP over the cycle, to provide a cyclical safety margin for automatic stabilizers.
- Most countries do not satisfy the preconditions for running a sustainable steady-state 3 percent deficit, namely:
  - nominal potential GDP growth of at least 5 percent annually; and
  - a debt level that is below 60 percent of GDP.

### Enforcement, transparency, and ownership (Section VI and recommendations)
- Strengthened enforcement and ownership are required to foster time-consistent policies; improvements should focus on greater transparency and national accountability.
- Creation of national fiscal councils that report to national parliaments is recommended to strengthen ownership:
  - Such councils would review Stability Programs.
  - They should help address transparency problems that produced overly-optimistic assumptions, reliance on one-off measures, creative accounting, and even misreporting.
  - Existing institutions in several euro-area countries could play the role of fiscal councils but would require fundamental changes to do so.
- In the interim, both the European Commission and Eurostat should be given more weight in vetting projections, assumptions, and reporting practices.
- Rewriting the rules now risks enshrining time inconsistencies; some proposals in circulation threaten the Pact’s credibility, e.g., softening deficit targets to accommodate structural reforms or excluding certain expenditure items from the deficit target.
- Successful reforms must be transparent, operationally simple, and accompanied by member-country commitment to both the letter and the spirit of the rules.

### Institutional balance and decision-making
- The SGP is two-pronged:
  - Preventive arm: urges countries to keep budgets at CBS over the medium run; emphasizes peer-driven multilateral surveillance and softer economic policy coordination, including opinions on annual Stability Programs issued by the ECOFIN Council and possibly early warnings.
  - Dissuasive arm: ensures respect for the Maastricht deficits and debt limits via the EDP; noncomplying countries face increasingly stringent surveillance under the EDP, which may eventually lead to sanctions.
- The EDP is ultimately peer driven: the Commission has the right of initiative at each stage, but the ECOFIN Council can modify Commission recommendations and retains decision-making authority.

### Box 1. The Excessive Deficit Procedure
- Definition and eligibility:
  - A deficit greater than 3 percent of GDP will trigger the EDP unless the excess is considered to be exceptional, temporary, and close to the reference value.
  - The criterion is also satisfied if the deficit has declined substantially and continuously and comes close to 3 percent of GDP.
  - For the debt ratio, a looser caveat applies: the ratio need only be approaching the 60 percent of GDP threshold at a satisfactory pace.
  - When preparing its initial report under the EDP, the Commission takes into account whether the deficit exceeds government investment and also considers “all other relevant factors, including the medium-term economic and budgetary position of the member state”.
- Exceptional, temporary, and closeness criteria:
  - Exceptional circumstances are defined as resulting from “an event outside the control of the member state... which has a major impact on the financial position of the general government, or when resulting from a severe economic downturn”.
  - Severe economic downturn is defined as a fall in real GDP by at least 2 percent.
  - A fall between 0.75 and 2 percent may be exceptional, given supporting evidence.
  - A less than 0.75 percent decline is not exceptional.
  - A deficit is temporary if it will “fall below the reference value following the end of the unusual event or the severe economic downturn”.
  - The SGP does not define the “closeness” criterion.
  - All three conditions (exceptional, temporary, and close) must apply for the escape clause to be utilized.
- Procedural stages and timelines:
  - First stage:
    - Within three months of the reporting date, the ECOFIN Council decides whether an excessive deficit exists.
    - If so, it immediately issues a recommendation giving:
      - four months to take “effective action”; and
      - a deadline for the elimination of the excessive deficit, typically the year following its identification, barring “special circumstances”.
  - Second stage:
    - After four months, if ECOFIN judges the member state not to be implementing measures, or measures inadequate, or data indicate the excessive deficit will not be corrected within specified time limits, it proceeds to the next step.
    - If the country is deemed to have taken effective action, the procedure is placed in abeyance.
    - Otherwise, within one month, the Council gives notice for the member state to take, within a specified time limit, measures to reduce the deficit.
    - This stage is applicable only to countries in the final stage of EMU.
    - The Council may request regular reports to monitor adjustment efforts under enhanced fiscal surveillance.
  - Final stage:
    - If the member state complies with the notice, the procedure is held in abeyance.
    - If not, the ECOFIN Council will move to the sanctions phase within two months.
    - By this timetable, sanctions can be imposed within ten months of the reporting date.
- Sanctions, deposits, and fines:
  - A non-interest bearing deposit will be required.
  - The first deposit comprises:
    - a fixed component of 0.2 percent of GDP; and
    - a variable component equal to one tenth of the difference between the deficit and the 3 percent, in percent of GDP.
  - Each following year, the Council may decide to intensify sanctions by requiring another deposit (variable component only).
  - No single deposit can exceed 0.5 percent of GDP.
  - If the excessive deficit has not been corrected two years after the deposit was made, it shall be converted into a fine.
  - If, before two years are up, the Council considers the excessive deficit to be corrected, it abrogates the procedure and returns the deposit.
  - Fines are not reimbursed.
  - Interest on deposits, and fines, shall be distributed among member states without excessive deficits (proportional to their share in total GDP).

### Box 2. A Fiscal Sustainability Rule?
- Definition and intertemporal solvency condition:
  - A fiscal plan is sustainable if it ensures government solvency.
  - Solvency requirement: the level of net debt (all as a percent of GDP) needs to be no larger than the present value of all future primary surpluses, discounted by the real interest rate minus the real growth rate.
  - The permanent primary surplus is defined as a constant level of the primary surplus whose present discounted value equals the present discounted value of actual or anticipated primary surpluses.
  - Simplified government intertemporal budget constraint: the debt-GDP ratio can be no greater than the permanent primary surplus divided by the permanent (long-run) differential between the real interest and real growth rate.
- The Permanent Balance Rule (PBR) concept:
  - A fiscal rule focusing on sustainability would take an intertemporal approach, exemplified by the “permanent balance rule” (PBR) of Buiter and Grafe (2003).
  - The PBR seeks a constant tax rate at least equal to:
    - the permanent expenditure share
    - plus the long-run growth-adjusted real interest cost of government debt
    - minus permanent government capital income.
  - The PBR has two pillars:
    - Positive pillar: focuses on solvency.
    - Normative pillar: promotes tax-smoothing (t = t^p) as the answer to sustainability.
  - The PBR yields a condition for the deficit, d, expressed with variables:
    - where g is total government expenditure,
    - k is the public capital stock,
    - θ is the gross financial return on the government capital stock,
    - r is the real interest rate,
    - n is the real growth rate,
    - b is the stock of debt,
    - the superscript p represents the permanent value.
- Determinants of sustainability:
  - Sustainability depends on four country-specific factors:
    - initial net debt,
    - the permanent primary surplus (incorporating such factors as public investment needs and implicit liabilities),
    - long-run growth,
    - the long-run real interest rate.
  - Implications:
    - A rule focused on sustainability would force a country to deal with the costs of aging today.
    - The borrowing restriction is loosened when interest rates or expenditure are temporarily high, or when the real growth rate is temporarily low (for example, following the adoption of structural reforms).
    - By contrast, the SGP only takes into account one of these four factors, and even that focuses on gross rather than net debt.
- Operational challenges and limitations:
  - Making a “sustainability rule” operational faces formidable costs and difficulties:
    - Need to derive estimates of long-term growth rates and interest rates for each country.
    - Need to lay out the path of future permanent expenditure plans for each country.
    - A true picture of future expenditure must account for contingent and implicit liabilities.
      - Contingent liabilities are uncertain, based on underlying risk facing the government, and could become more pronounced (for example, through Public-Private Partnerships).
      - Implicit liabilities are obligations without legal basis, grounded in expectations that can shift over time as new governments re-frame debates.
      - Liabilities can be both contingent and implicit (for example, an expected bailout of a private pension fund).
    - Normative pillar controversies:
      - Raises issues concerning the optimal size of government.
      - Raises issues concerning the incentive effects of high tax rates on growth and employment.
      - These issues are clouded by much uncertainty (see Disney, 2000).
  - Conclusion on operationality: Mechanically implementing a rule such as the PBR would therefore not be viable.

*Source: IMF content unit _pdp02 - Section III argues that fiscal rules are important to stem time-inconsistent, short-sighted (PDF).*

### Section III argues that fiscal rules are important to stem time-inconsistent, short-sighted

### _pdp02 - Section III argues that fiscal rules are important to stem time-inconsistent, short-sighted

### Key argument: role of fiscal rules
- Fiscal rules are important to stem time-inconsistent, short-sighted policies and to coordinate policies across countries in a currency union.
- An effective rules-based fiscal framework can constrain policymakers’ discretion and foster credible, time-consistent policies.
- Rules also play a crucial role in coordinating fiscal policies across different jurisdictions.

### Assessment of EMU’s fiscal framework (Sections IV–V)
- The basic design of the Stability and Growth Pact (SGP) and the Excessive Deficit Procedure (EDP) basically meets the requirements of a model fiscal rule, though some limited adjustments could improve operation.
- No case seen for major changes to Europe’s fiscal rules; scope exists for limited reforms to improve operation.
- There is no compelling case for rewriting SGP regulations that call for “close to balance or in surplus” (CBS) fiscal targets over the medium run; the present legal text offers sufficient flexibility to accommodate country-specific concerns.
- The EDP’s design is appropriate, but operational improvements are recommended:
  - Provide more flexibility in setting deadlines to better distinguish policies (defined narrowly to refer exclusively to budgetary policies) from economic circumstances.
  - Make the debt criterion in the EDP operational.
  - Preserve the EDP’s operational simplicity and transparency if procedures are changed.
- National Stability Programs should be debated formally in the context of national budgets to strengthen their authority, ownership, and enforcement over the medium run.
- Policies have improved following adoption of the SGP, but continue to fall short primarily due to deficiencies in enforcement (particularly during upswings) and weaknesses in ownership of the Pact.

### Specific numeric constraints and interpretations
- The Maastricht Treaty limits: 3 percent and 60 percent of GDP respectively (deficit and debt limits).
- The CBS rule has been interpreted as ruling out deficits that are systematically larger than ½ percent of GDP over the cycle, to provide a cyclical safety margin for automatic stabilizers.
- Most countries do not satisfy the preconditions for running a sustainable steady-state 3 percent deficit, namely:
  - nominal potential GDP growth of at least 5 percent annually; and
  - a debt level that is below 60 percent of GDP.

### Enforcement, transparency, and ownership (Section VI and recommendations)
- Strengthened enforcement and ownership are required to foster time-consistent policies; improvements should focus on greater transparency and national accountability.
- Creation of national fiscal councils that report to national parliaments is recommended to strengthen ownership:
  - Such councils would review Stability Programs.
  - They should help address transparency problems that produced overly-optimistic assumptions, reliance on one-off measures, creative accounting, and even misreporting.
  - Existing institutions in several euro-area countries could play the role of fiscal councils but would require fundamental changes to do so.
- In the interim, both the European Commission and Eurostat should be given more weight in vetting projections, assumptions, and reporting practices.
- Rewriting the rules now risks enshrining time inconsistencies; some proposals in circulation threaten the Pact’s credibility, e.g., softening deficit targets to accommodate structural reforms or excluding certain expenditure items from the deficit target.
- Successful reforms must be transparent, operationally simple, and accompanied by member-country commitment to both the letter and the spirit of the rules.

### Institutional balance and decision-making
- The SGP is two-pronged:
  - Preventive arm: urges countries to keep budgets at CBS over the medium run; emphasizes peer-driven multilateral surveillance and softer economic policy coordination, including opinions on annual Stability Programs issued by the ECOFIN Council and possibly early warnings.
  - Dissuasive arm: ensures respect for the Maastricht deficits and debt limits via the EDP; noncomplying countries face increasingly stringent surveillance under the EDP, which may eventually lead to sanctions.
- The EDP is ultimately peer driven: the Commission has the right of initiative at each stage, but the ECOFIN Council can modify Commission recommendations and retains decision-making authority.

*Source: IMF content unit _pdp02 - Section III argues that fiscal rules are important to stem time-inconsistent, short-sighted (PDF).*

### Box 1. The Excessive Deficit Procedure

### Box 1. The Excessive Deficit Procedure

### Definition and eligibility
- A deficit greater than 3 percent of GDP will trigger the EDP unless the excess is considered to be exceptional, temporary, and close to the reference value.
- The criterion is also satisfied if the deficit has declined substantially and continuously and comes close to 3 percent of GDP.
- For the debt ratio, a looser caveat applies: the ratio need only be approaching the 60 percent of GDP threshold at a satisfactory pace.
- When preparing its initial report under the EDP, the Commission takes into account whether the deficit exceeds government investment and also considers “all other relevant factors, including the medium-term economic and budgetary position of the member state”.

### Exceptional, temporary, and closeness criteria
- Exceptional circumstances are defined as resulting from “an event outside the control of the member state... which has a major impact on the financial position of the general government, or when resulting from a severe economic downturn”.
- Severe economic downturn is defined as a fall in real GDP by at least 2 percent.
- A fall between 0.75 and 2 percent may be exceptional, given supporting evidence.
- A less than 0.75 percent decline is not exceptional.
- A deficit is temporary if it will “fall below the reference value following the end of the unusual event or the severe economic downturn”.
- The SGP does not define the “closeness” criterion.
- All three conditions (exceptional, temporary, and close) must apply for the escape clause to be utilized.

### Procedural stages and timelines
- First stage:
  - Within three months of the reporting date, the ECOFIN Council decides whether an excessive deficit exists.
  - If so, it immediately issues a recommendation giving:
    - four months to take “effective action”; and
    - a deadline for the elimination of the excessive deficit, typically the year following its identification, barring “special circumstances”.
- Second stage:
  - After four months, if ECOFIN judges the member state not to be implementing measures, or measures inadequate, or data indicate the excessive deficit will not be corrected within specified time limits, it proceeds to the next step.
  - If the country is deemed to have taken effective action, the procedure is placed in abeyance.
  - Otherwise, within one month, the Council gives notice for the member state to take, within a specified time limit, measures to reduce the deficit.
  - This stage is applicable only to countries in the final stage of EMU.
  - The Council may request regular reports to monitor adjustment efforts under enhanced fiscal surveillance.
- Final stage:
  - If the member state complies with the notice, the procedure is held in abeyance.
  - If not, the ECOFIN Council will move to the sanctions phase within two months.
  - By this timetable, sanctions can be imposed within ten months of the reporting date.

### Sanctions, deposits, and fines
- A non-interest bearing deposit will be required.
- The first deposit comprises:
  - a fixed component of 0.2 percent of GDP; and
  - a variable component equal to one tenth of the difference between the deficit and the 3 percent, in percent of GDP.
- Each following year, the Council may decide to intensify sanctions by requiring another deposit (variable component only).
- No single deposit can exceed 0.5 percent of GDP.
- If the excessive deficit has not been corrected two years after the deposit was made, it shall be converted into a fine.
- If, before two years are up, the Council considers the excessive deficit to be corrected, it abrogates the procedure and returns the deposit.
- Fines are not reimbursed.
- Interest on deposits, and fines, shall be distributed among member states without excessive deficits (proportional to their share in total GDP).

*Source: Box 1. The Excessive Deficit Procedure*

### Box 2.  A Fiscal Sustainability Rule?

### Box 2.  A Fiscal Sustainability Rule?

### Definition and intertemporal solvency condition
- A fiscal plan is sustainable if it ensures government solvency.
- Solvency requirement: the level of net debt (all as a percent of GDP) needs to be no larger than the present value of all future primary surpluses, discounted by the real interest rate minus the real growth rate.
- The permanent primary surplus is defined as a constant level of the primary surplus whose present discounted value equals the present discounted value of actual or anticipated primary surpluses.
- Simplified government intertemporal budget constraint: the debt-GDP ratio can be no greater than the permanent primary surplus divided by the permanent (long-run) differential between the real interest and real growth rate.

### The Permanent Balance Rule (PBR) concept
- A fiscal rule focusing on sustainability would take an intertemporal approach, exemplified by the “permanent balance rule” (PBR) of Buiter and Grafe (2003).
- The PBR seeks a constant tax rate at least equal to:
  - the permanent expenditure share
  - plus the long-run growth-adjusted real interest cost of government debt
  - minus permanent government capital income.
- The PBR has two pillars:
  - Positive pillar: focuses on solvency.
  - Normative pillar: promotes tax-smoothing (t = t^p) as the answer to sustainability.
- The PBR yields a condition for the deficit, d, expressed with variables:
  - where g is total government expenditure,
  - k is the public capital stock,
  - θ is the gross financial return on the government capital stock,
  - r is the real interest rate,
  - n is the real growth rate,
  - b is the stock of debt,
  - the superscript p represents the permanent value.

### Determinants of sustainability
- Sustainability depends on four country-specific factors:
  - initial net debt,
  - the permanent primary surplus (incorporating such factors as public investment needs and implicit liabilities),
  - long-run growth,
  - the long-run real interest rate.
- Implications:
  - A rule focused on sustainability would force a country to deal with the costs of aging today.
  - The borrowing restriction is loosened when interest rates or expenditure are temporarily high, or when the real growth rate is temporarily low (for example, following the adoption of structural reforms).
  - By contrast, the SGP only takes into account one of these four factors, and even that focuses on gross rather than net debt.

### Operational challenges and limitations
- Making a “sustainability rule” operational faces formidable costs and difficulties:
  - Need to derive estimates of long-term growth rates and interest rates for each country.
  - Need to lay out the path of future permanent expenditure plans for each country.
  - A true picture of future expenditure must account for contingent and implicit liabilities.
    - Contingent liabilities are uncertain, based on underlying risk facing the government, and could become more pronounced (for example, through Public-Private Partnerships).
    - Implicit liabilities are obligations without legal basis, grounded in expectations that can shift over time as new governments re-frame debates.
    - Liabilities can be both contingent and implicit (for example, an expected bailout of a private pension fund).
  - Normative pillar controversies:
    - Raises issues concerning the optimal size of government.
    - Raises issues concerning the incentive effects of high tax rates on growth and employment.
    - These issues are clouded by much uncertainty (see Disney, 2000).
- Conclusion on operationality: Mechanically implementing a rule such as the PBR would therefore not be viable.

*Source: Box 2.  A Fiscal Sustainability Rule?*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/pdp/2005/_pdp02.pdf_